How To Write Standard Thesis Proposal: Valuation Methods for Complex Financial Instruments

Thesis Proposal:

Valuation Methods for Complex Financial Instruments

A. Introduction

Thesis Statement

Do current GAAP methods of valuing derivative instruments and other financial devices appropriately reflect their economic value?

Importance of Issue

The ongoing credit crunch has spread from its origins in the sub-prime mortgage market to affect investors across all financial sectors. The causes of this far-reaching issue are many, but some stand out. Improperly valued financial instruments on companies’ books can mislead investors, causing poor investment decisions. Specifically, entities that invested in securities backed by sub-prime mortgages were misinformed as to the high levels of risk associated with these instruments and, in many cases, overvalued them. They often failed to sufficiently research what could go wrong with these investments. The current consequences of falling financial markets are partially a result of market correction to the appropriate valuation levels for these assets. Proper initial fair value measurement could have helped to avoid this correction.

Fair value measurement also represents a current trend in financial reporting away from traditional historical cost accounting. Recent pronouncements such as FAS 157 and FAS 159 are evidence of FASB’s active support of this movement. FAS 157 clarifies and creates more rigor behind current fair value techniques, and FAS 159 allows managers the option to increase the amount of information they bring to investors in their financials. As these two standards were released within six months of each other in 2006, it is clear that the trend toward fair value measurement is as strong now as ever.

Methods of Investigation

I plan to research this topic using studies and articles published in the past five to six years. Anything prior to this may contain out-of-date information because of the rapidly changing nature of the fair-value movement in financial reporting regulation. I will use sources available through the Foster Business Library’s online catalog, found through such databases as ProQuest and the Social Sciences Research Network (SSRN). These and other databases I will use may include articles and studies from such industry publications as the Journal of Accountancy and CPA Journal. Additionally, I will refer to accounting guidance such as FAS 133: Accounting for Derivative Instruments and Hedging Activities in order to review the standards that my research may refer to. Information generated by Ernst & Young, such as Financial Reporting Development documents (FRDs) may also contain useful information.

B. Key Studies

1) “Effect of Derivative Accounting Rules on Corporate Risk-Management Behavior.” by Haiwen (Helen) Zhang in the working paper series of SSRN (2008, January).

            Zhang examines the effect of FAS 133: Accounting for Derivative Instruments and Hedging Activities on how companies manage their portfolios. The FASB’s intent with FAS 133 was to mandate recognition of derivative and hedging activities, but Zhang examines whether the standard had an additional effect on managerial decision making. Zhang notes that the structure of FAS 133 provides preferential accounting treatment for derivative instruments that are effective in hedging a company’s exposure to risk, along a continuum that varies with the overall effectiveness of the instrument. She finds that the firms in her study tend to show less volatile cash flows after the implementation of FAS 133, while the volatility of their earnings stays the same. It seems that these firms have succeeded in maintaining a steady earnings pattern in the face of a new financial reporting development by changing their investment strategies to counteract the mandated change in their accounting. Thus, Zhang concludes that FAS 133 has encouraged firms to manage the risk in their portfolios more prudently. This study gives evidence of the effect of fair value measurement standards on reporting entities, as FAS 133 was among the first standards to apply fair value to hedging instruments.

2) “Fair Value Accounting for Financial Instruments: Some Implications for Bank Regulation” by Wayne R. Landsman in the working paper series of SSRN (2006, August).

            In this working paper, Landsman compiles capital market studies that have examined some issues that must be resolved if regulators are to require mark-to-market, or fair value, valuation of financial instruments. He notes that both U.S. and international standards are headed toward fair value accounting for financial instruments, and so these issues must be resolved if such standards are to benefit financial statement users. First, he describes the problem of how to allow managers to report their financial instruments at fair value accurately while minimizing their ability to manipulate the models they must use to determine fair value. Second, he notes the issue of minimizing measurement error in calculations of fair value. Third, he writes that financial institutions that do business internationally may have to reconcile the values of their overseas financial instruments measured under differing fair value criteria. Landsman’s study will aid in showing how fair value measurement affects regulators.

3) Finance and Economics: Bearing it all; Accountancy” in The Economist (2007, July 21).

