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url: http://www.wiso.uni-koeln.de/workingpapers/bcfat/index.html
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Seminar für Allgemeine BWL und Wirtschaftsprüfung,
Universität zu Köln, Albert-Magnus-Platz, 50923 Köln
Tel.:+49 221 470 3089; Fax: +49 221 470 5165 hitz@wiso.uni-koeln.de
Abstract : Regulators such as the SEC and standard-setting bodies such as the FASB and the
IASB argue the case for the conceptual supremacy of fair value accounting vis-à-vis the traditional transaction-based model, notably on the relevance dimension. Recent standards on financial instruments and certain non-financial items adopt the new measurement paradigm.
This paper takes issue with the notion of superior decision usefulness of a fair value-based reporting system, with an emphasis on the theoretical soundness of the arguments put forward by regulators and standard-setting bodies. The research is based on the premise that conceptual reasoning not only represents a worthwile approach to accounting research, but is of particular importance for the a priori evaluation of accounting alternatives from a standardsetting perspective. Two approaches to decision usefulness are considered, the measurement or valuation perspective and the information economics perspective. Findings indicate that the decision relevance of fair value reporting can be constructed from both perspectives, yet the conceptual case is not strong. Notably, the hypotheses underlying standard-setting’s shift towards a fair value-based model turn out to be theoretically weak. One immediate implication of the research – a condition for the further implementation of fair value accounting – is the need to clarify standard setters’ notion of accounting income, its presumed contribution to decision relevancy and its disaggregation.
Key words : Fair value accounting; fair value paradigm; information perspective; measurement perspective; earnings volatility
JEL Classification: M41
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This paper is motivated by the ongoing shift of financial reporting standards for listed companies towards fair value reporting, notably the increasing importance of fair value as an accounting measurement attribute. Since the mid nineteen-eighties, FASB and IASB have systematically substituted market-based measures for cost-based measures. Starting out as a specific remedy for the inequities of the reporting model for certain financial instruments, fair value has manifested itself as the dominant measurement paradigm for financial instruments and, more recently, for non-financial items, e.g. goodwill under SFAS 142 and IAS 36, or investment property under IAS 40. The cost- and transaction-based reporting model is in decline, a new market-value and event-based model on the rise, with dramatic implications for the role and properties of balance sheet measurement and accounting income.
This shift in measurement paradigms is driven by the assumption of superior relevance of market-based measures. Both FASB and IASB stress the capacity of market prices to incorporate in an efficient, objective manner market consensus expectations about future cash flows. Opponents of fair value measurement on the other hand criticize the questionable reliability of fair value measures, especially those based on management’s expectations and calculations, when sufficient market prices are not available. Especially the implementation of fair value as a balance sheet measure is subject to intense discussion and debate. The ongoing controversy about fair value accounting for financial instruments, as recently highlighted by the rejection of IAS 39 (revised 2003) for full EU endorsement, illustrates both conceptual issues such as the alleged distortion of earnings and technical issues like the scope of fair value hedging. Apparently, the debate is far from resolved.
Prior empirical research on fair value accounting is mostly limited to financial instruments. Results so far support the incremental value relevance of fair value disclosures for securities (Petroni and Wahlen, 1995; Barth, Beaver and Landsman, 1996; Eccher,
Ramesh and Thiagarajan, 1996; Nelson, 1996) and derivatives (Venkatachalam, 1996) held by banks and insurance companies. Park, Park and Ro (1999) find value relevance of recognized fair values for available-for-sale securities under SFAS 115. While all these studies focus financial sector firms, Simko (1999) with a cross-industrial sample finds no significant sign of incremental value relevance for SFAS 107 disclosures, which is attributed to the insignificance of financial activities for these firms. With respect to other financial instruments, notably loans held by banks, results differ, which can be interpreted as lack of reliability due to private information. On the other hand, Beaver and Venkatachalm (2000)
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find value relevance for the discretionary component of loan fair values. The notion of perceived insufficient reliability is especially critical for non-financial instruments. Evidence so far rests on parallels from market-value regimes in Australia and the U.K. and must be considered cautiously. As an example, Barth and Clinch (1998) find value relevance for the remeasurement differences of non-current assets under Australian GAAP, yet further specification shows significant results only for negative amounts, i.e. asset write-ups are not value-relevant. Summarizing the extant empirical literature, the relevance of fair value measurement can only be supported for securities traded on highly liquid markets, while the evidence reinforces the importance of the reliability argument both for financial and nonfinancial assets.
Analytical research so far is mostly silent on the properties and desirability of fair value measurement. While the superiority of market values is unassailable under conditions of complete and perfect markets, the contribution of fair value in a realistic setting is unclear
(Barth and Landsman, 1995, Beaver, 1998). Exit value, entry value and value in use are not identical in a world of asymmetric information, transaction costs and rents; there is no aggreement on which alternative is the preferable measurement attribute from a conceptual perspective. Notably, the existing literature does not take issue with the theoretical assumptions and hypotheses underlying the fair value paradigm as articulated by standard setters.
This paper assumes that there is a demand for conceptual reasoning on accounting issues, especially with respect to standard-setting questions. Since the contribution of empirical research is inevitably small for the a priori evaluation of reporting alternatives, theoretical hypotheses and evaluations are required to assist standard setters in their task. We therefore consider the properties and contribution of fair value reporting to decision usefulness from two conceptual viewpoints, the measurement and the information perspective, with a special emphasis on the evaluation of the paradigmatic assumptions underlying regulators’ endorsement of fair value measurement.
One major result of this paper is that the conceptual foundations of the fair value paradigm cannot be unequivocally supported by theoretical reasoning. The paradigmatic assumptions are especially weak for model-based estimation of fair value and thus for valuation of non-financial positions. With regard to fair value as an accounting measure, standard setters do not present any specific case. Notably, no concept of fair value income is offered, despite the growing use of fair value in income determination. Application of
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different notions of decision useful income leads to different perceptions of the usefulness of fair value income and thus emphasizes the need to clarify and elaborate the concept of fair value accounting prior to further implementation.
The remainder of the paper is organized as follows. Section 2 describes the concept and proliferation of fair value reporting, with special emphasis on the paradigmatic assumptions underlying standard setters’ reasoning. Section 3 develops the methodology used for our conceptual analysis of the contribution of fair value reporting to decision usefulness.
In section 4, this methodology is applied to disaggregated reporting of fair value, whereas section 5 explores the use of fair value for balance sheet and income measurement. Section 6 concludes the basic results and points at areas for further research.
2.1 Fair value in FASB and IASB accounting standards
2.1.1 Fair value
Despite different wording, the definitions and meanings of the term “fair value” are basically equivalent in FASB and IASB pronouncements. The general FASB definition can be found in
SFAC No. 7, which describes fair value as “the amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale“ (Glossary). The IASB framework at present has no definition of fair value, yet a uniform definition can be found on the standards level:
“Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction” (e.g. IAS 39, par. 9;
IAS 41, par. 8; IFRS 3, Appendix A; IFRS 4, Appendix A). Taking into account the relevant interpretations, the FASB/IASB concept of fair value can be defined as specific hypothetical market price under idealised conditions. More precisely, fair value is the exit market price that would result under close-to-ideal market conditions, in a transaction between knowledgeable, independent and economically rational parties, who interact on the basis of an identical information set (complete information). The sharp distinction of fair value and value in use clarifies that fair value measurement is not to include specific competitive advantages, i.e. no private skills and no private information (SFAC No. 7, par. 24 a; JWG, 2000, par. 4.5).
The estimation of fair value follows a three-tier hierarchy. The governing principle is primacy of market-based measures, i.e. the refutable notion that market prices oder market
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data are more suitable and informative than internal estimates. Thus, market prices represent the best estimate of fair value, if market conditions satisfy the fair value definition. The relevant “quality” of market prices is assessed on the basis of the active-market-criterion, i.e. regular trading of the item on a sufficiently liquid market is required for market prices to qualify as fair-value-estimates.
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If market prices do not exhibit sufficient information quality or are not available, the second level of the estimation hierarchy requires to consider
(modified) market prices of comparable items, where comparability naturally refers to the cash flow profile. Only when such prices cannot be used either, marking to market fails and fair value is to be estimated using internal estimates and calulations. This marking to model, the use of accepted, theoretically sound pricing methods, represents a technique of last resort.
Ample guidance exists on valuation techniques for financial instruments, and accepted methods can be found in the market place. For non-financial items, fair value estimation rests on a present value approach. SFAC 7 and, with modifications, IAS 36, develop the principles and methods for such measurements. Notably, they adopt an “economic” view on measurement clearly grounded in modern neo-classical finance theory, and distinguish traditional from expected cash flow approaches.
