1995 American Accounting Association Accounting Horizons Vol. 9 No. 4 December 1995 pp.

97-107

COMMENTARY
Mary E. Barth and Wayne R. Landsman
Mary E. Barth is Associate Professor of Accounting at Stanford University, and Wayne R. Landsman is Professor ofAccountancy at the University of North Carolina at Chapel Hill.

Fundamental Issues Related to Using Fair Value Accounting for Financial Reporting
SYNOPSIS: This paper discusses fundamental issues relating to implementation of fair value accounting. We conclude that in settings economically equivalent to perfect and complete markets, a fair value accounting-based balance sheet reflects all value-relevant information, the income statement is redundant, income realization is not valuation-relevant, and intangible assets relating to management skill, asset synergies, or options are reflected fully in the balance sheet. In settings with more realistic market assumptions, fair value is not well-defined, resulting in three value constructs, entry and exit values and value-in-use. Because these are unobservable, implementation of fair value accounting requires their estimation, potentially introducing estimation error. Unless estimation error is severe, value-in-use is the appropriate construct for firm valuation for going concerns because it captures total firm value associated with an asset. Also, neither the balance sheet nor income statement reflects fully all value-relevant information and income realization potentially can be valuation-relevant, although management discretion can detract from its relevance. We point out that fair value accounting concepts apply equally to assets and liabilities. Finally, our discussion reveals no basis for recognizing in income only realized gains and losses, and that the concepts of core earnings and fair value accounting are unrelated.

I. INTRODUCTION The Financial Accounting Standards Board (FASB) recently has issued several standards requiring recognition or disclosure of fair value estimates for assets and liabilities, principally financial instruments (e.g., Statements of Financial Accounting Standards (SFAS) 87,105,107,115,119, and 121). In addition, many of their current agenda items and discussion documents address recognition and measurement issues relating to fair value accounting (e.g., Discussion Memoranda Recognition and Measurement of Financial Instruments and Distinguishing Between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both). Before implementing fair value ac-

counting on a more comprehensive basis, there is a need to explore its basic characteristics. This paper is a response to suggestions by the FASB that academics are in a position to contribute to its standard setting process by viewingfinancialreporting issues in a broader context than that associated with addressing specific issues raised in their discussion docuWe are indebted to the members of tbe Financial Accounting Standards Committee of tbe American Accounting Association, 1992 to 1995: D. Collins, G. M. Croocb, J. Elliott, T. Frecka, J. Gribble, E. ImbofF, C. McDonald, S. Penman, D. G. Searfoss, J. Smitb, R. Stephens, and T. Warfield; our frequent co-autbor. Bill Beaver; members of tbe Financial Accounting Standards Board; and J. Wablen for belpful discussions and comments. Of course, any errors and omissions rest solely witb us.

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ments (see FASB Status Report, August 21, 1995).^ Thus, our goal is to investigate several fundamental issues related to using fair value accounting for financial reporting.^ In particular, we address the following questions. What is meant by fair value? In realistic settings where fair value is not well-defined, are accounting measures based on one concept of fair value more value-relevant than those based on other concepts? How do fair value-based financial statements relate to firm value? In particular, does a fair value-based income statement provide value-relevant information beyond that provided by a fair value-based balance sheet? What are the implications for firm valuation of private information and estimation error in fair values? Is income realization valuation-relevant? As does the Committee on Accounting and Auditing Measurement, 1989-1990 (Barrett et al. 1991), we assume that fair values conceptually are relevant to financial statement users in assessing firm value, and define a financial statement item to be value-relevant if the information it reflects helps financial statement users to assess firm value. We define financial statement users broadly to include creditors and others in addition to equity investors. Although the FASB also deals with questions of recognition, i.e., determination of which financial statement items should be recognized, we assume that all assets and liabilities that potentially are recognizable under the present accounting model^including those that currently are not recognized such as brand names and research and development assetsare recognized. However, this assumption should not alter the basic tenor of the conclusions we draw. We base part of our analysis of fair value accounting on an example in two settings, a simple setting in which fair values are obtainablefi"omactively traded markets and a more realistic setting where these assumptions are relaxed.^ We also address twofinancialreporting issues with which the FASB is concerned.

