Brothers: In its last reported financial statements before it went bankrupt, Lehman Brothers reported a loss of $US 2.4 billion for the first six months ended May 31, 2008 (vs. a net income of $US 2.4 billion for the first six months ended May 31, 2007). The shift of $US 4.8 billion in net income is largely driven by a dramatic fall of $US 8.5 billion in Lehman’s revenues from principal transactions, which include realized and unrealized gains or losses from financial instruments and other inventory positions owned. A significant portion of the downward shift in principal transactions revenues is actually explained by unrealized losses of $US 1.6 billion in the first semester of 2008 vs. unrealized gains of $US 200 million in the first semester of 2007. Thus, accounting at fair value for some financial assets amplified Lehman's downward earnings performance. Hence, it can be put forward that FVA, through its magnifying impact on earnings volatility, may have contributed to aggravate investors', regulators' and governments' perceptions with respect to the severity of the crisis, itself characterized by record volatility in the prices of many securities and goods. On a related note, the increased volatility brought forward by FVA is conducive to the use of equity-based compensation, especially stock options, which value is then enhanced (according to the Black-Scholes model, volatility is one of the key inputs in option valuation). Prior research 此前的研究 suggests that there is a strong association between performance volatility and the use of stock options. 選項。 20 20 Through FVA, the outcomes from aggressive risk-taking in investment and financing strategies will directly flow into reported earnings, thus further leveraging the potential gains to be derived from stock options and other incentives. Many financial institutions involved in the current crisis made extensive use of stock options and other incentives, allowing unrealized gains on assets to be converted into cold hard cash. Does FVA Reflect Underlying Business Performance or Allow Financial Institutions to Delay the Day of Recognition? 20 20 See, for example, Magnan, Michel. 2006. 2006年。 Les options sur actions : création de richesse pour les actionnaires ou enrichissement des dirigeants au détriment des actionnaires ? Finance-contrôle-strategie 9(3): 221-235 .
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9 9 Some of the fiercest critics of FVA argue that, far from enhancing transparency and relevant financial reporting, it actually provides corporate managements with ways to avoid the day of recognition and to delay asset impairments. In other words, the adoption FVA undermines financial statements' conservatism and leads to changes in managerial behaviour. For instance, 例如， Ross Watts (Massachusetts Institute of Technology) argues that the elimination of conservatism brought by FVA leads to the capitalization of unverifiable future cash flows unto the balance sheet. 負債表。 21 22 21 22 Such unverifiability and managerial opportunities to make strategic valuation choices introduce significant noise into the financial reporting process that may be costly to investors. Moreover, by moving firms away from transaction-based accounting, FVA is contradicting SEC efforts to tighten revenue measurement and recognition standards to ensure that only completed sales transactions get reported into the financial statements and affect earnings. 23 23 Experience 經驗 shows that, until the advent of SAB 101, several firms had applied aggressive revenue recognition criteria that dramatically boosted reported earnings and growth rates. Earnings 盈利 restatements following the enactment of SAB 101 were often sizable and led to significant stock price falls, even if reported cash flows were not affected. In other words, conservative accounting provides information that is useful beyond the estimated cash flows from a particular contract and protects investors and creditors from managerial opportunism. The case of Lehman Brothers illustrates Ross' argument. As of November 30, 2007, 75.1% of assets measured at fair value were measured according to Level 2 or Level 3 inputs. In other 在其他 words, the large majority of assets supposedly valued at fair value were not valued on the basis of directly observable quoted prices. By May 31, 2008, that proportion had increased to 81.7% of assets measured at fair value, suggesting that barely 18% of assets supposedly valued according to FVA were “marked to market”. Further empirical work as well as the liquidation of Lehman Brothers will provide additional evidence regarding the extent to which its assets may have been overstated or purposely shifted into Levels 2 or 3 to hide developing losses and give management more discretion. At the very least, its actions suggest that FVA reporting may work well for investors when assets trade in deep and efficient markets but may become less transparent when market conditions become more difficult or less liquid. On that note, it is telling that Lehman Brothers was an early adopter of both SFAS 157 (Fair Value Measurements) and SFAS 159 (Option for fair value measurement), deciding to implement their provisions in the first quarter of its 2007 fiscal year. 21 21 Watts, Ross. 2003. 2003。 Conservatism in accounting part I: Explanations and Implications. Accounting Horizons 17(3), 207-221. 22 22 There is empirical evidence that effective auditing of FVA derived numbers requires very specialized valuation knowledge which may be difficult for auditors to gain and maintain (Martin, RD, JS Rich, TJ Wilks. 2006. Auditing Fair Value Measurements: A Synthesis of Relevant Research. Accounting Horizons 20(3), 287-303. 23 23 For instance, in 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin 101 - Revenue Recognition in Financial Statements which prescribes specific criteria to indicate when a transaction has been concluded, thus considerably reducing managerial discretion in the recognition of revenues. In contrast, fair value accounting does not rely on the conclusion of a transaction to estimate the value of an financial asset or contract.
