Fair Value Accounting

Table of ContentsFair Value Accounting Overview..................................................................................................................3

Stock Market Crash of 1929........................................................................................................................4

Statements of Financial Accounting Concepts.............................................................................................5

Collapse of Enron.........................................................................................................................................7

FASB on Fair Value Measurement...............................................................................................................9

Relevance vs Reliance................................................................................................................................11

Advantages and Disadvantages.................................................................................................................12

Impact.......................................................................................................................................................14

References.................................................................................................................................................15

Fair Value Accounting Overview

According to the latest pronouncement on fair value accounting, FAS 157, “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.” (FASB, 2006) This standard

explicitly states fair value as an exit price and indicates that the selling price controls the

expectations of the future benefits associated with assets and liabilities. Not all assets and

liabilities are required to be measured at fair value. Those that are under the new standard

include “investments in equity securities for which fair value is readily determinable,

investments in debt securities classified as held-for-trading or available-for-sale, direct

investments in loans held-for-sale, and derivative assets and liabilities.” (Rock Lefebvre, 2009)

Asset impairment is also tested using fair value measurement.

The first guidance on fair value accounting was introduced by the Financial Accounting

Standards Board (FASB) in 1975 requiring marketable securities to be recorded at fair value.

Although the first standard on fair value wasn’t until 1975, it has been a part of U.S. GAAP for

well over 50 years and similar terms can even be found on financial statements as early as

1925. Over the years, the original standard has been amended and extended a number of

times. The amendments were “shifting the focus on marketable securities to disclosing financial

instruments in a company’s financial statements, to valuing debt and equity securities that are

held for trading or sale, to requiring the changes in fair value to be recognized in the income

statement or other comprehensive income, and to the requirement of derivatives to be

measured at fair value.” (Rock Lefebvre, 2009)

Stock Market Crash of 1929

“From 1925 to the third quarter of 1929, common stocks increased in value by 120 percent in

four years. The decade of the 1920s was extremely prosperous and the stock market with its

rising prices reflected this prosperity as well as the expectation that the prosperity would

continue. The 1929 stock market crash is conventionally said to have occurred on Thursday the

24th and Tuesday the 29th of October. These two dates have been dubbed “Black Thursday”

and “Black Tuesday,” respectively.” (Harold Bierman, 2008) By the time the stock market crash

was finished in 1932, stocks had lost almost 90 of their worth.

A common practice in the 1920s included the act of “buying on margin”. “Buying stocks on

margin means that the buyer would put down some of his own money, but the rest he would

borrow from a broker. In the 1920s, the buyer only had to put down 10 to 20 percent of his

own money and thus borrowed 80 to 90 percent of the cost of the stock. Buying on margin

could be very risky. If the price of stock fell lower than the loan amount, the broker would likely

issue a "margin call," which means that the buyer must come up with the cash to pay back his

loan immediately.” (Rosenberg) It was because of the belief that the stock market prices would

be ever-rising that speculators neglected to heed the risks. The ability to buy on margin most

likely helped to inflate stock prices and also to worsen the stock market decline.

At the time, savings were not insured by the federal government and banking regulation did not

exist. When the stock market started to fall and banks began issuing “margin calls”, speculators

rushed to the banks to clean out their savings. When investors did not have the cash to pay for

the loan, banks started selling off the stocks which sent the market into a downward spiral.

Banks and investors were overly confident of their current financial position in the 1920s and

led to aggressive accounting practices in the use of fair value accounting for their stock assets.

Many banks did not have the ability to pay their members because they accounted for margin

calls at fair value, which at the time was at an over-inflated stock value. The aftermath of this

crisis resulted in the closure of 10,000 banks, half of all banks either merged or closed during

this period. “Fair value accounting was blamed for some dubious practices in the period leading

up to the Wall Street crash of 1929, and was virtually banned by the U.S. Securities and

Exchange Commission from the 1930s through 1970s.” (Ramanna, 2013)

Statements of Financial Accounting Concepts

In the 1980’s, the FASB issued two separate concept statements that relate to fair value accounting.

While concept statements are not a part of U.S. Generally Accepted Accounting Principles (U.S. GAAP),

they are used by the FASB to guide them in “developing sound accounting principles and provide [them]

and its constituents with an understanding of the appropriate content and inherent limitations of

financial reporting” (FASB, 1980).

