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Fair Value Accounting: Volatility and Smoothing. Allan Brender ETH Zurich 7 June 2004. The Story of a Company’s Financial Progress. Investors require a standard basis for this story to have comparability among companies Hence, IOSCO pressure on IASB

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fair value accounting volatility and smoothing

Fair Value Accounting:Volatility and Smoothing

Allan Brender

ETH Zurich

7 June 2004

the story of a company s financial progress
The Story of a Company’s Financial Progress
  • Investors require a standard basis for this story to have comparability among companies
  • Hence, IOSCO pressure on IASB
  • Establish uniform international standards for financial reporting, for all business activities
the story of a company s financial progress3
The Story of a Company’s Financial Progress
  • Financial statements and reporting have uses other than to inform investors:
    • Regulation
    • Taxation
    • Management compensation
  • These can lead to distortions and manipulation of the system
international accounting standards board
International Accounting Standards Board
  • Establish international financial reporting standards or international GAAP
  • Standards are for business activities
    • Standards for insurance contracts, not insurance companies
    • Some insurance company products (e.g. deferred annuities) are not insurance contracts
    • Some elements (e.g. equalisation reserves) will not be considered to be liabilities
financial instruments
Financial Instruments
  • IAS 32, 39 – financial instruments (other than insurance contracts)
    • IAS 32: disclosure and presentation
    • IAS 39: recognition and measurement
measurement of value
Measurement of Value
  • If a financial asset is held to maturity, it can be measured at amortised cost
    • Trading is not a consideration here
  • IASB’s general position is that most assets and financial liabilities can be traded; market value should be the measurement standard
market value or fair value
Market Value or Fair Value
  • An active market in a particular financial asset or liability may not exist
  • Determine fair value, the price that willing arm’s-length buyer and seller might agree to
  • The value of certain exotic assets is determined through use of models – questionable
  • Revision to IAS 39 : verifiable market value
ias 39
IAS 39
  • Hold to maturity – value at amortised cost
  • Available for sale – market value, but changes do not pass through profit or loss (until time of sale)
  • Trading – value at market with changes passing through profit or loss
  • New proposed fair value option
ifrs 4 insurance contracts
IFRS 4 – Insurance Contracts
  • Phase 1(2005):
    • Continue current liability valuation
    • Do not net reinsurance
  • Phase 2 (?):
    • Forward-looking valuation
    • Assumptions: best estimate plus market margin
    • Discounting at market rates
    • Recognize own credit rating (?)
what is fair value
What is Fair Value?
  • London Life (LL) – 4th largest Canadian life insurer
  • Royal Bank of Canada (RBC)– largest Canadian bank
  • Great West Life (GWL)– 3rd largest Canadian life insurer
  • RBC agreed to buy LL for CAD$ 2.4 billion
  • GWL bought LL for CAD$ 2.9 billion
what is fair value11
What is Fair Value?
  • What assumptions should be used in valuation?
    • The market’s
    • The company’s
  • How will we determine market value margins?
    • How will these compare to margins for adverse deviation?
  • Using fair values will introduce considerable volatility in financial reporting
  • Asset / liability matching (ALM) can reduce volatility if it is recognized in accounting
  • Canadian Asset Liability Method
  • BUT accounting theory holds assets and liabilities to be independent
    • Not necessarily consistent with market behaviour
  • Under current version of IAS 39, volatility would be distorted
  • Proposed fair value option
    • Contains an embedded derivative
    • Financial liability linked to assets valued at fair value
    • Exposure to changes in fair value is substantially offset by changes in value of another financial asset or liability
smoothing response to volatility
Smoothing: response to volatility

Consider the following example:

  • Stochastic valuation of variable annuities with minimum maturity guarantees
  • Based upon CTE(x) = TVaR (x) = E{X X>x}
smoothing response to volatility16
Smoothing: response to volatility
  • Current industry proposal to formally smooth capital requirements
  • Supporting arguments are based upon imprecision of the calculation
    • Do not recognize the volatility is a reflection of the market
  • “If one is comfortable with smoothing capital volatility, then income volatility should be smoothed as well and possibly more so”