compare the two for purposes of valuation
Recent deliberations by both the International Accounting Standards Board (IASB) and the Financial Accounting Standard Board (FASB) in the United States have focused on how fair values of assets and liabilities should be measured. The issue of when, rather than how, fair value measure- ment should be applied is still far from resolved, however. Fair values have been mandated for some assets and liabilities under both IASB and FASB standards, but it is fair to say that principles governing the applicability of fair values have yet to be articulated: when is fair value accounting ap- propriate and when is it not? Or, in terms of my charge for this paper, under what circumstances is fair value a plus or a minus?
To prepare for my task, I made a survey of pub- lic statements made for and against fair value ac- counting by a variety of standard setters, regulators, analysts, and preparers. The stated ‘mi- nuses’ typically point to the dangers of fair value estimates from marking to model rather than mark- ing to market, concerns about introducing ‘excess volatility’ into earnings, and feedback effects (on banks’ lending practices, for example) that could damage a business and, indeed, heighten systemat- ic risk. A few antagonists question whether fair values (for bank assets and liabilities, for example) really capture the economics of a business (in fos- tering core deposits and making loans). In counter- point, the proponents of fair value argue that fair value is a superior economic measure to historical cost. Consider the following arguments, often ad- vanced as ‘pluses’: • Investors are concerned with value, not costs, so
report fair values.
• With the passage of time, historical prices be- come irrelevant in assessing an entity’s current financial position. Prices provide up-to-date in- formation about the value of assets.
• Fair value accounting reports assets and liabili- ties in the way that an economist would look at them; fair values reflect true economic sub- stance.
• Fair value accounting reports economic income: in accordance with the widely accepted Hicksian definition of income as a change in wealth, the change in fair value of net assets on the balance sheet yields income. Fair value accounting is a solution to the accountant’s problem of income measurement, and is to be preferred to the hun- dreds of rules underlying historical cost income.
• Fair value is a market-based measure that is not affected by factors specific to a particular entity; accordingly it represents an unbiased measure- ment that is consistent from period to period and across entities. So self-evident do these points seem to be that
fair value accounting is often just presumed to be ‘more relevant’. The words, ‘fair value’ sound good (who could be against ice-cream and fair value?!) while ‘historical cost’ sounds, well, passé. As it turns, out, however, each of these statements becomes qualified under scrutiny. Can economic argument lead to constructive arguments for im- plementing fair value accounting?
1. Some preliminaries Pluses and minuses can only be evaluated against an alternative, so I will take the approach of asking if (or under what conditions) fair value accounting is an improvement over historical cost accounting. In discussions about fair value, people often pro- ceed at cross-purposes, so a few points need to be clear before we proceed.
1.1. What is fair value? Three notions of fair value accounting enter the
discussion, and one must be clear which is being entertained.
Accounting and Business Research Special Issue: International Accounting Policy Forum. pp. 33-44. 2007 33
Financial reporting quality: is fair value a plus or a minus? Stephen H. Penman*
*The author is at the Graduate School of Business, Columbia University, email@example.com This paper draws on some of the themes in a White Paper prepared for the Center for Excellence in Accounting and Security Analysis (CEASA) at Columbia Business School. See D. Nissim and S. Penman, The Boundaries of Fair Value Accounting, White Paper No. 2 (Center for Excellence in Accounting and Security Analysis, Columbia University, 2007). Comments re- ceived at the Information for Better Markets Conference have been helpful as has a close reading of the manuscript by Martin Walker and Pauline Weetman.
1. Fair value variously applied in a ‘mixed attrib- ute model’: In this treatment, fair value is used alternative- ly with historical cost for the same asset or lia- bility but at different times; the accounting is primarily historical cost accounting, but fair values are applied under certain conditions. Examples are fair values applied in fresh-start accounting (that then proceeds under historical cost accounting), impairment from historical cost to fair value (really a form of fresh-start accounting), using fair values to establish his- torical cost (for barter transactions and dona- tions, for example) or in the allocation of purchase price (between goodwill and tangible assets, for example), and reference to fair value to discipline estimates under historical cost ac- counting.
2. Fair value continually applied as entry value: Assets are revalued at their replacement cost, with current costs then recorded in the income statement, with unrealised (holding) gains and losses also recognised. Revenue recognition and matching is maintained but income, based on current costs, is said to be a better indicator of the future and not path-dependent.
