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Fair Value Accounting

Table of Contents
Fair Value Accounting Overview................................................................................. 3
Stock Market Crash of 1929....................................................................................... 4
Statements of Financial Accounting Concepts............................................................5
Collapse of Enron........................................................................................................ 7
FASB on Fair Value Measurement................................................................................9
Relevance vs Reliance.............................................................................................. 11
Advantages and Disadvantages...............................................................................12
Impact...................................................................................................................... 14
References................................................................................................................ 15

Fair Value Accounting Overview


According to the latest pronouncement on fair value accounting, FAS 157,
Fair value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at
the measurement date. (FASB, 2006) This standard explicitly states fair
value as an exit price and indicates that the selling price controls the
expectations of the future benefits associated with assets and liabilities. Not
all assets and liabilities are required to be measured at fair value. Those that
are under the new standard include investments in equity securities for
which fair value is readily determinable, investments in debt securities
classified as held-for-trading or available-for-sale, direct investments in loans
held-for-sale, and derivative assets and liabilities. (Rock Lefebvre, 2009)
Asset impairment is also tested using fair value measurement.
The first guidance on fair value accounting was introduced by the Financial
Accounting Standards Board (FASB) in 1975 requiring marketable securities
to be recorded at fair value. Although the first standard on fair value wasnt
until 1975, it has been a part of U.S. GAAP for well over 50 years and similar
terms can even be found on financial statements as early as 1925. Over the
years, the original standard has been amended and extended a number of
times. The amendments were shifting the focus on marketable securities to
disclosing financial instruments in a companys financial statements, to
valuing debt and equity securities that are held for trading or sale, to
requiring the changes in fair value to be recognized in the income statement

or other comprehensive income, and to the requirement of derivatives to be


measured at fair value. (Rock Lefebvre, 2009)

Stock Market Crash of 1929


From 1925 to the third quarter of 1929, common stocks increased in value
by 120 percent in four years. The decade of the 1920s was extremely
prosperous and the stock market with its rising prices reflected this
prosperity as well as the expectation that the prosperity would continue. The
1929 stock market crash is conventionally said to have occurred on Thursday
the 24th and Tuesday the 29th of October. These two dates have been
dubbed Black Thursday and Black Tuesday, respectively. (Harold
Bierman, 2008) By the time the stock market crash was finished in 1932,
stocks had lost almost 90 of their worth.
A common practice in the 1920s included the act of buying on margin.
Buying stocks on margin means that the buyer would put down some of his
own money, but the rest he would borrow from a broker. In the 1920s, the
buyer only had to put down 10 to 20 percent of his own money and thus
borrowed 80 to 90 percent of the cost of the stock. Buying on margin could
be very risky. If the price of stock fell lower than the loan amount, the broker
would likely issue a "margin call," which means that the buyer must come up
with the cash to pay back his loan immediately. (Rosenberg) It was because
of the belief that the stock market prices would be ever-rising that
speculators neglected to heed the risks. The ability to buy on margin most

likely helped to inflate stock prices and also to worsen the stock market
decline.
At the time, savings were not insured by the federal government and
banking regulation did not exist. When the stock market started to fall and
banks began issuing margin calls, speculators rushed to the banks to clean
out their savings. When investors did not have the cash to pay for the loan,
banks started selling off the stocks which sent the market into a downward
spiral. Banks and investors were overly confident of their current financial
position in the 1920s and led to aggressive accounting practices in the use of
fair value accounting for their stock assets. Many banks did not have the
ability to pay their members because they accounted for margin calls at fair
value, which at the time was at an over-inflated stock value. The aftermath
of this crisis resulted in the closure of 10,000 banks, half of all banks either
merged or closed during this period. Fair value accounting was blamed for
some dubious practices in the period leading up to the Wall Street crash of
1929, and was virtually banned by the U.S. Securities and Exchange
Commission from the 1930s through 1970s. (Ramanna, 2013)

Statements of Financial Accounting Concepts


In the 1980s, the FASB issued two separate concept statements that relate to fair
value accounting. While concept statements are not a part of U.S. Generally
Accepted Accounting Principles (U.S. GAAP), they are used by the FASB to guide
them in developing sound accounting principles and provide [them] and its

constituents with an understanding of the appropriate content and inherent


limitations of financial reporting (FASB, 1980).