fair value accounting for liabilities and the implications of fair value accounting for Statement of Financial Accounting Concepts of earnings and comprehensive income and the alternative concept of core earnings that presently is being discussed by the FASB (see AICPA Committee Report 1993). Our major conclusions are the following. Only in a simple setting economically equivalent to perfect and complete markets do the following conditions hold: (1) fair value is welldefined; (2) a fair value-based balance sheet reflects all value-relevant information; (3) a fair value-based income statement is redundant to valuation; and (4) income realization is irrelevant to valuation. In more realistic settings, standard setters must choose among
1 Although the views presented here are our own, tbey are based heavily on discussions we have had as members of the Financial Accounting Standards Committee of the American Accounting Association over tbe past three years, wbicb in its comment letters consistently bas been supportive of fair value accounting (see Accounting Horizons, September 1993 tbrougb June 1995 for several examples). We also benefited greatly from insigbts arising from joint research with Bill Beaver on fair value accounting (e.g., Barth et al. 1992, 1993, 1995a, and 1995b). Tbe ideas presented here also are based on tbe literature addressing issues relating directly to fair value accounting (e.g.. Beaver et al. 1982; Beaver and Landsman 1983; Beaver and Ryan 1985; Bublitz et al. 1985; Magliolo 1986; Bernard and Ruland 1987; Harris and Oblson 1987; Beaver et al. 1992; Bartb 1994; Barth, Landsman and Wahlen 1995; Bernard et al. 1995; Eccher et al. 1995; Nelson 1995; Petroni and Wahlen 1995). In addition, many of tbe conclusions we reacb bave been reacbed by otbers (see, e.g., Barrett et al. 1991). ^ Altbougb tbe FASB's present fair value accounting focus is on financial instruments, our discussion applies to all assets because, as noted below, tbe most important attribute of an asset as it relates to fair value accounting is wbether an estimate of its fair value is easily obtainable, either because active markets exist for it or tbere are accepted tecbniques for estimating its fair value, and not wbether it is a financial or nonfinancial asset. Nonetbeless, in practice, often it is more difficult to obtain fair values for nonfinancial assets because tbey typically are not actively traded nor are there accepted tecbniques for estimating their fair values. ^ In tbe more realistic setting, measurement error in fair value estimates exists, affecting tbeir relevance (Beaver et al. 1982; Beaver and Landsman 1983; Bartb 1991; Cboi et al. 1993; Barth 1994; and Bartb et al. 1995a). Tbrougbout, we use tbe terms estimation error and measurement error intercbangeably.

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three value constructs, entry and exit values and value-in-use. In such settings, neither the balance sheet nor the income statement reflects fully all value-relevant information and, if estimation error is not severe, value-in-use reflects flrm value under the going concern assumption more fully than other fair value constructs. Moreover, the presence of estimation error and private information enables income realization potentially to be valuationrelevant. This paper is organized as follows. Section two defines fair value. Section three presents the example we use to illustrate our points and evaluates the role of fair value accounting in the simple setting. Section four extends our analysis to the more realistic setting. Section five discusses fair value accounting for liabilities and section six discusses the implications of fair value accounting for the concepts of earnings, comprehensive income, and core earnings. Section seven summarizes and concludes the paper. II. WHAT IS FAIR VALUE? In SFAS 107, the FASB defines fair value as the amount at which an asset could be exchanged in a current transaction between willing parties, other than in a forced liquidation or sale. However, this definition of fair value is limiting because, except in settings that are economically equivalent to perfect and complete markets, fair value is not well-defined and alternative fair value constructs, entry value, exit value, and value-in-use, are likely to differ (see Beaver 1987). Entry value is an asset's acquisition price or, if relative prices change, an asset's replacement cost; exit value is the price at which an asset could be sold or liquidated; value-in-use is the incremental firm value attributable to an asset (see Beaver and Landsman 1983; Beaver 1987). Because the FASB is concerned with financial reporting of a firm's assets in place and not assets to be acquired, their definition of fair value should be interpretedfi:omthe perspective of a seller. Thus, their fair value concept is exit value. Moreover, it relates only to exchange transactions in which, by construction, the seller's exit value equals the buyer's

