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Highlights From SEC Roundtable On Measurement Uncertainty: 'Fair Value' Neither 'Fair,' Nor 'Value'; Separate 'Anchors' From 'Speculation'

At the SEC's November 8 Roundtable on Measurement Uncertainty, the first in a series of roundtables on emerging issues making up SEC's Financial Reporting Series, representatives of the SEC, FASB and PCAOB heard a range of views from investors, preparers, analysts, auditors and others. Among the panelists were the Chair andVice Chair of FEI's Committee on Corporate Reporting, Lorretta Cangialosi and Gary Kabureck (speaking in their personal capacity, not on behalf of FEI).

In this initial post on the SEC's roundtable, I am going to highlights some remarks by Prof. Stephen Penman of Columbia University, who called for the separation of, in essence, more factual information to be provided in the financial statements themselves, with more 'speculative' information provided in the footnotes and disclosures thereto. I'm also going to highlight some remarks by Pinto Suri, Senior Analyst, Flaherty & Crumrine. Both Penman and Suri, in my view (please see the disclaimer posted on the right side of this blog), strike me as the kind of people who would not be afraid to point out if the emperor had no clothes. Witness Suri's observation that: "Fair Value is neither 'fair,' nor 'value.'" Read more of Penman and Suri's and others' remarks below, and watch for more highlights from the roundtable in subsequent blog posts.
The importance of the SEC's Financial Reporting Series was underscored by the fact that SEC Chairman Mary L. Schapiro and most if not all of the commissioners were present as observers at the roundtable, with the SEC Chairman making brief opening remarks.

The SEC's Chief Accountant, Jim Kroeker, further crystallized the objective of the roundtable after some of the panelists made introductory remarks as follows: 

"Getting back to what do investors want and how do they use it... tradeoffs of providing more forward-looking, or results of, analyses of future transactions, seem to hit upon what accountants used to call the tradeoff between relevance and reliability, something may be more reliable if I put it on the books at cost, but is that more relevant? Getting to the heart of those issues would be very helpful for us."

Stephen Penman, of Columbia University, made remarks that were echoed by a number of other panelists:
"I think investors look for certainty in the accounts, and it’s all a question about handling your uncertainty. I think in the fundamental tradition, Benjamin Graham would say, ‘understand what you know, and separate from speculation; and when you accountants do your work, don’t mix speculation with what you know, because I need an anchor in the financial statements to build on, leave the speculation to me.’"

"For example, do I want to fair value core deposits, because I want a balanced book with the mortgage loans? Well, that’s a lot of speculation, and it gives me an income statement which is just changes in estimates, and I lose my anchor.   I’m trying to get something, in terms of information, the fair value of core deposits, but I’m going to destroy information that I can anchor on. I think this is the objectivity aspect of that, and of course this is the issue of the day, the extent to which you want to deal with uncertainty in the accounts, vs. in disclosures and footnotes, and where you draw that line."

Pinto Suri, Senior Analyst at Flaherty & Crumrine, concurred with Penman and made some significant points:
"I think that is the issue of the day, when we look across the financials landscape, you’ve got two major industries, banks and insurance companies. In one, you’ve still got a measure of amortized cost and a level of stability in the accounts; as an investor, what is most useful, is to be able to have a contrast, it’s the asymmetry of information that drives an investment decision; you have a management view of a base case of what they think it takes to remain a going concern, that’s important.
"What we are seeing in the new, upcoming proposals, particularly for insurance contracts , as well as to an extent even for financial instruments, challenges that very proposition.
"I think this asset-liability view,  in our view, is far from settled, theoretically, and practically speaking, I think it leaves us at a great disadvantage, not only because of volatility, but because you get marks like own credit, so, my liability Fair Value has dropped, why has it dropped, it dropped because the market thinks the value of my assets has dropped, so I’m  about to go bankrupt, but I book a four billion dollar gain?
"I think it defies credibility to have accounting like that flow thru, and, it’s not a question of adjusting it out, when you see accounting like that and you can’t trace it thru the financial statements, in the footnotes, that really reduces confidence, and it’s that confidence that then shows up in cost of capital, in reallocation out of particular other sectors, and that’s something that should be given some thought to."

