Econometrics of Fair Values

1. Econometrics of Fair Values Shyam Sunder Yale University Mid-Year Meeting of the AAA Financial Accounting and Reporting Section San Antonio, Tx, January 19-20, 2007

2. An Overview • Language of Debate: Labels Matter • Transforming a qualitative debate into a quantitative debate • So we, as researchers can add value to social policy through evidence on falsifiable propositions (beyond mere opinions) • A framework and results to • View valuation methods as econometric estimators of unobserved parameters of interest • Choose estimators on the basis of their objective properties, not opinions of one expert or another • Identify key determinants of dominance between historical and current values: degree of price instability and magnitude of measurement errors • Reflexivity of standards and practice in financial reporting • Time Permitting: American Accounting Association Sunder: Econometrics of Fair Values

3. Labels Matter • What is common to: • Unified Budget Act (1964, Lyndon B. Johnson) • Patriot Act (2002, George W. Bush) • Fair Values (1999, FASB) Sunder: Econometrics of Fair Values

4. “Pernicious changes with deceptively reassuring titles” • Choose labels to put potential opponents on defensive before the debate begins • Oldest trick in the book of policy rhetoric • Johnson wanted to use the social security surpluses to finance increased spending on Great Society programs and the Vietnam War (who can argue for non-unified budget?) • Bush wanted to fight the war on terror (who is against patriotism?) • FASB wants to use current values (who can be against fair values in accounting?) • “Fair” is a personal judgment, not a fact • To avoid misuse of language, put the rhetoric of “fair” aside, and talk about current values of which generations of accountants and researchers have thought and written about Sunder: Econometrics of Fair Values

5. The Proposal • 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 • Orderly transaction, not forced liquidation or a distressed sale • From eyes of a market participant, no entity specific assumptions • Highest and best use framework from the perspective of market participants even if the acquirer has different plans Sunder: Econometrics of Fair Values

6. The Valuation Debates • Relevance to investment decisions • Relevance to stewardship, management of enterprise resources, and contract enforcement • Other criteria for evaluation: reliability, bias, timeliness, representational faithfulness, cost of implementation Sunder: Econometrics of Fair Values

7. Qualitative versus Quantitative • Valuation debates have been largely been about qualitative characteristics of rules • Without a framework for quantified comparison, debates can go on for ever • People don’t change their minds • Theories are supposed to die only with their proponents (“science advances funeral by funeral”) • Even that is not true in case of fair values • Resurrection of current values under the new label after an interval of almost 70 years • How do we bring an element of quantified rationality to this debate? Sunder: Econometrics of Fair Values

8. Econometrics • Great achievements of econometrics arise from our willingness to • Postulate an underlying structure and unknown parameters of the problem • Characterize the properties of alternative estimators (e.g., OLS, GLS, 2SLS, etc.) as a function of the underlying environment • Choose an estimator appropriate to the postulated environment • Use data to estimate the unknown parameters, holding the structure constant • Examine propositions about the underlying parameter on the basis of estimates • Use alternative datasets of examine the propriety of assumed structure • When found inappropriate, change the assumed structure Sunder: Econometrics of Fair Values

9. Econometrics of Valuation • Can we use a similar strategy for documenting the properties of valuation rules in various environments? • It may not entirely get rid of judgments • But still, will move the debates among valuation rules from the domain of opinion into data • Let me explain, starting with one postulated structure • Remember, we can always change the postulated structure if we find a better one later • For now, let us focus on thinking about choice of valuation rules as we think about choice of econometric estimators Sunder: Econometrics of Fair Values

10. Postulated Structure • There are many resources in the economy (vector ω) • Each firm is a special bundle of some or all of these resources--a vector of proportions (vector w) • Current values of resources are subject to change over time: relative changes have a given mean vector (μ) and covariance matrix (Σ) • Historical costs of resources in the bundle are known • Relative changes in current values of the resources are observed with an (unbiased) error term (vector ε) which has covariance matrix (Δ) Sunder: Econometrics of Fair Values