entry value. More importantly, because their definition is not stated with reference to a particular economic setting, fair value in other situations is not defined. In particular, the definition makes no mention of a value-in-use concept of fair value for assets without active exchange markets, and is silent on what private information the buyer and seller each have. As discussed in section four, estimates of value-in-use can provide estimates of the value of intangible assets arising from management skilla dimension of which includes private information, asset synergies, and options, including growth options and the option to put the firm's assets to creditors. For ease of exposition, throughout we refer to these intangible assets as management skill. m . EXAMPLE AND SIMPLE SETTING Our simple setting is economically equivalent to perfect and complete markets. In this setting, fair value unambiguously equals market value, and hence there are no measurement issues regarding an asset's fair value, and market values reflect all value-relevant information, i.e., there is no private information. We use the following three period example to illustrate our points. Consider two all equity firms. Firm A and Firm B, whose assets are actively traded and worth initially $100. Without loss of generality, assume that there are no new equity issues by either firm during the three year period. Table 1 summarizes these firms' activities over the three years and represents the balance sheet and income statement for each under fair value accounting. Assume that Firm As assets grow to $110 in value in period 2, and then either fall to $100 or rise to $120 in two alternative states for period 3: 3A and 3B. Firm A's income
TABLE 1 Firm A FirmB Assets Income Assets Income $$100 $100 $110 100 120 10 -10 10 100 100 100 0 0 0

Period
1 2 3A 3B

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equals the year-to-year change in these values. In contrast, assume the value of Firm B's assets is constant at $100 and, accordingly, its income equals zero in each period. Because the value of Firm B's assets never changes, and consequently income always equals zero, it is irrelevant whether the firm turns over a fraction of its assets or merely holds its initial portfolio. In contrast. Firm A's assets rise to $110 in period 2, which is reflected hy a $10 gain^realized or unrealized in the period 2 income of $10. The period 2 financial statements reveal that Firm A has more assets than Firm B, and that this difference arises solely because of changes in the value of its assets, and not by acquiring additional assets. At the end of period 3, first assume that Firm A's assets drop in value to $100, i.e., state 3A occurs. The $10 loss indicates that either the firm's managers failed to sell its appreciated assets before the decline in value or they sold the initial assets and acquired other assets that declined in value. It is not relevant to firm valuation whether the period 3 loss is realized or unrealized. Alternatively, assume that state 3B occurs and Firm A's assets rise in value to $120. The $10 gain is reflected in the income statement and, as in state 3A, it is valuation-irrelevant whether the period 3B's gain is attributable to the initial assets or to assets acquired during period 2. Although some managers may be more skilled at selecting investments than others, i.e., state 3B is more likely than 3Ato occur, the intangible value of management's skill in selecting investments is reflected fully in the recognized assets' fair value. Simply put, well run firms will have assets that are worth more. Similarly, management skill is reflected fully in the income statement, which includes both realized and unrealized changes in fair values. Because in this setting an asset's fair value is unambiguous, the value of any separate asset related to management skill equals zero. In the more realistic setting discussed in section four, it is possible that the difference between an asset's value-in-use and its entry or exit value could reflect the value of management skill in selecting investments.

Note that in this simple setting the balance sheet provides all value-relevant information because, hy assumption, fair values of all assets are well-defined and ohservahle. The income statement reveals only that the period-to-period change in value results from changes in value of assets held rather than from acquisition of new assets. In this simple setting, this distinction regarding the source of the value change is not necessary for valuation and, in fact, income measurement is redundant."* In summary, if fair value accounting is applied in the simple setting: (1) fair value is well-defined; (2) the balance sheet reflects all value-relevant information and income measurement is redundant for valuation; (3) income realization is not valuation-relevant; and (4) any management skill is reflected fully in the balance sheet. Section four shows that in more realistic settings these three observations are not necessarily descriptively valid. IV. MORE REALISTIC SETTINGS We now turn to more realistic settings in which the assumptions of the simple setting are relaxed. In particular, we assume that markets are not economically equivalent to those that are perfect and complete. Thus not all assets are actively traded, resulting in the lack of availability of market prices for all assets, and fair values are not unambiguously unique, i.e., entry and exit values and valuein-use are not necessary equal. Implementation of fair value accounting requires selection of one of these three value constructs. However, selection of one by standard setters as the basis for financial statements does not resolve all implementation problems. Most notably, estimation issues remain because in many cases these value constructs are not observable. Estimation often is difficult for
Beaver (1987, especially 81-85) makes clear that the income statement is derived from the balance sheet and not vice versa. In particular, one can construct income either from firm value using an expected rate of return, or by calculating the difference in firm value between two successive dates. Beaver (1987) refers to the former (latter) income measure as ex ante (ex post) income.

