2014
Why “FAIR VALUE” is the Rule?
ACCOUNTING
CS1g-11
Fair Value-
The argument for fair value accounting
calculate executive bonuses. And after
at a given
is that it makes accounting information
asset prices began falling, many
unbiased estimate of the
potential market price of a good, service,
or asset. It takes into account such:
level of
more relevant. However, historical cost
financial executives blamed fair value
development
accounting is considered more
markdowns for accelerating the decline.
of social
conservative and reliable. Fair value
Objective
Factors
Subjective
Factors
productive
accounting was blamed for some dubious
capability
practices in the period leading up to the



a rational and
acquisition/pr
oduction/distr


characteristics
demand
For the past two decades, fair value
accounting—the practice of measuring
assets and liabilities at estimates of their
current value—has been on the ascent.
This marks a major departure from the
centuries-old tradition of keeping books
at historical cost. It also has
implications across the world of
business, because the accounting basis—
whether fair value or historical cost—
affects investment choices and
management decisions, with
consequences for aggregate economic
activity.
cost of and
costs, or costs
return on
of close
capital
substitutes

utility
risk
ibution costs,
replacement
actual utility
individually
perceived
supply vs.
Wall Street crash of 1929, and was
virtually banned by the U.S. Securities
and Exchange Commission from the
1930s through the 1970s. The 2008
financial crisis brought it under fire
again. Some scholars and practitioners
have connected its proliferation in
accounting-based performance metrics
to the actions of bankers and other
managers during the run-up to the crisis.
Specifically, as asset prices rose through
2008, the fair value gains on certain
securitized assets held by financial
institutions were recognized as net
income, and thus sometimes used to
Yet both Generally Accepted
Accounting Principles in the United
States and International Financial
Reporting Standards, adopted by nearly
100 countries worldwide, continue to use
fair value extensively—for example, in
accounts concerning derivatives and
hedges, employee stock options,
financial assets, and goodwill
impairment testing.
One explanation for the rise of fair value
accounting is that finance theory—in
particular, the idea that financial
markets are efficient and their prevailing
prices are reliable measures of value—
permeated academic accounting research
in the 1980s and 1990s, thus changing
opinions on the relative merits of
accounting “relevance” and
background factors such as members’
Goldman Sachs, Morgan Stanley, and
historical cost and fair value.
“reliability.” The FASB recognizes a
tenure on the board, their political
Merrill Lynch—were all enthusiastic
trade-off between those two goals and
affiliation, the backgrounds of
supporters of fair value rules for mergers
has justified the increased use of fair
contemporaneous members of the SEC,
and acquisitions during FASB
value accounting by arguing that it
broader market and macroeconomic
deliberations on the subject.
increases accounting’s relevance. Several
conditions, and biases, if any, among the
academics, have argued that it decreases
large audit firms.
A study that the Harvard Business
School doctoral student Abigail Allen
published in the May 2012 issue of
the Journal of Accounting and
Economics, “Towards an Understanding
of the Role of Standard Setters in
financial reporting’s reliability.
THE SHIFT TO FAIR VALUE
The possible motives for individuals
from financial services to support fair
value accounting are complex and
Standard Setting,” points to another
They found that the backgrounds of the
numerous; here is an outline of a few
explanation. The study covers all the
individual standard setters on the FASB
likely ones:
members of the Financial Accounting
predict which standards they have
Standards Board, which sets standards
proposed. Notably, those with a
for GAAP, from its inception, in 1973,
background in the financial services
through 2006. They investigated their
industry—defined for their purposes as
backgrounds and the nature of the
investment banking or investment
standards they proposed. To control for
management—are more likely to
This empirical link can be augmented
both hindsight and potential researcher
propose the use of fair value methods.
with anecdotal evidence. For example,
bias, they relied on the
Before 1993 the FASB included no
the Investment Company Institute, a
contemporaneous assessments of the
financial services veterans; now such
U.S. industry association of asset
largest audit firms as expressed in 908
members make up more than a quarter
management firms, strongly supported
separate comment letters filed at the
of the board (see the exhibit “The Shift
the use of fair value accounting when
FASB archives in Norwalk, Connecticut.
to Fair Value”). The link between fair
lobbying the SEC in 2008 on FASB
Specifically, they examined how the
value proposals and a background in
Statement 157, which helps define fair
auditors evaluated the proposed
financial services is robust to numerous
value. And in 2000 and 2001 the then
standards on the dimensions of
substantive controls, including other
three largest investment banks—

First, investment banks and
asset managers are accustomed
to using fair value in their dayto-day business to prepare inhouse balance sheets for riskmanagement purposes. This
familiarity with the method
may have shaped their
preferences in public financial
reporting standards.