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10 10 The Lehman case, as well as many others, raises the issue of FVA applicability as it is being extended from instruments traded in liquid and organized markets to credit-type instruments that are often securitized and which are not quite transparent about their underlying assets. The “ valuation of these credit-type instruments is made difficult by the lack of direct information, with heavy reliance on credit rating agencies' opinions. Moreover, the market for these instruments is not as deep and liquid than traditional instruments such as bonds, equities or foreign currencies. It does appear that markets were not as efficient as they should have been in assessing the value of these structured investment vehicles or securitized pools of assets and may have relied too much on the judgment of parties such as credit rating agencies which themselves had partial information and were facing some potential conflicts of interests (since they charged fees to render opinions on specific securities). Accounting and the Market: Mirrors Facing Each Other The integration of market values on corporate balance sheets mandated by accounting standard setters contrasts with the trend by many analysts and sophisticated investors to use financial statement data to gauge whether a firm's stock market value has moved away from its fundamental or “intrinsic value.” 24 24 These divergent trends raise a fundamental question as to the grounding of financial statements. More specifically, MacIntosh, Shearer, Thornton and Welker argue that the market uses accounting earnings, along with other information, to value firms' stock and other securities. 25 25 However, the prices of many of these securities underlie derivatives' prices, which then find their way into financial statements through FVA, thus completing a circular sequence! As MacIntosh et al. say: “ Companies' earnings determine security prices, which determine derivative prices, which determine companies' earnings In short, neither the accounting sign nor the financial market sign appear to be grounded in any external reality. Instead, each model appeals to the other model for the only “reality check” available.” Lehman Brothers' equity-based compensation illustrates the self-referential sequence that FVA introduces into financial reporting and stock market prices. In 2007, Lehman granted close to 39,000,000 deferred share units to its executives and employees. On the basis of the firm’s quoted stock price on the dates at which these grants were made, the overall value of the grant was around $2.7 billion. Since 2006, SFAS 123 has mandated the measurement and recognition 24 24 See, for example, Lee, MC, J. Myers, and B. Swaminathan. 1999. 1999年。 What is the intrinsic value of the Dow? The Journal of Finance 54(5), 1693-1741. 25 25 MacIntosh, NB, T. Shearer, DB Thornton, M. Welker. 2000. 2000。 Accounting as simulacrum and hyperreality: Perspectives on Income and Capital. Accounting, Organizations and Society 25(1), 13-
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11 11 of equity-based compensation at fair value, using an amortization method for grants that have a long-term vesting period, bringing Lehman Brothers' expense for equity-based compensation in 2007 to $1.8 billion, close to 25% of earnings before income taxes and equity-based compensation expenses. Hence, on the one hand, the amount reflected as an expense by Lehman on its financial statements reflects the current quoted price of its stock at grant date. On the other 在其他 hand, investors rely on Lehman's reported earnings to assess its prospects and value its stocks. The chain of decisions exactly matches the above quote from MacIntosh et al. In addition to 除了 equity-based compensation, a significant proportion of Lehman Brothers' assets were stocks and stock-based derivatives (more than a third of its FVA assets). Since shares traded on a stock market are all affected to a varying degree by the same secular trends and fluctuations, one can argue that Lehman Brothers earnings and its stock price were mutual reflections of one another, possibly detached from underlying real operations. Such a conclusion can probably be extended to many financial institutions deeply involved in the current crisis or engulfed by it. Interface between Financial Reporting and Regulatory Capital One key criticism against FVA is that its use in the current crisis has led to a reduction in the value of financial institutions' assets, which translated into a severe shrinking of their capital ratios, forcing them to deleverage and sell further assets at distressed prices, thus feeding the downward spiral. However, in that scenario, the issue is not necessarily the accounting itself but how financial regulators use accounting information. In other words, FVA-based financial reporting is only the messenger that a firm's solvency is undermined by its financial strategies or lending practices, but it is up to regulators to figure out how to use such information. 