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This piece is a research paper exploring a financial accounting topic.

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Introduction:

The purpose of this paper is to discuss the implications and benefits of switching to fair value accounting. Fair value accounting is a relatively new way of reporting as opposed to the more common method of historical costs. In January 2006, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115” was an exposure draft set out by the Financial Accounting Standards Committee of the American Accounting Association. This is a very current issue that standard-setters have been debating for years. The main reason to switch to the fair-value accounting method would be for the up-to-date values that better portray a company’s financial situation.

Three issues that discourage accountants and investors from endorsing fair value accounting are the use of estimates determined by the preparers of the financial statements, the lower reliability, and the lack of comparability. These concerns prevent people from agreeing with the fair value method even though there are clear benefits associated with it.

It is important to understand the financial statement effect and the comparability to other companies resulting from fair value account¬ing. The fair value method changes the amounts and disclosures that are reported on the financial statements; these must be understood by all users for the decision-making process.

There have been many articles written about fair value and its financial statement effects. By examining the various arguments and opinions, I was able to assess the costs and benefits of each method. I resolved that the fair value method is better and should be implemented as soon as more specifications are included in the exposure draft These specifications would include how to report fair value, what does and does not need to be included, and ways to prevent the extent of influence financial statement preparers have on the fair value amounts used. This paper will review current accounting rules, proposed accounting rules, the arguments related to each method, and a final analysis of my research findings.

Current Accounting Standards:

The change from historical costs to fair values started back in 1991 at a SEC conference when marked-to-market valuation was deter-mined as more relevant than historical costs. They determined that fair value information needed to be given in the financial statement dis-closures along with the historical cost amounts. After this conference, fair values were established as more beneficial for impairments on loans and long-lived assets, derivatives (FAS 133 and 155), securitizations (FAS 156), employee stock option grants (FAS 123R), hybrid financial instruments (FAS 155), business purchases, and intangible assets (Reiger, 2005; Fink, 2006).

The Statement of Financial Accounting Concepts (SFAC) 7 measures fair value with a present value when a market-based value is non-existent this method is not the most desirable, but can still be applied (Shortridge, Schroeder, & Wagoner, 2006; “Statement No. 7,” 2000).* Statement of Financial Accounting Standards (SFAS) 141 discusses intangible assets and requires that the initial amount should be based on fair value (Shortridge et al., 2006). The fair value found should be consistent with the future cash flows. This Statement suggests that fair value is a concern. SFAS 142 further explains SFAS 141 by recognizing intangibles that would not have been recognized using historical costs. It states that intangibles can decrease in value so they need to periodically be measured for impairment.

SFAS 144 considers the impairment or disposal of long-lived assets. This uses the fair value measure¬ments to decide if the asset is impaired from its carrying amount (Shortridge et al., 2006). It defines fair-value for an asset as “the amount that the asset could be purchased or sold for in a third-party transaction” (Shortridge et al., 2006, p. 38).

Proposed Exposure Draft and Response:

The FASB issued an Exposure Draft for Fair-Value Measurements (ED) in June 2004. This provides guidelines on how to value assets and liabilities using fair values and how to disclose them in the financial statement notes. The disclosures include how the fair value amounts are determined and any effect they have on earnings. It also states that “the fair value of an asset (or liability) is the amount at which the asset (or liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties other than in a forced or liquidation sale” (Epstern, Nach, & Bragg, 2006, p. 435).

The draft gives three levels of valuation, all summarized by Reiger. Level One, otherwise known as the market approach, “assumes that current market data is available” (Reiger, 2005, p. 44). Preparers are then able to use these numbers as given because it is the best evidence for fair value. Level Two is more difficult to find because market informa¬tion is unavailable, but comparable information is obtainable. Fair value would be determined by using the market value of the similar asset or liability and making minor adjustments. These adjustments can be done through valuation techniques including “present value of expected cash flows, option pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis” (Epstein et al., 2006, p. 435). Level Three is the most difficult to determine based on its lack of any market information. Fair value is computed by using the future cash flow based on the opinion of the per¬son valuing it. This level is not as reli¬able as the other two levels and can provide different values based on who is valuing the assets or liabilities (Reiger, 2005).