The first relevant statement was issued in 1980 as Concept Statement no. 2,
which covered Qualitative Characteristics of Accounting Information. The
main premise of Concept Statement no. 2 was to explain what characteristics
make accounting information useful for anyone that may prepare, audit,
and/or use the information from financial reports. While the concept of fair
value accounting is not actually mentioned in the statement, the specific
qualities financial statement information should have in order to be useful
can be applied. When there is a choice of how to present financial
information, judgement should be used to determine which presentation will
be more useful for the users.
The primary qualities that make accounting information useful for decision
making are relevance and reliability. To be relevant, financial information
should allow users to make predictions on possible future outcomes based on
prior or current data. On the other hand, reliable financial information is also
required, as without reliable information, users cannot depend on financial
reporting to faithfully represent accurate information. While fair value
accounting allows for more relevant financial information, historical cost is
much more reliable (Ramanna, 2013). These differences are explored in more
detail below.

FASB Concept Statement no. 5 on Recognition and Measurement in Financial


Statements of Business Enterprises was issued at the end of 1984. SFAC no.
5 states that an item should be recognized and reported in the financial
statements when it meets the definition of a financial statement element,
can be measured with sufficient reliability, is capable of making a difference
in a users decisions, and can be representationally faithful, verifiable, and
neutral (FASB, 1984). The financial statement item measurement attributes
that the FASB identified are shown below. While the example shown for each
attribute is specific towards assets, the opposite is true for a liability.

Historical Cost - The amount initially paid to acquire an asset.

Current Cost - AKA Replacement Cost or the amount to be paid to


acquire the same asset today.

Current Market Value - AKA Fair Value or the amount of cash


potentially acquired if the asset was liquidated today.

Net Realizable Value - AKA Settlement Value or the undiscounted


cash the asset is expected to bring in over its life minus any direct
costs.

Present Value of Future Cash Flows - The present value of future


cash inflows that an asset is expected to bring in less any discounted
outflows expected to be required.

While many items may all initially be recognized with the same attribute,
such as historical cost, the FASB recognized that not all financial statement
items can be measured and reported with the same methods or attributes as
certain attributes are a better reflection of the item over time (FASB, 1984).

Collapse of Enron
Enron is often looked at as the poster child for the abuse of fair value (markto-market) accounting. Enron was an energy derivatives broker who through
their external auditors gained the right to use mark-to-market accounting on
their financial statements. This accounting allowed Enron to adjust their
outstanding derivatives contracts to market value and book the unrealized
gains and losses to their income statements. It was because of the
complexity and difficulty of applying these rules to long-term futures
contracts and the ability of Enron to influence energy prices of commodities
that Enron was able to develop valuation models based on their own
assumptions. The article The Rise and Fall of Enron, from the journal of
accountancy states, For a company such as Enron, under continuous
pressure to beat earnings estimates, it is possible that valuation estimates
might have considerably overstated earnings. Furthermore, unrealized
trading gains accounted for slightly more than half of the companys $1.41
billion reported pre-tax profit for 2000 and about one-third of its reported
pre-tax profit for 1999. (Thomas, 2002) Enron used its ability to influence
energy markets to artificially inflate the market value of their derivatives and
along with aggressive accounting estimates were able to book unrealizable

expected future gains on their income statements. This practice along with
Enrons use of special purpose entities which kept liabilities off the books led
to unrealistic view of the companys financial position. An eventual SEC
investigation looked into related party transactions and Enron restated their
financials back 4 years with special purpose entity consolidation and
recommended adjustments from Arthur Anderson over that time frame. This
restatement resulted in another $591 million in losses over the four years as
well as an additional $628 million in liabilities as of the end of 2000. The
equity markets immediately reacted to the restatement, driving the stock
price to less than $10 a share. One analysts report stated the company had
burned through $5 billion in cash in 50 days. (Thomas, 2002) Enrons
abusive use of mark-to-market accounting was the main reason for their
inflated income and contributed to their bankruptcy.

