Relevamiento y análisis de casos

Mutual funds and hedge funds typically apply fair value accounting. They choose to do so voluntarily (with little regulation in the case of non-registered funds), as part of the contract between investors in the fund. Investors buy into the fund at book value based on fair value and redeem out of the fund at this same “net asset value.” Accordingly, they are willing to accept fair value as value to shareholders, with no perceived gains and losses for shareholders, new or old, in these transactions. That is, withdrawal from the fund at fair value is deemed to be a no-arbitrage (zero net-present-value) transaction. There has been little shareholder protest about the accounting for these funds.

We learn the following from this free-market accounting choice:

1. Fair value accounting is chosen where shareholder welfare is determined by exposure to market prices, so Principle 1 is satisfied.

2. The value of individual assets is not determined by the realized profits from sale of those assets; historical cost information does not enter the valuation, so Principle 3 is satisfied.

3. These funds consist of net assets where the value of the fund is simply the sum of the values of individual assets and liabilities (with no value jointly determined), so

Principle 2 is satisfied. If a fund takes canceling long and short positions, both are fair

valued, so again Principle 2 is satisfied.

4. Both unrealized and realized gains and losses are reported, so Principle 5 is satisfied 5. Estimates of fair value are tolerated, but only to the extent that shareholders do not

anticipate gains or losses to different classes of shareholders on withdrawal from the fund.

6. The approximation in using fair value accounting for actively managed funds, discussed in Section IV, is typically accepted; shareholders withdraw from funds at book value even though additional value may be added from the settlement of positions after they leave.

Point 5 is the most tentative. Hedge funds recognize estimation as being the rub of fair value accounting, and valuation committees, auditors, and boards spend considerable time on it. However, market solutions also emerge. If estimates are viewed as doubtful, fund managers place assets in side pockets or limit investments in illiquid assets to a small proportion of the fund. Lock-up periods are applied so that investors cannot withdraw until the uncertainly in the valuation is resolved. If

__________________________________________________________________________________ performance is seen as particularly important, the realization principle is applied – an important difference in accounting in moving from a hedge fund to a private equity fund, for example.

This behavior of investors in their self-interest is a guide for accounting more generally, and for regulators designing solutions for shareholders. However, shareholders in business corporations do not redeem directly from the firm at call, but rather through the sales of their claims in secondary markets (a stock repurchase forced by shareholder activism aside). Thus mechanisms like lock-ups are not available as protection against the imperfections of fair value accounting. This argues for a stricter adherence to the five principles so that the share price at which a shareholder redeems reflects an accounting based on value added for shareholders.52 Historical cost accounting can be seen as placing assets and liabilities in a side pocket in the accounts, to be marked to market only when a sale is realized. Or, to use the other analogy, historical cost applies the accounting used in private equity rather than a hedge fund when the principles are not satisfied.53

Point 6 advises on the use of fair value accounting in Case C1b of the active investor, discussed in the last section, where the principles are strictly violated but an approximation may be acceptable. In investment funds, the approximation appears to be adopted under the following circumstances:54

(i) The fund manager can sell the security at the market price, on call; that is, little performance is necessary to find a customer.

(ii) Performance involves only a timing issue, that is, when to sell.

52 _{For closed-end mutual funds, shareholders redeem in the secondary market rather than at net asset value. For these funds,}

some evidence suggests there is little difference between the pricing (in the secondary market) of estimated fair values and those based on quoted prices from active markets. See T. Carroll, T. Linsmeier, and K. Petroni, “The Reliability if Fair Value versus Historical Cost Information: Evidence from Closed-End Mutual Funds,” Journal of Accounting, Auditing and

Finance, 18 (Winter, 2003), 1-23. However, for banks and insurance companies, evidence suggests that fair values of debt

and equity securities obtained from active markets are related to these firms’ share prices, but those estimated from thinly traded markets are not. See M. Barth, “Fair Value Accounting: Evidence from Investment Securities and the Market Valuation of Banks,” The Accounting Review 69 (January 2004), 1-25 and K. Petroni and J. Whalen, “Fair Values of Equity and Debt Securities and Share Prices of Property-liability Insurers,” Journal of Risk and Insurance (December 1995), 719­ 737.

53 _{One might argue that experience with fair value accounting outside of investment funds does not particularly recommend}

it. The Enron episode comes to mind. But that was not entirely market-based behavior. Fair value accounting for gas contracts was approved by the SEC in 1992. Though license was presumably taken, management, auditors and other agents acted under this sanction. Presumably, fair value accounting would not have been adopted at Enron (and approved by the auditors) if it were not part of GAAP.

54 _{The cynic might say that the approximation is acceptable because investors don’t really expect funds to add value to}

market value. Indeed research indicates that mutual funds barely beat the performance of standard stock indexes on average.

Real estate investment trusts involved in speculation also mark to market even though some timing performance is required to arbitrage prices as part of the speculative endeavor. These two conditions appear to hold approximately for these trusts, though real estate markets may be less liquid than security markets. One can imagine situations where the approximation would not be appropriate: The long-term investor sees the “reversion of prices to fundamental value” as taking some time, and so views fair value accounting as introducing a short-term focus. One can also imagine prices deviating further from fundamental value (as in Case C1b and in a sustained price bubble or a “depressed market”), in which case the approximation would produce perverse results. However, despite these prospects, fund investors see an advantage of using fair value accounting rather than waiting for realization.55

55

Archival research also examines experience with fair value accounting. Some of this research in reviewed in W. Landsman, “Fair Value Accounting for Financial Instruments: Some Implications for Bank Regulation,” Bank of International Settlements Working Paper No. 209, August 2006 and M. Barth, Research and Global Financial Reporting (Foundations and Trends in Accounting, 2006), at http://www.nowpublishers.com/product.aspx?product=ACC. Our companion document, Fair Value Accounting in the Banking Industry reports on research on fair value accounting in the banking industry.

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