Fair value accounting

Margaret Woods considers the arguments for and against fair value accounting

A quick test of your knowledge of International Accounting Standards ahead of the 2005 deadline. What is the common link between IFRS 2, IFRS 3, IAS 19, IAS 36, IAS 38, IAS 39, IAS 40 and IAS 41? Answer: they all require the use of fair values for one or more classes of assets or liabilities, and, thus provide evidence of the fact that the use of fair value accounting is gaining ground, and is strongly supported by the major standard setters, particularly the IASB.

In principle, fair value accounting sounds attractive - surely if something is 'fair' then it must also be good? The implications for accounting practice, however, are huge and highly controversial. Amongst the questions being debated are: how reliable are fair values?; how easy is it to audit fair values?; will fair value accounting work in practice?; and what are the implications for performance measurement? Such a controversial topic is worthy of consideration by all practising accountants, and the aim of this article is to discuss briefly the main issues relating to fair value accounting.

In considering the merits or otherwise of using fair value instead of historic cost on a balance sheet it is helpful to go back to basics and consider the purpose of financial statements. The IASB's conceptual framework states that financial statements fulfil two purposes - the assessment of stewardship and the provision of information for economic decision-making, and the relevance and usefulness of fair value needs to be assessed within this context.

IAS 39 can be used to illustrate the potential impact of the use of fair value upon a company's performance. If a bank trades in options as a way of generating profit, IAS 39 requires that the options are included in the balance sheet at 'fair value,' which is defined as the market exit (selling) price. Any change in the fair value of the relevant assets or liabilities over the accounting period is then taken through the income statement. This changes the nature of the income statement, and forces its readers to re-think how they wish to measure performance, because net income before tax may now no longer be a consequence of the bank's economic activity but instead include profit arising purely out of an increase in the fair value of assets. In other words, changes in market values will lead to a change in the results reported in the income statement, and it may become difficult to attribute performance changes to internal or external (market) reasons.

Whether one approves or disapproves of this redrafting of the income statement depends upon one's interpretation of what is required of the statement. If the use of fair values means that market prices impact upon income - and, hence, performance - then it is almost inevitable that income will become more volatile as a result. Opponents of fair value accounting argue that this is a bad thing because it will make it more difficult for stakeholders to get a real sense of whether management have been good stewards of resources or not. Furthermore, the profits arising from value changes may not have been realised, and recognition of unrealised gains goes against the traditional prudent approach to accounting. In contrast, supporters of fair value argue that the purchase of assets that fall in value is indicative of poor stewardship which should be recognised in the performance statement.

In essence, fair value implies a shift away from a basic income statement towards a broader comprehensive income statement, such as that deployed in the US, within which profit is made up of multiple components. Unfortunately, however, the IASB has not yet completed its comprehensive income project, and so it might also be argued that using fair values without comprehensive income is muddying rather than clearing the waters when it comes to performance appraisal. In addition, there may be tax implications for companies if tax liability is linked to a broader measure of profit performance than at present.

Reliability

Some observers also raise questions about the reliability and comparability of fair values for certain assets. In cases where there is a well defined and liquid market, then defining the fair value is not problematic. For illiquid assets or liabilities, however, it may be necessary to use a model to derive the value, such as one based on the present value of the future cash flows. The model's assumptions, such as the relevant discount rate, may vary widely between institutions and types of assets/liabilities and such variations raise questions about the reliability of the values. Furthermore, fair values based on internal models will also have implications for the auditors, as their verification is dependent upon accepting the logic of the underlying valuation model. As a result, some opponents of fair value go so far as to suggest that they can only sensibly be used in relation to items for which there are efficient markets for standard products.

The counter argument is that even if there is a degree of potential unreliability to the values, they are still very useful to decision-making because they represent the economic reality as opposed to an accounting 'fiction' in the form of amortised cost. If one holds the view that a balance sheet should represent the potential liquidation value of a company, then fair values are preferable to those based on historic cost because they offer some indication of break up value, and so a fair value based balance sheet is a more faithful representation of the net worth of its components and, hence, of a company's financial position. This would be a very strong argument if all balance sheet items were based on fair values, but when (as at present) they include a variable blend of both historic cost and fair value measurement systems it is more difficult to justify. Apples and oranges cannot sensibly be added together.

Fair values also increase the risk of misunderstanding on the part of existing or potential investors. Fair value might be the realisable market value but it remains true that the net fair value from a balance sheet will not necessarily equate to the market value of the company because of the existence of internally generated goodwill in the form of intangible assets. Fair value may thus bring a balance sheet value closer to the market one, but it will never match it exactly unless non-purchased intangibles are recognised on the balance sheet. Using fair values for decision-making, therefore, remains relatively difficult.

The arguments for and against fair value accounting raise fundamental questions about core accounting issues, such a how performance should be measured, and the relative merits of the qualities of relevance versus reliability. Fair value accounting can be seen as a paradigm shift in the focus of financial reporting, that moves it away from a historic focus and closer to one which provides a current perspective on value. The most interesting question is how long it will take for the full range of non-financial assets, and particularly internally generated goodwill, to be measured in this way. Even if the regulators want such changes, they may face substantial opposition to their introduction from both companies and the profession itself.

Margaret Woods is senior lecturer in accounting and finance at Nottingham University Business School.