Fair Value Losses Research Articles

Analysing the growing interplay of accounting and regulatory capital: A state-of-the-art review

Accounting standards and prudential regulation are key elements of the financial system and are increasingly seen as complementary concepts despite their divergent objectives. This paper examines the growing convergence of accounting and Basel capital requirements in the wake of the latest financial crisis and reviews the empirical evidence on the risk behavioural and economic implications arising from the interactions. Loan loss provisioning under the IFRS 9 expected credit loss model as well as the prudential filter for unrealized fair value losses form the central link between accounting and regulatory capital as they align loss recognition and measurement methods. The remaining conceptual and methodological differences may trigger procyclical effects on banks’ capital and lending with negative consequences for financial stability. Based on the findings, the paper contributes to the discussion about a strict decoupling of the two systems to reconcile the conflict between accounting and regulatory objectives and identifies avenues for future research.

Discount rate behaviour in fair value reporting

Despite the importance of reliable financial information to financial professionals, little is known in the behavioural finance literature about the opportunistic behaviour in discount rate selection for fair value measurement, and its adverse impact on the reliability of financial information. This short communication contributes to the literature on discount rate behaviour by revealing the potential opportunistic behaviour in the selection of discount rates. Using biological assets where the market price is usually not available, I show that a wide range of discount rates are applied for estimating fair values, but the range of rates used does not seem to be related to economic factors. Further, firms that report both larger fair value gains and larger fair value losses use higher discount rates suggesting that the discretion available to managers is used opportunistically in some cases. To gain more insights into behavioural aspects of discount rate selection, I also suggest a set of research questions pertaining to discount rate behaviour. This helps to form the agenda for future research in this area.

Are Level 3 Fair Value Gains and Losses Return Relevant? Evidence from Fas 157 Rollforward Disclosures

We examine whether fair value re-measurements on illiquid assets convey useful information to investors. Specifically, we investigate the return relevance of unrealized Level 3 fair value gains and losses (FVGL) for a sample of 219 listed U.S. banks from 2008 to 2017. We find that Level 3 FVGL are generally priced. Importantly, our results show that FVGL recognized in net income, reflecting largely changes in expected cash flows, are more return relevant than FVGL recognized in other comprehensive income (OCI), which mainly reflect changes in illiquidity. Therefore, for illiquid assets, the distinction between cash flow revisions and illiquidity-induced value changes matters for equity investors. Further, we find that non-trading FVGL are more return relevant than trading FVGL due to greater uncertainty about the cash flow implications of trading FVGL. Finally, Level 3 fair value losses are more relevant than gains, indicating that losses are perceived as more credible than gains.

Impairments of Greek Government Bonds under IAS 39 and IFRS 9: A Case Study

International Financial Reporting Standard 9 (IFRS 9) 9 introduces new impairment rules responding to the G20 critique that International Accounting Standard 39 (IAS 39) results in the delayed and insufficient recognition of credit losses. In a case study of a Greek government bond for the period 2009–2011 when Greece’s credit rating declined sharply, this paper highlights the discretion that preparers have when estimating impairments. IFRS 9 relies more on management expectations and will lead to earlier impairments. However, these appear still delayed and low if compared to the fair value losses.

IAS 39 reclassification choice and analyst earnings forecast properties

In October 2008, the International Accounting Standards Board amended IAS 39 to allow banks to retroactively reclassify financial assets that previously were measured at fair value to amortized cost. By reclassifying financial assets, a bank can potentially avoid recognizing the unrealized fair value losses and thereby increase its income and regulatory capital during a market downturn. We examine the implications of the reclassification decision by banks for the properties of financial analyst earnings forecasts during 2008–2009, when economic conditions were highly volatile. We find that the reclassification choice during the financial crisis reduced analyst forecast accuracy and increased forecast dispersion. We also find that the observed decline in analyst forecasting ability is limited to the year of adoption when the economic environment was highly volatile.

Why Did Financial Institutions Sell RMBS at Fire Sale Prices During the Financial Crisis?

Much attention has been paid to the large decreases in value of non-agency residential mortgage-backed securities (RMBS) during the financial crisis. Many observers have argued that the fall in prices was partly caused by fire sales. We use capital requirements and accounting rules to identify circumstances where financial institutions had incentives to engage in fire sales and then examine whether such sales occurred. For financial institutions subject to credit-sensitive capital requirements, capital requirements increase as an asset’s credit becomes impaired. When accounting rules require such an asset’s value to be marked-to-market and the fair value loss to be recognized in earnings, a capital-constrained firm can improve its capital position by selling the credit-impaired asset even if it has to accept a liquidity discount to do so. In contrast, a financial firm whose fair value losses are not recognized in earnings for the purpose of calculating capital requirements is more likely to satisfy capital requirements by selling liquid assets whose value has not fallen and hence would be unlikely to engage in fire sales. Using a sample of 5,000 repeat transactions of non-agency RMBS by insurance companies from 2006 to 2009, we show that insurance companies that became more capital-constrained because of operating losses (uncorrelated with RMBS credit quality) and also recognized fair value losses sold comparable RMBS at much lower prices than other insurance companies during the crisis.

Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities?