3. Fair value continually applied as exit value: Assets and liabilities are remarked each period to current exit price, with unrealised gains and losses from the remarking recorded as part of (comprehensive) income.
The pluses and minuses of fair value in applica-
tions (1) and (2) can be debated, but note that both are really modified cost accounting; both maintain standard revenue recognition – applying exit prices to recognise value from business activity only on actual exit of the product or service to the market – but with modifications to the expense matching.1 Application 3 applies exit values to continually remark assets and liabilities but with- out actual exit (realisation).
The FASB, in its recent Statement 157, Fair Value Measurements endorses fair value as exit value, with a seeming nod from the IASB subject to some minor reservations:2
‘Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’ While the IASB and FASB presumably envision
exit values being applied to determine fair value in the mixed attribute model (1), I will limit my com- ments to fair value applied in (3).3 It is the recog- nition of exit values without an historical exit transaction that places this fair value accounting in such contrast to historical cost accounting. The top-line notion of revenue disappears, and income is simply the change in fair values on the balance sheet. Accordingly, the accounting issues are quite different. Continually remarking equity invest- ments to fair value rather than using the equity method involves different issues from impairing equity method investments for a permanent loss under mixed attribute accounting. And so with marking inventories, core deposits, bank loans, in- surance contracts, debt, and so on to fair value on a continual basis. ‘Fair value accounting’ as envi- sioned in application (3) is a potential shift in par- adigm.4
1.2. Fair value to whom? As with any policy issue, prescriptions cannot be
made without an understanding of the objectives of the exercise. To whom are we reporting? Whose pluses and whose minuses? Different users may demand different accounting reports, and confu- sion reigns if issues are discussed at cross purpos- es. A shareholder might recognise a gain from a fall in the market value of debt as creditworthiness deteriorates, but not the creditor. Bank sharehold- ers might wish to see bank deposits at fair value, but not the depositors. A bank regulator would also be concerned about reporting deposits at less than face value if such reporting affected depositors’ confidence in the banking system. While an in- vestor might welcome the information about volatility that fair value accounting reveals, not so a central banker who might be concerned about feedback effects on systematic risk. A bank regula- tor might be concerned about marking up banks’
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1 For example, impairment to fair value under application (1) fresh-starts the matching of expenses to future revenues when there is a downward revision in future revenues antici- pated, that is, cost have expired. Application (2) matches cur- rent costs rather than historical costs to (current) revenues. FASB Statement 33 (now suspended) was an experiment with application (2), but those issues are not part of the current de- bate. See Statement of Financial Accounting Standards No. 33, Financial Reporting and Changing Prices (Norwalk, Conn.: FASB, September 1979).
2 See Statement of Financial Accounting Standards No. 157, Fair Value Measurements (Norwalk, Conn.: FASB, September 2006), paras 5–15 and Discussion paper, Fair Value Measurements Part 1: Invitation to Comment (London: IASB, November 2006).
3 Statement 157 is explicit in stating that the standard deals with the measurement of fair value (when fair value measure- ments are applicable), not with the issue of when fair value measurements are applicable. IASB discussion documents have the same flavour. However, the application question is very much open and (presumably) part of the conceptual framework agenda.
4 Under application (3), some assets or liabilities might be carried at fair value (continually) while others are carried at historical cost (continually). So, marketable securities might be marked to market, with inventories at historical cost. This form of a ‘mixed attribute model’ differs from moving be- tween fair value and historical cost for the same asset and lia- bility.
capital during speculative times with the resulting incentive for profligate lending.5
In this talk, I take a shareholder perspective: what are the pluses and minuses of using fair value accounting (rather than historical cost accounting) for reporting to shareholders? This, I submit, is hardly controversial; the shareholders are the own- ers to whom management and auditors report. But it does mean that, if standard setters have a broad- er set of constituents in mind, with an objective of general purpose financial reporting, then they may see the issues differently.
