Dr. Tom Linsmeier, a member of the Financial Accounting Standards Board and formerly the Russell E. Palmer Endowed Professor and Chairperson of the Department of Accounting and Information Systems at the Eli Broad College of Business, presented a seminar to students and faculty last Friday at the Broad College on “Economics, Politics and Accounting Standard Setting in the Midst of the Global Financial Crisis.”
Dr. Linsmeier addressed the need for a major financial policy response with regard to the current global financial crisis. He said that there is need to alter the way financial instruments are accounted for in financial statements in order to reveal potential losses before they actually occur.
“If we look at the 140 banks that failed in 2009, all of them, if you walk into time before their failure, 12 months, nine months, six months, before were all well capitalized,” he said. “By three months before their failure, some were well capitalized, some were not, but then it was too late to do anything about it.”
This suggests that the mixed attribute model, which allows some financial instruments to be reported at amortized cost and some at fair value, currently used by most banks does not adequately reflect the financial health of banks, according to Dr. Linsmeier. He also said that the difference between the interest rates on interbank loans and the short-term U.S. government debt spiked in the summer of 2007, an indicator that banks had already recognized credit risk problems in the interbank interest rates far earlier than they recognized the problem in their accounting.
“If the existing indicator is doing such a poor job, why shouldn’t we give some other indicator – the fair value of assets- a chance to provide information about what those assets are worth?” he asked.
The former professor lauded the potential usefulness of fair value measures of financial instruments as a means of providing timely information regarding the unrealized gains and losses of financial institutions. Unlike the amortized cost model, which invariably suppresses the timely reporting of some or all unrealized gains and losses, the fair value model is a more transparent approach.
“Some assert that fair value can be too high in good economic times when markets can become irrationally exuberant; this is an issue but as long as lower cost information is provided investors and the public can use both pieces of information to make their own evaluations of whether market prices are overvalued and to take actions consistent with their beliefs” he said. He also said that investors want as much credible and timely information about the health of financial institutions as possible.
Dr. Linsmeier compared the current financial crisis to the Japanese banking crisis in the 1990s. Just a few years before its collapse, the Japanese financial market was characterized by above-trend economic growth, near-zero inflation and the relaxation of restrictions on permissible activities of previously tightly segregated institutions, including the raising of different types of lending ceilings.
“Japan was projected to be a better economy than the U.S., but they have not returned to a healthy financial state since then,” Dr. Linsmeier said.
The fair value approach is not without its shortcomings. Some parties have blamed the failure of the banking system on the use of fair value and not bad loans, according Dr. Linsmeier. The critics of the fair value approach argue that the firms reporting unrealized losses under fair value accounting may experience adverse feedback effects that cause further deterioration of market prices and increase the overall risk of the financial system.
In his presentation, Dr. Linsmeier proposed the comprehensive adaptation of the fair value model along with full disclosures of amortized costs.
“My job is a job of change management within the constraints of the government regulations,” he said. “I think we will be better off in the long term using the fair value model but the hardest part of my job is to manage change and convince people to adopt this model.”
Dr. Linsmeier’s seminar presentation was the second in a series of interdisciplinary research seminars on international business topics, sponsored by the International Business Center (MSU-CIBER) and supported by the Broad School.
“The purpose of this series is to provide a state-of-the-art dialogue with prominent international business scholars doing cutting-edge research in positions which set the agenda for international business research,” said Tomas Hult, director of MSU-CIBER. “The idea is that these speakers will be unique resources, providing unique value and cutting across the boundaries of the Broad School’s departments and units.”
Dr. Linsmeier has served as chairperson of the Financial Accounting Standards Committee and president of the Financial Accounting and Reporting section of the American Accounting Association. He is a member of the American Institute of Certified Public Accountants and his work has been published in The Accounting Review, Journal of Accounting Research, Accounting Horizons, Management Science, Journal of Accounting Auditing, and Finance, Journal of Business, Finance and Accounting and Financial Analysts Journal.
By Emma Ogutu