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value-in-use because it involves, e.g., prediction of future cash flows, selection of an appropriate discount rate, and knowledge of asset synergies. It also can be difficult for entry and exit values if transaction prices do not exist. Moreover, even when market prices exist, the potential for private information in an imperfect market can result in market prices that do not reflect all value-relevant information (Rajan and Sarath 1995).^ Entry Value, Exit Value, or Value-in-Use? The concepts of entry and exit values and value-in-use have a long history in the accounting literature (see, e.g., Edwards and Bell 1961; Chamhers 1966; Sterling 1970), and Beaver and Demski (1979) make clear that it is the ahsence of perfect and complete markets that results in these three values differing. Thus, each can provide different information about an asset's value. At the time of acquisition, value-in-use will be no less than entry value for it to be rational to buy the asset. In contrast, exit value can be greater or less than afirm'svalue-in-use, or entry value, because it is established by others. Clearly, an asset's value-in-use can differ from firm to firm. Although in principle the three values can differ, the most important differences are those between value-in-use and the other two because only value-in-use always reflects differential management skill, including exploiting synergies among assets. Thus, the differences between value-in-use and exit and entry values are measures of management skill. Consistent with the FASB's definition of fair value which focuses on exit value, we define the value of management skill as the difference between value-in-use and exit value.^ Because value-in-use is the only measure that always captures total firm value associated with an asset and is consistent with the going concern tenet of GAAP, value-in-use should be the focus of fair value accounting.' Even though intangible assets such as management skill are excluded under the present accounting model, there is ample evidence that share prices reflect them (see, e.g., Fama and French

1995; Penman 1992; Bernard 1994; Barth et al. 1995b; Barth, ElUott, and Finn 1995; and Ryan 1995). However, fair value accounting based on value-in-use likely will be the most difficult to implement because estimating value-in-use involves incorporating firm-specific and potentially private information. It is possible that measurement error could be so severe for value-in-use that exit or entry value estimates could be more value-relevant. There are two, not necessarily mutually exclusive, types of measurement error. The first is unsystematic error arising from general uncertainty, and the second is systematic error arising from management exercising discretion in determining the estimates. Measurement error affects the validity of claims by some that managers' ability to manage income, and hence investors' perceptions of firm value, would be eliminated or reduced under fair value accounting (see, e.g., appendix A in SFAS 115). These claims are not necessarily valid because estimates of value-in-use are based on managers' private information and they are also subject to potentially severe estimation error. By selectively revealing their information, managers strategically can affect gains and losses recognized under fair value accounting. Even without private information.
^ Additional problems are introduced if fair value accounting is implemented on a piece-meal basis, with hedge accounting being a prominent example. Frequently, the hedged item is recognized at historical cost, but the hedging instrument, which generally is a financial instrument, typically is off-balance sheet. Even if the hedging instrument were recognized at fair value, there is still a mismatch (a measurement anomaly in the FASB's terminology) unless the hedged item also is recognized at fair value. ^ Management skill need not be positive, i.e., poor management of an asset can result in value-in-use less than entry or exit value if the manager's wage exceeds his marginal product. Moreover, although exit values reflect what others are willing to pay for an asset, entry values may reflect some of the value attributable to a firm's management skill to the extent that the firm is willing to pay up to its value-in-use. Of course, actual entry and exit values depend on a variety of factors including market competitiveness. '' If the objective of financial statements is to reflect information from other than a going concern perspective, e.g., that of liquidation, then exit value should he the focus. However, in the case of liquidation, valuein-use and exit value are the same.