The first relevant statement was issued in 1980 as Concept Statement no. 2, which covered

“Qualitative Characteristics of Accounting Information”. The main premise of Concept

Statement no. 2 was to explain what characteristics make accounting information useful for

anyone that may prepare, audit, and/or use the information from financial reports. While the

concept of fair value accounting is not actually mentioned in the statement, the specific

qualities financial statement information should have in order to be useful can be applied.

When there is a choice of how to present financial information, judgement should be used to

determine which presentation will be more useful for the users.

The primary qualities that make accounting information useful for decision making are

relevance and reliability. To be relevant, financial information should allow users to make

predictions on possible future outcomes based on prior or current data. On the other hand,

reliable financial information is also required, as without reliable information, users cannot

depend on financial reporting to faithfully represent accurate information. While fair value

accounting allows for more relevant financial information, historical cost is much more reliable

(Ramanna, 2013). These differences are explored in more detail below.

FASB Concept Statement no. 5 on “Recognition and Measurement in Financial Statements of

Business Enterprises” was issued at the end of 1984. SFAC no. 5 states that an item should be

recognized and reported in the financial statements when it meets the definition of a financial

statement element, can be measured with sufficient reliability, is capable of making a

difference in a user’s decisions, and can be representationally faithful, verifiable, and neutral

(FASB, 1984). The financial statement item measurement attributes that the FASB identified are

shown below. While the example shown for each attribute is specific towards assets, the

opposite is true for a liability.

Historical Cost - The amount initially paid to acquire an asset.

Current Cost - AKA Replacement Cost or the amount to be paid to acquire the same

asset today.

Current Market Value - AKA Fair Value or the amount of cash potentially acquired if the

asset was liquidated today.

Net Realizable Value - AKA Settlement Value or the undiscounted cash the asset is

expected to bring in over it’s life minus any direct costs.

Present Value of Future Cash Flows - The present value of future cash inflows that an

asset is expected to bring in less any discounted outflows expected to be required.

While many items may all initially be recognized with the same attribute, such as historical cost,

the FASB recognized that not all financial statement items can be measured and reported with

the same methods or attributes as certain attributes are a better reflection of the item over

time (FASB, 1984).

Collapse of Enron

Enron is often looked at as the poster child for the abuse of fair value (mark-to-market)

accounting. Enron was an energy derivatives broker who through their external auditors gained

the right to use mark-to-market accounting on their financial statements. This accounting

allowed Enron to adjust their outstanding derivatives contracts to market value and book the

unrealized gains and losses to their income statements. It was because of the complexity and

difficulty of applying these rules to long-term futures contracts and the ability of Enron to

influence energy prices of commodities that Enron was able to develop valuation models based

on their own assumptions. The article The Rise and Fall of Enron, from the journal of

accountancy states, “For a company such as Enron, under continuous pressure to beat earnings

estimates, it is possible that valuation estimates might have considerably overstated earnings.

Furthermore, unrealized trading gains accounted for slightly more than half of the company’s

$1.41 billion reported pre-tax profit for 2000 and about one-third of its reported pre-tax profit

for 1999.” (Thomas, 2002) Enron used its ability to influence energy markets to artificially

inflate the market value of their derivatives and along with aggressive accounting estimates

were able to book unrealizable expected future gains on their income statements. This practice

along with Enron’s use of special purpose entities which kept liabilities off the books led to

unrealistic view of the company’s financial position. An eventual SEC investigation looked into

related party transactions and Enron restated their financials back 4 years with special purpose

entity consolidation and recommended adjustments from Arthur Anderson over that time

frame. “This restatement resulted in another $591 million in losses over the four years as well

as an additional $628 million in liabilities as of the end of 2000. The equity markets immediately

reacted to the restatement, driving the stock price to less than $10 a share. One analyst’s

report stated the company had burned through $5 billion in cash in 50 days.” (Thomas, 2002)

Enron’s abusive use of mark-to-market accounting was the main reason for their inflated

income and contributed to their bankruptcy.

FASB on Fair Value Measurement

In the fourth quarter of 2006, the FASB released their Statement of Financial Accounting

Standards no. 157 on “Fair Value Measurements”, which “defines fair value, establishes a

framework for measuring fair value in generally accepted accounting principles (GAAP), and

expands disclosures about fair value measurements” (FASB, 2006). The FASB released this

statement because of the confusion over the previously limited GAAP guidance on fair value.

