Fair Value Accounting
Investors, accountants and executives have two measures that they utilize to determine the value of company’s assets, that is, the amount those assets would bring in if sold today (fair value) and the price originally paid for the assets (historical cost or acquisition cost). Twenty-five years ago, prior to the advent of the internet, corporate financial statements relied on price originally paid for the assets, which possesses the vital virtue of being easily verifiable (Sherman and Young, 2016). Today firms utilize fair value for a vast array of asset classes in the hope that the analysis or audit of the balance sheets will reveal a more accurate picture of the current economic reality. Given that not every individual or business entity agrees on what fair value means, the measure has resulted in immense subjectivity into the process of financial reporting, thus, creating novel challenges for both people who prepare and use financial statements.
The aftermath of the 2008 financial crisis saw a myriad of adjustments made to the techniques of applying fair value and adopted by the IASB, Financial Accounting Standards Board and the Public Company Accounting Board. The objective of these changes was to provide better guidance to auditors on how to verify fair value of assets (Sherman and Young, 2016). Nonetheless, the outcome has been more confusion rather than improved clarity. As such, fair value accounting has proved to be difficult and often controversial and subjective. A good example is the accounting treatment of Greek bonds by the European banks in 2011 in the period where the Greek government faced a seemingly endless stream of debt. According to the report by Sherman and Young (2016), write-downs of Greek bonds varied from twenty-one percent to fifty-one percent which is a notable discrepancy when one contemplates that all large European financial institutions are audited by the same four accounting firms and use the same market data. For instance, the Royal Bank of Scotland acknowledged a charge to earnings of 733 million euros in the second quarter of 2011 following a fifty-one percent write-down from the balance sheet value of 1.45 billion euros for its Greek government bond portfolio. While questionable, this financial decision by the Royal Bank of Scotland was in adherence to the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) fair value hierarchy. This fair value hierarchy stipulates that if observable market prices are available, then companies must use them. Based on that understanding, the Royal Bank of Scotland recognized that market prices had reduced by just over half the price paid for the Greek bonds when they were issued (Sherman and Young, 2016).
There are certain financial institutions that did not employ the same fair value accounting technique as the Royal Bank of Scotland or at least not to the same extent. For instance, CNP Assurances and BNP Paribas in France analyzed the same data and decided to write the Greek bonds down by only twenty-one percent. These two financial institutions rejected the market prices on the questionable grounds that the mart was too illiquid at that time to accord a “fair” valuation. As such, CNP Assurances and BNP Paribas resorted to the “level 3” fair value estimates in a process referred to as mark-to-model, contrary to the mark-to-market valuation employed by the Royal Bank of Scotland (Sherman and Young, 2016).
The fact that such difficulties exist in tradable securities means that even bigger problems in fair value accounting lie in the application of fair value precepts to intangibles such as patents, research and development projects, goodwill and earn-out agreements. This situation is aggravated by the provision that disclosures regarding how intangible assets are valued must provide only basic information about the assumptions generated by the estimates. As such, it is difficult to see how the situation could improve when it comes to fair value accounting since the length of annual reports could be overwhelming when there is full disclosure of the assumptions behind fair value estimates despite them being extremely prominent.
Fair Value in Financial Accounting Standards (FAS)
According to Financial Accounting Standards (FAS 157), fair value is the price that would be paid to transfer a liability or received to sell an asset in an orderly business transaction among market participants at the date of measurement. This description is a shift from the long-standing practice of utilizing the transaction price for a liability or asset as its initial fair value. The implication of this change in description is that fair value will no longer be based on what a person pays for something; rather, it will be based on what the person can sell it for, also referred to as the exit price. This shift in definition of fair value also emphasizes that it will be market-based which requires the contemplation of what other market participants may pay for the asset. Therefore, the amount of available data to measure fair value will determine how the valuation of a liability or asset is determined.
FAS 157 outlines certain valuation techniques such as income approach, market approach and cost approach. These methods of valuation require inputs that represent the assumptions that market participants would utilize for pricing a liability or asset. As Sinnet (2007) denotes, observable inputs are based on the market data derived from independent sources, for example, stock exchange prices. However, in situations whereby there is no active market for a liability or asset, unobservable inputs are utilized to portray the assumptions of the reporting entity. This standard offers a fair value hierarchy that accords the highest priority to quoted prices in active markets and lowest priority to unobservable inputs as Sinnet (2007) asserts.