11. Two Sources of Error in Valuation • Consider two sources of error in valuation of a bundle of resources • Values change over time but the valuation rule ignores these changes (price movement errors) • Current values we use to revalue the bundle are prone to errors due to imperfection and incompleteness of markets (measurement errors) Sunder: Econometrics of Fair Values

12. Choose a Metric and Magnitude of Errors of Valuation Rules • Let us focus on the expected mean squared error as the metric of errors (used in most econometrics; we could also use bias or other metrics) • Magnitudes of the errors depend on • Parameters (Δ, Σ, μ, and ω), and • Valuation rule used to adjust historical to current values • The space of valuation rules is very large; even linear subject is huge; let us just focus on the three elements of this subset (historical cost, general price level and current value) Sunder: Econometrics of Fair Values

13. Historical Valuation • Has price movement errors because it ignores changes in prices from the time of acquisition to present • The size this error (MSE) depends on parameters of the economy: • The mean of the vector of relative price changes (μ), and • The covariance matrix of the vector of relative price changes, (Σ) • Greater the “magnitude” of these two parameters, greater is the movement error associated with historical valuation • Since historical valuation ignores changes in prices, it is free of measurement errors Sunder: Econometrics of Fair Values

14. Current Valuation • It has price measurement errors arising from assessment of current values • Again, the size this error (MSE) also depends on parameters of the economy: • If we assume that the relative changes in current values are measured without bias (ε = 0), the MSE arising from the mean of measurement errors is zero • The error arises from the covariance matrix of the vector of measurement errors in relative price changes (Δ) • Greater the “magnitude” of this covariance matrix, greater is the measurement error associated with current valuation • Since current valuation takes into account the changes in prices, it is free of price movement errors Sunder: Econometrics of Fair Values

15. General Price Level Valuation • GPL uses a single price index to adjust historical values towards current values • The use of a single price index reduces the price movement error associated with the historical estimator but does not eliminate it • The use of a single price index also introduces some measurement error, although it is not as large as the error associated with current value estimator • The total error associated with GPL estimator depends on the values of the parameters μ, Σ, Δ and ω. • Let us look at the picture as a schematic graph Sunder: Econometrics of Fair Values

16. Behavior of Price Movement Error with Respect to Aggregation Sunder: Econometrics of Fair Values

17. Behavior of Price Measurement Error with Respect to Aggregation Sunder: Econometrics of Fair Values

18. Behavior of Total (Valuation) Error with Respect to Aggregation Sunder: Econometrics of Fair Values

19. How Do These Estimators of Value Perform • Which estimator of is associated with lower mean squared value • It depends on the parameters of the economy • With high price volatility and low measurement errors, current value estimator dominates • With low price volatility and high measurement errors, GPL, and even historical value estimator may dominate • In general, we should not expect that the MSE minimizing estimator will be any of the three we have explicitly considered • Instead, it is likely to be some intermediate specific price index estimator of value Sunder: Econometrics of Fair Values

20. Testable Implications of Theory • Current valuation would be more informative for firms and industries whose • Assets have a large mean rate of price change • Assets have more variability in price changes • Assets are traded in relatively perfect and complete markets (accurately measured CV) • Real estate, mineral deposits, films, software, patents have large measurement errors • Instead of cross-sectional tests (e.g., Gheyara and Boatsman 1980, Ro 1980), we could benefit from paying more attention to characteristics of assets of firms and industries Sunder: Econometrics of Fair Values

21. Testable Implications of Theory • Efficient valuation rules would vary across assets, firms and industries • Level of aggregation at which current values are chosen has a major impact on the properties of valuation (left open in FASB’s proposal) Sunder: Econometrics of Fair Values

22. What Do We Learn from This Theory? • Theories of valuation can be integrated into a framework to facilitate direct comparison of their properties in specified environments • When current prices change, and are prone to measurement errors, neither the current nor general price level valuation is necessarily the min(MSE) estimator of the unobserved economic value of assets • Generally, min (MSE) estimator is likely to be a specific price index rule • If the measurement errors are sufficiently large relative to movement errors, historical cost can be the min (MSE) estimator • Which valuation rule has min (MSE) is a matter of econometrics, not theory or principle (depends of relative magnitude of parameters of the economy) Sunder: Econometrics of Fair Values

