1. 1 ACCOUNTING STANDARDS BOARD ROUNDTABLE ON MEASUREMENT IN FINANCIAL REPORTING Economic Perspectives on Accounting Measurement Michael Bromwich 24 April 2006

2. 2 Look in a non-analytical way at incorporating predictions of future including those embodied in market prices into accounts using a purely decision – making perspective Trick for standard setters is to incorporate predictions without allowing too many degrees of freedom for manipulation of accounting information by management.

3. 3 Very Big Topic As very large and fast growing literature; often with differences Touch on: (i) Reasons for Fair Value (ii) Problems

4. 4 The Meaning of Fair Value Fair values are estimates of what market prices without incorporating any transactions costs will be in the situation of equilibrium. Strictly no general decision by standard setters between exit and entry prices in imperfect markets but generally favour exit prices and FASB exit prices for existing standards

5. 5 Estimates They can be based on market prices of identical or similar transactions (with adjustment for differences), recognised valuation procedures and managerial forecasts.

6. 6 Fair Values: Definitions “ the amount at which an asset (liability) could be bought(incurred) or sold (settled) in a current transaction between willing parties, that is, other than a forced or liquidation sale.” SFAS 133 “ the price at which an asset or liability could be exchanged in a current transaction between knowledgeable willing, unrelated parties.” FASB Exposure Draft on Fair Value Measurement (2004) FASB

7. 7 IASB “ the amount for which an asset could be exchanged, or a liability could be settled, in a current transaction between knowledgeable, willing parties in an arm’s length transaction.” (IAS 32, Financial Instruments) Note: underlined differences Latest:FASB 2006: Fair value is the price that would be received for an asset or paid to transfer a liability in a transaction between market participants Fair Values Definitions II

8. 8 Attraction of FVs to standard setters – FV objective- little scope for manipulation; – FV reflect market views of the future.

9. 9 Characteristics of Markets Knowledgeable, arms length participants Willing (motivated to transact) and legally and financially able to transact with access to all public information with sufficient expertise and due diligence Sufficient transactions to guarantee Equilibrium Orderly transactions not under duress Deep and liquid markets

10. 10 All price takers – no economies of scale Full knowledge and informationally efficient markets Complete and perfect markets No public goods and no externalities Thus informationally efficient markets not sufficient Additional Assumptions for Welfare Maximising Equilibrium

11. 11 Reflect views of marginal traders  Do not measure value to others (rents); incorporate monopoly rents  Asset and liability values are noisy  Firm’s revenue cash flow may not reflect changes in asset values and liabilities  Do not reflect private information  Broad range of imperfections and frictions even in ideal markets (monetary items)  Affected by government policy  Under or overshoots rational bounds Characteristics of Market Prices

12. 12 FASB Arguments: Only fair values reflect the amount, the timing and risk of future cash flows and other impacting factors as seen by the market (SFAC no 7.) Values should not be contaminated by management views as will differ between companies and therefore the same accounting item will be valued differently by different companies but perhaps do not trust management Logic of Fair Values I

13. 13 Logic of Fair Values II Allows managers to be judged by how well they have taken past market opportunities e.g.. Whether have swapped fixed interest loan for variable one where interest declined but not a strong argument. Makes management “tell it as it is” Consistent with assets and liabilities approach Works well for some financial assets and liabilities where markets are deep and liquid and can be expected not to attract super profits but see below

14. 14 LOGIC OF FAIR VALUES III  Valuation models in finance say that in perfect and complete market in equilibrium, can equate  economic wealth (V 0 ) (PV of cash flows as seen by management)  With stock market value (P 0 ) because all above normal profits competed away  Is what could get for opportunity if sold or pay if bought.

15. 15 Market Information Includes market’s view of public managerial estimates therefore to deny this in accounting seems strange. By no means all managerial information non- verifiable

16. 16 Logic of Fair Values III In a perfect and complete market in equilibrium, the value of the firm is equal to its net asset value evaluated at market prices using all publicly available information which is fully impounded in market prices. Here an increase (decrease) in the market value of the firm’s net assets is unanimously preferred (disliked) irrespective of preferences. Thus, when fair values of a firm’s assets and liabilities are aggregated they yield an objective valuation of the firm based on its cash flows, risk and timing (as seen by the market).

17. 17 Using assets and liabilities 1)Can substitute the market prices for cash-flows if are ALL traded in perfect and complete markets in equilibruim and are priced at, say, 10%.  Arguments are based on the relationship: Accounting equity = Market Value of intangibles + Market Value of tangible assets + Market Value of financial assets – Market Value of liabilities = Market Value of Equity But here accounting purely representational

18. 18 Using assets and liabilities Information given already known to the market via the prices of assets and liabilities in the market and therefore no “surprise” value. No indication of super profits- all earn normal return. No one would pay for this information

19. 19  Where internal goodwill (NPV) exists in disequilibrium : Accounting equity = internal goodwill (P 0 ) + net asset value = Market Value of Equity therefore accounting alone cannot capture value of the firm. ALL ACCOUNTING SYSTEMS SECOND BEST More generally, P 0 acts as bridge between A 0 and V 0 includes differences between information sets of stock market and accounting, that is the conservative accounting treatment of items like assets and liabilities markets, intangibles, project NPVs,R&D. This argument not used by standard setters until the Canadian paper.

20. 20 Problems Often such markets do not exist therefore are simulating them but the results are often incorrigible, that is no empirical referents exist. Large scope for managerial discretion Results in complex standards often with non-verifiable results. For example, impairment, revenue recognition And FV on initial recognition

21. 21 FASB want to use fair values (FV) but have not considered what this means for non-financial assets. Presumably investors interested in PVs of assets and liabilities, as estimated by management. Thus, FVs substitute market views (values) for those of management.

22. 22 Problems with Fair Values III Non-financial assets do have economic values but mainly not reported especially internal goodwill and intangibles and no guarantee that changes in Financial Values of financial items correlated with changes in non-financial assets and even if there are these correlations are not known. Thus with FVs for financial items not possible to say how, if at all, changes affect non-financial assets. With public information, fully diversified investors and time additive time preferences, only items of interest changes in physical productivity of firm and economy (ignoring information that generates better trading)

23. 23 Therefore FV for financial items has produced a ‘black hole’ in accounts. Theory of “second best” problems. Accounting reports are lopsided or use asymmetric treatment of financial and non-financial items. Solution would seem to be the use of some variant of value to the business or deprival value

24. 24 CONCLUSIONS: Use market values also for non-financial items where legitimate. May capture some internal goodwill. Allow value to the business reasoning including value in use where necessary.

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