“Fair” Values Shyam Sunder Yale University AAA Doctoral Consortium Lake Tahoe June 13-17, 2007

Sunder: Econometrics of Fair Values 2 An Overview Language of Debate: Labels Matter Transforming a qualitative debate into a quantitative debate –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 Base social policy on falsifiable propositions, not opinions –Researchers can add value to social policy through evidence on falsifiable propositions (beyond mere opinions)

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 Econometrics of Valuation Consider two sources of error in valuation of a bundle of resources –Values change over time but the valuation rule ignores or deals imperfectly with 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 6 Behavior of Price Movement Error with Respect to Aggregation

Sunder: Econometrics of Fair Values 7 Behavior of Price Measurement Error with Respect to Aggregation

Sunder: Econometrics of Fair Values 8 Behavior of Total (Valuation) Error with Respect to Aggregation

Sunder: Econometrics of Fair Values 9 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 10 Bottom Line This theory suggests that which valuation rule has min (MSE) is a matter of econometrics, not theory or principle (depends of relative magnitude of parameters of the economy). Any policy presumption that the current values yield more accurate valuation in general is not borne out by analysis.

Sunder: Econometrics of Fair Values 11 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

Sunder: Econometrics of Fair Values 12 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)