In summary, fair value represents a specific current value, i.e. exit value under idealised conditions. Measurement follows a strict three-tier-process, with a preference for marking to marking vis-à-vis marking to model. Fundamental properties of fair value are the highly idealised market conditions required and the primacy of market-based measures. One inevitable characteristic of any economic valuation is the lack of verifiability, which the fair value concept attempts to mitigate with its emphasis on (objective/verifiable) market valuation. Thus, the reliability of fair value estimates declines with each level of the hierarchy, especially with the shift away from marking to market.
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While FASB standards refer to the active-market-criterion without further elaboration, IFRS offer a standard definition, according to which “an active market is a market in which all the following conditions exist: (a) the items traded within the market are homogeneous; (b) willing buyers and sellers can normally be found at any time; and (c) prices are available to the public.” (IAS 36, par. 6; IAS 38, par. 8; IAS 41, par. 8). From a normative viewpoint, this criterion seems unappropriate, since it refers to the “time dimension” of liquidity, i.e. the speed, with which a transaction partner can be found, rather than the “price dimension”, i.e. the price reaction to the transaction, which represents the theoretically valid indicator of information quality. See also section 4.3.1 for these results.
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2.1.2 Implementation of fair value in existing accounting standards
The systematic shift towards fair value measurement, the initiation of the fair value paradigm, is inexorably linked to the accounting for financial instruments and the specific problems involved. The triggering event was the Savings-and-Loans-debacle in the U.S. during the nineteen-eighties, which resulted in regulatory action by the SEC, which among other things advised FASB to develop a standard on accounting for certain debt securities at their market value instead of amortized cost. The underlying notion was that historical cost accounting had hindered proper identification of the financial status of S&L’s; notorious practices were the designation of securities as investments in order not to write down the carrying amount, and the realisation of gains on securities trading above their book values (“cherry picking” or
“gains trading”) (Cole, 1992; Wyatt, 1991; White, 2003). Despite its limited scope, this initiative represented a major evolution in accounting thought on the regulatory level.
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The immediate reaction in the wake of the S&L crisis represents the starting point for the implementation of fair value measurement and the evolution of the fair value paradigm both in FASB and IASB standards. Starting as a special rule for certain securities, fair value measurement was soon identified as the most relevant attribute for financial instruments. Full fair value accounting for financial instruments was advocated by the IASC in its 1997 discussion paper, which represented the basis for the Joint Working Group Draft Standard in
2000. Paralleling this process was the gradual implementation of fair value for nonfinancial items, where SFAC 7 on the present value measurement of fair value constituted a landmark conceptual step. Thus, the implementation of fair value accounting represents a gradual, ongoing process, whose current status shall be summarized briefly.
Both US-GAAP and IFRS require the disclosure of fair value for basically all financial instruments (IAS 32, SFAS 107). Rules on fair value accounting for financial instruments are also equivalent, with one notable exception. IAS 39 and SFAS 115, 133 require trading securities and derivatives held for trading or as part of a fair value hedge to be measured at fair value with revaluation gains and losses taken directly to income. Availablefor-sale-securities are also carried at fair value, but gains beyond the historical cost ceiling are recognized as other comprehensive income until realization takes place. In both regimes,
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Former FASB member Arthur W yatt refers to it as “possibly the most significant initiative in accounting principles development in over 50 years.” (Wyatt (1991), p. 80), a notion emphasized by the testimony of
SEC General Counsel James Doty to the U.S. Senate, who made it clear that “the time has run out on ‘onceupon-a-time-accounting’”.
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financial obligations, except derivatives, are in principle accounted for at cost, equally securities held-to-maturity. This mixed model approach is an expression of standard setters’ reluctance and interested parties’ resistance to implementation of full fair value accounting, despite a consensus on its conceptual merits. IASB has taken a big step into this direction with the 2003 revision of IAS 39, which introduces the “fair value option”, the option to designate any financial instrument as “measured at fair value through profit and loss” at inception.
However, objections especially from bank regulators, notably the European Central Bank, have resulted only in a partial endorsement by the EU and in an Exposure Draft proposing to limit the fair value option to such instruments for which fair value can be reliably measured.
Unlike for financial instruments, the implementation of fair value as measurement attribute for non-financial items is quite different in US-GAAP vis-à-vis IFRS accounting.
Notably, FASB standards at present require fair value exclusively as a measure for impairment losses, i.e. invariably preclude the recognition of fair value gains beyond the cost ceiling. Specifically, fair value represents the relevant impairment measure for goodwill acquired in a business combination, certain intangible assets (SFAS 142) and long-term-assets
(SFAS 144). IAS 36 requires similar impairment rules, with recoverable amount, i.e. the higher of value in use and fair value less cost to sell, as the relevant measurement attribute.
Yet, for fair value accounting, IFRS standards go far beyond FASB provisions. The revaluation model, which can be chosen for measurement of property, plant, and equipment
(IAS 16) and of actively traded intangibles (IAS 38) requires full fair value measurement, with gains beyond the carrying amount taken to other comprehensive income, yet depreciation measured on the basis of revalued amounts. The fair value model provided optionally for investment property (IAS 40) and compulsory for biological assets (IAS 41) even requires full fair value accounting with gains and losses directly taken to income.
In summary, IFRS implement the fair value paradigm more aggressively. While the
FASB obviously takes a cautious stance especially on fair value measurement for nonfinancial items, the IASB assumes a more progressive role and implements the fair value paradigm in a more consequent manner, accepting the deconstruction of the twin pillars of the historical cost model, cost-based measurement and transaction-based income recognition. The discussion on accounting for insurance contracts, where IASB intends to provide a full fair value accounting in the second phase, illustrates the board's commitment to fair value measurement, thus underscoring the impetus and determination of the development.
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2.2 Paradigmatic foundations and the debate on fair value accounting
The move towards fair value accounting is frequently characterized as a shift in paradigms
(e.g. Barlev and Haddad 2003). We share this notion and believe that this process is based on firm beliefs and assumptions and thus needs to be taken seriously, with evaluation beginning at the roots of the development. Therefore, the paradigmatic foundations of fair value accounting shall be briefly elaborated as a starting point for conceptual evaluation.
A paradigm can be defined as a set of values and beliefs shared by a specific community. Thomas S. Kuhn in his “Structure of Scientific Revolutions” extensively discusses this term in the context of scientific methodology and develops his influential theory of the process and drivers of paradigm shifts. Accordingly, with respect to financial reporting, a paradigm shall be defined as a set of shared beliefs on the objectives of financial reporting and on the accounting principles by which these can be achieved. It is grounded in firm assumptions, and characteristically requires a theoretical foundation or vindication.
Specifically, a measurement paradigm represents a consensus on the measurement attributes required to achieve the reporting objective in question. Once a financial reporting paradigm is adopted by regulatory institutions, it becomes the guiding principle for accounting regulation, i.e. standard-setting.
The move towards fair value measurement results from the adoption of the fair value paradigm by standard-setting bodies such as FASB and IASB. The initiating event was the
Savings-and-Loans-Crisis referred to previously, which laid open the deficiencies – or, in
Kuhns terminology, the anomalies – of the present reporting system based on the historical cost/matching paradigm. This model, whose roots are usually traced to the Paton and Littleton
(1940) monograph, seemingly was incapable of coping with financial instruments and the business models of information-era/service-oriented firms founded on intangible assets. On the standard-setting level, these problems and the conceptual debate had already resulted in the adoption of an asset-liability approach instead of the traditional revenue-expense approach, yet without daring to move towards current value measurement (Storey, 1999). The financial instruments debate triggered by the S&L crisis represents the critical event initiating the “revolution”, i.e. the shift from the historical cost paradigm towards the fair value paradigm.
The fair value paradigm rests on the the decision usefulness paradigm, which was only established with the formation of the FASB and the conceptual framework project, which drew from the Trueblood report. Thus, unlike the historical cost model, fair value
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measurement rests conceptually on a clearly stated reporting objective: the provision of information to investors to enable them to asses the amounts, timing and uncertainty of future cash flows from an investment in a firm’s shares or debt securities (SFAC 1, par. 37; IASB framework, par. 15). More specifically, the fair value paradigm rests on two theoretical assumptions. The first and most fundamental assumption is that (hypothetical) market prices aggregate in an efficient and virtually unbiased manner the consensus expectations of investors in the market concerning the cash flow pattern of the security ( information aggregation hypothesis ):
„An observed market price encompasses the consensus view of all marketplace participants about an asset or liability’s utility, future cash flows, the uncertainties surrounding those cash flows, and the amount that marketplace participants demand for bearing those uncertainties.” (SFAC No. 7, par. 26).