While GAAP did address fair value accounting, the principles were divided up within various

other standards. By addressing these issues, the FASB also was able to add consistency to how

fair value was measured as well as expand the required disclosures on how the measurement

were obtained.

This new statement defines fair value, as put simply, the “exit price”, which was consistent with

prior definitions. However, FAS no. 157 also added two new areas to the definition which clarify

the specific market to be used to determine an item’s fair value. First, FAS no. 157 requires that

the fair market measurement be taken from the principal market, unless it is unavailable, at

which point management can use the most advantageous market. The principal market is

defined as being “the market in which the reporting entity would sell the asset or transfer the

liability with the greatest volume and level of activity for the asset/liability” while the most

advantageous market is the market in which the reporting entity would sell the asset or

transfer the liability with the price that maximizes the amount that would be received for the

asset or minimize the amount that would be paid to transfer the liability, while considering

transaction costs” (FASB, 2006). Second, FASB requires that the asset or liability is being valued

at it’s highest and best use, or in other words, in a way or classification that would maximize its

worth.

FAS no. 157 changed fair value measurement in that it established a fair value measurement

framework in order to increase the comparability of fair value between companies and

decrease the risk investors faced when relying on their measurement. The framework creates a

hierarchy of types of fair value measurements based on how easily the information is able to be

independently verified and it’s reliability. The framework is based on the inputs, or risk

assumptions, that management uses in their valuation of fair value items. Inputs can be either

observable or unobservable based on if their market sources are external or internal,

respectively.

The highest section of the fair value measurement hierarchy is Level 1, where unadjusted

quoted prices from active markets for identical assets or liabilities are used to determine an

item’s fair value measurement. To use Level 1 inputs, management must have the ability to

access the quoted prices at the measurement data in an active market. Next, Level 2 inputs are

those inputs that are also observable, either directly or indirectly, for the asset or liability, other

than a quoted price for an identical asset/liability in an active market. Examples of Level 2

inputs include but are not limited to the quoted prices for similar assets/liabilities (rather than

identical), or quoted prices for identical assets/liabilities in a non active market.

Finally, a Level 3 input is an unobservable input. Simply put, a Level 3 input is where there is not

a lot of markets or activity for a particular asset or liability at the measurement date. Instead,

unobservable inputs are used where management uses their own assumptions about the

market and asset/liability to determine the item’s fair market valuation. Level 3 valuations carry

the highest risk for investors. In order to address the elevated risks, FAS no. 157 requires

several additional disclosures about how the fair value was determined, including a

reconciliation of the item’s beginning balance to ending balanced over the period.

In 2010, the FASB issued Accounting Standards Codification Topic 820 on “Fair Value

Measurement”. It was quickly amended in 2011, when the International Accounting Standards

Board (IASB) was about to issue a standard of fair value accounting and agreed to work with the

FASB to reach a higher level of consistency for better transparency and comparability between

the two generally accepted accounting principle frameworks as a part of their overall

agreement to develop common standards between the two.

Relevance vs Reliance

The debate of fair value accounting primarily revolves around relevance and reliability.

Relevance is defined in the glossary of the FASB Statement of Financial Accounting Concepts

No.2 as the capacity of information to make a difference in a decision by helping users to form

predictions about the outcomes of past, present, and future events or to confirm or correct

expectation (Poon, 2004). Using fair value correctly will allow users to make decisions based on

up to date information. This will assist users in the difficult decisions of whether to invest in a

firm or not. Relevance is one of the main reasons why the use of fair value has been promoted

for many years.

Reliability is defined in the glossary to the FASB Statement of Financial Accounting Concepts No.

2 as the quality of information that assures that information is reasonably free from error and

bias and faithfully represented what it purports to represent. When there is a well-established

and liquid market fair value is well defined and non-controversial. However, this is not always

the case. Many firms have assets and liabilities that are not liquid so there is not a sure way to

have these values properly estimated. This is a situation that an estimation of fair value will

involve prediction of future cash flows and appropriate discount rates. These estimates involve

management's projections and assumptions. This gives an opportunity for management to

mask deliberate miscalculation and manipulation of the financial statements making the

financial statements potentially less reliable. Both the FASB and JWG realize that some

significant measurement issues must be resolved and are working together to develop more

guidance on fair value estimation and controls.

Advantages and Disadvantages

Proponents of fair value accounting argue that valuing assets at their current value gives

investors and financial statement users more transparency when viewing the balance sheet.