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the existence of general uncertainty about fair values results in a situation that permits managers to manage recognized fair values. Also because of the existence of measurement error, particularly that associated with management discretion, it is possible that separate disclosure of the components of value-in-use relating to exit value and the intangible value attributable to management skill provides more value-relevant information than disclosure of only the total, i.e., aggregation can reduce information. This is especially true if measurement error differs for the two components, as one might expect in the situation just described. Existence of private information also complicates the measurement task because current market prices may not reflect managers' private information about asset values. One can view the existence of private information as a dimension of management skill, such as the ability to select assets. Private information can only be reflected in an asset's valuein-use, and not its entry or exit value. For example, consider the value of Firm A's assets at the end of period 2 in the example. Suppose Firm A's managers know that its assets will trade at $110 at the end of the next period, but there is no transaction in period 2 that reveals this amount. Assume this asset is not actively traded, e.g., it is a municipal bond, and has a market price of $100 in periods 1 and 2. Thus, Firm A's managers possess private information and, based on this information, know the asset will soon trade at $110. The value-in-use to Firm A is $110, and for other flrms it is $100. Because otherfirmslack Firm A's private information, they are indifferent between holding the asset or selling it today for $100. Firm A can realize the $10 difference between value-in-use and the market price of $10 simply by waiting until the rest of the market learns Firm A's private information and the asset's market price moves to $110. Alternatively, they can establish tbe asset's value by selling it to an equally informed buyer, thereby recognizing tbe $10 gain, or by credibly revealing their private information to tbe market, wbicb will drive its market price up to $110. Tbe sale of tbe

asset and its associated realized gain is not wbat is informative. Ratber, it is tbe information tbat Firm A's managers reveal tbat enables tbem to obtain a buyer at $110. As a practical matter, selling tbe asset may be tbe only credible way for a firm's managers to establish tbe value of a particular asset about wbicb tbey bave private information.^ Is Income Realization Valuation-Relevant? Altbougb in tbe simple setting income realization is redundant tofirmvaluation, in tbe absence of perfect and complete markets and tbe presence of measurement error tbis is not necessarily tbe case.^ Income realizations tbat occur from asset transfers in arm's lengtb transactions establisb entry value for tbe buyer, exit value for tbe seller, but not necessarily value-in-use for eitber party. Accordingly, separate disclosure by the seller of realized and unrealized gains and losses can provide information about values-in-use for tbose remaining assets tbat are similar in nature to tbose sold. Estimation error enbances tbe potential for income realization to provide information about asset values because entry and exit values are firmly establisbed for buyer and seller. ^ However, because managers often bave incentives to realize selectively
This example illustrates that even for financial assets value-in-use can differ across firms, especially if they are inactively traded. This conclusion appears to contrast with that of Leisenring, Northcutt, and Swieringa (FASB Status Report, August 21, 1995), who assert that "value-in-use...of financial instruments should not vary from entity to entity..." The reason for the apparent difference is that we admit the possibility of market imperfections, most notably private information, whereas they assume implicitly that financial assets' markets essentially are equivalent to those that are perfect and complete. The extent to which value-in-use for a financial instrument differs across firms depends on the degree of market imperfections. 5 Barth et al. (1993, 1995h) examine conditions under which halance sheet information is value-relevant incremental to income statement information and vice versa. 1 In the extreme, if all firm assets are sold, then the issues relating to management discretion do not exist and the assets' fair values are firmly established at exit value hecause management has foregone any possible value-in-use.

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gains or losses to influence assessments of asset values byfinancialstatement users, e.g., "cherry-picking," realized amounts can provide a biased picture of the value of the assets still held (Barth et al. 1990; Warfield and Linsmeier 1992; Barth 1994; Barth, Landsman and Wahlen 1995). Of course, knowing this, financial statement users are likely to factor this into their value assessments. Thus, it is not clear whether knowing realized gains and losses in addition to the sum of realized and unrealized gains and losses increases the knowledgefinancialstatement users have about the firm's assets' exit and entry values, let alone values-in-use. In summary, in the more realistic setting of imperfect and incomplete markets: (1) fair value is not well-definedi.e., entry and exit values and value-in-use can differ; (2) because each of the three value constructs may be unobservable, implementation of fair value accounting requires their estimation, thereby introducing the potential for measurement error; (3) one primary difference between valuein-use and the other two constructs relates to the intangible value of management skill; (4) fair value accounting should focus on valuein-use because it is the only measure that always captures totalfirmvalue associated with an asset and is consistent with the going concern tenet of GAAP; (5) separate disclosure of the components of value-in-use potentially is informative in the presence of measurement error; (6) separate disclosure of realized and unrealized gains and losses can provide information about asset fair values that otherwise would be unavailable if only the total were disclosed, although there is information loss in the presence of measurement error and if managers selectively realize gains and losses. V. FAIR VALUATION OF LIABILITIES Thus far we have considered only all equity firms, yet most firms have liabilities. Although valuation of liabilities conceptually is the same as valuation of assets, it is troubling to some that as a firm's financial condition worsens, tbe fair value of its liabilities de-