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With these informational properties, market prices incorporate exactly the information demanded by investors, which financial reporting should convey. According to the second paradigmatic assumption, investors can extract these implicit consensus expectations from market prices in order to revise and improve their own projections ( information inference hypothesis ). Market price information thus directly satisfies the assumed informational needs of investors and therefore contributes in an ideal manner to financial reporting’s decision usefulness objective. In an important step, SFAC 7 generalizes this reasoning for any market value satisfying the fair value definition. That is, synthetically generated market prices are also considered to have these desirable informational properties. The FASB therefore arrives at a fundamental conclusion:
„For measurements at initial recognition or fresh-start measurements, fair value provides the most complete and representationally faithful measurement of the economic characteristics of an asset or a liability.” (SFAC 7, par. 36)
Standard-setting bodies establish elaborately the conceptual supremacy of fair value measurement with reference to theoretical economic reasoning embodied in the two fundamental paradigmatic assumptions. With the adoption of SFAC 7, the FASB lends
“constitutional character” to the fair value measurement objective: Following the normative function of the conceptual framework, fair value measurement is an alternative to be considered in any future standard-setting initiative. Since the arguments put forward in favor of fair value refer to its relevance, i.e. the correspondence of reported information and
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For equivalent conjectures in IASB standards see for example IAS 32, par. 87; IAS 36, par. BCZ11; IAS 40, par. 40, B36.
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required information, reliability concerns are the prime argument capable of declining fair value measurement in future projects, especially where balance sheet recognition is concerned.
The implementation of the fair value paradigm has ever since been a contentious issue. While many aggree on the benefits of fair value disclosures, opinions differ especially with regard to fair value measurement of recognized items and the treatment of revaluation gains and losses. While these discussions involve many specific issues with respect to the items in question, the fundamental questions of the fair value debate can be summarized as follows (see e.g. Barth, 2000: 18-22; Wyatt, 1991: 84):
- Does fair value represent decision useful information? Is there a valid theoretical background to standard setters’ paradigmatic assumptions?
- Should fair values be disclosed, or is there a conceptual case for recognition in basic financial statements?
- Are revaluation gains from fair valuation regular components of income or should they be recognized outside earnings?
- What are the basic properties of fair value income and its contribution to the decision usefulness objective?
The aim of the following chapters is to contribute some conceptual thoughts to these questions. Of notable concern is the fair value paradigm and the underlying assumptions, which represents the intellectual basis for the presumed relevance of fair value accounting.
The scientific evaluation of the paradigm hinges critically on the validity of these paradigmatic assumptions, a path which this paper, in contrast to the previous literature, will take. In doing so, we consider both a measurement and an information perspective.
3.1 Measurement perspective
The so-called measurement perspective represents the traditional view on the information function of financial reporting, especially of financial accounting. It is rooted in the neoclassical theory of value and income developed by economists such as Hicks, Fisher and
Lindahl (for an overview see Liang, 2001). The fundamental notion underlying the
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measurement perspective is that accounting should directly measure and report the basic information required by investors, which is the value of the firm, or at least a fraction of it.
Thus, firm valuation is delegated to the reporting entity. Under the measurement perspective, stocks like assets, liabilities and equity and flows like income are measures well-defined and exhibit an economic character.
In an ideal world of complete and perfect markets, disclosure of the market values for all the firm’s assets and liabilities directly reports firm value and thus the desired investor information. Earnings equal economic income. Obviously, the measurement perspective is deeply rooted in such a scenario (Barth, 2000: 15; Beaver, 1998: 4, 76). Here, decision useful information is information on the contribution of assets and liabilities to enterprise value.
Thus, the benchmark measurement attribute is value in use.
For a realistic setting, however, neither value nor income are well-defined concepts and the orthodox measurement perspective runs into difficulties (Beaver and Demski, 1979).
Yet, the measurement approach is influential for real-world accounting, a fact witnessed by the traditional, unchallenged use of the terminology of valuation in accounting (Barth, 2000:
15-18; Beaver, 1998: 76). Therefore, we distinguish the orthodox measurement perspective from its real-world corrollary, the “decision-model-approach” (Beaver and Demski, 1974:
177). Here, the decision problem of a typical investor is regarded in order to directly delineate information demands. For purposes of this paper, the decision problem is reduced to security valuation. Therefore, investors demand information that directly feeds into their present-value calculus. Under this variant of the measurement perspective, decision useful information is
(aggregated) information on future cash flows and their risikiness.
3.2 Information perspective
The measurement perspective underlies the a-priori-research conducted roughly until the nineteen-sixties (Liang, 2001: 224-29). Criticisms of the restrictive assumptions of this view on “informative” reporting were aggravated by the development of information economics, which lead to the famous “impossibility result” for normative accounting principles (Demski,
1973; Beaver and Demski, 1979) and resulted in the establishment of a new research paradigm, the information perspective.
In information economics, useful information is defined in an abstract manner as information capable of transforming a-priori-expectations (beliefs) into a-posterioriexpectations, which induces revisions and therefore improvements of decisions. In the latter
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case, an information system has information content; if the benefits of the improved decisions exceed the price of the information procurement and processing, the information system has information value. Comparison of information systems is conducted based on their fineness , i.e. their capability to partition the event space.
From the information perspective, financial reporting represents but one information system competing with others.
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Since information matters only in its capability to revise expectations, the form of its presentation does not matter. Thus, specific accounting representations such as balance sheets, captions and categories such as assets, liabilities etc. are irrelevant, since only the content of the information transmitted is of interest.
The rise of the information perspective is usually associated with the growing importance of empirical accounting research (Beaver, 1998). Yet, information perspective criteria can also be extracted and used for the purpose of conceptual evaluation. In this paper, two variants of decision usefulness from an information perspective shall be distinguished.
Information content refers to the “newness” of accounting information and is assumed for such information that is first released to the semi-efficient stock market via financial reporting and is valuation relevant, i.e. capable of altering investors’ expectations with respect to the valuation of the firm. Value-relevance-research recognizes a second, less rigid form of decision usefulness: the function of financial statements to aggregate in an efficient manner valuation-relevant information regardless of its information content, thus providing costefficient capital markets information (Barth, 2000: 16; Beaver, 2002: 461). Aggregation of value-relevant information will therefore be considered as the second variant of decision useful information production under the information perspective. It is assumed, when (1) the data in question would exhibit information content were they not known in public, and (2) the provision of these data via financial reporting can be reconstructed as cost-efficient information aggregation.
3.3 Usefulness of theoretical reasoning
This analysis sets out from the conviction that there is potential use to conceptual reasoning on the desirability of financial reporting alternatives, i.e. that there is a case for a-priori economic analysis. Thus, the impossibility result is not accepted: The denial of the usefulness
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A thorough textbook description of the information economics approach to financial reporting is given by
Christensen/Demski (2003).
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of applying conceptual criteria on the grounds of the specifity of individual decision contexts employs a Paretian notion of economic efficiency which is not suitable for economic analysis.
Economic analysis requires an assessment of the welfare implications of different alternatives which can only be properly assessed on the basis of Kaldor-Hicks-efficiency. This means that there is a case for analysing reporting alternatives on the basis of conceptual criteria if they can be reconstructed as hypothetical consensus of the majority of constituents (Cushing,
1977).
For the following analysis, we assume that measurement and information perspectives approaches represent conceivable views of decision usefulness from an investor perspective. One advantage of this approach is that it represents a-priori research and therefore produces results on hypothetical reporting alternatives prior to implementation.
Empirical research, on the contrary, in most cases represents a-posteriori research and is thus of limited use for questions of accounting regulation. Therefore, conceptual reasoning represents a worthwile, methodologically sound approach. It is of special interest to regulators and standard-setting bodies: Without making final judgements or recommendations, a-priori results on the contribution of alternative regulations to conceivable measures of decision usefulness improves standard setters’ knowledge and is therefore capable of improving standard-setting decisions.
4.1 Measurement perspective
The first part of the analysis considers the decision usefulness of the fair value measure itself.
That is, the form of fair value disclosure and aggregation is not considered. This abstract perspective can be thought of as the disclosure of the fair values for all assets and liabilities an enterprise holds. It allows for the evaluation of the informational properties of fair value. Plus, it is consistent with the view taken by the fair value paradigm: Both the fundamental information aggregation and the information inference hypotheses regard fair value per se rather than questions of (aggregated) fair value accounting or even fair value income.
As a starting point, an orthodox measurement perspective is taken, with mixed results. In a world of complete and perfect markets, fair value equals market value equals value in use
(Barth and Landsman, 1995; Beaver, 1998). The sum of fair values for all the firm’s assets and liabilities (N positions) thus constitutes a precise measure of firm value and is therefore decision useful:
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V t
=
N ∑ n
=
1
VIU t n = n
N ∑
=
1
FV t n .
