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Is Fair-Value Accounting Fairer?

Sep 29, 2014 | Budget Process

Few topics elicit more yawns than a deep dive into accounting standards. Yet, there may be good reasons to grab a cup of coffee and pay attention to the way our government does its bookkeeping. As a National Affairs article by Jason Delisle and Jason Richwine and a Congressional Budget Office (CBO) report on federal mortgage guarantees remind us, accounting methods can make a big difference for budget projections.

According to the official method for evaluating credit programs spelled out in the Federal Credit Reform Act (FCRA) of 1990, the federal government earns healthy profits from its federal student loan portfolio and the single-family loan guarantee program, to the tune of $184 billion and $63 billion respectively. But as we have explained before, there are different methods to evaluate the budgetary impact of federal programs. Using a different accounting method, known as fair-value accounting, CBO projects that these programs could actually cost the government $95 billion and $2 billion respectively. (Click here to read more about fair-value accounting.)

What accounts for the large difference in these estimates?

It boils down to assumptions about market risk.

For most programs, the federal government accounts for cash in and cash out every year. However, FCRA requires the federal government to record the long-term budgetary cost of credit programs upfront. This means that, on the year the program is enacted, the budget must reflect all future outlays and revenues from each loan or guarantee.

Both the FCRA and the fair-value standards account for the declining value of money and for the risk that investments will turn out worse than expected – for instance, the possibility that anyone receiving a federal loan or guarantee may default – by evaluating different scenarios and the probability they will occur. However, the official (FCRA) method does not put a price to taking risks in the same way the private sector does. As Delisle and Richwine explain:

In finance, uncertain amounts are worth less than certain amounts, owing to the risk aversion of most individuals. Imagine a game in which a coin is flipped one time to determine a player's winnings. "Heads" results in a $100 payoff, whereas "tails" gives the player nothing. Although the potential payoff for this game is $100 and the average payoff is $50, few people would elect to play the game if they were offered the option of just taking a certain $50, or even $45. People tend to prefer certainty even when the certain option pays less than the average value of a risky alternative. The same principle explains why people invest in bonds rather than stocks much of the time — bonds are safer, even though they have a lower rate of return.

Using the official method in FCRA, a certain outcome is worth the same as an uncertain one. Fair value, on the other hand, tries to price that uncertainty by putting a "risk premium" on higher-risk assets, thus reflecting the intangible cost of uncertainty.

Why Does It Matter?

In some sense, whether we use fair value or FCRA to make budget projections is an academic exercise. Although deficit projections would be slightly worse under fair value, either way they are projected to grow unsustainably.

But as Delisle and Richwine explain, using FCRA can have real policy implications by creating an incentive among policymakers to put the government's finances at more risk than they intend.

As one example, FCRA accounting would allow the federal government to leverage government debt to buy risky stocks and bonds (even somewhat troubled assets) and then score this as deficit reducing – these funds are sometimes even used to pay for more spending. This happens despite the fact that the higher returns stocks offer comes in exchange for higher volatility and risk. (To avoid this, the TARP program used fair-value estimates.)

Official accounting methods may also help justify new or expanded credit programs which on average are self-financing but riskier, instead of grant programs or other safer alternatives.

On the other hand, opponents of fair-value point out that this method does not match the most likely budgetary implications of certain programs and argue it would therefore make it much harder to understand and compare what is happening in the budget. In addition, they argue that the federal government can bear risk better than the private sector, and therefore does not face the same "risk premium" as in the private sector.

Regardless of your view, the Delisle and Richwine piece is certainly worth a read. This seemingly dry debate over accounting methods has important consequences for the federal budget. That’s why it demands our attention and perhaps a second cup of coffee.