Mark-to-market valuation and accounting refers to the accounting standards of according a value to the financial position held by a financial instrument based on the prevailing fair market price and not the book value or original cost of the instrument. Since the early 1990s, fair value has been a crucial aspect of the Generally Accepted Accounting Principles (GAAP). In this regard, investors, accountants and executives demand the utilization of fair value during the estimation of the value of liabilities and assets. This prerequisite is hinged on the desire by investors to get a more accurate and realistic appraisal of a company’s current financial position. This is why mark-to-market valuation is a valuable technique to investors, accountants and executives since it is a measure of fair value that takes into account changes in the fair value of liabilities and assets over times.
A good example given by Metzger (2010) is financial instruments that are traded on a futures exchange, for instance, commodity contracts that are marked to market by financial institutions on a daily basis at the close of the market. Since banks tend to invest significantly in financial instruments traded on a futures exchange, they mark to market using two steps. First, banks calculate an estimate of the net realizable value of their portfolio of asset-backed securities. This process entails discounting the cash flows of these assets. Second, based on fair value accounting, banks take a haircut on the net realizable values that takes into consideration the price at which they could sell these assets. It is vital to note that when the market is not functioning, the haircut undertaken by banks is extremely large. This implication is of immense significance since it suggest that the large decrease in the value of bank assets is not as a result of a decrease that has certainly occurred; instead, it is due to the market’s judgment of the risk of resale by a buyer. According to Wallison (2009), it is this risk that when analyzed in fair value accounting forces bank to write-down assets as is seen in the examples of the Royal Bank of Scotland and financial institutions such as CNP Assurances and BNP Paribas.
Relevance and Reliability
The discourse on fair value accounting tends to revolve around issues of salience and reliability. As Poon (2004) outlines in his report, fair value is defined in the Financial Accounting and Standards Board’s Preliminary View documents as an estimate of the price a business entity would be paid if it has been relieved of a liability or realize if it has sold an asset on the reporting date in an orderly exchange that is motivated by normal business consideration. Poon (2004) further states that relevance is described in the glossary of the Financial Accounting and Standards Board Statement of Financial Accounting Concepts Number 2 as the capability of information to influence a decision by assisting users to formulate predictions regarding the outcomes of the past, present and future events or to correct or affirm expectation.
When it comes to reliability, it is described in the glossary to the Financial Accounting and Standards Board Statement of Financial Accounting Concepts Number 2 as the quality of information that ensures that information is reasonably devoid of error and bias and as such, faithfully represents what it purports to represent. As a financial estimate of exit value in normal market condition, fair value is not only well defined but also noncontroversial in situations whereby there are well-established liquid markets. However, in situations whereby there is no liquid market, that is, where a fair value estimate will entail selection of proper discount rates and prediction of future cash flows, fair value estimates are contingent on measurement error and management’s assumptions. Through this technique, companies are capable of masking deliberate manipulation and miscalculation of their numbers.
It is imperative to note that both JWG and Financial Accounting and Standards Board (FASB) recognize that certain significant assessment issues about fair value accounting must be resolved and as such, the international bodies are working on coming up with better guidance about estimating fair value, as well as, formulating proper controls. Nonetheless, Poon (2004) point out that the utilization of fair value estimates by companies is a critical part of preparation of financial statements such as the universal implementation of estimates in pension accounting. This is because fair value accounting tends to be reliable information that is useful in business decision making in scenarios whereby markets are transparent and liquid for all liabilities and assets. Notwithstanding, as Bies (2005) denotes, since numerous liabilities and assets do not have an active market, the techniques and inputs for assessing and estimating their fair value tend to be more subjective and thus, their valuations are also less reliable.
As the intricacy and variety of financial instruments increases in the current global market, the need for autonomous verification of fair value estimates also increases among individuals and firms. While this is a positive change, verification of valuations that are not based on observable market prices is still a challenge. This is because the majority of the values will be on methods and inputs chosen by company management. Moreover, estimates derived from these judgments will likely be difficult to verify. This is why Bies (2005) emphasizes that both users and auditors of financial statements, including credit portfolio managers will need to focus more on discerning how liabilities and assets are computed and how reliable these valuations are when making business or financial decisions based on them.
The Financial Accounting and Standards Board issue ASU 2018-13 on August 28, 2018 which signifies a change in fair value measurement disclosure prerequisites from those of ASC 820. The amendments stipulated under ASU 2018-13 are the outcome of a wider disclosure project known as Financial Accounting and Standards Board Concepts Statement, Conceptual Framework for Financial Reporting – Chapter 8: Notes to Financial Statements which the international body finalized on August 28, 2018 (Deloitte, 2018). The Financial Accounting and Standards Board implemented the guidance in the Concepts Statement to enhance the efficiency of ASC 820’s disclosure prerequisites for fair value accounting. These alterations apply to all business entities.