Obviously, fair value represents an ideal measurement attribute under these conditions. Many proponents of fair value measurement have, at least implicitly, in mind such a scenario. Yet, this setting not only represents an idealised world, it also does not have a role for financial reporting: By definition, complete information can be taken at no cost from the market
(Bromwich, 1977: 592; Ronen, 1974: 147). Financial reporting, however, is an institution created by the deficiencies of real world markets, notably asymmetric information and transaction costs.
As for the neoclassical scenario, the measurement perspective in a real world scenario of incomplete and imperfect markets requires investors to agree on one concept of value. Only if value is identically defined and thus independent of individual preferences and beliefs can the valuation task be delegated to the financial reports, i.e. the reporting entity.
Such an agreement on the value concept is only accomplished when separation of consumption and investment decisions is feasible: In that case, investors base their decisions on the present value of cash flows only and need no information on their timing, amounts and uncertainty, since they establish their preferred cash flow and consumption pattern via capital market transactions. Finance theory shows that such irrelevance of individual preferences is given when markets satisfy the spanning and the competitivity criteria (Grossman and Stiglitz,
1977; DeAngelo, 1981). Spanning prevails on a well-developed capital market which allows cash flows from non-financial investments to be duplicated and thus insured. Individual preferences concerning risk and timing are reflected in state prices which determine value.
The competitivity assumption requires that neither investments in non-financial positions nor capital market transactions have an impact on state prices. Spanning and competitivity thus are required for the present-value-criterion and therefore the shareholder-value-objective to hold.
Real-world conditions can generally be expected to roughly fulfill these separation criteria, except for “exotic” investment projects that create cash flows which cannot be hedged via capital market transactions. Value in use thus still represents the benchmark measurement attribute from a measurement perspective. However, fair value as a specific market value concept will normally not equal value in use. Additionally, no market prices exist for many assets, especially not for intangibles constituting competitive advantages.
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Whereas firm value conceptually equals the sum of the values in use for all identifiable assets and liabilities, the respective fair valuation systematically underestimates firm value:
V t
= n
N ∑
=
1
VIU t n = n
N ∑
=
1
FV t n + g t
.
Unlike market value, a positions’s value in use incorporates two components, the asset or liability in question plus a fraction of intangible assets, i.e. management skill. On the firm value level, the sum of these unidentifiable (not separable) intangibles equals goodwill (g) which accounts for the difference between firm value and market values of assets and liabilities.
At this point, the conceptual case for fair value measurement from a measurement perspective can only be made for a idealised scenario of complete and perfect markets which has no demand for financial reporting. Even if well-developed markets are assumed for a realworld-setting, fair value measurement under such conditions leads so systematic undervaluation of a firm since market values do not incorporate a firm’s competitive advantages resulting from specific intangible assets. The case for fair value measurement is thus weak.
Yet, if we look at fair value measurement from a less restrictive decision-modelapproach and consider not whether fair value measurement can produce an unbiased measure of firm value, but whether it can facilitate or improve individual valuations, a case can be made. Precisely, for activities not associated with rents, which do not interact with the firm’s other activities, valuation can be separated. Investors can combine the fair values of these activities and the present value of cash flows from other activities (c) in order to arrive at firm value:
V t
= n
M
=
1
FV t n +
τ
T
=
t
+
1
( 1
E
+ t
[ ] k ' c
)
τ
τ − t
This separation model illustrates how fair value information can improve decision making and is thus decision useful, if it allows for cheaper – a part of the valuation task is delegated to the reporting entity – and/or for more precise valuation, if higher quality cash flow projections can be reached for the remaining activities. This approach is well established in financial analysis (Penman, 2004: 455) and provides the case e.g. for fair value reporting for investment property and, if one is inclined to assume separability, for financial activities. Yet, it not only requires separability and zero rents for the activities in question, but also high
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information quality of fair value: Fair value can only substitute subjective projections if it represents an unbiased measure of the present value of future cash flows, i.e. the validity of the information aggregation assumption underlying the fair value paradigm is vital. This will be further explored once the information perspective has been considered.
4.2 Information perspective
From an information perspective, fair value’s contribution to decision usefulness is not evaluated on the basis of its convergence with value in use, but on its capability to alter expectations and thus revise decisions, or to efficiently aggregate value-relevant information.
Starting with the narrow concept of useful information, information content, the analysis brings up a straight-forward result: Since fair value, by definition, is only to include information publicly available in the market place, it cannot by itself revise expectations of market participants and therefore has no information content, let alone information value.
This is especially true for fair values estimated via marking-to-market, i.e. market prices.
Conceptually, it also applies to synthetical fair values generated by internal models, since the principle of market-based-measurement requires to use market data and to emulate market expectations. However, in practice internal estimates and assumptions, i.e. private management information, are incorporated into such fair values, leading to the awkward result that information content can only be achieved where fair value estimation violates the conceptual foundation of market-based measurement. Of course, these results are of a theoretical nature, since fair value measurement is applied to the entity-specific resources and obligations, information which is inherently private and thus of potential information content.
Yet, the fact that for a scenario of full disclosure of an entity’s assets and liabilities, full fair value measurement creates no additional information content since market participants can perform such a market valuation themselves points to a certain contradictiveness of the fair value concept.
However, the usefulness of fair value measurement may be reconstructed from a broad information perspective, if fair value in an efficient manner aggregates value relevant information. Since the question whether financial reporting constitutes the efficient means for reporting such information is hard to evaluate in a stringent manner, the central issue is whether fair value information is potentially value relevant. As pointed out, value relevance is assessed by the hypothetical question whether the respective information were capable of altering investors beliefs and action on publication if it were not publicly available.
15

Therefore, similar to the decision-model-approach, the ultimate evaluation of fair value rests on its informational properties, the question of what kind of information it transports and whether this information is of valuation relevance / potential information content. This evaluation obviously corresponds with the theoretical validity of the fair value paradigm and shall be assessed in the next section, which differentiates the two sources of fair value estimates, market prices and marking to model.
4.3 Informational properties of fair value
4.3.1 Marking to market
The interpretation of market price as the present value of future cash flows is well accepted in economics and finance. Yet, it is not descriptive of the nature of the expectations incorporated. More specifically, it is not clear what kind of information, i.e. what information set is processed and in what manner. Thus, the analysis of the informational properties of fair value as a market price is inextricably linked to the question of market efficiency. While the generic definitions are attributed to the seminal work of Fama (1970), a more specific concept shall be used for the purposes of this paper. The so-called Fama-Rubinstein -efficiency emphasizes the notion of “consensus expectations” which is central to the fair value paradigm. Accordingly, a market where naturally market participants hold heterogeneous expectations is efficient with respect to a specific information set. This information set can be conceptualized as consensus expectations, i.e. the set of homogeneous expectations that, if held by all market participants, would result in the identical price like the one witnessed in the presence of heterogenous expectations. That is, prices evolve as if each investor held the identical information set, that is consensus expectations (Rubinstein, 1975: 818). This concept of information efficiency confirms that any market price can, in principle, be reconstructed as an aggregate of consensus expectations (Verrecchia, 1979: 960).
The relevant question now concerns the nature of this information set. Specifically, the assumption traditionally held in economics that market prices efficiently aggregate the private information dispersed in the market place (v. Hayek, 1945: 526) needs further examination. That is, the informational quality of fair value as market price and thus the validity of the paradigmatic information aggregation assumption rests on the extent to which investors’ private information is factored into the market price, i.e. on the degree of market information efficiency in the strong Fama sense. The modern theory of asset pricing under
16

asymmetric information, notably rational expectations equilibria and strategic trader models, give valuable insights into this question.
Application of the theory of rational expectations to asset pricing emphasizes the dual role of prices: Not only does the price system in equilibrium balance supply and demand and clear the market; it also represents a source of information for market participants, who extract from market prices knowledge about other investors’ private information. Thus, a major result of this strand of research is the information content of market prices : Investors with individual expectations (private information sets) will act differently if they also survey market prices, that is the additional market price information is capable of inducing revisions in investment decisions (Grossman, 1981: 549-54). A second important result concerns the degree of informational efficiency, i.e. the information set that can be inferred from market prices. The Grossman-paradox illustrates that perfectly informative, “fully revealing” prices cannot exist in an equilibrium with costly information acquisition, because perfect inference from prices eliminates incentives for private information collection, which in turn reduces the informativeness of prices (Grossman, 1976). The implication is that only where additional noise inhibits the quality of prices as sufficient statistics for consensus expectations will incentives for information acquisition prevail. This leads to the paradox result that the biasedness of the price system is a condition for its informativeness; market efficiency in the strong sense cannot be accomplished. Noisy rational expectations equilibria recognize these precepts and show that, given stochastic noise, the informational quality of market prices, i.e. the degree of private investor information diffusion and aggregation, increases with reduced investor risk aversion and with the precision of their private information, whereas it is reduced with the cost of private information acquisition and with noise (Grossman and Stiglitz, 1980;
Diamond and Verrecchia, 1981; Hellwig, 1980; Verrecchia, 1982).
