11 Making Informed Judgments Part 9 Statistics, Measurement, and the Financial Crisis Navigating Accounting, ® G. Peter & Carolyn R. Wilson, © NavAcc LLC. Modified by [Your Name].

22Menu  Statistics and measurement Statistics and measurement  Mark-to-market controversy Mark-to-market controversy  Statistics and informed judgments Statistics and informed judgments  Closing thoughts Closing thoughts View in Slide Show Mode > click hyperlink.

33 Statistics and Measurement  Confidence intervals and hypothesis testing:  These concepts from introductory statistics courses can help you better understand the factors that affect the dispersion of measures and the confidence you should have when using the measures for decision making.  Valuation techniques’ inputs:  Measures are determined using valuation techniques.  Inputs to these techniques are typically based on data drawn from benchmark sampling distributions, such as:  Comparable company (cross sectional) samples  Historical (time series) samples  Market price samples Things You Need to Know Return to menu

44 Statistics and Measurement  Inferences:  Basic statistics tells us that decision makers “confidence” in their estimates increases with sample size, the stability of distribution from which the benchmark data is drawn, and the extent to which the sampling distribution is comparable to the distribution of the variable being estimated.  The probability a decision maker will reject a null hypothesis and the validity of the test also depends on these factors. Things You Need to Know Return to menu

55 Mark-to-Market Accounting Controversy  Fair values role in the economic crisis-  There is widespread debate about whether fair-value (mark-to- market) accounting helped cause the financial crisis and whether it should be suspended or modified.  Fair value-  The price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date (FASB ).  Debated valuation techniques-  Market prices for identical or similar assets: mark-to-market  Discounted cash flow model, which has two inputs: expected future cash flows and risk adjusted discount rates. Things You Need to Know Return to menu

66 Mark-to-Market Accounting Controversy  Argument against mark-to-market:  Some have argued that forcing banks to mark-to-market “toxic assets” using almost non-existent market prices would unfairly decrease the banks regulatory capital to levels that would trigger regulatory intervention.  Rather, they favor using discount cash flow models, claiming they are much more reliable when markets collapse.  Argument favoring mark-to-market:  Those who favor mark-to-market agree that market prices are less reliable because of infrequent trading, but they argue there are enough trades to find benchmark prices. Things You Need to Know Return to menu

77 Statistics and Informed Judgments  How can statistical concepts help preparers devise disclosure strategies that increase the credibility of reported numbers?  How can these concepts help investors, regulators, and other users of reported numbers?  Do the these concepts and the factors that determine the dispersion of measures suggest ways arguments on both sides of the mark-to-market controversy could have been framed to be more effective? Questions Return to menu

88 Statistics and Informed Judgments  During a credit crisis, how should regulators modify decisions based on ratios determined using balance-sheet measures?  Do you agree with those who advocate measuring toxic assets based on the discounted cash flow model rather than market prices during a financial crisis? Why or why not? Questions Return to menu

99 Statistics and Informed Judgments  Statistical concepts suggest investors, regulators, and others who use accounting measures should place less reliance on the measures when they are based on fewer benchmark observations and/or the related sampling distribution is not representative of the measurement context.  Capital adequacy ratios and other ratios based on balance sheet measures reflect the dispersion of the underlying measures. Take Aways Return to menu

10 Statistics and Informed Judgments  Regardless of whether the values of toxic assets were estimated using market prices or discounted cash flow models, either …  The dispersion of the estimates increased dramatically between 2006 and 2008 because the traditional benchmark distributions were not comparable to the current measurement context or  There was so much uncertainty associated with the values of the toxic assets, they became immeasurable: experts could no longer specify possible outcomes and related probabilities. Take Aways Return to menu

11 Closing Thoughts  Concepts learned in introductory statistics courses can help you gain important insights about measurement and related controversies:  Given the high degree of uncertainty associated with the fair values of toxic assets, regulators should have placed far less reliance on ratios that depend on these values.  Preparers could have disclosed information about the size of samples that underpin measures and the stability and comparability of the benchmark sampling distributions. Return to menu

12 Closing Thoughts  The argument in favor of using discounted cash flow models (DCF) to estimate the fair value of toxic assets rather than market prices during a financial crisis has some merit. However, it seems to be greatly exaggerated.  Market participants who would most likely buy toxic assets from banks and other financial institutions are sophisticated investors who likely use the DCF model. These investors know nearly as much as the sellers about related cash flows and risks.  Any informational advantage sellers have in these situations is greatly diminished by the consequences of the staggering uncertainty about the economy and the related paucity of benchmark data needed for estimating appropriate risk adjusted discount rates. Return to menu