1.3. My approach Normative statements about accounting issues
are often statements of the author’s received wis- dom combined with some a priori thinking: here is what I think about the matter, says the author, sup- ported by some inductive and deductive logic. This approach, applied in the ‘accounting theory’ era of the 1950s to the 1970s, gave us numerous prescrip- tions but little resolution. It would be helpful to refer to concrete research results for answers, but theoretical and empirical research has not delivered a definite resolution either. Recent accounting- based valuation theory has given us some insight to which I will refer later. Empirical research (of the type discussed by Wayne Landsman) documents correlations between fair value measurements and stock prices that are useful for understanding whether fair values are ‘relevant to investors’. But it does not give us much of a handle on the policy question of whether fair values should be reported in place of historical cost accounting (which, re- search shows, is also relevant to investors).6
My approach, I must confess, is largely a priori. But I hope to get some bite by taking what might be referred to as a demand approach. Accounting, as I see it, is a product and products are a matter of design. The design – and the quality of the product – should be judged on how well it serves the cus- tomer. So, with the customer identified as the shareholder (above), I ask which product features – fair value or historical cost – help (or frustrate) the customer. Unfortunately, inferring demand from statements made in the current regulatory en- vironment is difficult, given that regulation affects behaviour. We do observe the voluntary applica- tion of fair value accounting (without the coercion of regulation) in some situations – unregulated hedge funds use fair value accounting, for example – and so we can defer to ‘the market’ for lessons. Such observations are limited, however, so I resort to a priori analysis. But I do so with an eye to the shareholder; I presume that shareholders require accounting information for two purposes: 1. Valuation. Shareholders use accounting infor-
mation to inform them about the (fair) value of the equity: What is the equity worth?
2. Stewardship. Shareholders use accounting in- formation to assess the stewardship of manage- ment, the owners’ employees: How efficient have managers been in making investments and conducting operations to add value for shareholders?
More concretely, I force an orientation to practi- cal tasks for which information is demanded: To what extent does fair value accounting aid or frus- trate the tasks of equity valuation and monitoring managers’ stewardship? This focus, also, is hardly controversial. The first task is that of the equity an- alyst, the second the pursuit of those involved in corporate governance on behalf of shareholders.
In view of the above, many of the points I make below are not particularly original. I want to be a little more analytical than simply listing the stan- dard litany of complaints about and statements in favour of fair value accounting. But, in doing so, some well-worn points come to the surface. By presenting them in a more organised framework, my hope is that they will be more imperative.
1.4. Information for better markets It is often said that financial reporting should have
the objective of providing all relevant information to capital markets. So (it follows), if both historical cost information and fair values are relevant, both should be reported. Nothing here subtracts from that position (if one wants to adopt it). The issue is which measurement basis should go through the discipline of the accounting system to determine the summary, bottom-line numbers, earnings and book value on which investors and analysts focus (for whatever bounded rationality reason). Alternatives to the accounting information (within the system) can, of course, be supplied in footnotes, much like some fair value information is now disclosed.
2. The conceptual merits of fair value accounting versus historical cost accounting As with most accounting issues, it is important to distinguish conceptual issues from those that have
Special Issue: International Accounting Policy Forum. 2007 35
5 Papers that deal with fair value from the view of the cen- tral banker and bank regulator include A. Enria et al., Fair Value and Financial Stability Occasional Paper Series No. 13, European Central Bank, April 2004; G. Plantin, H. Sapra, and H. Shin, ‘Marking to market, liquidity, and financial stability’, Monetary and Economic Studies (Special Edition), October 2005; K. Burkhardt and R. Strausz, ‘The effect of fair vs. book value accounting on banks’, unpublished paper, Free University of Berlin, April 2004; and ‘Fair value accounting for financial instruments: some implications for bank regula- tion’, BIS Working paper No.209, August 2006.
6 Indeed, inferences from the empirical research are limited because stock prices, from which ‘relevance’ is inferred, are de- termined from information under current accounting practices, and those prices might be different under alternative practices.
to do with measurement. Here I ‘conceptualise’ how both fair value accounting and historical cost accounting would satisfy the valuation and stew- ardship goals of shareholder reporting, in principle (if measurement were no problem). I then overlay the concepts with measurement in Section 3.