A different theoretical branch, the so-called strategic trader models , yield additional results on the determinants of market prices’ information quality. Here, the focus lies on the strategic implications of the use of private information by insiders, especially on the factors which determine the speed and amount at which such insiders give their information into the market and have it factored into the price system. In a seminal model, Kyle (1985) shows that in Bayes-Nash-equilibrium, the “aggressiveness” of the insider’s use of his private information critically depends on the amount of non-information-based trading, which provides noise and thus camouflage for the insider. Market makers, on the other hand, anticipate the insider’s strategy and make price adjustments that are inversely correlated with the amount of noise trading, i.e. the possibility to compensate losses from trading with the
17

insider with gains from trading with uninformed market participants. This result leads to the important implication that the market liquidity in its price dimension, i.e. the price reaction to an order, results endogeneously as a reaction to insider trading and is thus a theoretically sound indicator of adverse selection or information quality of the price system (Kyle, 1985;
Glosten and Milgrom, 1985). Follow-up models refine these results and demonstrate that the quality of market prices increases with the competition among insiders and the precision of their private information, and decreases with their risk aversion and with the volume of noise trading (Kyle, 1984; Holden and Subrahmanyam, 1992; Subrahmanyam, 1991; Vives, 1995).
The theory of asset pricing under asymmetric information thus yields several insights into the informational properties of fair value estimated as market price. At the outset, the Grossman paradox shows that this fair value cannot be fully informative: unbiased consensus expectations cannot be inferred. Theoretical models illustrate the factors that determine the quality of partially revealing market prices. More recent insights from behavioral finance theory suggest that additional to noise, irrational market behavior is a factor reducing the information quality of market prices (Shleifer ,2000). Thus, the paradigmatic information aggregation assumption holds roughly only for specific assets traded on organized, highly liquid markets. For positions not traded on organized exchanges, markets can be characterized as search markets (Krainer and LeRoy, 2002). Under these circumstances, market prices normally cannot be interpreted in the paradigmatic sense, since they result from specific transactions between two parties and rather indicate value in use than aggregate the consensus expectations of numerous market participants.
As for the second paradigmatic hypothesis, rational expectations equilibrium models reconstruct the “learning from prices” assumption, according to which investors infer information about the probability distribution of cash flows. However, this conditioning of expectations rests on strict assumptions, especially normal distribution of cash flows, which are not descriptive of reality. In fact, one price can be the result of an infinite number of cash flow profiles. The notion of infering precise information on the timing, amounts and uncertainty of consensus cash flow expectations is thus not very realistic; the revision of a subjective present value estimate sure is.
Given the mixed findings on the theoretical validity of the fair value paradigm, the implications for the decision usefulness of market price reporting needs consideration. The result that market prices have information content in that their disclosure induces revision of decisions exclusively based on individual information sets demonstrates the valuation
18

relevance of market price information for the respective positions. Applying this result to aggregated reporting, the disclosure of a sum of market prices for homogeneous positions, e.g. fair value of trading securities, conveys information relevant for the valuation of the firm as a whole. Investors learn about the consensus present value for the positions in question and can thus extract useful information from financial reports. Therefore, given sufficient information quality, the decision usefulness of (aggregated) market price disclosures can be reconstructed from the broad information perspective. As pointed out, information content, i.e. decision usefulness in the strict information economic sense, is questionable for publicly available market prices given the disaggregated disclosure of a firm’s assets and liabilities.
From a measurement decision-model perspective, requirements for market prices to represent useful information are more restrictive since the information quality needs to be higher than or at least equal to the quality of the investors’ individual projections, which are substituted by market price information in a separation calculus. Obviously, the decision to substitute one’s own projections for a biased aggregated consensus forecast is context-specific and critically depends on the private information set and the cost structure of the investor in question. Yet, tentative reasoning suggests that only prices for positions traded on highly liquid markets should be traded, with no hints to investor sentiment or irrationally motivated biasedness. Similar to the information perspective, the case for substitution seems weak with respect to prices for positions not traded on organized markets, and can normally only be made based on cost considerations rather than based on the notion of improved estimation quality.
4.3.2 Marking to model
With the move from market price valuation to the modelling of a synthetic market value, fair value becomes a hypothetical market price under ideal rather than idealised conditions. This is due to the neoclassical character, the strict assumptions underlying contemporary pricing models. The CAPM is representative of these models and illustrates the ideal character of resulting estimates. It is the foundation of present value calculations and is explicitly suggested by FASB and IASB as valuation method. Underlying the CAPM are the assumptions of perfect and complete markets, notably no transaction costs and perfect information. Thus, the valuation methods underlying fair value modelling usually do not take into account the influence of information asymmetry on market pricing, which is of course due to the infant state of this line of research (O’Hara, 2003: 1336). Plus, they assume equilibrium states, while financial reporting is a result of disequilibrium situations (Peasnell,
19

1977: 164). In brief, valuation methodology rests on strict assumption not descriptive of reality that lead to systematic overvaluation of assets vis-à-vis “real” market prices. This biasedness is aggravated by standard setters’ pragmatic guidance on marking-to-model, which allows for the ignorance of risk, i.e. for risk neutral valuation where the reporting firm can demonstrate that the estimation of risk premia is only feasible with undue costs (SFAC 7, par.
62; FASB, 1999, par. 82).
A second fundamental informational feature of synthetic fair value is the lack of verifiability and, thus, of reliability. This is characteristic of any economic valuation, which axiomatically rests on projections and expectations of the future. Since such prospective data represents soft information, only plausibility and consistency judgements can be made.
Despite the inevitability of the decline of reliability down the estimation hierarchy, existing guidance on marking-to-model does not cope with it in an appropriate manner. Although the emphasis on market data represents a suitable reaction to the loss of verifiability, the lack of specificity and of prescriptiveness, for example for risk measurement or for cash flow projections, creates numerous loopholes, opportunities for the exercise of management judgement and discretion and thus for earnings management (Benston et. al.
, 2003: 39).
5
Therefore, the traditional argument that fair value reporting reduces incentives and opportunities for management discretion seems to focus market price valuation rather than marking-to-model. It does not hold for the majority of non-financial assets which cannot be marked to market, questioning the reliability of the fair value concept as a whole.
While the reliability issue is grave, from the perspectives taken here the issue of information aggregation is equally important. A straightforward result is that model-based fair value cannot, by definition, represent an aggregate of expectations spread in the market place:
Since valuation rests on the information set of one person or one organisation, this fair value loses its capacity to efficiently collect and aggregate consensus expectations on the cash flows of the relevant position. The paradigmatic information aggregation assumption fails, and so does the theoretical case for fair value reporting. Rather than market information, modelbased fair value incorporates management’s private information and assumptions, that is value in use.
5
For example, SFAC 7 discusses various methods for calculation of risk premia, such as portfolio theory and arbitrage pricing, yet simultaneously critizises their descriptiveness with reference to behavioral pricing
(par. 62-71), thus giving no final guidance. Even more, par. 62 allows for discounting with a risk free rate of interest only if no reliable estimate of the risk premium can be made. The recent Exposure Draft on fair value measurement (FASB (2004)) does not alleviate theses concerns.
20

From a measurement, decision-model perspective this result forbids the qualification of fair value as an estimate of fundamental value. The investor rather needs to trade off the benefits of private information incorporation into such fair values against the danger of systematic biasedness due to earnings management. Again, no definite results emerge, yet the overall suitability of such estimates as replacements for individual investor expectations is reduced, the case for decision usefulness rather weak.
Since the fair value paradigm has an information-economic flavor, the collapse of the paradigmatic information aggregation assumption, the impossibility to reproduce market expectations and thus to simulate “informative” market prices, impairs the decision usefulness of synthetic fair value from an information perspective. The reconstruction of fair value reporting as an efficient aggregation of value-relevant information fails. Yet, model-based fair value is capable of creating useful information in the strict, information content sense, when credible communication of private management information takes place. Empirical evidence suggests this is happening (Beaver and Venkatachalam, 2000; Barth and Clinch, 1998). This leads to the result that fair value reporting on the marking-to-model level is only capable of reconstruction when the fair value definition is violated and elements of value in use are incorporated. Obviously, this effect refutes rather than confirms the paradigmatic foundations of fair value measurement.