26 26 Messenger or Contributor? The above discussion suggests that assigning a messenger role to accounting potentially downplays its actual importance and relevance to the current crisis since the message is not neutral but conditioned by accounting standards. However, two issues arise from the use of FVA-derived information in regulatory oversight. First, FVA information is highly volatile and unstable. For example, according to FVA, the wild fluctuations of the stock market over the past few weeks, with many daily closings showing gains or losses from the preceding day of between 5-10%, imply similar fluctuations in any stock market-based assets. Hence, a firm may be solvent one day (assuming a large stock market gain), insolvent the next two days (assuming large stock market losses), and solvent again on the fourth day! While informative, is FVA-based 26 26 For instance, Irene Wiecek from the University of Toronto argues that “...the credit crisis is not the fault of accounting. 會計。 It is the fault of overly lenient lending practices”. On top of that, she says there was a lack of oversight and regulation in this area” (G. Jeffrey, 2008).
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12 12 financial reporting useful to regulators in planning and timing their interventions? The answer is 答案是： that FVA information alone is probably necessary but is not sufficient. Other performance and risk metrics are needed to identify the targets of regulatory actions. A similar argument can be used to justify that FVA information is not sufficient for long term governance purposes as it is not stable enough and difficult to verify. In some sense, the reliance on FVA-based information may have two opposite implications regarding the length and severity of the current crisis. On 在 one hand, the discretion underlying FVA figures have allowed managers to delay the day of recognition when underlying subprime assets started to unravel. Moreover, the additional volatility that it introduces into financial statements may have amplified the impression of financial performance and stability in the bubble period. On the other hand, once the values of underlying assets started crashing, FVA induced balance sheet realignments and recapitalizations may have further magnified the crisis. 27 27 Second, some argue that FVA values are actually a red herring and that the real issue is the quality of the accompanying disclosure. 28 28 For example, Susan Schmidt, a former governor of the Federal Reserve Board and bank CFO argues that the focus should be on disclosure so that everyone, regulators and investors alike, understand the drivers behind fair value estimates. Actually, FVA derived can be deceptive: up until close to the crisis, both Lehman Brothers and AIG appeared solvent and sufficiently capitalized, with significant portions of their balance sheet relying on FVA. However, what the FVA point estimate values did not tell was the extent of the downfall risk both firms were facing if events did not evolve according to expectations, Lehman because of its exposure to collateralized debt obligations and AIG because of its exposure to credit-default swaps. Looking at both firms' financial statements before the crisis, it would have been difficult to assess the potential magnitude of losses to be incurred because of these exposures. Hence, it can be ventured that FVA without adequate additional disclosure is neither fair nor a good reflection of value that is at risk. Conclusion 結論 27 27 In that regard, it may be useful to note that other accounting standards beyond FVA may have played a role in the willingness of financial institutions to embark on a subprime asset growth strategy. One such standard relates to the recognition of gains upon the securitization of pools of assets (“sale accounting”). Essentially, under certain conditions, accounting practices allow for the accelerated recognition of gains upon the securitization of long-term assets, even if cash flows are spread out over many years. For instance, it has been reported that it was popular for banks that issued Collaterized Debt Obligations and similar instruments to retain the super-senior tranche and, at the same time, buy Credit Default Swaps from third parties. Since the cash portion held by the bank paid a higher spread that the cost to insure the bond, the bank was allowed to report upfront the amount of the difference to be realized over the life of the contract (Otherwise called a negative-basis trade). Earlier in 2008, AIG, the failed insurance giant, was forced by its auditor, PriceWaterhouseCoopers, to stop this practice as it was deemed that under current market conditions, it was impossible to reliably quantify the spread differential. For AIG, the shift in accounting practice translated into billions of dollars in write-offs (Credit Investment News, February 18, 2008, pp. 1 and 10.). 28 28 Leone, M. 2008. Fair Value: It's the Disclosure, Stupid. CFO.com. November, 20.