clines. Using debt as a representative liability, we provide two related explanations for wby this is appropriate. The value of debt equals the discounted value of the cash fiows the issuer contractually promises the debtholder.^^ The debt's discount rate depends on the riskiness of its issuer. As thefirmbecomes less likely to honor its obligation, the debt becomes riskier, the appropriate discount rate becomes higher, and the value of the debt decreases if the contractual interest rate is not adjusted to refiect the debt's riskiness. This is true whether or not the debt is traded. This decrease in value is a transfer of wealthfi-omthe debtholder to the issuing firm. Effectively, the debtholder contractually has committed to accept an interest rate that subsequently proves to be economically too low. A related, and economically equivalent, explanation to understand why the value of debt declines as a firm's financial condition worsens is to note that debt contains an option held by the issuing firm to put the firm's assets to the debtholder at a striking price equal to the face value of the debt (Smith 1976). This option is an economic asset of the issuing firm (Swieringa and Morse 1985; Barth, Landsman, and Rendleman 1995; Kimmel and Warfield 1995), the value of which increases as the firm's financial condition worsens, thereby decreasing the value of its debt. Under fair value accounting, in a period in which the issuing firm's financial condition worsens it recognizes in income as a credit the decrease in its liabilities' fair values. This credit represents the amount of wealth transferredfi-omcreditors to equityholders during the period.^^ As with assets, conditional on the relative amounts of measurement error associated with entry and exit values and valuein-use, fair value accounting for liabilities
1' For purposes of the discussion in this section, we assume that asset and liability values can be characterized using a discounted cash flow approach. Although such a characterization of value may not hold, the conclusions we draw largely are unaffected if other plausible characterizations are considered. ^^Revsine (1981) makes a similar point in the context of inflation accounting.

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should focus on value-in-use.^^ Although it appears that exit value may differ from valuein-use for some liabilities, such as those involving the provision of services instead of cash, they may not differ depending on management's actions. For example, in the case of warranties an exit value is what the firm would have to pay a third party to assume its obligation, and value-in-use is the value of the firm's services required to discharge its obligation. However, value-in-use equals exit value if management contracts with a third party to meet its obligation. As with assets, the case could be made for disclosing estimates of liabilities' exit values and values-in-use if there is estimation error. In summary, fair value accounting for liabilities is conceptually no different than for assets. The decrease in liabilities' fair values arising from a deterioration of a firm's financial condition represents the transfer of wealth from creditors to equityholders. VI. COMPREHENSIVE INCOME AND CORE EARNINGS The FASB is concerned with how, if at all, fair value accounting relates to the concepts of earnings and comprehensive income and the alternative concept of core earnings. A primary distinction between earnings and comprehensive income discussed in the FASB's Concepts Statements is that unrealized holding gains and losses are candidates for comprehensive income but not earnings. Our discussion of fair value accounting in section four admits the possibility that separate disclosure of realized and unrealized gains and losses provides value-relevant information. However, our discussion provides no basis for recognizing in income only realized gains and losses.^^ This conclusion is consistent with that reached by Leisenring, Northcutt, and Swieringa (FASB Status Report, August 21,1995) who conclude that changes in fair values should be reported as a component of comprehensive income rather than reported only in the balance sheet as part of owners' equity. IVIany contend that financial statement users can glean more value-relevant informationfroman income statement based on a con-

cept of core earnings. Although core earnings is not precisely defined, it appears to refer to partitioning income into two major components: one relating to income provided by a firm's ongoing operating activities, and another relating to income provided by gains and losses on primarily nonoperating assets. Core earnings resembles the concept of permanent earnings discussed in the academic literature.^^ It is possible that a partition of income based on operating versus nonoperating activities is informative if operating earnings have different valuation implications than nonoperating earnings, e.g., different risk characteristics, resulting in investors applying different weights to the two components when valuing thefirm.^^However, fair value accounting and the concept of core earnings are unrelated in that the former relates to accounting measurement and the latter relates to disaggregation of recognized amounts. Thus, standard setters should consider the concept of core earnings apart from their consideration of fair value accounting. In summary, fair value accounting provides no basis for recognizing in income only realized gains and losses. Although the concept of core earnings may provide value-relevant information to financial statement users, the concepts of core earnings and fair value accounting are unrelated. VII. CONCLUSION This paper discusses fundamental issues relating to implementation of fair value ac1^ Entry value is a less common concept with liabilities than it is with assets. It refers to the price a firm would pay to acquire its present obligations. ^* It is an open empirical question whether disclosure and recognition have different valuation implications (see Imhoff et al. 1993; Bernard and Schipper 1994; and Barth and Sweeney 1995). '^ Studies investigating permanent earnings include, among others. Beaver and Morse (1978), Beaver et al. (1980), Lipe (1986), Beaver (1987), Kormendi and Lipe (1987), Collins and Kothari (1989), Cornell and Landsman (1989), Easton and Zmijewski (1989), Ramakrishnan and Thomas (1991), Barth et al. (1992, 1993), and Barth, Elliott, and Finn (1995). 1^ Analogously, separate disclosure of income, sales, and assets by geographic and business segments may provide additional value-relevant information than that provided by reporting aggregate amounts.

