What is “Fair value accounting”?

Asset and liability values are determined on the basis of their fair values (typically market prices) on the measurement date (i.e., approximately the date of the financial statements).

For example, under this model, the reported value of land on the balance sheet would represent its market price on the date of the balance sheet, and the reported value of finished goods inventory would represent its estimated current sales price less any direct costs of selling. Income, under this model, simply represents the net change in the fair values of assets and liabilities during the period.

1. 1. 1. 1.  An Example

A company starts Year 1 raising $100,000 in cash; $50,000 from issuing equity and $50,000 from issuing 6% bonds (at par). This company uses the $100,000 raised to buy a condominium on that day, which it rents out for $12,000 per year. At the end of Year 1, the company still owns the condo, which is valued at $125,000. Also, the market value of the bonds has fallen to $48,000. Now also assume that during Year 2, the company earns rental income of $12,500, the condo is valued at $110,000 at year end, and the market value of the bonds has increased to $50,500. Assume the condo’s useful life is 50 years and its salvage value is $75,000 at the end of that period. Also assume that rental income (interest on bonds) is received (paid) in cash on the last day of the year.

1. 1. 1. 1. Contrasting Historical Cost and Fair Value Models

Our example shows how the balance sheet and income statements evolve over time under the historical cost and the fair value models. We see that there are considerable differences in the financial statements prepared under these models. What causes these differences? What is the underlying logic behind these two models of accounting? We list here some of the fundamental differences between the two models with the objec­tive of answering these questions:

• Transaction versus current valuation. Under historical cost accounting, asset and liability values are largely determined by a business entity’s actual transactions in the past; the valuation need not reflect current economic circumstances. In con­trast, under the fair value model, asset or liability amounts are determined by the most current value using market assumptions; the valuation need not be based on an actual transaction.
• Cost versus market based. Historical cost valuation is primarily determined by the costs incurred by the business, while under the fair value model it is based on market valuation (or market-based assumptions).
• Alternative income approaches. Under the historical cost model, income is de­termined by matching costs to recognized revenues, which have to be realized and earned. Under the fair value model, income is determined merely by the net change in fair value of assets and liabilities

• Income under historical cost accounting is a distinct construct that attempts to measure the current period’s profitability, that is, ability of a business to generate revenues in excess of costs. In our example, we recognized revenue of $12,000 to which we matched the following costs: depreciation $500 (which is Year l’s share of the long-term cost of using the condo) and interest $3,000 (which is Year l’s share of the cost of financing the condo). Under this approach, asset (or liability) balances are often determined by how income is measured; for example, the depreciated value of the condo on the balance sheet is determined by the depreciation expense charged against income.

  Income under the fair value model is not separate from the valuation of the business’s assets and liabilities; it is merely a measure of the net change in the value of assets and liabilities. For example as shown above, Year l’s fair value income of $36,000 is determined by a $9,000 increase in cash, a $25,000 increase in the condo’s fair value and a $2,000 decrease in the fair value of debt. Therefore, one could argue that the income statement is superfluous under the fair value accounting model.

The major advantages of fair value accounting:

• Reflects current information. There is no denying that fair value accounting re­flects current information regarding the value of assets and liabilities on the balance sheet. In contrast, historical cost information can be outdated, giving rise to what may be termed “hidden” assets or liabilities. By reflecting more current information, fair value accounting is argued to be more relevant for decision making.
• Consistent measurement criteria. Another advantage that the standard setters stress is that fair value accounting provides the only conceptually consistent mea­surement criteria for assets and liabilities. At present, financial accounting follows a mish-mash of approaches that is termed the mixed attribute model. For example, fixed assets such as land and building are measured using historical cost, but finan­cial assets such as marketable securities are recorded at current market prices. Even for the same item, inconsistent criteria are used because of conservatism; for ex­ample, inventory is usually valued at cost unless market value drops below cost, in which case it gets measured at market value. Under fair value accounting, it is hoped that all assets and liabilities will be measured using a consistent and con­ceptually appealing criterion.
• Comparability. Because of consistency in the manner in which assets and liabili­ties are measured, it is argued that fair value accounting will improve comparability, that is, the ability to compare financial statements of different firms.
• No conservative bias. Fair value accounting is expected to eliminate the conser­vative bias that currently exists in accounting. Eliminating conservatism is ex­pected to improve reliability because of neutrality that is, reporting information without any bias.
• More useful for equity analysis. One complaint of traditional accounting is that it is largely oriented to provide information useful for credit analysis. For example, the use of conservative historical costs is more designed to provide an estimate of a business’s downside risk than evaluate its upside potential. Many argue that adopting the fair value model will make accounting more useful for equity analysis.

The major disadvantages of fair value accounting:

• Lower objectivity. The major criticism against fair value accounting is that it is less reliable because it often lacks objectivity. This issue is crucially linked to the type of inputs that are used. While nobody can question the objectivity of Level 1 inputs, the same cannot be said about Level 3 inputs. Because Level 3 inputs are unobservable and based on assumptions made by managers, many fear that the ex­tensive use of Level 3 inputs-especially for operating assets and liabilities-will lower the reliability of financial statement information.
• Susceptibility to manipulation. Closely linked to lower objectivity is the con­cern that fair value accounting would considerably increase the ability of managers to manipulate financial statements. Again, this issue is closely linked to the use of Level 3 inputs-it is more difficult to manipulate fair values when Level 1 or Level 2 inputs are used.
• Use of Level 3 inputs. Because Level 3 inputs are less objective, a crucial issue that will determine the reliability of fair value accounting is the extent to which Level 3 inputs will need to be used. The need to use Level 3 inputs is obviously expected to be greater for operating assets and liabilities. If Level 3 inputs are widely used, then many believe that the fair value accounting model will reduce the reliability of the financial statements.
• Lack of conservatism. There are many academics and practitioners who prefer conservative accounting. The two main advantages of conservatism are that (1) it naturally offsets the optimistic bias on the part of management to report higher in­come or higher net assets, and (2) it is important for credit analysis and debt con­tracting because creditors prefer financial statements that highlight downside risk. These supporters of conservative accounting are alarmed that adopting the fair value model-which purports to be unbiased-wili cause financial statements to be prepared aggressively, therefore reducing its usefulness to creditors, who are one of the most important set of users of financial information.

Excessive income volatility. One of the most serious concerns from adopting the fair value model is that of excessive income volatility. As we noted earlier, under the fair value accounting model income is simply the net change in value of assets and liabilities. Because assets (or liabilities) are typically large in relation to income and because fair values can change significantly across time, changes in fair values of assets can cause reported income to become excessively volatile. Much of this volatility is attributable to swings in the fair value of assets and liabilities rather than changes in the underlying profitability of the business’s operations, so it is feared that income will become less useful for analysis. Standard setters are aware of this problem and have embarked on a project for changing financial statement presentation, which will consider also reporting intermediate income measures that reflect the firms operations.