The ASU tweaks the disclosure objective paragraphs of ASC 820 to exclude the term “at a minimum” from the statement “an entity shall disclose at a minimum,” as well as, other open-ended disclosure prerequisites to foster the proper exercise of discretion by business entities. Also, the disclosure objective included in ASC 820-10-50-1C according to Deloitte (2018) states that the objective of the disclosure prerequisites in this subtopic is to offer users of financial statements with information regarding liabilities and assets computed at fair value in the balance sheet or disclosed in the notes to financial statements:
- The uncertainty in the fair value computations as of the reporting date.
- The valuation methods and inputs that a financial reporting entity utilizes to arrive at its assessment of fair value, including assumptions and judgments that the entity makes.
- How alterations in fair value computations impact a business entity’s cash flows and performance.
Novel Disclosure Prerequisites
Based on the report by Deloitte (2018) on fair value accounting disclosures, the novel disclosure prerequisites in ASU 2018-13 outlined below are not applicable to nonpublic entities.
Level 3 Range and Weighted Average utilizes to formulate significant unobservable inputs
Currently, entities are required to avail quantitative information regarding critical unobservable inputs for Level 3 fair value accounting. It is vital to note that the amendments pursuant to ASU 2018-13 ass an incremental prerequisite for entities to disclose the range and weighted average utilized to formulate crucial unobservable inputs, as well as, how this average was computed for fair value accounting within Level 3 of fair value hierarchy. Entities may also disclose other quantitative information in connection with the weighted average if these entities determine that such information represents a more rational and reasonable technique of reflecting the distribution of critical unobservable inputs utilized to develop Level 3 fair value accounting.
Level 3 Alterations in Unrealized Losses or Gains
According to the report by Deloitte (2018), entities are expected to disclose the amount of total losses or gains pursuant to ASU 2018-13 for the period acknowledged in OCI that can be attributed to fair value alterations in liabilities and assets held by the entities as stipulated in the statement of financial position date and grouped under Level 3 of the fair value accounting hierarchy. Important to note is that this disclosure prerequisite builds on the prevailing prerequisite to disclose such total unrealized losses and gains for the period unrecognized in earnings, otherwise known as changes in net assets pursuant to ASC 820-10-50-2d. A private entity or entity that is nonpublic is not required to implement either of these prerequisites.
The report by Deloitte (2018) states that ASU 2018-13 was initially drafted by the Financial Accounting and Standards Board to exempt only private business entities from the novel disclosure prerequisites and some modified disclosure prerequisites.
Modified Disclosure Prerequisites
Level 3 Fair Value Accounting/Measurements
The new ASU 2018-13 amends the section of the Codification that obligates other entities apart from nonpublic entities to avail a narrative description of the sensitivity of the fair value computation to alterations in unobservable inputs. As such, the ASU denotes that such entities are not required to disclose information regarding sensitivity to future alterations in fair value, but are required to disclose information regarding uncertainty in computation from the use of critical unobservable inputs that could have been discordant at the reporting date (Deloitte, 2018).
Level 3 rollforward
Pursuant to ASU 2018-13, private entities are not required by the Financial Accounting and Standards Board to complete a reconciliation of the opening balances to the closing balances of the Level 3 fair value accounting (Deloitte, 2018). Instead, these entities are required to only disclose separately the Level 3 fair value accounting during the period attributed to transfers in and out of Level 3 and purchases and issues. It is vital to note that ASU 2018-13 does not alter the quantitative Level 3 rollfoward disclosure prerequisites under the prevailing United States Generally Accepted Accounting Principles for business entities that are not nonpublic entities.
Net Asset Value Disclosure of Estimates of Timing of Future Liquidity Events
According to the report by Deloitte (2018), pursuant to ASU 2018-13, entities are no longer needed to estimate and disclose the timing of liquidity events for investments computed at fair value. Rather, the prerequisite to communicate such events is applicable only when they have been announced publicly or relayed to the reporting entities by the investees. Should the timing be unknown, the entities are obligated to disclose that fact.
Eliminate Disclosure Prerequisites
Policies related to the timing of transfers between levels of the fair value hierarchy and the valuation process
Under the prevailing Generally Accepted Accounting Principles, entities are required to formulate and consistently adhere to a policy for determining when transfers between fair value hierarchy levels have taken place. This prerequisite is unchanged due to the implementation of ASU 2018-13. Nonetheless, the ASU excludes the prerequisite to disclose this policy in the notes prepared by firms to the financial statements. In addition, ASU 2018-13 excludes the prerequisites in ASC 820-10-50-2(f) for entities or firms to disclose their valuation processes.
Transfers between Level 2 and Level 1 of the Fair Value Hierarchy
ASU 2018-13 excludes the prerequisite for business entities other than nonpublic entities to communicate the amounts of and reasons for transfers between Level 2 and Level 1 for liabilities and assets held by the companies at the end of the reporting period that are computed at fair value on a continuous basis. According to Deloitte (2018), the Financial Accounting and Standards Board does not believe that the benefits of the disclosure of transfers between Level 2 and Level 1 of the fair value hierarchy supersede the costs.
