1. Fair Value of Investments
Prepared for: Prof. Shimin Chen
102 Financial Accounting
Prepared by: Group 1, Section 1 (Term 1)
081153 081125 081112
081083 081032 081026
Submitted Date: November 14, 2008
This is to certify that this work is entirely and exclusively my/our own, except for those
cited and noted.
Team Number: Group 1
China Europe International Business School
1

2. Executive Summary – An Introduction
With the adoption of IFRS (International Financial Reporting Standards), companies are required
to measure some assets, liabilities, and equity at fair value. However, methods for calculating
fair value has only been incorporated by the IASB (International Accounting Standards Board),
the governing body of IFRS, on a piecemeal basis over many years, mainly in terms of what
various particular situations called for over time1.
Furthermore:
“As a result, guidance on measuring fair value is dispersed across many IFRSs and it is not
always consistent. Furthermore, the current guidance is incomplete, in that it provides neither a
clear measurement objective nor a robust measurement framework. The Board believes that this
adds unnecessary complexity to IFRSs and contributes to diversity in practice2.”
The IASB itself is still in the process of addressing this issue, and a concrete plan is expected to
be in place by 2010. The IASB’s objectives are3:
a) “to establish a single source of guidance for all fair value measurements required or
permitted by existing IFRSs to reduce complexity and improve consistency in their
application;
b) “to clarify the definition of fair value and related guidance to communicate the
measurement objective more clearly; and
c) “to enhance disclosures about fair value to enable users of financial statements to assess
the extent to which fair value is used to measure assets and liabilities and to provide them
with information about the inputs used to derive those fair values.”
IFRS & US GAAP
We delimit our scope to the fair valuation of investments. For US companies complying with
US GAAP, guidance on the fair valuation of investments is provided under FAS 157 “Fair Value
Measurements” (October 2006). For many companies in the rest of the world that comply with
IFRS, the relevant provision is found in IAS 39 “Financial Instruments: Recognition and
Measurement.”
1
http://www.iasb.org/Current+Projects/IASB+Projects/Fair+Value+Measurement/Fair+Value+Measurement.htm.
Accessed October 9, 2008.
2
Ibid.
3
Ibid.
2

3. We acknowledge that there has thus far been no concrete implementation to align IFRS and US
GAAP, but indications point toward the US adopting the former. As a matter of fact, the IASB
and FASB (Financial Accounting Standards Board, USA) have already begun a convergence
process to make their respective standards compatible, as pledged under the “Norwalk
Agreement” which occurred as early as 2002 4 . Furthermore, the US SEC has charted a
roadmap that allows foreign companies that list on US exchanges to report exclusively in IFRS
by 20095.
Key Tackling Points
Tabulated in the following are key provisions in IAS 39 and FAS 157 most applicable to this
research:
Accounting Regulation IFRS (IASB) US GAAP (FASB)
Guidance Principle/Rule IAS 39 FAS 157
Key Provisions  Financial Assets and Financial Liabilities  The fair value of assets and liabilities reflects
(investments) shall be held in the balance sheet at current market observations7.
fair value, i.e. market price (trading price
between counterparties) plus transaction costs6.
Fair Value Hierarchy  Market price  Level 1 – Observable market prices
 Where a market price is unavailable, the  Level 2 – Observable inputs that are not
valuation should be consistent with market generated from active markets but consistent with
practices in valuing that security, and/or fair market expectations.
value is based on the best information to value  Level 3 – Unobservable inputs that should be
the security consistent with market expectations8. consistent with market expectations9.
4
http://www.journalofaccountancy.com/Issues/2007/Jun/IfrsComingToAmerica.htm. Accessed November 12,
2008.
5
Ibid.
6
IAS 39 Financial Instruments: Recognition and Measurement, IASB.
file:///Users/Alex/Documents/AFF/CEIBS/102%20-%20Financial%20Accounting/Project/IASB%20-%20IAS%203
9.pdf. Accessed November 13, 2008.
7
Summary of Statement No. 157, Fair Value Measurements, FASB.
http://www.fasb.org/st/summary/stsum157.shtml. Accessed November 13, 2008.
8
“Revised Fair Value Hierarchy,” Information for Observers, IASB, 25 May 2006, London.
http://www.iasb.org/NR/rdonlyres/BB4CADFA-FC30-412F-B7B7-383E583AF256/0/ObNotes_FVM_0605ob08b.p
df.
9
Ibid.
3

4. The Problem
Building from the previous section, the problem arises when unobservable inputs need to be used
to derive fair value consistent with market expectations. In effect, existing accounting policies
and regulations allow companies to engage in subjective reasoning and internal valuation
techniques – among others – yet still be compliant with fair value regulations.
To test our position, we analyze financial institutions that actively invest in the financial markets.
We attempt to find the difficulties in which current accounting rules allow companies to measure
their investments at fair value.
Financial Institutions – Active Investors in Financial Markets
Specifically, we want to research the above issue in light of the growing significance of hedge
funds (with around USD 1.7 trillion in assets under management as at 200810) vis-à-vis the
financial crisis of 2008, triggered by falling home prices and mortgage defaults in the US,
particularly in the subprime segment.
CDO Anatomy
Collateralized Debt Obligations (CDO) played a key role in the unraveling of the financial crisis.
As a brief background, CDOs are a type of asset-backed security and structured credit product,
constructed by pooling together fixed-income and credit assets, then dividing or “slicing” them
into tranches tiered on the basis of credit rating. Normally, tranches are: Senior (AAA),
Mezzanine (AA to BB), and Equity (unrated, i.e. the riskiest tranche)11.
There are four primary roles in the construction of CDOs12:
 The Asset Manager is responsible for pooling together the collateralized assets, e.g.
mortgages, etc., in a process called “warehousing.” To acquire these collateralized assets,
the Asset Manager is usually provided financing by an investment bank.
 The Investment Bank acts as the underwriter of the CDO. The Investment Bank works
with the asset manager in providing financing to acquire the assets to be collateralized, and
sometimes, also works alongside the asset manager in determining which assets to pool
together. The Investment Bank also tiers the CDO into its senior, junior, and equity
10
“Hedge Funds Lost $100 Billion on Investor Withdrawals;” Yamazaki, Tomoko; Bloomberg News; November
13, 2008.
11
http://en.wikipedia.org/wiki/Collateralized_debt_obligation. Accessed November 13, 2008.
12
Ibid.
4

5. tranches (“slicing”). Subsequently, the Investment Bank works with credit rating agencies
to determine the credit risk of each tranche. Finally, the Investment Bank sells the CDOs to
investors.
 Credit Rating Agencies, such as S&P and Moody’s, conduct stress testing and sensitivity
analyses on CDOs architectured by the investment banks. This allows them to apply ratings
on the CDOs, which are a key consideration in CDO pricing13.
 The Investors in CDOs are normally hedge funds and banks. CDOs are an attractive
investment because they offer higher returns than more conventional fixed-income securities
(e.g. corporate bonds) of the same credit rating.
Real-World Observation
CDOs are a key basis for our research as they are not priced by an open market, and are thereby
difficult to price, often being recorded at par value14. Many investor-firms (banks, hedge funds)
that suffered considerable writedowns and credit losses were active players in the CDO market.
As there were rising delinquencies in the underlying assets of the CDOs (e.g. mortgage defaults),
investors incurred large losses on the deterioration in value of the CDOs. What were once held
at par value were recorded as losses and written-off.
In the following, we tabulated key information that allows us to conduct side-by-side analysis on
the firms we chose to analyze in this research, their respective accounting treatment of fair value,
and corresponding credit-related losses.
13
“ ‘ Race to Bottom’ at Moody’s, S&P Secured Subprime’s Boom, Bust;” Smith, Elliot Blair; Bloomberg News;
September 25, 2008.
14
Ibid.
