Timeliness of impairments during the 2007-2009 financial crisis and fair-value accounting
The financial crisis of 2007-2009 adversely impacted the solvency of US financial system and raised questions on the role of accounting approaches. To date, the debate has centered on whether the use of fair value accounting information by users of financial reports yielded significant adverse feedback effects that exacerbated the crisis. For example, recognition of the marked-down value of illiquid securities such as mortgage-backed securities (MBS), raised solvency issues for several financial institutions. Fair value accounting (also known as “Mark-to-Market” accounting) in layman terms entails recognition of an asset at its observable market value or the present value of its future projected cash flows. However, one aspect of fair value accounting that not received as much attention is that in cases where timely and accurate fair values are not directly observed, in order to accurately and reliably measure fair values the reporting firm must invest in information systems and control systems. This could be beneficial to the financial system.
The insurance industry provides a natural setting to investigate the impact of recurring fair value versus amortized cost measurement on the timeliness of insurers’ non-temporary (i.e. other-than-temporary) impairments on their non-agency residential mortgage-backed securities (NAMBS) around the 2007–2009 financial crisis. Unlike largely predetermined amortized cost measurement, recurring fair value measurement requires firms to invest in information and control systems that may discipline impairments. Exploiting statutory accounting requirements that PC (life) insurers measure most non-investment grade securities at fair value (amortized cost) and disclose security-level accounting information, we predict and find that PC insurers record timelier impairments of the same NAMBS than life insurers. This finding is important because timelier loss recognition enhances financial institutions’ internal, market, and regulatory discipline, thereby reducing the procyclicality of their investment and financing decisions.
Urooj Khan, Stephen G. Ryan, and Abhishek Varma. “Fair Value versus Amortized Cost Measurement and the Timeliness of Other-than-Temporary Impairments: Evidence from the Insurance Industry” The Accounting Review (2019), Forthcoming.
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Dr. Abhishek Varma is an Associate Professor of Finance at Illinois State University. His research interests span the areas of investments, investor behavior, corporate governance and financial institutions. Dr. Varma’s publications have appeared or are forthcoming in several reputed journals including The Accounting Review, Journal of Corporate Finance, Financial Management, Journal of Banking and Finance, and Journal of Financial Services Research. His research has also been cited in the Wall Street Journal and has been abstracted in the CFA Digest.
Dr. Varma received his Ph.D. in Finance and M.S. in Statistics degrees from Washington State University in 2009. Prior to that he worked in the Premier Banking division of Hongkong and Shanghai Banking Corporation (HSBC). Dr. Varma obtained his Bachelor of Commerce (Honors) degree from University of Delhi, India.