FASB on Fair Value Measurement


In the fourth quarter of 2006, the FASB released their Statement of Financial
Accounting Standards no. 157 on Fair Value Measurements, which defines
fair value, establishes a framework for measuring fair value in generally
accepted accounting principles (GAAP), and expands disclosures about fair
value measurements (FASB, 2006). The FASB released this statement
because of the confusion over the previously limited GAAP guidance on fair
value. While GAAP did address fair value accounting, the principles were

divided up within various other standards. By addressing these issues, the


FASB also was able to add consistency to how fair value was measured as
well as expand the required disclosures on how the measurement were
obtained.
This new statement defines fair value, as put simply, the exit price, which
was consistent with prior definitions. However, FAS no. 157 also added two
new areas to the definition which clarify the specific market to be used to
determine an items fair value. First, FAS no. 157 requires that the fair market
measurement be taken from the principal market, unless it is unavailable, at
which point management can use the most advantageous market. The
principal market is defined as being the market in which the reporting entity
would sell the asset or transfer the liability with the greatest volume and
level of activity for the asset/liability while the most advantageous market is
the market in which the reporting entity would sell the asset or transfer the
liability with the price that maximizes the amount that would be received for
the asset or minimize the amount that would be paid to transfer the liability,
while considering transaction costs (FASB, 2006). Second, FASB requires
that the asset or liability is being valued at its highest and best use, or in
other words, in a way or classification that would maximize its worth.
FAS no. 157 changed fair value measurement in that it established a fair
value measurement framework in order to increase the comparability of fair
value between companies and decrease the risk investors faced when relying

on their measurement. The framework creates a hierarchy of types of fair


value measurements based on how easily the information is able to be
independently verified and its reliability. The framework is based on the
inputs, or risk assumptions, that management uses in their valuation of fair
value items. Inputs can be either observable or unobservable based on if
their market sources are external or internal, respectively.
The highest section of the fair value measurement hierarchy is Level 1,
where unadjusted quoted prices from active markets for identical assets or
liabilities are used to determine an items fair value measurement. To use
Level 1 inputs, management must have the ability to access the quoted
prices at the measurement data in an active market. Next, Level 2 inputs are
those inputs that are also observable, either directly or indirectly, for the
asset or liability, other than a quoted price for an identical asset/liability in an
active market. Examples of Level 2 inputs include but are not limited to the
quoted prices for similar assets/liabilities (rather than identical), or quoted
prices for identical assets/liabilities in a non active market.
Finally, a Level 3 input is an unobservable input. Simply put, a Level 3 input
is where there is not a lot of markets or activity for a particular asset or
liability at the measurement date. Instead, unobservable inputs are used
where management uses their own assumptions about the market and
asset/liability to determine the items fair market valuation. Level 3
valuations carry the highest risk for investors. In order to address the

elevated risks, FAS no. 157 requires several additional disclosures about how
the fair value was determined, including a reconciliation of the items
beginning balance to ending balanced over the period.
In 2010, the FASB issued Accounting Standards Codification Topic 820 on
Fair Value Measurement. It was quickly amended in 2011, when the
International Accounting Standards Board (IASB) was about to issue a
standard of fair value accounting and agreed to work with the FASB to reach
a higher level of consistency for better transparency and comparability
between the two generally accepted accounting principle frameworks as a
part of their overall agreement to develop common standards between the
two.

Relevance vs Reliance
The debate of fair value accounting primarily revolves around relevance and
reliability. Relevance is defined in the glossary of the FASB Statement of
Financial Accounting Concepts No.2 as the capacity of information to make a
difference in a decision by helping users to form predictions about the
outcomes of past, present, and future events or to confirm or correct
expectation (Poon, 2004). Using fair value correctly will allow users to make
decisions based on up to date information. This will assist users in the
difficult decisions of whether to invest in a firm or not. Relevance is one of
the main reasons why the use of fair value has been promoted for many
years.

Reliability is defined in the glossary to the FASB Statement of Financial


Accounting Concepts No. 2 as the quality of information that assures that
information is reasonably free from error and bias and faithfully represented
what it purports to represent. When there is a well-established and liquid
market fair value is well defined and non-controversial. However, this is not
always the case. Many firms have assets and liabilities that are not liquid so
there is not a sure way to have these values properly estimated. This is a
situation that an estimation of fair value will involve prediction of future cash
flows and appropriate discount rates. These estimates involve management's
projections and assumptions. This gives an opportunity for management to
mask deliberate miscalculation and manipulation of the financial statements
making the financial statements potentially less reliable. Both the FASB and
JWG realize that some significant measurement issues must be resolved and
are working together to develop more guidance on fair value estimation and
controls.