Much attention has been paid to the large decreases in value of non-agency residential mortgage-backed securities (RMBS) during the financial crisis. Many observers have argued that the fall in prices was partly driven by decreased liquidity and fire sales. We investigate whether capital requirements and accounting rules at financial institutions contributed to the selling of RMBS at fire sale prices. For financial institutions subject to credit-sensitive capital requirements, capital requirements increase as an asset’s credit becomes impaired. When accounting rules require such an asset’s value to be marked-to-market and the fair value loss to be recognized in earnings, a capital-constrained firm can improve its capital position by selling the credit-impaired asset even if it has to accept a liquidity discount to do so. Using a sample of 5,014 repeat transactions of non-agency RMBS by insurance companies from 2006 to 2009, we show that insurance companies that became more capital-constrained because of operating losses (uncorrelated with RMBS credit quality) and also recognized fair value losses sold comparable RMBS at much lower prices than other insurance companies during the crisis.

Mark-to-Market Accounting: Guilty or Not?

As the recent credit crisis unfolded, fair value accounting provoked a fierce debate among politics, academics, and bankers. Even though many believe that fair value accounting exacerbated the crisis, some commentators argue that fair value accounting was the prime reason for the financial meltdown. Proponents, on the other hand, believe fair value accounting prevented more calamitous consequences of the credit crisis by acting as an early warning system. This article traces the role of fair value accounting during the crisis in light of these arguments. In this context, the article focuses on two key arguments so as to find out whether fair value worsened the crisis. The first argument is that fair value accounting played a significant role in actual or potential bank failures. With respect to bank failures, we found that fair value accounting did not play a significant role during the crisis. The problem for many broker-dealers and banks was short-term funding difficulty after the interbank markets dried up. For some others, credit losses rather than fair value losses played a key role in bank failures. The second argument in the context of the crisis was the alleged procyclical effects of fair value accounting. Given its hybrid features and the extent to which it impacted upon balance sheets as revealed by empirical data, we conclude that fair value accounting in its current form did not cause pro-cyclical behavior and a downward spiral. <b>TOPICS:</b>Accounting and ratio analysis, legal and regulatory issues for structured finance

Fair value accounting for liabilities: The role of disclosures in unraveling the counterintuitive income statement effect from credit risk changes

When liabilities are accounted for at fair value, a deterioration of a company’s credit risk results in the reporting of an income statement gain; an improvement in a company’s credit risk results in a loss. Many argue that these income statement effects are counterintuitive and that financial statement-users are likely to misinterpret fair value gains as positive signals and fair value losses as negative signals. Utilizing an experiment with CPAs as participants, we find that these arguments are indeed valid. Specifically, we find that over 70% of the participants incorrectly assess a company’s credit risk as improving (deteriorating) when a fair value gain (loss) is recognized. We also find that disclosures that explicitly specify the relation between the direction of the credit risk change and the income statement effect significantly reduce participants’ misinterpretations, and are more beneficial when fair value gains versus losses are recognized. These findings provide empirical evidence in the debate over the recognition of company-specific credit risk changes and offer direction for improving disclosures in the area of fair value accounting.

The IAS/IFRS after the crisis: limiting the impact of fair value accounting on companies' capital

The recent financial crisis has demonstrated that fair value accounting can affect not only the relevance of accounting information but also companies' assets integrity. In countries where company laws prompt companies to maintain minimum legal capital, the recording of unrealized losses may reduce a company's assets to a level below minimum thresholds. If fair value losses are transitory and do not reflect an actual lowering of a company's assets value, fair value accounting may still prompt shareholders to consider an unnecessary recapitalisation or the “premature” dissolution of a firm. This article examines the pros and cons (also in the light of the recent financial markets crisis) of fair value as an accounting technique and illustrates the effects of the adoption of IAS/IFRS on the legal capital system. It also examines the various solutions that can be used to limit the distorted effects created by the interaction between fair value accounting and the system of legal capital set out by the second council directive 77/91/EEC.

Limiting the Impact of Fair Value Accounting on Companies’ Capital

The recent financial crisis has demonstrated that fair value accounting can affect not only the informational importance of annual accounts but also a company’s financial integrity. In legislations where standards of company law prompt companies to maintain minimum amounts of capital (or an equilibrium between assets and liabilities) the recording of unrealised losses may reduce a company’s share capital to a level below minimum thresholds. If fair value losses are transitory and do not reflect an actual lowering of a company’s assets’ value, fair value accounting may still prompt shareholders to consider an unnecessary recapitalisation or the “premature” dissolution of a firm. The negative consequences arising from interaction between fair value accounting and the legal capital rules can be prevented by neutralising (through appropriate rectifications of accounting numbers) fair value profits and losses for the sole purpose of respecting the provisions for share capital maintenance. This solution would make it possible to limit the impact of accounting rules on companies’ capital without prejudicing the informational importance of annual accounts.

Reclassification of Financial Assets under IAS 39: Impact on European Banks' Financial Statements

In response to the financial crisis, the IASB issued on 13 October 2008 an amendment to IAS 39 which enables entities to reclassify non-derivative financial assets held for trading and financial assets available-for-sale. This paper examines the influence of this controversial amendment on the 2008 financial statements of 219 European banks which apply IFRS. I find that approximately one-third of the sample banks have taken extensive advantage of these reclassification opportunities. The mean reclassification amount is 3.9% of total assets and 131% of the book value of equity, respectively. I further document that reclassifying banks avoid substantial fair value losses, and hence, report significantly higher levels of return on assets (ROA), return on equity (ROE), book value of equity and regulatory capital. In particular, the mean ROE switches sign from a negative ROE of −1.4% to a positive ROE of 1.3% due to gains from reclassifications. Overall, this paper documents a substantial impact of the amendments on banks' financial statements and suggests analysing these reclassifications with particular caution.