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13 13 The purpose of the appendix was to briefly present fair value accounting, its origins, application and implications for financial reporting as well as its potential role during the current financial crisis. While no definite conclusion can be reached at this early stage, there is reason to believe that fair value accounting is more than just a messenger carrying bad news and, therefore, may have contributed to the acceleration of the crisis, especially in the financial sector. While the 雖然 relevance of fair value accounting for investors cannot be questioned, its other qualities (or weaknesses) may have been overlooked by standard setters and regulators. Fair value accounting for financial instruments is part of a broader trend in accounting standard setting to move away from “accounting” toward estimating expected future cash flows and incorporating into financial statements, ie, “forecounting”. 29 29 The trend undermines decades if not centuries of accounting practices and concepts such as conservatism and verifiability and requires a completely set of valuation skills and knowledge from accountants. The current crisis constitutes the first serious challenge to this trend, and to fair value accounting in particular, and is likely to generate abundant empirical research over the next few years which will allow us to better assess the pros and cons of fair value accounting. However, if not fair value accounting, what else? Standard-setters, and many accounting academics, argue that there is no alternative measurement or reporting model. 30 30 For instance, 例如， Barth (2007, p. 12), a member of the International Accounting Standards Board, argues that “Although opponents of more comprehensive use of fair value have some legitimate concerns, standard setters are unaware of a plausible alternative.” In contrast, Watts (2003, p. 219) argues that accounting standard setters should focus on accountants' core competence, ie, “...providing verifiable conservative information that market participants can use both as inputs in their own valuation and as calibration for their own and others' unverifiable information ” 31 31 As such, I would argue that the debate is at two levels: Barth is talking about the measurement of a final output while Watts refers to the validity of the various measurement inputs, the output being of some importance but mostly in terms of providing financial statement users and other stakeholders to adapt, modify or “test-drive” the resulting output. Beyond fair values, measurement assumptions and hypotheses are probably more critical since they allow users to reconstruct the reality according to their own priors. 29 29 Magnan, Michel; Cormier, Denis. 2005. 2005年。 From Accounting to “Forecounting”. Canadian Accounting Perspectives 4(2): 243-257. 30 30 Barth, Mary. 2007. 2007。 Standard-Setting Measurement Issues and the Relevance of Research. Accounting and Business Research , Special Issue, 7-15. 31 31 Watts, RL 2003. Open citation.