Summing up, the decision usefulness of disaggregated fair value information can be reconstructed both from an information and a measurement perspective, yet only under specific conditions. Notably, the paradigmatic foundations of fair value measurement appear theoretically valid only for prices taken from organized, sufficiently liquid markets and can therefore hardly be applied to reporting for non-financial items, which typically require model-based estimation. Where market prices are used, additional concerns arise because such measurement of assets and liabilities is based on publicly available information not specific to the entity and thus increases reliability, yet deprives management of possibilities for signalling private information. These results are, of course, of a very general and abstract nature. The purpose of the next section is to look at the reporting issues involved, i.e. to investigate aspects of the form of fair value reporting.
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5.1 The case for fair value accounting
The form of reporting is irrelevant from a strict information perspective. Thus, when we focus on such issues, we assume that especially recognition versus disclosure matters due to cost of information acquisition and processing. Other reasons for the relevance of presentation are contracting issues which are not addressed here. The theoretical case for the relevance of the reporting form is supported by the empirical evidence in general and specifically for fair value reporting (Ahmed, Kilic and Lobo, 2004; Beatty, Chamberlain and Magliolo, 1996).
The paradigmatic foundations of fair value measurement refer to fair value per se and thus do not specify or support any specific form of aggregation or presentation. Notably, no case is made for fair value accounting, since the disclosure of fair values would suffice to benefit from the alleged informational properties. Yet, as pointed out, fair value is increasingly being used for balance sheet and income measurement. Assuming a positive role for historical cost based financial statements, notably for contracting reasons (Watts, 2003), this implementation of fair value accounting therefore requires theoretical support beyond the informational quality of fair value by itself. It is the task of the following section to analyse the properties and potential decision usefulness of fair value accounting. Despite articulation, we distinguish between balance sheet valuation and fair value income for expository reasons.
5.2 Fair value balance sheet
The move from historical cost accounting towards fair value accounting emphasizes an economic approach to accounting measurement, where economic values are reported on the balance sheet, partly estimated on the basis of theoretical pricing models. This emphasis on the valuation function of the balance sheet, coupled with the paradigmatic foundations that rest on a stocks perspective, illustrates the growing importance of the balance sheet as a standalone instrument of investor information (Barker, 2004: 166; Razaee and Lee, 1995: 217). In the terminology of accounting theory, the asset-liability approach and thus an informative role of the balance sheet is strengthened vis-à-vis the traditional revenue-expense approach, which is on the decline. An immediate implication of this is an increase in book value of equity: Fair value accounting closes the gap between market valuation and historical cost of an asset or a liability, thus eliminating hidden reserves.
As pointed out, the information perspective does not allow for evaluation of different reporting formats. Therefore, this approach will not be used intensively here. The
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only implications are that, in accordance with the results of the previous sections, the high degree of aggregation associated with balance sheet format reporting substantially inhibits the inference of the underlying consensus present value, let alone the cash flow profiles. This is especially true where fair values based on market prices and such based on modelling are mixed together and, more severly, where heterogeneous positions valued at different measurement attributes are summed up in one balance sheet caption. From a strict information perspective, the high degree of information aggregation characteristic for balance sheet measures thus leads to a negative assessment of potential decision usefulness.
Similarly, the prior results on the orthodox measurement perspective evaluation of fair value measurement can be applied to balance sheet measurement, since they are independent of aggregation. Book value of equity under fair value accounting does eliminate hidden reserves for recognized assets and thus narrows the gap between accounting value and enterprise value (market value of equity). Yet, for conceptual reasons, it cannot eliminate this gap, which is constituted of two further elements: the fair values for identifiable, yet not recognisable positions such as certain internally-generated assets (“recognition gap”), and the fair values of the remaining, non identifiable factors incorporated into goodwill (“goodwill gap”). Fair value accounting is neither conceived for nor capable of measuring directly the value of the firm. The perception of book value under fair value accounting as a measure of enterprise value is thus ill-founded.
The overall negative evaluation from a strict measurement perspective can once more be modified using the less restrictive decision-model approach. By assuming cleansurplus accounting and rewriting the cash-flow valuation model so far assumed as residual income model, the notion of book value of equity as heuristic measure of a fraction of enterprise “value” can be confirmed. The residual income valuation formula depicts firm value as the sum of book value of equity plus the present value of future residual earnings
(Ohlson, 1995; Edwards and Bell, 1964). In doing so, it confirms the valuation relevance of aggregated accounting data. Numerous proponents even argue the superiority of accountingbased valuation, since it reduces the fraction of firm value to be estimated based on projections, notably the terminal value problem, relieves the valuation task of the difficult forecasting of dividends and thus “brings value forward in time” (Penman, 2004: 160;
Penman and Sougiannis, 1998; Penman, 1998). Although accounting valuation theory is silent on the comparative advantages of different measurement attributes, this basic idea suggests that fair value accounting is superior to historical cost accounting, since it “brings more value on the balance sheet” and c.p. reduces the present value of residual earnings to be forecasted.
23

Certainly, this represents a rather crude argument in need of further elaboration. Especially, the predictive ability of earnings and residual earnings under different measurement regimes is crucial and needs further exploration.
Thus, the increasing economic character of the balance sheet reduces the valuation gap and insofar focuses the estimation problem on residual earnings valuation. Intuitive reasoning suggests superior decision usefulness of fair value accounting from a decisionmodel (measurement) perspective. Ultimate evaluation, however, rests on the informational properties of fair value income, which will be the subject of the following section.
5.3 Fair value income
5.3.1 On the evaluation of income concepts
The discussion of fair value income in the literature and by regulators so far seems somewhat paradox. The analysis of the properties and decision usefulness of fair value income is not part of the fair value paradigm, which rests solely on a stock perspective. Scientific evaluation is equally sparse, since most empirical studies focus the value relevance of fair value dislcosures and analytical papers so far have not taken issue with fair value income. These facts contrast starkly with the prominent role of earnings in the capital market, which is normally equally reflected and recognized by the theoretical literature (Beaver, 1998: 38, 89-
124). Additionally, the most contentious aspects of the debate on fair value accounting center on its implications for earnings. While the debate is in principle concerned with the fundamental questions of recognition versus dislosure, the qualification of revaluation gains and losses and the disaggregation of income (performance reporting), the practical, sometimes even political discussion focuses on the volatility issue .
Opponents of fair value income claim that current valuation leads to increased volatility of earnings, with negative implications for predictive ability (e.g. Christie, 1992: 87;
Poon, 2004: 40; Wilson and Rasch, 1998: 24). In a more subtle vein, it is argued that fair value measurement for certain positions only will lead to “artificial” volatility and “distorted” earnings, because revaluation gains and losses are economically compensated by the valuation differences for positions not measured at fair value (“mismatching”) (e.g. Mauriello and
Erickson, 1995: 181; Beatty, 1995: 28). This argument was first discussed with the introduction of SFAS 115, which does not allow fair valuation of financial liabilities, yet in a compromise solution alleviates volatility concerns by reporting fair value differences for available-for-sale securities outside earnings.
24

Proponents of fair value income, on the other hand, stress its economic character and argue that remeasurement gains and losses express “real economic volatility” (e.g. Sprouse,
1987: 88; Wyatt, 1991: 84). Plus, income realisation based on “objective” market values allegedly deprives management of a device for earnings management (e.g. Barlev and
Haddad, 2003: 384, 395).
The volatility debate, which serves as a motivation for further analysis, poses two problems. First, the notion that the move to fair value accounting generally leads to increased earnings volatility is invalid. It rests on an isolated view on a single position and neglects compensation effects when a number of positions, especially both assets and liabilities, are remeasured at fair value. Therefore, volatility implications need to be considered separately for each rule or standard in question. Second, evaluation of fair value vis-à-vis historical cost concepts of income requires a notion of “appropriate volatility”, that is, a concept of informative income (Gellein, 1986: 16). Yet, due to the impossibility theorem, there is no one, universally accepted definition of income under conditions of imperfect and incomplete markets (Beaver and Demski, 1979). More probematically, standard-setting bodies do not take on their role, which is to make such welfare-relevant decisions: Neither FASB’s nor
IASB’s framework exhibits a clear definition of the income concept pursued, despite the emphasis on the informational role of earnings (Barker, 2004: 158, 164).
Evaluation of fair value income must therefore be conducted on the basis of concepts that are conceivable from a standard-setting perspective, that is, concepts that can be reconstructed as consensus criteria for the overwhelming majority of investors addressed.
Accounting theory discusses numerous notions of “informative” or “quality” earnings
(Schipper and Vincent, 2003). For purposes of this paper, the two concepts of economic income and of persistent earnings shall be considered and applied to the conceptual cases of pure fair value accounting (event-based income) and pure historical cost accounting
(transaction-based income).
