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Fair Value Accounting, Historical Cost Accounting, and Systemic Risk Policy Issues and Options for Strengthening Valuation and Reducing Risk

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Center for Corporate Ethics and Governance CHILDREN AND FAMILIES The RAND Corporation is a nonprofit institution that helps improve policy and EDUCATION AND THE ARTS decisionmaking through research and analysis. ENERGY AND ENVIRONMENT HEALTH AND HEALTH CARE This electronic document was made available from www.rand.org as a public service INFRASTRUCTURE AND of the RAND Corporation. TRANSPORTATION INTERNATIONAL AFFAIRS LAW AND BUSINESS Skip all front matter: Jump to Page 16 NATIONAL SECURITY POPULATION AND AGING PUBLIC SAFETY Support RAND SCIENCE AND TECHNOLOGY Purchase this document TERRORISM AND Browse Reports & Bookstore HOMELAND SECURITY Make a charitable contribution For More Information Visit RAND at www.rand.org Explore the RAND Center for Corporate Ethics and Governance View document details Limited Electronic Distribution Rights This document and trademark(s) contained herein are protected by law as indicated in a notice appearing later in this work. This electronic representation of RAND intellectual property is provided for non- commercial use only. Unauthorized posting of RAND electronic documents to a non-RAND website is prohibited. RAND electronic documents are protected under copyright law. Permission is required from RAND to reproduce, or reuse in another form, any of our research documents for commercial use. For information on reprint and linking permissions, please see RAND Permissions. This report is part of the RAND Corporation research report series. RAND reports present research findings and objective analysis that address the challenges facing the public and private sectors. All RAND reports undergo rigorous peer review to ensure high standards for research quality and objectivity. Fair Value Accounting, Historical Cost Accounting, and Systemic Risk Policy Issues and Options for Strengthening Valuation and Reducing Risk Michael D. Greenberg, Eric Helland, Noreen Clancy, James N. Dertouzos C O R P O R A T I O N Center for Corporate Ethics and Governance Fair Value Accounting, Historical Cost Accounting, and Systemic Risk Policy Issues and Options for Strengthening Valuation and Reducing Risk Michael D. Greenberg, Eric Helland, Noreen Clancy, James N. Dertouzos Supported by the Goldman Sachs Global Markets Institute The research described in this report was supported in part by the Goldman Sachs Global Markets Institute, with additional support from the generosity of RAND’s donors and by the fees earned on client-funded research, and was conducted in the RAND Center for Corporate Ethics and Governance, a part of the RAND Institute for Civil Justice. Library of Congress Control Number: 2013950607 ISBN: 978-0-8330-8212-1 The RAND Corporation is a nonprofit institution that helps improve policy and decisionmaking through research and analysis. RAND’s publications do not necessarily reflect the opinions of its research clients and sponsors. Support RAND—make a tax-deductible charitable contribution at www.rand.org/giving/contribute.html R® is a registered trademark. © Copyright 2013 RAND Corporation This document and trademark(s) contained herein are protected by law. This representation of RAND intellectual property is provided for noncommercial use only. Unauthorized posting of RAND documents to a non-RAND website is prohibited. RAND documents are protected under copyright law. Permission is given to duplicate this document for personal use only, as long as it is unaltered and complete. Permission is required from RAND to reproduce, or reuse in another form, any of our research documents for commercial use. For information on reprint and linking permissions, please see the RAND permissions page (www.rand.org/pubs/permissions.html). RAND OFFICES SANTA MONICA, CA • WASHINGTON, DC PITTSBURGH, PA • NEW ORLEANS, LA • JACKSON, MS • BOSTON, MA DOHA, QA • CAMBRIDGE, UK • BRUSSELS, BE www.rand.org Preface Fair value accounting (FVA) refers to the practice of updating the valuation of assets or secu- rities on a regular basis, ideally by reference to current prices for similar assets or securities established in the context of a liquid market. Fair value accounting is typically distinguished from historical cost accounting (HCA), which instead records the value of an asset as the price at which it was originally purchased. For decades, policymakers and professional experts have debated the relative merits of FVA and HCA and the quality of the information that each approach provides to investors and other key users of financial statements. In the wake of the 2008 financial crisis, conflicting arguments have been made about the contributions of valu- ation approaches in triggering the crisis. Critics have raised basic questions about the appro- priateness of FVA methods, even as advocates pointed out that greater transparency in asset pricing and balance sheets ought to help protect against risk and speculative bubbles. The purpose of this report is to investigate and clarify the relationship between these two accounting approaches and systemic risk to the financial system. Specifically, the report exam- ines the risk implications of FVA and HCA in the various situations in which each is used; assesses the role that these accounting approaches have played historically in financial crises, including the 2008 financial crisis, the savings and loan crisis of the 1980s, and the less devel- oped country (LDC) debt crisis of the 1970s; and explores insights about systemic risk that can be gleaned from better understanding the accounting approaches. This study was funded with support from the Goldman Sachs Global Markets Institute, with additional support from the pooled resources of the RAND Center for Corporate Ethics and Governance. This report should be of interest to policymakers, regulators, financial ser- vices executives, accounting professionals and standard-setters, members of the business com- munity, and other stakeholders with broad interests in accounting standards, valuation, risk management, systemic risk, and the global banking system. The RAND Center for Corporate Ethics and Governance The RAND Center for Corporate Ethics and Governance is committed to improving public understanding of corporate ethics, law, and governance and to identifying specific ways in which businesses can operate ethically, legally, and profitably. The center’s work is supported by contributions from private-sector organizations and individuals with interests in research on these topics. The center is part of the RAND Institute for Civil Justice, which is dedicated to improv- ing the civil justice system by supplying policymakers and the public with rigorous, nonpar- iii iv Fair Value Accounting, Historical Cost Accounting, and Systemic Risk tisan research. Its studies identify trends in litigation and inform policy choices concerning liability, compensation, regulation, risk management, and insurance. Questions or comments about this report should be sent to the project leader, Michael Greenberg (at [email protected]). For more information on the RAND Center for Cor- porate Ethics and Governance, see http://www.rand.org/jie/cceg or contact the director ([email protected]). Contents Preface ........................................................................................................... iii Figures and Tables ............................................................................................. ix Glossary ......................................................................................................... xi Summary .......................................................................................................xiii Acknowledgments ............................................................................................ xix Abbreviations .................................................................................................. xxi CHaptER ONE Introduction ..................................................................................................... 1 Arguments and Counterarguments About FVA .............................................................. 2 Systemic Risk, Accounting Standards, and Prudential Regulation ........................................ 3 Purpose of This Study ........................................................................................... 3 Research Methods ................................................................................................ 4 Organization of This Report ................................................................................... 5 CHaptER TWO Background: The Debate over FVA and HCA ............................................................ 7 What Are the Sources of Deep Disagreement over FVA and HCA? ...................................... 7 What Do Consumers of Accounting Information Really Want to Know? ............................. 8 Do Different Types of Users of Accounting Information Want to Know Different Things? ......... 9 How Are Business Models and Investment Time Frames Relevant? ...................................11 Asset Volatility: Error or Information? .....................................................................12 Is Either Accounting Approach More Subject to Misinformation? .....................................13 Concluding Observations ......................................................................................15 CHaptER THREE Systemic Risk and Accounting Approaches ...............................................................17 What Is Systemic Risk? .........................................................................................17
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