Second, GAAP profits defined
on a fair value basis rather than
a historical cost basis accelerate
the recognition of gains,

particularly in periods of rising
Members are chosen by the trustees of
privately held companies in the United
asset prices. To the extent that
the private Financial Accounting
States—which are less oriented toward
managerial bonuses are based
Foundation in a poorly understood
capital markets than their publicly
on GAAP profit numbers,
process that is often influenced by the
traded counterparts are—have recently
financial services executives
Securities and Exchange Commission.
set up their own accounting standards
reap richer rewards in a fair
The growth in the proportion of FASB
board, the Private Company Council, in
value regime.
members who have backgrounds in
part to get away from fair value
financial services may represent the
accounting.
Third, the use of fair value to
determine impairment of
goodwill from M&A activity (in
lieu of the historical cost
approach of amortizing
goodwill) imposes, on average,
less drag on earnings, thus
potentially boosting M&A
activity—a major revenue
source for investment banks.
Does this mean that the selection
process for FASB members has been
captured by special interests from
finance? It’s hard to say for certain.
growth in that industry—and the
growth in its political clout. Also, the
SEC and the FASB have generally
viewed the asset-management sector of
the financial services industry not as a
special interest but as a consumer of
accounting information whose interests
need to be protected. In any case, more
research is needed to explain why
financial services representation has
increased.
What is clear is that it has increased,
with a concomitant impact on
accounting standards. Perhaps tellingly,
http://hbr.org/2013/03/why-fairvalue-is-the-rule/ar/1
*Did Fair-Value Accounting
Contribute to the Financial
Crisis?
The recent financial crisis has led to a
major debate about fair-value
accounting. Many critics have argued
that fair-value accounting, often also
called mark-to-market accounting, has
significantly contributed to the financial
crisis or, at least, exacerbated its
severity. In this paper, we assess these
arguments and examine the role of fairvalue accounting in the financial crisis
using descriptive data and empirical
evidence. Based on our analysis, it is
unlikely that fair-value accounting
added to the severity of the 2008
financial crisis in a major way. While
there may have been downward spirals
or asset-fire sales in certain markets, we
find little evidence that these effects are
the result of fair-value accounting. We
also find little support for claims that
fair-value accounting leads to excessive
write-downs of banks' assets. If
anything, empirical evidence to date
points in the opposite direction, that is,
toward the overvaluation of bank assets
during the crisis.
https://www.aeaweb.org/articles.php
?doi=10.1257/jep.24.1.93
**Fair Value Accounting,
Historical Cost Accounting, and
Systemic Risk. Policy Issues and
Options for Strengthening
Valuation and Reducing Risk
Fair value accounting (FVA) refers to
the practice of updating the valuation of
assets or securities on a regular basis,
better understanding the accounting
ideally by reference to current prices for
approaches.
**The Key Question Is Not
Whether Fair Value
Accounting (FVA) or
Historical Cost Accounting
(HCA) Is "Better" but Instead
How to Ensure That Each Is
Implemented Properly
similar assets or securities established in
the context of a liquid market; historical
The authors find that FVA was
cost accounting (HCA) instead records
probably not a primary driver of the
the value of an asset as the price at
2008 crisis. Moreover, they suggest that
which it was originally purchased. In the
neither FVA nor HCA is objectively
wake of the 2008 financial crisis,
conflicting arguments have been made
about the contributions of valuation
approaches in triggering the crisis. This
report investigates and clarifies the
information and lead to risk
accumulation problems and the
potential for market distortion.

Improving the quality of both FVA and
HCA information in financial statements
should be a priority consideration for
policymakers.
"better" than the other. Instead, both
**Recommendations
accounting approaches can provide
useful information for different contexts

when applied rigorously, but when they
Consider new steps to strengthen
are implemented poorly or when
institutional governance and control
accounting approaches and risks to the
regulatory oversight is weak, both FVA
mechanisms that in turn support higher-
financial system. The authors examine
and HCA can produce misleading
quality fair value accounting (FVA) and
the risk implications of FVA and HCA
information that can increase systemic
historical cost accounting (HCA)
in the various situations in which each is
risk across the financial sector. The
used; assess the role that these
authors conclude with a series of
accounting approaches have played
recommendations for how FVA and
relationship between these two
historically in financial crises, including
the 2008 financial crisis, the savings and
loan crisis of the 1980s, and the less
developed country debt crisis of the
1970s; and explore insights about
systemic risk that can be gleaned from
HCA, and the financial information
that both methods generate, can be

practices within financial firms.

with systemic risk to the financial

that FVA was a primary driver of the
systemic risk to the banking sector in
2008 financial crisis.

and audit oversight in connection with
Available empirical evidence does not
provide strong support for the claim
When implemented poorly, both FVA
and HCA can produce misleading
Strengthen FVA and HCA approaches
to valuation by improving regulatory
system under some circumstances.
improved to better protect against
the future.
Both FVA and HCA can be associated
both approaches.

Tighten generally accepted accounting
principals (GAAP) standards in
connection with both FVA and HCA, to
improve the quality of information
provided about the impact of liquidity

Evaluate whether asset risk-weighting in
pricing on each valuation approach.
bank capital requirements has the
Clarify whether financial statements
potential to contribute to perverse risk
truly are required to disclose sufficient
effects and contagion, in connection
detail about FVA mechanics to allow
with FVA.
users of financial statements to
reconstruct and assess the details of
valuation models for themselves.