5.3.2 Fair value as economic income (measurement perspective)
Economic income is usually associated with Hicks’ definition of income, according to which
“a person’s income is what he can consume during the week and still expect to be as well off at the end of the week as he was at the beginning” (Hicks, 1946: 176). It is the change in firm value during one period and thus a direct measure of individual welfare or consumption potential. In a setting of certainty, economic income equals the interest on firm value at the
25

beginning of the period. For uncertainty, this expected income is modified by an unexpected component.
Since it requires a strict definition of value, economic income is well defined only in a neoclassical setting. It is thus the income concept typically associated with an orthodox measurement perspective (Beaver, 1998: 49, 57, 64-67). Yet, it is of conceptual merit even for analysis of real-world income concepts, since it allows for comparative analysis of relevant properties and emphasizes differences compared to ideal “earnings quality” (Schipper and
Vincent, 2003: 97). Therefore, some remarks shall be made on the conjecture that fair value income represents a superior estimate of economic income since is rests on economic valuation (i.e. market valuation). In doing so, we assume that rents, i.e. net present value, are a component of economic income.
6
Any concept of accounting income that satisfies the clean-surplus condition will over time result in accumulated earnings that equal the cash flow surplus. Thus, for the whole life of a firm, fair value income equals historical cost income equals economic income.
Differences are only inter-temporal and result from different degrees of delayed or biased recognition of accounting income. For fair value income, recognition is less delayed, that is, the gap between creation and accounting recognition of value is smaller than for historical cost accounting. Income realization does not rest on market transactions but on market valuation. Yet, even under fair value accounting, value differences attributable to unrecognized intangibles and goodwill are not recognized until they result in cash transactions. Thus, fair value income as one variant of an economic approach to income measurement differs systematically from the concept of economic income (Hicksian income).
This is especially relevant for firms not in a steady state, that is for firms with increasing or declining net assets (Zhang, 2000: 132).
Thus, fair value income represents no valid indicator of economic income, since, given growth, both earnings measures differ systematically, where the differences increase with the gap between firm value and the book value of equity. From a strict measurement perspective, decision usefulness cannot be supported. Apparently, proponents of fair value income who insist on its capability to depict “economic reality” implicitly employ such an economic perspective on income measurement. However, the systematic differences indicate that this argument is ill-founded, because mismatching occurs due to unrecognized assets and
6
For the distinction between economic income in a narrow sense and such “economic profit” see
Christensen/Demski (2003), pp. 40, 50.
26

goodwill and impairs fair value income’s capacity to express economic reality, since in such cases it does not represent an acccurate measure of change in firm value. As it turns out, even from an economic income perspective, earnings variations in a full fair value model incorporate elements of “artificial volatility” and thus do not accurately portray economic reality.
5.3.3 Predictive ability
While economic income already incorporates firm valuation and thus does not leave a prediction task for investors, it is this formation of expectations about the future that is the prime concern of investors in a realistic setting. The concept of predictive ability can therefore be reconstructed as a conceivable consensus criterion for decision usefulness (Beaver,
Kennelly and Voss, 1968). It can be reconciled both with information and measurement perspectives on decision usefulness, yet needs further elaboration. In accordance with notions hinted at in the frameworks,
7
above all for its prevalence in valuation practice and accounting theory (Beaver, 1999: 163; Schipper and Vincent, 2004: 99), predictive value shall be measured by the degree of earnings persistence .
Earnings persistence refers to the degree to which present earnings persist into the future. The concept thus assumes that investors conduct valuations based on estimates of future earnings. The residual income model provides one rationale for this assumption. In a more precise specification, earnings persistence is defined by the autocorrelation of unexpected earnings components (Lipe, 1990: 50, 52). As two extreme points of theoretical reference, permanent and transitory earnings can be distinguished. While a permanent earnings shock is assumed to persist in equal amount for all future periods, transitory earnings shocks have no implications for future earnings at all (zero autocorrelation) (Ohlson, 1999;
Ramakrishnan and Thomas, 1998).
Opponents of fair value accounting who resort to the volatility issue typically have an income concept of earnings persistence in mind, when they claim that introduction of fair value accounting creates volatility due to erratic market value movements that deprive accounting income of its predictive ability. This notion in many cases stems from the traditional conjecture in accounting theory that focussing either income statement or balance sheet results in a decline in information quality of the opposite reporting instrument. Thus, it
7
Although, as pointed out, the frameworks elaborate no concept of informative earnings, several paragraphs hint at the concept of persistent earnings. See e.g. SFAC 1, par. 44; SFAC 5, par. 31; IASB Framework, par.
28.
27

is argued, the focus of fair value accounting on balance sheet information comes at the price of a loss in the informativeness of the income statement (e.g. Christie, 1992: 95, 101). The validity of this conjecture is to be evaluated, starting on the level of single positions held at fair value.
The assumption of erratic, non persistent moves in asset values is a traditional subject of debate in the literature on efficient (capital) markets. Specifically, the characterization of asset values as following a Martingale-process lends vindication to the conjecture of decreasing earnings persistence. Values (prices) follow a Martingale-process if today’s value represents the best estimate, i.e. expected value, of the future value: E t
[V t+1
] =
V t
. The well-known random walk property satisfies this definition (LeRoy, 1989: 1589). For an asset following a Martingale, the fair game property of efficient markets theory applies. It states that for a given information set, no abnormal return can be made on an efficient market by using that information. More specifically, with respect to the fair value concept, which rests on the assumption of efficiency in the semi-strong sense, the expected abnormal return of using publicly available information for asset valuation is zero. This means that any deviation from expected value, i.e. current value, is by definition unexpected, and there is an equal chance of positive and negative deviations. This is the result of the Samuelson theorem , which presents a strong case against the usefulness of fair value income: Since today’s value incorporates all relevant information, any deviation from it cannot be predicted (Samuelson,
1965, 1973). Differences between expected return and realized return, i.e. “unexpected fair value income”, are unpredictable and uncorrelated, thus purely transitory .
However, a closer look suggests that the Martingale property cannot be generalized for any market value or market price, since the fair game property refers to the return on an asset, which consists of both a revaluation and a cash flow component. Only when the expected return on the asset equals the expected cash flow will any deviation from today’s value be transitory, i.e. unexpected. That is, for assets whose cash flow patterns do not satisfy this property – this will be the case for any asset subject to deterioration –, the expected value follows a trend, with deviations from this trend occuring randomly. That is, the change in fair value consists of an expected and an unexpected component (fair value shock). For an expected (market) rate of return k and cash flows c, the change in fair value can be decomposed:
FV t
−
FV t
−
1
= ×
FV t 4
−
E t 4
( c
3
) expected change in fair value
+
[ t
−
E t
−
1
( FV t
)
] fair value shock
28

Therefore, the conjecture of random movements in fair value is too crude a qualification, since it applies only to a fraction of the revaluation difference. This is further illustrated by looking at fair value income, which is defined as the change is fair value plus the cash flow realized. Realized fair value income equally consists of an expected and an unexpected fraction: x t
FV
=
=
FV t k
−
FV t
−
1
FV t
−
1
+ c t
+
[ c expected fair value income
−
E ( c t
|
Ω t
−
1
)
]
+
[ cash flow shock
4
−
E
(
FV t
|
Ω
4 3
) ] fair value shock
The unexpected cash flow component is strictly transitory, because fair value is independent of the current cash flow realization. Yet, the fair value shock is partly persistent, since it directly bears on current fair value which by itself is multiplied with the market return to yield expected income. Additionally, systematic deviations from expected fair value income occur when the position is associated with rents. If the firm can use the position in a favorable way compared to the market or has private information concerning its prospective cash flows, the
“unexpected” component of fair value income will be correlated and thus have predictive ability.
Summing up, the Samuelson theorem presents a theoretic backing for the conjecture of random moves in fair value and thus the distortion of income’s predictive ability. Yet, at a second glance, it needs to be applied cautiously. It turns out that changes in fair value can indeed be correlated in time, despite market efficiency. A fair value income measure which incorporates the cash flow component will exhibit certain persistence, since fair value shocks bear on expected return.
These results, however, concern single assets only and are not of a comparative nature. Thus, the next step is to compare fair value accounting income to the transactionbased concept. Since such earnings numbers are the result of a complex measurement process and also include revenues and gains stemming from transactions and events not recognized on the balance sheet, a thorough investigation is not attempted. Yet, important points can be made with reference to a stylized scenario, where a single-asset firm is assumed that produces one good for a limited number of periods and sells it at uniform numbers, capitalizing on a competitive advantage that enables the firm to demand above-market prices.