Arguments for Fair Value Accounting
Few people and entities will question the salience of information based on market prices since information about historical cost is based on market prices at which liabilities were initially incurred and assets were initially acquired. On the other hand, fair value is based on the prevailing or current market prices. Fair value evinces the impacts of alterations in market conditions and alterations in fair value portray the impact of changes in market conditions when they occur. Contrary to fair value, information about historical cost evinces only the impacts of conditions that existed when the business transaction took place and the impacts of price changes are displayed only when they are realized.
Since fair value includes current information regarding the prevailing market expectations and conditions in its computation, it is expected to provide a superior foundation for prediction than the outdated historical cost figures. This is because the outdated cost figures evince outdated market expectations and conditions as Poon (2004) reports. Proponents for determination of fair value in accounting normally advance the notion of reporting the financial position of companies as they are and improving transparency. As Ebling (2001) reports, they also point to areas such as the savings and loans industry or pension accounting where fair values make problems such as poor performing loans and deficits visible much earlier, thus, fostering corrective action.
Arguments against Fair Value Accounting
Critics of fair value accounting argue that it has hastened the fall of defined benefit schemes and formulated a false short-term visibility in pension funding. As Power (2010) denotes, critics are of the opinion that the financial crisis evinces the pro-cyclicality of fair values when accounting is tightly combined with prudential regulatory systems and the unreliability of marking to techniques in asset markets that are less than liquid, particularly for assets that are held for the long-term. The critics of fair value accounting also assert that its impact is likely to be more demanding loan agreements and more restrictive lending policies than are necessary for formidable risk management, as well as, pricing that is higher than is economically ideal. Numerous criticisms have also been brought forward regarding the subjectivity and potentially bias and manipulative nature of fair value accounting. However, as Power (2010) emphasizes, the debate on fair value accounting appears to hinge on fundamentally discordant perceptions and interpretations of the basis for reliability in accounting. Thus, this makes this discourse less of a technical dispute and more about acceptability politics.
The prevailing techniques of accounting for financial instruments have been of immense concern to accounting standard-setters all over the world. These concerns regarding financial instruments commence from the observation that markets now exist for the various financial risks that emanate from the instruments or for the instruments themselves. Moreover, there are discordant comprehensions of what it takes for an accounting estimate to be considered as reliable. Nonetheless, proper changes in accounting principles are not possible without certain extra effort from all capital market participants, including those who prepare financial statements, regulators, auditors and users of financial statements. As such, fair value accounting and reporting require more detailed and extensive analysis of the assumptions and methods utilized in determining the values acknowledged in the financial statements compared to historical cost-based precepts. However, transparency of the true economic consequences, that is, rewards and risks, emanating from the utilization of financial instruments is still vital and justifies the shift towards a fair value based model for accounting and financial reporting.
It is important to note that when it comes to fair value accounting, mark-to-market financial reporting has its shortcomings, particularly for derivatives. For instance, fair value that is based on market prices can be difficult to determine for lightly traded and intricate financial instruments. The situation is aggravated by the fact that these derivatives fall within the level 3 where there are notable changes in disclosure requirements by the Financial Accounting Standards Board. Other shortcomings of the mark-to-market financial reporting are that banks have successfully argued that from a theoretical perspective, market prices do not represent fair value and the other people have also challenged the relevance of market prices. Despite these issues regarding fair value accounting, it is still proper for financial reporting since it fosters transparency, inter-period equity, accountability, consistency and risk management.
Bies, S. (2005). Fair value accounting. Federal Reserve Bulletin, 91, 26-30.
Deloitte. (2018). FASB issues standard to amend required fair value measurement disclosures.
Ebling, P. (2001). Fair value accounting: breaking a butterfly upon a wheel?. Balance Sheet,
9(1), 22-26. doi: 10.1108/09657960110695268
Metzger, L. (2010). Mark to market governments. The Journal Of Government Financial
Management, 59, 16-20.
Poon, W. (2004). Using fair value accounting for financial instruments. American Business
Review, 22, 39-44.
Power, M. (2010). Fair value accounting, financial economics and the transformation of
reliability. Accounting And Business Research, 40(3), 197-210. doi: 10.1080/00014788.2010.9663394
Sherman, H., & Young, S. (2016). Where Financial Reporting Still Falls Short. Retrieved from
Sinnett, W. (2007). New fair value standards stress HOW not just WHAT. Financial Executive,
Wallison, P. (2009). Fixing fair value accounting. OECD Journal On Budgeting, 9(2), 1-8. doi: