Is Fair Value Accounting Fair?

1. Introduction

In this paper, the fair value accounting measurement for assets and liabilities will be discussed in terms of its major advantages and disadvantages. It will build upon previous literature about the debates among fair value and its conclusions made by other researchers. Furthermore the role of fair value measurement relating to financial crises will be discussed. This will be done by digging into research results and literature leading back to the 1920’s.

1.1 What is Fair Value Accounting (FVA)?

According to the Financial Accounting Standards Board (FASB) and the International Financial Reporting Standards (IFRS), fair value accounting 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. In other words, it is the practice of measuring as accurately as possible the current value of an asset or a liability. This measurement is an alternative for the reporting based on historical costs, which is the use of the nominal value of an asset when acquired by the company. Also this method gets updated, although less frequently than fair value. For historical cost accounting, most common updates are depreciation, amortization and impairments.

In this paper, the main question is, if the use of fair value makes information more valuable compared to using historical cost method, since it seems to be a tradeoff between relevant and reliable information. This tradeoff exists because the current fair value measurement rules are not completely fraud resistant. To explain this, it should be known how the standard setters provide guidelines for the use of the fair value and how the regulations are set regarding to mandatory disclosures. The next section covers this topic.

1.2 The Fair Value Hierarchy

The fair value hierarchy is used to implement the idea of fair value accounting. First of all, level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date (Standards, 2013). According to the standards, quoted prices provide the most reliable evidence of fair value. Nevertheless, if an active market for a particular asset or liability does not exist, a problem arises that is solved by the second level in the hierarchy, which are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly (Standards, 2013) . So basically making an estimate based on similar assets or liabilities in active or inactive markets. Yet, it could be the case that also the second level is difficult to implement. In order to overcome that problem, the standards provide a third and last level: inputs are unobservable inputs for the asset or liability (Standards, 2013). This level thus relies on the best information available for an asset or liability including entity’s own data.

For the disclosures of financial statements prepared in accordance with IFRS, the objective is to provide information to the user of the financial statements about the use of the fair value and therefore the disclosure information should help to assess the following: Firstly, the valuation techniques and inputs used to develop the measurements for assets and liabilities that are measured at fair value on a recurring or non-recurring basis in the financial position after recognition. Secondly, the effect of the measurements on profit or loss or other comprehensive income for the period recurring fair value measurements using significant unobservable inputs (Level 3). Similarly, according to the FASB there are two important standards (SFAS), namely No. 107 and No. 119. The first standard requires disclosure of fair value estimates of all recognized assets and liabilities, and as such, was the first standard that provided financial statement disclosures of estimates of the primary balance sheet accounts, including securities, loans, deposits, and long-term debts (Landsman, 2007). The second standard requires disclosures of fair value estimates of derivative financial instruments, including futures, forward, swap and option contracts (Landsman, 2007). These standards are implemented to improve the transparency and the reliability, which will be discussed later in this paper.

1.3 Fair Value and Financial Crises

The debate about fair value measurement and other accounting measurements of assets and liability has been ongoing since the 1920’s, although this subject was completely different from what it is now, there was a long evolution necessary to come to the point of the issue of IFRS 13, the latest amendment on fair value in 2013. Above, the subjects of the debates are a widespread of different thoughts. Somehow, most debates focus on the disadvantages and advantages, the role of fair value on financial crises and the comparison with historical cost accounting. Furthermore, professionals are not agreeing on whether fair value accounting has an exacerbated effect during a financial crisis or, the other way around, inhibitory effect. For instance, proponents argue that fair value accounting rules required financial institutions to write down their assets to abnormally low market prices even when the intuitions did not intend to sell at those prices, this in turn decreased bank’s regulatory capital, forcing them to take actions that led to even further declines (Badertscher, Burks, & Easton, 2012). In contrast, defenders counter argue that fair value accounting unlikely have led to pro-cyclical effects during the crisis.

This paper mainly focuses on the first two subjects. First of all, the advantages of fair value accounting will be discussed and compared to historical cost accounting (HCA), in the hope to brighten the view on fair value accounting and its positive aspects. Secondly, the major disadvantages will be argued, in order to make clear which problems should be dealt with and if it is possible to mitigate the negative effects of fair value accounting. Thirdly, some insights in the relationship of fair value accounting and financial crises will be given, whether if fair value accounting has a negative impact and makes financial crises worse or even is a cause of financial crises, or maybe it decreases the distress and helps to recover from crises.

2. Informativeness as the main advantage of Fair Value Accounting

One of the main advantages of fair value accounting (FVA) over historical cost accounting (HCA) is that it tends to be more informative for the users of financial statements (FS). As we know, every user of financial statements demands other information provision. In order