Fundamental Issues Related to Using Fair Value Accounting for Financial Reporting counting. We conclude that in the simple setting economically equivalent to perfect and complete markets, a fair value accountingbased balance sheet reflects all value-relevant information, the income statement is redundant, income realization is not relevant to valuation, and any intangible asset relating to management skill, asset synergies, or options is reflected fully in the balance sheet. However, in settings in which the market assumptions are more realistic, fair value is not well-defined, giving rise to three value constructs, entry value, exit value, and value-inuse. Because none of these is always observable, implementation of fair value accounting requires their estimation, thereby introducing the potential for estimation error. Unless estimation error is severe, value-in-use is more appropriate for firm valuation for going con-

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cerns than the other two constructs because it is the only construct that captures total firm value associated with an asset, including intangibles relating to management skill. Also in the more realistic setting, neither the balance sheet nor income statement reflects fully all value-relevant information and income realization potentially can be valuation-relevant, although management discretion can detractfi*omits relevance. We also point out that fair value accounting concepts apply equally to assets and liabilities. Finally, our discussion of fair value accounting reveals no basis for recognizing in income only realized gains and losses, and that although the concept of core earnings may provide value-relevant information to financial statement users, the concepts of core earnings and fair value accounting are unrelated.

REFERENCES American Institute of Certified Public Accountants (AICPA). 1993. The Information Needs of Investors and Creditors, a Report on the AICPA Special Committee's Study of the Information Needs ofToday's Users of Financial Reporting. Barrett, M. J., W. H. Beaver, W. W. Cooper, J. A. Milbum, D. Solomons, and D. P. Tweedie. 1991. American Accounting Association Committee on Accounting and Auditing Measurement, 1989-1990. Accounting Horizons 5 (September): 81-105. Barth, M. E. 1991. Relative measurement errors among alternative pension asset and liability measures. The Accounting Review 66 (July): 433-463. . 1994. Fair value accounting: Evidence from investment securities and the market valuation of banks. The Accounting Review 69 (January): 1-25. , W. H. Beaver, and W. R. Landsman. 1992. Market valuation implications of net period pension cost. Journal of Accounting and Economics 15 (March): 26-62. .^ and . 1993. A structural analysis of pension disclosures under SFAS 87 and their relation to share prices. Financial Analysts Journal 49 (January/February): 18-26. , , and . 1995a. Value-relevance of banks'fair value disclosures under SFAS 107. Working paper. University of North Carolina and Stanford University. _ and ^ . 1995b. The relative importance of tbe balance sbeet and income statement: An examination of the financial distress hypothesis. Working paper. University of Nortb Carolina and Stanford University. , and M. A. Wolfson. 1990. Components of bank earnings and tbe structure of bank sbare prices. Financial Analysts Journal (May/June): 5360. , J. A. Elliott, and M. W. Finn. 1995. Market rewards associated witb increasing earnings patterns. Working paper. University of Chicago, Cornell University, and Stanford University. , W R. Landsman, and R. J. Rendleman. 1995. Accounting for financial instruments: An option pricing-based approacb to measuring corporate debt. Working paper. University of Nortb Carolina and Stanford University. -, and J. M. Wahlen. 1995. Fair value accounting: Effects on banks' earnings volatility, regulatory capital, and value of contractual cashfiows.Journal of Banking and Finance 19 (June): 577605. , and A. P. Sweeney. 1995. Differential information environments and the relation between accounting amounts and sbare prices: Cost of capital and recognition versus disclosure. Working paper. Harvard Business School and Stanford University.

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