23. References • In this summary, I have drawn on the work of many colleagues. Here are some references: • Ijiri (Econometrica 1968), Tritschler (TAR 1969), Sunder (JAR 1978), Hall (JAR 1982), Sunder and Waymire (JAR 1983), Sunder and Waymire (JAR 1984), Shriver (JAR 1986), Shriver (TAR 1987), Shih and Sunder (CAR 1987), Tippett (ABR 1987), Lim and Sunder (JAE 1990), Lim and Sunder (TAR 1991), Jamal and Sunder (CAR 1995) Sunder: Econometrics of Fair Values

24. Reflexivity of Financial Reporting • In social systems, measurement is a part of a larger cycle that cannot be ignored if we wish to understand its properties • If we measure because we wish to use the measures for deciding, the choice of measurement affects decisions, which in turn affects what we measure • The current debate on the consequences and wisdom of returning to current values could benefit greatly from consideration of reflexivity • Financial derivatives: why is it so difficult to devise accounting for them? • Derivatives beget standards, which beget more derivatives • Standard setters need to consider the larger game Sunder: Econometrics of Fair Values

25. American Accounting Association • Over eight thousand members from 75 countries of the world, each with his/her own diverse ideas, initiatives, innovations, and energy • It has been an eye-opener for me to learn about all the wonderful things AAA members do • For these few months in which you have given some of us the privilege to hold office • We see it as our responsibility to provide efficient shared facilities, services and forums to make it easier you to achieve your goals • In this spirit, let me mention a few activities now underway at AAA Sunder: Econometrics of Fair Values

26. Internet and Ideas • An academic organization is primarily about ideas • As you know, Internet is bringing about radical transformation in the way ideas, innovations and research is disseminated, and ultimately to how it is generated • What does this mean for AAA as in organization? • Aggregators, search engines, electronic publications, new platforms, competition, intellectual property, administrative structure and finances of the Association • Intellectual Property & Structure Task Force (Past President Andrew D. Bailey, Jr., chair) will submit its interim report in Spring to help prepare us for this new, still rapidly changing environment Sunder: Econometrics of Fair Values

27. Competition of Ideas and Platforms • AAA publishes 12 journals and 16 newsletters • Many if not most academic disciplines are moving to electronic platforms (even skipping print publications in some cases) • AAA will experiment with electronic innovations by acquiring such a platform as a nursery for new ideas and forums for publication, discussion, and debate • Evolutionary (bottom up) approach to journals in contrast to top-down command-and-control • Let new entrants challenge the current occupants and let the latter adjust themselves to the challenges • Audit Section’s initiative on Current Issues in Auditing (CIA) in electronic form as the first step; other sections? Sunder: Econometrics of Fair Values

28. Global Digital Accounting Archives Project • Joint effort with the European and other accounting associations (Gary Previts, Chair) • Existence of accounting archives in many parts of the world, some digitized • Linking digital archives from a single Internet portal • Identify the existence of other such archives and link them • Encourage digitization of accounting and business archives • Encourage efforts to save important archives • Encourage discussion of, and research on, the academic contributions of the accounting archivists in US and abroad are doing (sessions in Chicago meetings) Sunder: Econometrics of Fair Values

29. Arthur Andersen, LLP • Glorious history of the Arthur Andersen • Important records in their archives of great value to researchers/historian of accounting • AAA Task Force to save the AAA archives and find a university home for them when the legal situation permits • Effort led by Past President Arthur Wyatt Sunder: Econometrics of Fair Values

30. We Academics • It is difficult for most people in the world to understand academics • We spend years working on things of no apparent value to the world • How many of us can explain to our moms what we do with our time, and why? • Why do deans find so difficult to herd us cats? We teach incentives, but are largely impervious to them • I think it is because of imagination • We revel in, and value, thoughts heretofore not imagined • Thoughts change the world, even without intention to do so • Let us assemble in Chicago in August, to revel in, and share our imaginations • Greg Waymire and his Program Committee is hard at work to make it fun for us all Sunder: Econometrics of Fair Values

31. See You in Chicago!www.som.yale.edu/faculty/sunder Shyam.sunder@yale.edu