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1. www. fargroup.eu Fair value accounting and the present crisis of financial markets Florence, September 18, 2009

2. The causes of present financial market’s crisis In common opinion, two main causes: the financial instruments, above all derivatives the fair value accounting (FVA) ‘‘The problems that exist in today’s financial markets can be traced to many different factors. One factor that is recognized as having exacerbated these problems is fair-value accounting.” American Bankers Association, 2008

3. The FVA in Italy At present, it can be adopted by: all listed companies all the other companies provided for by D. Lgs. 38/2005 The consequence of the European Directive 51/2003 full adoption: all stock companies will have to deal with FVA

4. The fair value measurement (1) “The value for which an asset or a liability could be exchanged between a willing buyer and e willing seller, with knowledge of the market end without compulsion” Fair value is a market value Market value can be reasonably determined when the market is active “A market is active if quoted prices are readily and regularly available from an exchange, dealer, broker .. and those prices represent actual and regularly occurring market transactions on an arm’s length basis” IAS 39 (AG71)

5. The fair value measurement (2) When the market is not active: an entity establishes fair value by using a valuation technique • recent arm’s length market transactions between knowledgeable, willing parties Mark to market • if available, reference to the current fair value of another instrument that is substantially the same • discounted cash flow analysis Mark to model • option pricing models

6. The fair value measurement (2) When the market is not active: an entity establishes fair value by using a valuation technique 600 billion dollars is the amount of financial instruments measured with the mark-to-model logic that the most important American banks had among their assets in 2008 ! L. Moyer, How fair is fair value accounting?, Forbes, 25/06/09

7. FVA and the financial market’s crisis (1) The crisis made the financial markets not active Prices of financial instruments don’t mirror the fundamental value of the companies FVA forced many companies to impair the financial instruments they have in their portfolios Citigroup has written down more than $50 billion in assets To sidestep recording heavier impairments, other companies sold their assets, increasing the price downturn in the market

8. FVA and the financial market’s crisis (2) Many people think FVA cranked out the financial market’s crisis and, then, stressed the market downturn “FVAhas been extremely and needlessly destructive of bank capital in the past year, and is a major cause of current credit crisis and economic downturn.” “The rules have destroyed hundreds of billions of dollars of capital in our financial system, causing lending capacity to be diminished by ten times that amount” W. Isaac, Former Federal Deposit Insurance Corp. Chief

9. FVA and the financial market’s crisis (2) Many people think FVA cranked out the financial market’s crisis and, then, stressed the marked downturn Many governments also rushed through rule changes USA: more freedom to use models to value illiquid assets and more flexibility in recognising losses on long-term assets in their income statements EU: companies are allowed to reclassify their financial instruments in a way that rescue them from FVA rules

10. Disavowing FVA? (1) The SEC opinion: • FVA did not play a meaningful role in the numerous bank failures of 2008 • Historical cost-based measures would likely increase investor uncertainty and reduce investor confidence Academic literature: • There is no empirical evidence that historical cost accounting is better than fair value accounting • In time of market instability, market reactions can be even more extreme if fair-value estimates are not disclosed

11. Disavowing FVA? (2) “Investors require an accounting standard that reports a relevant and useful value of financial instruments regardless of the direction of markets.” “Fair-value accounting with robust disclosures provides more reliable, timely, and comparable information than amounts that would be reported under other alternative accounting approaches.” Consumer Federation of America, Centre for Audit Quality, Council of Institutional Investors, Investment Management Association, and CFA Institute – November 2008

12. Reviewing FVA FVA is a complex problem to cope with Present rules concerning FVA of financial instruments have to be revised “If you think that you understand IAS 39 then you obviously haven’t read it properly” Sir David Tweedie Last July, the IASB has issued an Exposure Draft of the new version of the IAS 39

13. The revision of IAS 39 in short All financial assets into two categories Loans and securities which share the characteristics of loans will be measured at cost, if entities can show they will hold them for the long term Everything else (equities, derivatives etc.) will be measured at fair value

14. Market concept in FVA The character of markets, in terms of how well they operate, is fundamental to what results may be expected from using fair values in different situations. Standard-setters have not, as far as is known, empirically investigated the characteristics of markets. Rather, they have merely listed a number of assumptions that are tantamount to assuming well-organized markets Michael Bromwich 2007

15. The market efficiency myth Economic theory of market efficiency has stated that markets regulate themselves and financial innovation is always beneficial “Much of the past 30 years of macro-economics was spectacularly useless at best, and positively harmful at worst” Paul Krugman “The crisis has cast into doubt much of what we thought we knew about economics” Barry Eichengreen

16. A few questions to fuel our debate • Who tipped the first domino of the present crisis? • Can GAAP really influence the economic and financial systems? • Has the FVA turned out to be unsuccessful so that we have to come back to historical cost accounting? • Will the market efficiency concept still hold water?

17. Thank you for your kind attention Francesco Giunta Dipartment of Business Administration Florence University Via delle Pandette, 9 50127 FIRENZE francesco.giunta@unifi.it www.fargroup.eu