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UNIVERSITÄT ZU KÖLN UNIVERSITY OF COLOGNE
Kölner Diskussionspapiere zu Bankwesen,
Unternehmensfinanzierung, Rechnungswesen und Besteuerung
Cologne Working Papers on Banking, Corporate Finance,
Accounting and Taxation
Working Paper 05/2005*
The Decision Usefulness of Fair Value Accounting – A Theoretical Perspective
Joerg-Markus Hitz
July 2005
* url: http://www.wiso.uni-koeln.de/workingpapers/bcfat/index.html
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The Decision Usefulness of Fair Value Accounting – A Theoretical Perspective
Joerg-Markus Hitz
Seminar für Allgemeine BWL und Wirtschaftsprüfung,
Universität zu Köln, Albert-Magnus-Platz, 50923 Köln
Tel.:+49 221 470 3089; Fax: +49 221 470 5165
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 standard-
setting 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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1 Introduction
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 non-
financial 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 Fair value accounting – a shift in standard-setting paradigms
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.1 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.
1 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.2
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. Available-
for-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,
2 Former FASB member Arthur Wyatt 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 ‘once-upon-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 non-
financial 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).3
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
3 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 Research methodology: Measurement and information perspectives
on the a priori evaluation of accounting concepts
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-posteriori-
expectations, 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.4 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 cost-
efficient 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
4 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 Decision usefulness of fair value as a measurement attribute
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:
13
∑∑==
==N
1n
nt
N
1n
ntt FVVIUV .
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.
14
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:
.11
t
N
n
nt
N
n
ntt gFVVIUV +== ∑∑
==
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 real-
world-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-model-
approach 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:
[ ]∑∑
+=τ−τ
τ
= ++=
T
1tt
tM
1n
ntt )'k1(
cEFVV
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
15
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.
16
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
17
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
18
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
19
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,
20
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, model-
based 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.
21
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.
22
5 Decision usefulness of fair value accounting
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 stand-
alone 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
23
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 clean-
surplus 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 accounting-
based 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.
24
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 decision-
model (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.
25
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
26
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.
27
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.
28
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: Et [Vt+1] =
Vt. 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:
[ ]444 3444 21444 3444 21shock fair value
t1tt
fair valuein change expected
t1t1t1tt )FV(EFV)c(EFVkFVFV −−−− −+−×=−
29
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:
[ ] ( )[ ]444 3444 2144 344 2143421shock fair value
1
shock flowcash
1
income fair value expected
1
1
|)|( −−−
−
Ω−+Ω−+×=+−=
ttttttt
tttFVt
FVEFVcEcFVkcFVFVx
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 transaction-
based 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
30
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. Transaction-
based 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.
31
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
32
recognition. Future research into the properties and quality of fair value residual income
appears promising.
6 Conclusions and Implications
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.
33
(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.
34
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38
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 Interessenkonftlikte aus Sicht der Betriebswirtschaftslehre
03/2005 Kuhner, Christoph 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