Fair Value Accounting 

Standards

Fair Value Accounting

Fair value accounting contains a superior basis for financial reporting than the outdated historical cost model.

FROM: SEP-OCT 2005 ISSUE | BY HAN DONKER

In recent years, international standard setters and regulators such as the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have begun to favour the use of fair value accounting over historical cost accounting in financial reporting. A key reason for this shift in methodology is to improve the relevancy of the information contained in financial reports. The general principle underlying the shift is that up-to-date information improves investors' and regulators' abilities to make informed decisions.

To date, the fair value concept is applied in several IASB standards, such as IAS 16Property, Plant and Equipment; IAS 37Provisions, Contingent Liabilities and Contingent Assets; IAS 38Impairment of Assets; IAS 39Financial Instruments; IAS 40Investment Properties; IAS 41Agriculture; IFRS 2Share-basedPayment; and IFRS 3 Business Combinations.

In Canada, the Accounting Standards Board (AcSB) is considering the adoption of International Financial Reporting Standards (IFRS), which are based on fair-value accounting. Notably, the AcSB is working on a research project on behalf of the IASB to analyze various measurement bases for financial accounting. Part of the project focuses specifically on the use of fair value accounting, and the AcSB plans to release a discussion paper prior to the end of the year.

Fair Value Concept

Standard setters define fair value as the amount for which an asset or liability can be exchanged between knowledgeable, willing parties in an arm's length transaction. In an active market, fair value equals observed market price. If there is no active market, fair value is an estimate of value in use. The FASB distinguishes between three levels for estimating fair value:

• Using quoted prices for identical assets or liabilities in active markets whenever that information is available (market values);
• If quoted prices are not available for identical assets or liabilities, fair value should be estimated using quoted prices of similar assets or liabilities (market equivalents);
• If quoted prices of identical or similar assets or liabilities are not available or not objectively determinable, fair value should be estimated using valuation methods based on present value techniques of future earnings, or cash flows and valuation techniques.

Fair value based on the judgment of future cash flows is entity-specific, which means that the same asset can be measured differently for two companies because of different borrowing rates and managerial appraisals. Thus, the reliability of fair value estimates declines with the shift from liquid markets to non-traded items.

Models of Fair Value Accounting

Essentially, we can distinguish between four fair value models with respect to the incorporation of realized and unrealized holding gains and losses. The key characteristics of each model — equity, mixed, income, and full fair value — are outlined below.

With the equity approach, all unrealized fair value changes are admitted in a revaluation reserve. When the transaction is realized, fair value changes are disclosed in equity. Realized holding gains do not affect the income statement. IAS 16 is an example of this approach.

With the mixed approach, unrealized fair value changes are admitted in a revaluation reserve, but realized fair value changes are reflected in the income statement instead of equity. One such example is IAS 39.

With the income approach, all holding gains and losses resulting from changes in fair value will be reflected in the income statement. In the full fair value model, all fair value changes are reflected in the income statement, including internally generated goodwill. Self-produced goodwill is the difference between the equity value of the firm (or discounted future cash flows of the firm) and the book value of equity, where fair values are used to measure separable assets and liabilities. Internal goodwill refers to the organizational efficiency of a firm and should be distinct from purchased goodwill, which is recognized on the balance sheet as an intangible asset. The measurement and capitalization of self-produced goodwill is not recognized because of a lack of reliability.

Firm Valuation and Fair Value

Advocates of fair value accounting argue that the historical cost approach is meaningless if there is no relationship between the reported financial performance of the firm and its market capitalization. Yet historical cost accounting is the benchmark treatment and a growing gap is visible between the market capitalization of firms and book values based on historical cost accounting. So how should investors assess the performance and financial position of a company that values its assets at historical costs? And, what is the market value of equity worth if a firm has a progressive depreciation policy based on historical cost accounting?

The historical cost approach does not incorporate aspects of future values. However, it is highly questionable whether fair value accounting would undo the gap between market capitalization and the book value of equity, even if we measure all assets and liabilities at fair value. There will always be a divergence between the market value of a firm and the net value of its assets, especially when current accounting practice does not report internally generated goodwill and does not recognize assets such as management skills and labour force. Adding to the gap is the fact that synergies between assets are not measured because identifiable assets are measured item-by-item.

Relevance Versus Reliability

The debate about fair value accounting versus historical cost accounting often revolves around the divergence between relevance and reliability. As fair value accounting provides information about current market conditions, it contains a superior basis for expectations than outdated historical cost figures. The fair value approach is the most relevant measure for assets and liabilities; however, some argue that historical cost accounting is the most appropriate way to measure assets or liabilities that are held to maturity.

Advocates of historical cost accounting refer to reliability of information that is reasonably free from error and bias. If markets are not liquid, estimation of fair value will inevitably be subject to managerial judgment, private information, and uncertain assumptions about future values, such as future cash flows and discount rates. Critics of fair value accounting emphasize the role personal judgment plays in the valuation process when market prices are not available, and reliability continues to be a topic of debate.

Performance Reporting and Volatility

Advocates of fair value argue that income smoothing and earnings management are possible under the historical cost framework. If corporate results turn out badly, management can influence reported income under historical cost accounting through the sale of assets, as a profit is reported if the net selling price of an asset is larger than the book value based on historical costs. But, under fair value accounting, the asset is already at fair value and the result is reflected in the income statement, thereby reducing the possibility of income smoothing.

Within the fair value paradigm, more and more assets and liabilities are measured on a continuing basis that reflects market conditions at the balance sheet date. After initial recognition, a firm that chooses the fair value model will report a gain or loss arising from a change in the fair value of that asset or liability. If assets are measured on a continuing basis that reflects market conditions, depreciation costs with a regular pattern will be less common. The result may be a new development where write-offs with a regular pattern are replaced by annual impairment tests with an irregular pattern, such as goodwill. But annual impairment tests are less predictable than annual depreciation costs, and lead to more volatility in earnings and more discussion between accountants and management.

Opponents of fair value accounting claim that the fair value approach increases volatility and reduces the predictability of earnings. What are the consequences when the fair value of long-term debt decreases because of a downgrading of a firm's credit rating? The firm will report a gain instead of a loss because of a lower valuation of long-term debt. Interest rate changes immediately influence the valuation of financial liabilities. Fair value accounting reflects changes in financial conditions as the result of fluctuation in interest rates, credit quality, and movements in foreign currency rates. When the full fair value model is applied to our example on long-term downgraded debt, firms will report an impairment loss of internal generated goodwill that reflects a more realistic outcome.

Overall, the use of fair value accounting reduces the possibility of income smoothing. And when income and equity become more volatile because of changes in market conditions, fair value accounting better reflects a company's exposure towards risk. But the fact remains that while standard setters use a variety of valuation concepts, historical cost accounting is still the benchmark approach — for now. Currently, accountants may use several valuation concepts within a single financial report; however, the mix of different concepts and models and the consequences for equity and income does reduce transparency and performance measurement. Yet as more and more entities embrace fair value accounting, the professional judgment of accountants and knowledge of sophisticated valuation techniques will take on even greater importance in the marketplace.

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Han Donker, PhD, RA, is an associate professor of accounting at the University of Northern British Columbia, where he teaches International Accounting Standards. E-mail donker@unbc.ca.