            This article discusses some of the unintended effects of fair value accounting for financial instruments. The author notes that the standard “mark-to-market” model commonly associated with fair value measurement cannot always be applied to complex derivative instruments because there is not often an arm’s-length market where they can be traded smoothly and openly. Therefore, the author conceives a “mark-to-model” method, where values must be calculated using a computer model. However, the author contends that a problem arises with this valuation technique when a market forms for the instruments that have previously been valued based on a model. For example, when a firm must sell off collateral supporting a complex mortgage-backed derivative, the sale price it obtains sets the market price for that formerly un-priced asset. If that price is significantly lower than the value the firm had previously assigned to that asset, then it follows that all such assets must be written down. This is essentially what has happened in the sub-prime mortgage crisis, with firms being required to revalue their holdings at significantly lower values. This article does a fine job at explaining this process.

4) “Does Recognition versus Disclosure Matter? Evidence from Value-Relevance of Banks’ Recognized and Disclosed Derivative Financial Instruments” by Anwer S. Ahmed, Emre Kilic, and Gerald J. Lobo in Accounting Review (forthcoming).

            The authors analyze whether investors react differently to derivatives disclosed in the notes than to those recognized on the balance sheet. The passage of FAS 133: Accounting for Derivative Instruments and Hedging Activities allowed them to study several firms that made the transition from footnote disclosure of their derivative instruments to mandatory recognition post-FAS 133. They calculated valuation coefficients in the portfolios of a sample of firms and found that valuation coefficients on derivatives that were only disclosed pre-FAS were insignificant, while those on the same derivatives once they were recognized post- FAS 133 became significant. Additionally, for those firms they studied that held both disclosed and recognized derivatives pre-FAS 133, they found that the valuation coefficients were only significant on the recognized derivative instruments. These findings both support their conclusion that recognition and disclosure are not looked upon equally by investors, and that FAS 133 has succeeded in increasing financial statement transparency.

C. Key Issues

Decision Factors

In order to determine whether current fair value measurement techniques accurately represent the true economic value of financial instruments, we must first arrive at an unbiased definition of fair value itself. In FASB’s abstract of its recently issued FAS 157: Fair Value Measurements, it offers the following: “This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.” The author makes it clear that fair value, although valued by management, is not specific to the firm holding the investment at all, but should reflect a value determined collectively by the market. Therefore, any discussion of whether fair value measurement techniques are accurate must be based around whether the measurement equates to the market’s opinion of the underlying item.

Historical Considerations

Valuation techniques used in the past have shaped the present move toward fair value measurement. Historical cost was a simple valuation method that kept assets on the books at the same value over time. However, fair value accounting has been introduced gradually into the traditional cost method of accounting over many decades. Standards dealing with inventory, investments, financial instruments of all kinds, business combinations and stock options have all been infused with fair value adjustments (Miller & Bahnson, 2007). Additionally, write-downs of impaired assets to amounts less than their original cost or book value are variations on fair value accounting.

However, no unifying principle had been in place to tie fair value accounting together across accounting disciplines until the issuance of FAS 157: Fair Value Measurements in fall 2006. The standard states that “[f]air value is 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” (FAS 157, paragraph 5). Prior to this statement, arguments persisted as to whether entry or exit prices; that is, whether the price to buy an item or sell it; were more appropriate in fair value measurement. The FASB quietly resolved this argument with FAS 157, coming down in favor of exit pricing. Overall, pronouncement such as FAS 157 can be seen as regulators’ efforts to neaten fair value definitions as financial reporting moves toward fair value measurement in an increasing number of areas.

Financial Services Firms

Financial services firms are affected by two main standards with relation to valuing their derivative instruments. FAS 133: Accounting for Derivative Instruments and Hedging Activities first required firms to place all derivative instruments on the balance sheet at fair value, and offered several categories into which to flow the gains and losses related to these instruments, based on the intended purpose of the derivative. Fair value measurement is critical for FAS 133 compliance because this standard is the first to require that derivative instruments be placed on the balance sheet at all, and they therefore must be valued properly from the beginning.

Additionally, FAS 133 affected financial services firms indirectly. As studied by Haiwen Zhang in her working paper, The Effect of Derivative Accounting Rules on Corporate Risk-Management Behavior, FAS 133 gives preferential accounting treatment to managers who are able to effectively use derivative instruments to hedge business risk. In order to make their hedges effective, managers of financial institutions are managing risk far more cautiously in order to qualify for the preferred treatment they can only get with effective hedging instruments on their balance sheets. Therefore, FAS 133 is indirectly affecting risk-management behavior.