2.1. The concepts behind fair value accounting Putting aside measurement issues, fair value ac-
counting conveys information about equity value and managements’ stewardship by stating all as- sets and liabilities on the balance sheet as their value to shareholders:7
• the balance sheet becomes the primary vehicle for conveying information to shareholders;
• with all assets and liabilities recorded on the balance sheet at fair value, the book value of eq- uity reports the value of equity (the Price/Book ratio = 1.0);
• the income (profit and loss) statement reports ‘economic income’ because it is simply the change in value over a period;
• following the economic principle that current changes in value do not predict future changes in value, earnings cannot forecast future earnings. But this is of no concern for valuation, because the balance sheet provides the valuation;
• (unexpected) earnings, being a shock to value, reports on the risk of the equity investment. Volatility in earnings is informative for value at risk;
• the P/E ratio is Price/Shock-to-value, that is, a realisation of value at risk (with a very different interpretation to that under historical cost);
• income reports the stewardship of management in adding value for shareholders. In short, the balance sheet satisfies the valuation
objective and the income statement provides infor- mation about risk exposure and management per- formance.
The accounting for investment funds – mutual funds and hedge funds – applies this strict fair value accounting, and investors are willing to trade in and out of these funds at book value (‘net asset value’) with the presumption that book value equals value (with no gains and losses between shareholders). Further, the income (returns) for these funds is accepted as a comprehensive meas- ure of the fund managers’ investment perform- ance, both the investment success and the volatility to which investors have been subjected. The accounting is sufficient; one does not require a balanced scorecard.
2.2. The concepts behind historical cost accounting
Historical cost accounting is often misinterpret- ed in the debate, with the criticism that it reports a balance sheet with old, historical costs rather than current values. This statement is correct, but belies an understanding about how historical cost works for valuation and performance assessment. Under historical cost accounting, • the income statement is the primary vehicle for
conveying information about value to sharehold- ers, not the balance sheet;
• earnings report how well the firm has performed in arbitraging prices in input (supplier) markets and output (customer) markets; that is, historical cost earnings reports the value-added buying in- puts at one price, transforming them according to a business model, and selling them at another price;
• in contrast to fair value accounting, current in- come forecasts future income on which a valua- tion can be made;
• the P/B ratio is typically not equal to 1.0 and the P/E ratio takes current earnings as a base and multiplies it according to the forecast of future earnings;
• earnings do not report shocks to value, but shocks to trading in input and output markets;
• earnings measure the stewardship of manage- ment in arbitraging input and output markets, that is, in adding value in markets. Historical cost accounting views value as gener-
ated in business by purchasing inputs (from suppli- ers), transforming them according to a business plan, and selling the consequent product (to cus- tomers) over cost; in short, value is added by arbi- traging (entry and exit) prices in input and output markets for goods and services according to a business plan. Historical cost accounting does not report the (present) value of expected outcomes from the business plan. Rather, it reports on progress that has been made in executing the plan,
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7 This idea is close to that of ‘value in use’ but with a focus on the shareholder rather than on the entity. The value-in-use concept (or its variant, ‘deprival value’) appears (for example) in Accounting Standards Board, Statement of Principles for Financial Reporting (London: ASB, 1999), Australian Accounting Research Foundation, Accounting Theory Monograph No. 10, Measurement in Financial Accounting (AARF, 1998) and has long been part of the discussion, for ex- ample in J. Horton and R. Macve, ‘ ‘Fair value’ for financial instruments: how erasing theory is leading to unworkable global accounting standards for performance reporting’, Australian Accounting Review 10 (July 2000): 26–39 and R. Macve and G. Serafeim, ‘“Deprival value” vs “fair value” measurement for contract liabilities in resolving the “revenue recognition” conundrum: towards a general solution’. Unpublished paper, London School of Economics, June 2006.
recognising value added (earnings) from actual transactions in the input and output markets being arbitraged. The income statement comes to the fore with a matching of revenues (value received from transactional exit prices) with costs (value surrendered in transactional input prices). The bal- ance sheet is not a statement of values (for the large part), by design, but rather a by-product of this matching, with liabilities such as accrued ex- penses, deferred revenues, and deferred taxes gain- ing their legitimacy from the matching process rather than as representations of the value of obli- gations.
The term, ‘historical cost’ is unfortunately pejo- rative. A better term, one that captures the essence, is ‘historical transactions accounting’, for the ac- counting reports a history of transactions, and it is that history of engaging with markets from which valuations are made and management performance assessed.
3.3. The demand for fair values A demand for fair values could be imputed if
historical cost information is shown to be deficient for valuation and performance evaluation, with fair values providing the remedy. Here I compare the two for purposes of valuation.
To separate concepts from measurement issues, it is helpful t
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