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14 14 However, underlying the debate, one must not lose sight that various financial and economic interests are at play – additional powers for standard setters, additional business for providers of accounting and valuation services, increased uncertainty about their bonuses for managers and executives, etc. Hence, viewpoints and arguments from interested parties must be reframed accordingly. 據此。 The debate goes further than accounting and financial reporting and deals with the essence of what accountants are expected to contribute to society and, implicitly, what competences and skills they must possess to deliver in that regard. One may surmise that current accounting standards, such as those relating to fair value, probably overstretch accountants' capabilities and prior learning and obscure other informational needs by investors and other interested stakeholders. 利益相關者。
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15 15 References 參考文獻 Aboody, D., Mary E. Barth, and Ron Kasznik. 2004. 2004年。 Firms' voluntary recognition of stock-based compensation expense. Journal of Accounting Research 42(2), 123-150. Barth, Mary. 2007. 2007。 Standard-Setting Measurement Issues and the Relevance of Research. Accounting and Business Research , Special Issue, 7-15. Barth, ME, WH Beaver and WR Landsman. 2001. 2001年。 The relevance of the value relevance literature for accounting standard setting: another view. Journal of Accounting and Economics 31, pp 77–104. Barth, Mary E , Landsman, Wayne R , Wahlen, James M . 1995. Fair value accounting: Effects on banks' earnings volatility, regulatory capital, and value of contractual cash flows. Journal of Banking & Finance 19 (3-4), 577-605 . Bernard, V., R. Merton, and K. Palepu (1995). Mark-to-Market Accounting for Banks and Thrifts: Lessons from the Danish Experience. Journal of Accounting Research 33 (Spring), 1-32. Cudahy, RD. and WD Henderson. 2005. 2005年。 From Insull To Enron: Corporate (Re)Regulation After The Rise And Fall Of Two Energy Icons. Energy Law Journal 26 (1), 35-110. Financial Accounting Standards Board. 2008. 2008年。 Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information. Exposure-Draft. Norwalk, CT. Financial Accounting Standards Board. 2006. 2006年。 Financial Accounting Standard 157 - Fair Value Measurements . 測量 。 Norwalk, CT. Financial Accounting Standards Board. 2006. 2006年。 Financial Accounting Standard 159 - The Fair Value Option for Financial Assets and Financial Liabilities . Norwalk, CT. Flesher, DL and T. Flesher, 1986, Ivar Kreuger's contribution to US financial reporting, The Accounting Review 61 (3): 421-434. Gonedes, N., and Dopuch, N. 1974. Capital market equilibrium, information production, and selecting accounting techniques: Theoretical framework and review of empirical work. Journal of Accounting Research , 12: 48–129. Holthausen, RW and RL Watts. 2001. 2001年。 The relevance of the value-relevance literature for financial accounting standard setting. Journal of Accounting & Economics 31 (1-3), 3-75. Jeffrey, G. 2008. Mark market debate down as a draw. The Bottom Line, December, p. 27. 27。 Lee, MC, J. Myers, and B. Swaminathan. 1999. 1999年。 What is the intrinsic value of the Dow? The Journal of Finance 54(5), 1693-1741.
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16 16 Landsman, WR 2006. Fair Value Accounting for Financial Instruments: Some Implications for Bank Regulation. Bank for International Settlements Paper Leone, M. 2008. Fair Value: It's the Disclosure, Stupid. CFO.com. November, 20. McFarland, J. and J. Partridge. 2008. 2008年。 Mark-to-market' accounting rules fuel debate. The Globe and Mail – Report on Business. November 20. MacIntosh, NB, T. Shearer, DB Thornton, M. Welker. 2000. 2000。 Accounting as simulacrum and hyperreality: Perspectives on Income and Capital. Accounting, Organizations and Society 25(1), 13-60. Magnan, Michel. 2006. 2006年。 Les options sur actions : création de richesse pour les actionnaires ou enrichissement des dirigeants au détriment des actionnaires ? Finance-contrôle-strategie 9(3): 221-235 . Magnan, Michel; Cormier, Denis. 2005. 2005年。 From Accounting to “Forecounting”. Canadian Accounting Perspectives 4(2): 243-257. Martin, RD, JS Rich, TJ Wilks. 2006. 2006年。 Auditing Fair Value Measurements: A Synthesis of Relevant Research. Accounting Horizons 20(3), 287-303 Venkatachalam, M. 1996. Value-relevance of banks' derivatives disclosures. Journal of Accounting and Economics 22, pp 327–55. Wahlen, J., JR Boatsman, RH Herz, GJ Jonas, KG Palepu, SG Ryan, K. Schipper, CM Schrand, DJ Skinner. 2000. 2000。 Response to the FASB Preliminary Views: Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value. Accounting Horizons 14(4), 501-508 Watts, Ross. 2003. 2003。 Conservatism in accounting part I: Explanations and Implications. Accounting Horizons 17(3), 207-221. Weil, R. 2001. After Enron, “mark to market” accounting gets scrutiny. Wall Street Journal “華爾街日報” (December 4).