To respond to the Exposure Draft, the Financial Accounting Standards Committee of the American Accounting Association issued “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115” in January 2006 (The Committee, 2007). With the fair value option, firms are able to decide, on a contract-by-contract basis, which assets and liabilities they want to report at fair value. This decision is entirely determined by the preparer, instead of an unbiased outsider, like a standard-setter. Since there is some subjectivity, the Fair Value Option also requires disclosures to explain what method is used, how fair values are found, and how it affects the earnings (The Committee, 2007).

Considerations Before the Switch: Strengths: The main improvement from historical cost to fair value measurements is the better picture of the economic condition of a company. The economic condition allows investors to see when a firm is financially Fair value narrows the gap between accounting book value and market value. unstable or troubled. Over the life cycle of a firm, “fair value income equals historical cost income equals economic income,” but the recogni¬tion of value is less delayed for fair value income than the other two, so it presents more relevant informa¬tion (Hitz, 2007, p. 348). Fair value narrows the gap between accounting book value and the market value. The Fair Value Option also allows users to choose accounting methods to illustrate that it is sometimes appropriate for different entities to use different approaches (Singleton-Green, 2007).

Fair value helps limit the use of earnings management because earnings are based more on the balance sheet instead of the income statement (Fink, 2006), It can even improve the balance sheet because assets and liabilities are currently shown at historical cost. If they have gained value over the years, the fair value would represent the true value of these assets and liabilities, especially regarding the cost of the firm’s inventory. The required disclosures offer relevant information so investors can see how estimates were found and whether the firm is giving a fair estimate of its assets or liabilities. Fair value measurements are therefore more relevant to investors. Relevance: According to SFAC No. 2, relevance is defined 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 prior expecta¬tions” (as cited in Hitz, 2007, p. 335). Historical costs are not rele¬vant because they do not provide us with current, up-to-date information. After the purchase of an asset, the historical cost is not relevant any-more. The fair value provides essential information about the asset after the purchase. When many assets are reported at historical cost, the total assets can be undervalued. Fair value shows a more complete and relevant picture.

Reliability. Reliable information must be “representationally faithful, verifiable, and neutral” (Miller & Bahnson, 2006, p. 18). Miller and Bahnson show that fair value is reliable. They argue that “market values are more reliable than costs because they more faithfully represent current cash flow potential. Further, values are more verifiable than costs because they are observed in numerous independent transactions, not just one exchange involving the reporting entity. Finally, values are neutral because they exist separate and apart from that entity” (2006 p. 18).

Others believe the reliability declines when fair value is used because information and assumptions used to compute fair values are made by financial statement preparers. If the preparer provides an accurate representation of the firm, then the information is more relevant. If the fair values are skewed or biased, there is reduced reliability. “Implementing fair value in an imperfect and incomplete market requires preparers of financial statements to understand the multistage game between rivals in the product market so as to estimate market-clearing prices” (Reis, 2007, p. 559). Private company information and irrational market behavior also lessen the reliability. The estimations are not based on arm’s-length transactions either, unlike historical cost (Shortridge et al., 2006). Historical cost is based on real purchase prices instead of estimated current values, making the income statement more reliable. Our main concern is whether we can trust the opinions and estimates that emerge from the preparers. Conservatism: In regard to the debate between relevance and reliability, conservatism is used to “encourage accountants to consider the uncertainties surrounding their measurements and the impact those uncertainties and risks might have on decision-makers” (Shortridge, 2006, p. 16). Preparers must disclose information on how they arrived at the amounts, the risks and uncertainties they took into consideration, and an analysis of the possible outcomes if they used different assumptions (Shortridge, 2006). This allows us to see what other amounts they could have arrived at and whether we agree with the preparer’s assumptions. The use of conservatism increases the reliability, but may decrease the relevance. Extra facts can be useful in analyzing performance, but if users do not understand the disclosed information, then it is not relevant to the decision.

Volatility. Volatility occurs more often when the fair value method is used. Hodder et al. found that earnings volatility under the fair value measurement is more than five times the volatility of currently reported net income (as cited in The Committee, 2007). The amounts can change rapidly on the balance sheet and skew the financial ratios for one period. The income statement will reflect the changes in the fair value from one period to the next as well. Neri Bukspan, the chief accountant at Standard & Poor’s Corp., said the changes can be based on “the fair value of the collateral, the creditworthiness of the borrower, or interest rates” (as cited in Davenport, 2006, p. 4). Anytime there is a sales shock, the fair value income is more volatile because it shows a one-time boost in that period, but decreases after-wards (Hitz, 2007).