[In a reference that apparently related to proposals such as the IASB’s proposed accounting for insurance contracts, and other proposals on deck at FASB and the IASB, Suri added]:
"Putting on a façade of mathematical precision, whether its probability weighted estimates, or confidence  intervals, or anything like that, I am reminded of Lotfi A. Zadeh , the founder of fuzzy logic,  the principle of incompatibility: ‘as a system’s complexity increases, meaningful statements lose precision and precise statements lose meaning.’ I think that would be… because as we start putting on all kinds of mathematical constructs on things that are inherently uncertain, you will just open up to more lack of confidence down the road.
Kroeker later channeling Prof. Penman’s remarks, saying,
I am enamored of, the idea of reporting, clean, ‘know what you know, and then talk about the uncertainty,’ whether that’s in the financials or otherwise, but as Stephen [Penman] described,.. when I hear that, that initially rings, something with me, but I think, putting myself in the position of somebody trying to set accounting standards... if you think of, one of the issues in the financial crisis was not just comparability, but transparency around lending activities and the credit you’ve extended, and in any model, uncertainty seems inherent in that , unless we’re just going to go to a strict cost model, and I think  that’s really where the rubber starts to hit the road, is, what is it, and then how, if we have an anchor, how  do we convey, certainly not everyone looks the same, not everyone’s loan is at 100 cents on the dollar, how do we do that, of course we’re trying to project that which we think would default either at a fair value basis or otherwise; … I’m really interested in, you hear words like mixed attribute model,  and you wonder why sometimes people say that as if it’s a bad thing, and then in the other context, you might want to know multiple attributes before you bought an asset, how you can provide more info about here’s the cost, but here’s what I expect, I don’t know if there’s a way to think about operationalizing that.

Prof Penman replied:
"A big conceptual issue is whether we want an asset-liability, balance sheet focus, or an income statement focus, and what one is good for, and what one is not good for. The [FASB and IASB] boards have tried to sort out their conceptual framework, and initially taken the balance sheet view.

And so, on mortgages, on loans, the idea is now you try to get them at value, so what do you do? You mark them to market, level 1, .and then you bring the bubbles into the financial statements, thank heavens we didn’t have that in 2007, or things could be far worse, if everything had been marked to market, the bubbles come into the financial statements, fortunately the gains go into OCI rather than income
" .. If you’ve got level 3, you’ve got estimates, additional problems, your income statement becomes changes in estimates, you’re basically arbitraging borrowing and lending rates, in the income statement…
"If you go amortized historical cost, sort of like level 3, prospective reserving, how do you get out of this dilemma?

"Here’s the solution: Historical cost….[recognizing credit spread and amortizing it…] yes, we can have disclosures of fair values, understanding they could be bubble prices on the loans, and the problem for mortgages is, you’ve got to match the book on the other side… getting certainty into the statements
If we had that sort of accounting, yes, we would have had the  financial crisis, but maybe it wouldn’t have been that bad, banks would not have booked until reasonably assured that you really would have got it, prices and estimates are just speculation in the financial statements."
Gary Kaburek, VP and Chief Accounting Officer, Xerox Corp., recalled that at an SEC financial instruments roundtable 5 yrs ago, during discussion about whether a co’s long-term debt should be marked to market or not, got him thinking: “Should disclosure be a substitute for recognition, should we revisit that conventional wisdom, going back to what Prof. penman said, people want consistency, they want objectivity, someone said, leave the speculation to us, maybe something should be perhaps in the footnotes going forward [rather] than actually recognized and measured on the face of the financial statements, maybe that’s something long-term [to consider in standard-setting],not necessarily something that could be operationalized quickly. 
Suri added: 
"Absolutely, I couldn’t agree with you more, one of the things we need is truth in labeling, fair value is neither fair, nor value;  we need to get that on the table, get comfortable with that, the Earth’s not going to shatter. These items should be moved into disclosure, these are traditional add-ons that are useful to assess what management is doing…
"… This concept of OCI has become a dumping ground; as we hear more and more about new proposals coming in, more and more fair value inserted, [with] offset to OCI… OCI going to look more and more like a trash dump, if it doesn’t belong in earnings, it doesn’t belong in OCI, it should go into the footnotes, and it’s very useful as an add-on, to see, here’s what management is doing, are they credible, here’s what the market is doing…

"…when you look at disclosures today, 20, 30, 40,50 pages, and I can’t reconcile an of those tables to what’s in the balance sheet, it’s more quantity, and no quality, that’s something you need to be cognizant of as well, people start tuning things out.
"…Accounting appears to be a naïve application of basic theory, ignores certain basic tenets of economic theory, issue is fair value does not belong in primary financial statements.."
Toward the end of the panel, Suri added, “For the financial institution space, we ought to rethink whether we are accounting for the markets, or from the markets .”

I will post some more highlights from the SEC’s Financial Reporting Series roundtable in a follow-up post(s).
Posted: 11/11/2011 5:18:20 PM by Edith Orenstein | with 0 comments

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