Consider developing or adding metrics of
valuation robustness to augment
http://www.rand.org/pubs/research_r
eports/RR370.html
**Advantages of Fair Value
Accounting
standard financial disclosures under
GAAP.

Consider adding disclosure requirements
to address situations in which market
power and other forms of price
endogeneity are likely to influence FVA
observed market values.

When strengthening regulatory capital
requirements, consider the potential for
perverse asset valuation and
institutional governance effects.
1.Reduced Net Income
Using fair value accounting, when
values of assets decrease, the company’s
calculated net income decreases. When
the company’s value of liabilities
increase, the company’s calculated net
income also decreases. Net income is the
bottom line of a company’s Income
Statement. This amount reflects the
amount the company pays taxes on.
This is an advantage to companies
because a lower net income results in
lower taxes. These affects to assets and
liabilities also cause a decrease in the
equity of the company. A lower equity
results in less money a company must
decide what to do with. This usually
results in less employee bonuses, which
means more money in the company’s
pocket.
2.Realistic Financial Statements
Companies reporting under this method
have financial statements that are more
accurate than those not using this
method. When assets and liabilities are
reported for their actual value, it results
in more realistic financial statements.
When using this method, companies are
required to disclose information
regarding changes made on their
financial statements. These disclosures
are done in the form of footnotes.
Companies have an opportunity for
examining their financial statements
with actual fair values, allowing them to
make wise choices regarding future
business operations.
3.Investors Benefit
Fair value accounting offers benefits for
investors as well. Because fair value
accounting lists assets and liabilities for
their actual value, financial statements
reflect a clearer picture of the company’s
heath. This allows investors to make
wiser decisions regarding their
investment options with the company.
The required footnote disclosures allow
investors a way of examining the effects
of the changes in statements due to fair
values of the assets and liabilities.
http://www.ehow.com/list_7304119_a
dvantages-fair-valueaccounting.html
**Disadvantages of Fair Value
Accounting
1. Frequent Changes
In volatile markets, an item's value can
change quite frequently. This leads to
major swings in a company's value and
earnings. Accountants typically write off
losses on items against a company's
earnings. Publicly held companies find
this difficult as investors may find it
difficult to value the company with such
swings in place. Additionally, the
potential for inaccurate valuations can
lead to audit problems.
2. Less Reliable
Accountants may find fair value
accounting less reliable than historical
costs. For example, accountants
typically look to the market when
finding a new value for assets or
investments. When an item has different
values in different regions, however,
accountants must make a judgment call
on valuing items on the books. If a
company with similar assets or
investments values items differently
than another, issues may arise because
of the accountant's valuation method.
3. Inability to Value Assets
Businesses with specialized assets or
investment packages may find it
difficult to value these items on the open
market. When no market information is
available, accountants must make a
professional judgment on the item's
value. Accountants must also make sure
that all valuation methods used are
viable and take into account all
technical aspects of the item.
Essentially, companies must have strong
reasons for placing values on assets and
investments.
4. Reduces Book Value
A company's book value is the total of
all assets owned. Historically, a
company's book value changed when a
company purchased new assets and/or
disposed of old assets. Fair value
accounting now changes a company's
book value for seemingly arbitrary
issues. For example, if an asset or
investment experiences a significant
drop in value for a short time period, a
company may need to make accounting
adjustments. If the value goes back up,
the adjustment did nothing but drop the
company's book value for a small time
period.
**CONCLUSION
The extent of the optional use of fair
value has arguably been too wide. This
has made the accounting for financial
instruments harder to understand,
comparability between entities even
within the same sector has been
diminished, and it has probably
increased the use of less reliable values.
The IASB has been considering major
extensions to the use of fair value – the
full fair value model for financial
instruments; in the valuation of
obligations under insurance contracts
and for revenue recognition generally.
Overall, we see no case for the extension
of the use of fair values in accounting
standards at present, particularly in
areas where markets are non-existent or
thin, such as partially complete sales or
insurance contracts. The current crisis
has highlighted the risks of using
unreliable values. The IASB should not
allow further classes of liabilities to be
stated at fair value, beyond those
currently permitted. Conversely, the
IASB should not narrow the definition
of fair value to a current market exit
value, but permit some flexibility to
allow that different sorts of current
value might be needed in different
circumstances. ACCA does not believe
that fair value accounting is a cause of
the banking crisis. The calls for its
suspension can be seen as trying to
sweep the problems under the carpet,
which would, if allowed, risk
undermining the remaining confidence
in the financial system. Some may not
have accepted the answers produced by
fair value accounting and therefore
concluded that the method must be
wrong. Others perhaps have believed the
figures but considered the information
too dangerous to be in the public
domain. There have also been criticisms
that fair value has removed the role of
the accountant’s judgement by allowing
values to be dictated by whatever could
be achieved in the market on a given
balance sheet date. The process is still
unfolding and only hindsight will tell us
if the values for many of the instruments
in question will turn out to be
unrealistically low or about right.
www.pwc.com/en_US/us/cfodirect/as
sets/pdf/.../pwc_fair_value_2013.pdf