Comparability. The contract-by-con¬tract basis set by the ED causes less comparability within a company and within an industry (Fink, 2006; The Committee, 2007). It does not make sense that a company can use the fair value method for one asset and the historical cost for a similar asset (Davenport, 2006). It can already be difficult to compare companies in current conditions, but using the contract-by-contract basis allows for more diversity and more troubles for investors and analysts to figure out what method is used when and where. Over time, it will only get worse for the users.

Other Problem Areas: Not only are reliability and volatility concerns, but many other areas raise questions. In determining fair value for Level 3 items, a company must compute the anticipated cash flow and the pres¬ent value of expected future cash flow. First, a specific cash flow is needed by itself through the use of historical data and cash flow models. Then, the estimation of the future cash flow life cycle is hard to determine (Rieger, 2005). Estimations on unknown future events can be miscalculated. Therefore, Level 3 items are based mainly on the preparer’s opinion. If investors make decisions based on faulty numbers, the company may get into legal trouble.

Examining debt fair value has the ability to make a company appear more affected by interest-rate risk than it really is. When companies’ creditworthiness is decreased, the debt would be marked down on the balance sheet which would allow the company to realize more income (White & Vakili, 2007). It is not rational “for a company to show rising earnings when its debt-repayment capacity is declining” (Fink, 2006, p. 60). If financial companies base loan prices on what others have been selling at, and that price is really low, then many would try to sell the loans which further drives the price down (“Book-keeping error,” 2007).

The Debate:

The main reason for financial statements is to increase the decision usefulness for investors and analysts in a cost-effective manner. Valuing assets at fair value can be difficult and time-consuming, but it is already required to estimate goodwill impairments, allowance for doubtful accounts, and depreciation. The information for a disclosure is already gathered by the preparers for internal purposes, so it is reasonable to require the disclosures on the statements without any extra cost. On the other hand, complex, multinational companies argue that it is not cost beneficial for them to provide all the assumptions they use (Fink, 2006).

The financial statement disclosures provide the users more use¬ful information for evaluating the company’s reasons behind each measurement used. Fair values give more complete information than historical cost measurements that are conservative and irrelevant. The increased volatility that occurs just indicates real economic volatility that may be essential to making a decision. When looking at the banking industry, the fair value income better represents the firm’s risk, but this is only within an industry containing financial instruments as its main operations (The Committee, 2007).

Then again, fair value can lead to undervaluation of a firm because it does not incorporate competitive advantages from specific intangible assets (Hitz, 2007). Fair value also violates SFAS No. 154 which states “an accounting principle once adopted shall not be changed in accounting for events and transactions of a similar type” (as cited in The Committee, 2007, p. 194). The ED is inconsistent with SFAS 154 when allowing preparers to choose whichever measurement they want without justification. These can reduce the decision usefulness.

Before the fair value measure¬ments can be fully executed, I believe the Fair Value Option needs to be removed so firms will have to follow set rules in determining which assets and liabilities are valued at fair value. This addresses the comparability issue and part of the subjectivity issue. More guidelines need to be provided in order for financial statement preparers to know which method they are allowed to use for each type of asset or liability. While reliability is still a concern, we have to trust financial managers to truth-fully portray how the company is performing. This will also require the auditors to be more thorough so as not to miss any attempts to manipu¬late the numbers.

By continuing to improve on these smaller issues, more users will be willing to switch to the fair value valuation method. The preparers need to understand all the benefits fair value provides. Then, the draft will eventually become reality.

Conclusion:

The fair value debate is continu¬ous when deciding whether the benefits outweigh the costs. We have to assess how much reliability is given up for increased relevance. Another consideration is the extra amount of work that is involved in switching over. Many more estimations are calculated with different techniques. The estimations, along with the option of which assets and liabilities will be valued using fair value, reduce the comparability. If the minor modifications given above are executed into the drafts, many problem areas will be resolved. Fair value, assuming the amounts are determinable and truthful, informs users how the company is doing < based on current values. Fair value is a better method than historical cost when valuing assets and liabilities.

Works Cited

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