Advantages and Disadvantages


Proponents of fair value accounting argue that valuing assets at their current
value gives investors and financial statement users more transparency when
viewing the balance sheet. Another reason they support fair value
accounting is because they argue it decreases the chances of another
Enron to happen. They believe that people will be able to clearly notice
slow changes in a firm's value before a collapse might happen. Advocates of
fair value accounting strongly argue that the financial crisis could have been

avoided if the assets and liabilities on a banks balance sheet were valued at
market rates, instead of historical cost. The public has been increasingly
aware of fair value accounting since the financial crisis. Another big reason
why fair value accounting is needed is because it would allow a level playing
field in the market. If firms were forced to use fair value accounting the
decisions made by the general public would be a lot more informed. It takes
an expert to understand the valuation of assets on a firm's balance sheet,
thus giving the expert an advantage in historical cost accounting.
One of the main issues with fair value accounting is finding a market price
that is relevant and reliable. Critics of fair value accounting argue that for
assets that are not in a liquid market there is no real way to find the true
market price. Many derivatives and financial instruments do not have a
market in which they are traded on a daily basis, causing firms to use
judgment and estimations to find their market value. This could potentially
bring manipulation of financial statements into play.
Another issue with fair value accounting is the vulnerability of an economy
during a downturn. An economy is only as strong as the confidence of the
investing public. Forcing firms to mark to market could cause investors to
pull money out of the stock market causing an economic downturn to turn
into a recession.
The last issue that critics have with fair value accounting is the cost of
implementation. Finding the true value of an asset can be extremely costly.

Firms would have to deal with the cost of additional employees to monitor
fair value adjustments. Also, because the inherent risk associated with the
audit increases the cost of performing an audit would significantly increase.
However, many financial and economic scholars argue that the benefits of
fair value accounting greatly outweigh the costs.

Impact
The implication of which financial reporting measurement has been debated
for decades and has caused a major impact on the accounting standards
used in todays profession. Fair value is a relevant measure of assets and
liabilities when they are traded actively on the market, while historical cost is
more appropriate when management intends to hold the assets or owe
liabilities until maturity. Switching over to fair value from historical cost has
increased the need for more detailed and expanded disclosure on financial
statements. Under FAS 157 it is required that additional disclosures are
required for gains and losses, a reconciliation of the beginning and ending
balance is required in order to include any gains and losses that may have
occurred. Entities like financial institutions and insurance companies have a
hard time using the fair value method because they hold many large longterm financial assets and liabilities and it can be difficult to value and can
exhibit price volatility. Another impact that fair value has had the financial
statement is that it involves more use of judgment and not being bias on
managements part. The added use of judgment adds to the concern of
reliability, management can record improper fair value measurement and

inflate the value of the companys assets. The use of fair value accounting
effects public accounting as well. The use of judgment by management
increases causing inherent risk to increase, this in turn drives up the price of
audits.

Conclusion
The debate of the use of fair value accounting has been raging since the
stock market crash of 1929. it has intensified in recent years after the
financial crisis of 2008. Critics are against fair value accounting because they
feel that the increased audit costs and the ability for management to
manipulate the financial statements are not worth the pros of having all
investors on a level playing field. The difficulties behind providing balance
sheets at market price, is one issue that FASB has been working on figuring
out. We believe that if fair value is done properly with the proper disclosures
then it is the best method and should be adopted by the Unites States.

References
Abdel-khalik, R. (2008). The case against fair value accounting. Retrieved from
https://www.sec.gov/comments/4-573/4573-229.pdf
FASB. (1980). Concept statement no. 2.
FASB. (1984). Concept statement no. 5.
FASB. (2008). Statement of financial accounting standards no. 157.
Harold Bierman, J. (2008). The 1929 stock market crash. Retrieved from EH.Net
Encyclopedia: http://eh.net/encyclopedia/the-1929-stock-market-crash/
PwC. (2008). Fair value accounting: Is it an appropriate measure of value for
todays financial instruments? Retrieved from
http://www.pwc.com/us/en/point-of-view/assets/pwc_pointofview_fairvalue.pdf
Ramanna, K. (2013). Why "fair value" is the rule. Harvard Business Review.
Rock Lefebvre, E. S. (2009). Fair value accounting: the road to be most travelled.
Certified General Accountants Association of Ontario.
Rosenberg, J. (n.d.). The stock market crash of 1929. Retrieved from about
education: http://history1900s.about.com/od/1920s/a/stockcrash1929.htm
Thomas, C. W. (2002). The rise and fall of enron. Journal of Accountancy.

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