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6. Firm Man Group plc The Blackstone Group Citigroup Goldman Sachs Bear Stearns Bank of China
Institution Type Hedge Fund Manager Private Equity, Financial Advisory Universal Bank Securities Firm, applied for Securities Firm, sold to JPMorgan Commercial Bank
commercial bank status in 2008 in 1Q08
Hedge Fund Business Various Proprietary, Fund of Funds Alternative Investments Proprietary (Global Alpha) Bear Stearns Asset Management NA
Auditor PwC Deloitte KPMG PwC Deloitte PwC
Fiscal Year End 31 March 31 December 31 December 30 November 30 November 31 December
Compliance IFRS US GAAP US GAAP US GAAP US GAAP IFRS
Fair Value Provision IAS 39 FAS 157 FAS 157 FAS 157 FAS 157 IAS 39
Subprime/Mortgage/CDO None specifically disclosed. None specifically disclosed. As at 31DEC07, USD 29.3 billion As of NOV07, USD2.11 billion (of Securitized USD 113 billion of As at 31DEC07, USD4.99 billion
Valuations However, PEMBA Credit Advisers, net exposure in CDOs. which USD 507 million are Level CDOs by 2006. Completed (2.13% of investment securities), of
manager of Man Group plc’s credit 3), including USD 316 million in acquisition of Encore Credit which: 71% (AAA), 26% (AA), 1%
portfolio, issued CDOs of EUR 300 CDOs backed by subprime Corporation in early-07 that would (A), of which all are ABS. Group
to 558 million in 2008. PEMBA mortgages. generate USD 1 billion in subprime unloaded all US subprime related
has structured 6 CDOs since 2002. loans per month. USD 43 billion CDOs by end-2007.
of mortgages, mortgage- and
asset-backed securities held in
proprietary trading inventories as at
30NOV06.
Writedowns and Unknown Unknown USD 55.1 billion USD 3.8 billion USD 3.2 billion. Two hedge USD 2 billion
Credit-related Losses as funds suffered USD 1.5 billion in
15
at Aug. 12, 2008 losses during 2-3Q07.
16
52W Share price DOWN 69% DOWN 69% DOWN 71% DOWN 69% NA DOWN 59%
Source: Respective company reports.
15
Banks' Subprime Losses Top $500 Billion on Writedowns (Update1), Yalman Onaran, Bloomberg News, August 12, 2008.
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a8sW0n1Cs1tY. Accessed November 13, 2008.
16
Google Finance. http://finance.google.com/.
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7. Valuation Difficulty
As part of our investigative efforts, we were able to interview a former auditor of KPMG.
To protect the person’s identity (henceforth referred to as “our Source”), we will not
disclose the person’s name when citing our reference17.
Our Source audited a Hong Kong subsidiary of Citigroup, which served as a legal entity
vehicle for booking Citigroup investments. It contained mortgage-backed securities
(MBS). For the MBS that were sold, their selling price was recorded as their fair value.
For MBS that the subsidiary were still holding, their prices were quoted by Citigroup’s
traders in London. KPMG recognized the difficulty in these valuations, and they were
able to correspond with Citigroup’s CFO in London. The quotes provided by the traders
were reiterated. As shown above, Citigroup’s total losses on subprime mortgages and
credit-related securities are over USD 55 billion as at August 12, 2008.
We also look deeper into Bear Stearns. Two of its hedge funds that had large exposure
to subprime mortgages failed in 2-3Q08 and racked up around USD 1.5 billion in losses,
as shown above. The valuations of around 60% of the hedge funds’ net worth were
provided by the hedge fund manager and his team. In fact, Bear Stearns’ auditor,
Deloitte & Touche, warned of such valuations in their 2006 report released in May
200718.
Conclusion – A Call to Action
With the advent of today’s financial crisis, financial market participants find it
increasingly difficult to fairly value their portfolios. Information needed to make fair
valuations have become scarce, leading participants to resort to alternative techniques
such as internal valuation models, etc.19.
The leading auditors are engaged in extensive discussions to resolve the issue, but
nothing specific is yet in place: Ernst & Young20, PricewaterhouseCoopers21, KPMG22,
and Deloitte & Touche23.
17
KPMG Auditor. Email correspondence, November 2008.
18
“Bear Stearn’s Bad Bet;” Goldstein, Matthew; Henry, David; BusinessWeek; October 11, 2007.
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a8sW0n1Cs1tY. Accessed November
2008.
19
Fair Value Pricing: 2008 Survey Results. Deloitte.
20
Global Hedge Fund Survey 2007: Navigating New Complexities. Ernst & Young, in cooperate with
Ipsos MORI.
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8. We believe that firm resolve and concrete action needs to be taken by the authorities and
governing bodies of accounting standards. With the convergence of accounting
standards toward IFRS, the results of the IASB’s plan to enhance the fair value
framework by 2010 are key in stabilizing the financial markets and restoring investor
confidence.
21
Fair value measurements: Make your views count. PricewaterhouseCoopers, April 2007.
22
Defining Issues. KPMG, March 2008.
23
Ibid.
8