Auditors

The public accounting industry should be pleased with recent developments in fair value measurement. FAS 157 removes clarifies many issues regarding the acceptability of clients’ fair value measurement practices, and it offers an appendix containing over 60 previously issued pronouncements where fair values are used (Miller & Bahnson, 2007). Thus, auditors will likely see fewer differences in opinion with management over fair value issues, as GAAP has been made clearer.

            Public accountants may also see such standards as FAS 157 as a further sign of the more toward the Conceptual Framework the FASB has been developing (Miller & Bahnson, 2007). Many in public accounting welcome this framework as a base for uniting standards systems used around the globe. The FASB further defines the Conceptual Framework as one that is essential to fulfilling the Boards’ goal of developing standards that are principles-based, internally consistent, and internationally converged” (Bossio, 2008). This principles based framework is appealing to auditors because it allows more flexibility within GAAP to report the underlying economic reality of a firm.

Changes Necessary

Some inherent problems persist within fair value accounting across its entire application. Under fair value measurement, managers are given more freedom to manipulate estimates and assumptions to suit their financial reporting goals. Fair value regulations must seek to minimize this ability to manipulate while still allowing managers to disclose all necessary information (Landsman, 2006). Additionally, they must limit the extent to which errors in estimates or calculations may skew fair values.

            In order to more appropriately consolidate operations across national borders, fair value measurement must also be standardized internationally. Especially in an interconnected financial world where one firm may trade simultaneously in such distant locations as London, Tokyo, and New York, it is important that regulators work to bring the standards for valuing financial products, and all reporting standards for that matter, under one unified framework for ideal effectiveness.

External Users

Financial statement users have already seen the benefits of fair value measurement of derivative instruments, whether they know they have or not. Ahmed, Kilic and Lobo studied the effects of balance sheet recognition vs. simple footnote disclosure of derivative instruments on value-relevance for investing firms. They discovered that valuation coefficients on recognized derivatives are significant, while valuation coefficients on derivatives that were only disclosed are not, suggesting that these investment companies place a high level of importance on derivative instruments only when recognized at fair value on the balance sheet. As FAS 133 now requires this balance sheet recognition, investors will benefit from the improved fair value recognition.

FAS 159: The Fair Value Option for Financial Assets and Financial Liabilities goes further to promote fair value measurement by allowing companies a one-time election to report certain financial instruments at fair value that were not previously reported as such. FAS 159 simplifies the accounting for derivative instruments by allowing a firm to report financial instruments at fair value and classify the related changes in fair value in earnings (Wilson & Marshall, 2007). This will result in a one time charge to earnings, after which all of a firm’s financial assets and liabilities will be on the books at their updated fair values.

D. Preliminary Expectations

I expect to find that, for the most part, current fair value measurement techniques as applied to complex financial instruments are effective at reporting the true economic value of the assets and liabilities they describe. I expect that many studies I find will note that deficiencies still exist in regards to minimizing management manipulation, and I hope to find ways currently underway to help prevent these issues. I hope that further research and continuing media coverage of fair value accounting this spring will reveal how fair value measurement of derivative instruments can further be refined.

References

Ahmed, Anwer S., Kilic, Emre and Lobo, Gerald J. (forthcoming) Does recognition versus disclosure matter? Evidence from value-relevance of banks’ recognized and disclosed derivative financial instruments. Accounting Review.

Bossio, R. (2008, February 4). Conceptual Framework—Joint Project of the IASB and FASB: Project Information Page. <http://www.fasb.org/project/conceptual_framework.shtml>. Accessed on March 17, 2008.

Finance and Economics: Bearing it all; Accountancy. (2007, July 21). The Economist, 384(8538), p. 80.

Kawaller, Ira G. (2007, March/April) Interest rate swaps: accounting vs. economics. Financial Analysts Journal, 63, 15-20.

Landsman, Wayne R. (2006, August) Fair value accounting for financial instruments: Some implications for bank regulation. Retrieved March 17, 2008, from Social Science Research Network.

Miller, Paul B. W., & Bahnson, Paul R. (2007, November 1) Refining Fair Value Measurement [Electronic Version]. Journal of Accountancy. Retrieved February 25, 2008, from Factiva Online Database.

Wilson, Arlette C. and Marshall, Beverly (2007, May) How the fair value option will simplify accounting for some hedging transactions. The CPA Journal, 77(5), 32-33.

Zhang, Haiwen (Helen). (2008, January) Effect of derivative accounting rules on corporate risk-management behavior. Retrieved March 17, 2008, from Social Sciences Research Network.