5.

3 Case Study The trend toward fair value accounting The debate Critics contend that GAAP is seriously flawed. Some in the accounting profession go so far as to pronounce financial statements almost completely irrelevant to the financial analyst community. The fact that the mar et value of publicly traded firms on the !ew "or Stoc #$change is an average of five time their asset values serves to highlight this deficiency. %any reformers& including 'AS( chairman )obert *er+& believe that fair value accounting must be part of the anwer to ma ing financial statements more relevant and useful. Advocates of fair value accounting say it would give users of financial statements a far clearer picture of the economic state of a company. (ut switching from historical cost to fair value re,uires enormous effort. -aluing assets in the absence of active mar ets can be very sub.ective& ma ing financial statementsless reliable. /n fact& disputes can arise over the very definition of certain assets and liabilities. The cru$ of the fair value debate is this0 each hide agrees that relevance and reliability are important& but fair value advocates emphasi+e relevance& while historical cost advocates place greater weight on reliability. )elevance versus )eliability The pertinent conceptual guidance for ma ing trade1offs between relevance and reliability is provided by 'AS( Concept Statement !o 2& 3ualitative Characteristics of Accounting information. /t provides guidance for ma ing standard1setting decisions aimed at producing information useful to investors and creditors. Concepts Statement !o.2 states0 The ,ualities that distinguish 4better5 6more useful7 information from 4inferior5 6less usefull7 information are primarily the ,ualities of relevance and reliability... The ob.ective of accounting policy decisions is to produce accounting information that is relevant to the purposes to be served and is reliable. Critics of fair value generally believe that reliability should be the dominant characteristic of financial statement measures. (ut the 'AS( has re,uired greater use of fair value measurements in financial statements because it perceives that information as more relevant to investors and creditors than historical cost information. /n that regard& the 'AS( has not accepted the view that reliability should outweigh relevance for financial statement measures. Some critics also interpret reliability as having a meaning that differs in at least certain respects from how that term is defined in the 'AS(8s Conceptual 'ramewor . Some critics e,uate reliability with precision& and others view it principally in term of verifiability. *owever& Concepts Statement !o.2 defines reliability as 4 the ,uality of information that assures that information is reasonably free from error or bias and faithfully represents what it purports to represent.5 with respect to measures& it states that 4 the reliability of a measure rests on the faithfulness with which it represent& what it

purports to represent& coupled with an assurance for the user& which come through verification& that it has that representational ,uality.5 thus& the principal components of reliability are representational faithfulness and verifiability. Although there are reliability concern associated with fair value measures& particularly when such measures may not be able to be observed in active mar ets and greater reliance must be placed on estimates of those measures& present1day financial statements are replete with estimates that are viewed as being sufficiently reliable. /ndeed& present1 day measures of many assets and liabilities 6and changes in them7 are based on estimates& for e$ample& the collectibility of receivables& salability of inventories& useful lives of e,uipment& amounts and timing of future cash flows from investments& or li elihood of loss in tort or environmental litigation. #ven though the precision of calculated measures such as those in depreciation accounting is not open to ,uestion is not open to ,uestion since they can be calculated down to the penny& the reliability of those measures is open to ,uestion. Precision& therefore& is not a component of of reliability under Concepts Statement !o.2. /n fact& concepts statement !o.2 e$pressly states that reliability does not imply certainty or precision& and adds that any pretension to those ,ualities if they do not e$ist is a negation of reliability. 3uestions 9. :hat you thin is the fundamental problem with financial statements based upon the historic cost measurement principle used under ;S GAAP.< 2. :hat do you thin of the principle 4...accounts must reflect economic reality5 as a core principle of measurement in accounting< 3. *ow would you measure economic reality< =. :hat is reliability in accounting<