For a situation where all expectations are precisely fullfilled, fair value income will, in time, decline. Despite uniform cash flows, the interest component of fair value, which offsets the cash flow component, will decline, leading to an increase in “fair value
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depreciation”. Transaction-based income, on the other hand, is uniform due to straight-line depreciation and thus presents a more adequate picture of enterprise performance. On the other hand, fair value residual income is constant in time and depicts the competitive advantage, i.e. the fraction of sales that is earned on top of market expectations. Transactionbased residual income increases in time and thus seems less accurate. These, however, are rather crude qualifications that only serve as a starting point. Predictive ability matters where expectations are not fulfilled, i.e. where economic shocks occur. Therefore, the implications of a sales shock and an interest rate shock are pondered.
A sales shock , the increase in products produced and sold due to an unexpected rise in demand, results in an unexpected increase for both event-based fair value income and the transaction-based historical cost income. Insofar, both concepts reflect the “good news”.
Since historical cost income returns to a steady path in the following period, it suggests greater persistence. Notably, a persistent sales shock will result in a fully persistent income shock, since the additional revenue will reoccur over the following periods. Clearly, this property of historical income is what many proponents of transaction-based income recognition have in mind, because fair value income is less stabile: It exhibits a one-time shock in the period of the economic shock and then declines in the following periods. If one shares the strict definition of useful income as persistent income, a case can be made for transaction-based accounting. Put differently, the volatility criticism can be supported from this perspective.
However, a second glance at the time-series behavior of the two earnings numbers shows a property of fair value income so far hardly encountered in the literature. Since transaction-based income will only recognize the effects of the economic shock on current period’s sales, it cannot discriminate one-time shocks from lasting, i.e. persistent effects. This lack of responsiveness contrasts sharply with fair value income, which will c.p. react the stronger, the more persistent the economic shock. More precisely, since the fair value shock captures the revisions of cash flow expectations for all future periods, it will correlate with the persistence of the sales shock. The fair value shock as a component of fair value income, unlike unexpected historical cost income, discriminates the persistence of economic shocks and thus allows for a more precise state partition. That is, despite its lack of persistence in the traditional definition, fair value income represents the finer information system than historical cost income.
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This property is further demonstrated by considering a lasting interest rate shock , the unexpected negative shift of the term structure of interest rates, which modifies cost of capital and therefore the discount factor underlying the fair value of the firm’s asset. This represents an eonomic event that alters the company’s value, yet leaves the cash flows unchanged. Historical cost income therefore completely neglects this event, whereas fair value income rises unexpectedly. Whereas transaction based income again is more steady and persistent, the rise in fair value income is followed by declines due to the interest rate effect, i.e. negatively autocorrelated. Yet, unlike historical cost, fair value income signals the occurrence of a valuation relevant event and thus transports more information.
In conclusion, the fundamental conjectures against the predictive ability of fair value income can be supported if one employs the traditional concept of earnings persistence. Fair value income incorporates economic shocks more extensively , since their implications for all future periods are immediately recognized, and more completely , because cash-flow-irrelevant shocks are also recognized. This greater responsiveness to valuation relevant events impairs the steadiness of the earnings number, that is the autocorrelation of earnings (shocks). Yet, in informing more precisely and more thoroughly about these relevant events, it represents the finer information system. Put differently, fair value income incorporates more information than transaction-based income, whose stability may be deceptive: the persistence of historical cost income appears far more “artificial” than the “volatility” of fair value income.
Our analysis of fair value income illustrates that the positions taken and conjectures made on its desirability rest on specific notions of informative income. Since economic income and persistent income represent two different income concepts, many arguments against and in favor of fair value accounting cannot be compared, i.e. they are incommensurable. Thus, final conclusions and evaluations of desirability cannot be reached.
Yet, the discussion points at an important insufficiency underlying the debate and the shift to fair value accounting. Up to this present day, accounting standard-setters fail to communicate the income concept that is pursued with the implementation of fair value measurement.
Discussion so far suggests that they have none, which severly inhibits future progress and consistency in standard-setting. The results here indicate that the relevant concept is not one of earnings persistence, which serves as problematic vindication for the transaction-based model (revenue-expense approach). Rather, residual income seems a path worthwile of deeper exploration. Coupled with the merits of “bringing value forward in time”, one advantage of fair value income is that it focuses economic rents and is less disturbed by effects of delayed
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recognition. Future research into the properties and quality of fair value residual income appears promising.
This paper examines the potential decision usefulness of fair value reporting from two conceptual viewpoints, the measurement and the information perspective. As a point of reference, the paradigmatic assumptions underlying the move to market valuation are extracted from standard setters’ pronouncements. The analysis of the fair value measure shows that decision usefulness can be reconstructed for fair value as a price taken from liquid markets. The conceptual case for marking to model, on the other hand, is less strong. Notably, the paradigmatic assumptions do not hold for the fair value of most non-financial assets, putting into question the theoretical backing for fair value reporting and its universal use as preferred measurement attribute. In a second step, fair value accounting is analysed. Standard setters offer no reasoning as to the desirability and implementation of fair value as a balance sheet and income measure. Most strikingly, no income concept is given. Application of a traditional measure of predictive ability, earnings persistence, suggests the relative inferiority of fair value income vis-à-vis transaction-based income and therefore lends support to criticisms of unrepresentative income volatility. However, further examination demonstrates that fair value income is a superior indicator of the occurrence and persistence of valuation relevant economic events, leaving an unclear picture. There are at least three immediate implications of this research for standard-setting:
(1) There is a theoretical case for the disclosure of prices taken from organized, sufficiently liquid markets, since these allow for the rough inference of the market’s consensus expectations concerning amounts, timing and uncertainty of future cash flows. Fair value disclosures for traded financial instruments can thus be supported. Given the conceptual merits as to income determination, full fair value accounting for financial instruments appears as the superior path, despite reliability concerns for non-publicly-traded instruments and distortions vis-à-vis the economic income model.
(2) Since fair value measurements based on valuation models do not inform about consensus expectations, the conceptual backing for fair valuation of non-financial items appears ill-founded. Additionally, empirical evidence supports the notion of grave reliability concerns for fair values not taken from active markets. At present, there is no conceptual case for generalising the fair value paradigm to non-financial items such as property, plant and equipment or even intangibles.
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(3) The special case against incorporating fair value measures into the core financial statement is further supported by the vagueness of the income concept thus pursued.
Theoretical reasoning demonstrates that the relative superiority of fair-value vis-á-vis transaction-based income varies critically with the notion of predictive ability applied. As long a standard-setters are hesitant to elaborate their notion of fair value income and its contribution to decision usefulness, the transaction-based income concept should be sustained for non-financial items.
The results affirm the need for a definition of useful income which standard setters so far have failed to develop. The fundamental discussion of financial reporting quality triggered by the Enron failure, which among other things resulted in a committment to more
“principle-based” standard-setting and a joint conceptual framework project undertaken by
FASB and IASB, represents a unique opportunity for standard setters to remedy this fundamental deficiency. Conceptual, normative accounting research can lend valuable support to this task. Since fair value income as an economic concept puts more emphasis on balance sheet valuation and implies a more economic concept of income, residual income valuation appears as a particularly promising concept for further exploration.
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Kölner Diskussionspapiere zu Bankwesen, Unternehmensfinanzierung,
Rechnungswesen und Besteuerung
Cologne Working Papers on Banking, Corporate Finance, Accounting and Taxation
Hrsg./ed.:
Thomas Hartmann-Wendels , Seminar für ABWL und Bankbetriebslehre, Universität zu Köln
Norbert Herzig , Seminar für ABWL und betriebswirtschaftliche Steuerlehre, Universität zu Köln
Dieter Hess , Seminar für ABWL und Unternehmensfinanzen, Universität zu Köln
Carsten Homburg , Seminar für ABWL und Unternehmensfinanzen, Universität zu Köln
Christoph Kuhner , Seminar für ABWL und für Wirtschaftsprüfung, Universität zu Köln
Wirtschafts- und Sozialwissenschaftliche Fakultät, Universität zu Köln
Albertus-Magnus-Platz, 50923 Köln
Bisher erschienene Beiträge / Contributions:
01/2005 Hautsch, Nikolaus
Hess, Dieter
Bayesian Learning in Financial Markets – Testing for the
Relevance of Information Precision in Price Discovery
02/2005 Kuhner, Christoph
03/2005 Kuhner, Christoph
Interessenkonftlikte aus Sicht der Betriebswirtschaftslehre
Zur Zukunft der Kapitalerhaltung durch bilanzielle
Ausschüttungssperren im Gesellschaftsrecht der Staaten
Europas
04/2005 Hitz, Joerg-Markus The Decision Usefulness of Fair Value Accounting – A
Theoretical Perspective
38