Another reason they support fair value accounting is because they argue it decreases the

chances of another “Enron” to happen. They believe that people will be able to clearly notice

slow changes in a firm's value before a collapse might happen. Advocates of fair value

accounting strongly argue that the financial crisis could have been avoided if the assets and

liabilities on a bank’s balance sheet were valued at market rates, instead of historical cost. The

public has been increasingly aware of fair value accounting since the financial crisis. Another big

reason why fair value accounting is needed is because it would allow a level playing field in the

market. If firms were forced to use fair value accounting the decisions made by the general

public would be a lot more informed. It takes an expert to understand the valuation of assets

on a firm's balance sheet, thus giving the expert an advantage in historical cost accounting.

One of the main issues with fair value accounting is finding a market price that is relevant and

reliable. Critics of fair value accounting argue that for assets that are not in a liquid market

there is no real way to find the true market price. Many derivatives and financial instruments

do not have a market in which they are traded on a daily basis, causing firms to use judgment

and estimations to find their market value. This could potentially bring manipulation of financial

statements into play.

Another issue with fair value accounting is the vulnerability of an economy during a downturn.

An economy is only as strong as the confidence of the investing public. Forcing firms to mark to

market could cause investors to pull money out of the stock market causing an economic

downturn to turn into a recession.

The last issue that critics have with fair value accounting is the cost of implementation. Finding

the true value of an asset can be extremely costly. Firms would have to deal with the cost of

additional employees to monitor fair value adjustments. Also, because the inherent risk

associated with the audit increases the cost of performing an audit would significantly increase.

However, many financial and economic scholars argue that the benefits of fair value accounting

greatly outweigh the costs.

Impact

The implication of which financial reporting measurement has been debated for decades and

has caused a major impact on the accounting standards used in today’s profession. Fair value is

a relevant measure of assets and liabilities when they are traded actively on the market, while

historical cost is more appropriate when management intends to hold the assets or owe

liabilities until maturity. Switching over to fair value from historical cost has increased the need

for more detailed and expanded disclosure on financial statements. Under FAS 157 it is

required that additional disclosures are required for gains and losses, a reconciliation of the

beginning and ending balance is required in order to include any gains and losses that may have

occurred. Entities like financial institutions and insurance companies have a hard time using the

fair value method because they hold many large long-term financial assets and liabilities and it

can be difficult to value and can exhibit price volatility. Another impact that fair value has had

the financial statement is that it involves more use of judgment and not being bias on

management’s part. The added use of judgment adds to the concern of reliability, management

can record improper fair value measurement and inflate the value of the company’s assets. The

use of fair value accounting effects public accounting as well. The use of judgment by

management increases causing inherent risk to increase, this in turn drives up the price of

audits.

Conclusion

The debate of the use of fair value accounting has been raging since the stock market crash of

1929. it has intensified in recent years after the financial crisis of 2008. Critics are against fair

value accounting because they feel that the increased audit costs and the ability for

management to manipulate the financial statements are not worth the pros of having all

investors on a level playing field. The difficulties behind providing balance sheets at market

price, is one issue that FASB has been working on figuring out. We believe that if fair value is

done properly with the proper disclosures then it is the best method and should be adopted by

the Unites States.

References

Abdel-khalik, R. (2008). The case against fair value accounting. Retrieved from https://www.sec.gov/comments/4-573/4573-229.pdf

FASB. (1980). Concept statement no. 2.

FASB. (1984). Concept statement no. 5.

FASB. (2008). Statement of financial accounting standards no. 157.

Harold Bierman, J. (2008). The 1929 stock market crash. Retrieved from EH.Net Encyclopedia: http://eh.net/encyclopedia/the-1929-stock-market-crash/

PwC. (2008). Fair value accounting: Is it an appropriate measure of value for today’s financial instruments? Retrieved from http://www.pwc.com/us/en/point-of-view/assets/pwc_pointofview_fairvalue.pdf

Ramanna, K. (2013). Why "fair value" is the rule. Harvard Business Review.

Rock Lefebvre, E. S. (2009). Fair value accounting: the road to be most travelled. Certified General Accountants Association of Ontario.

Rosenberg, J. (n.d.). The stock market crash of 1929. Retrieved from about education: http://history1900s.about.com/od/1920s/a/stockcrash1929.htm

Thomas, C. W. (2002). The rise and fall of enron. Journal of Accountancy.