IMGCAP(1)][IMGCAP(2)]Critics of fair value accounting have indicted it as being the cause, or at least having exacerbated, the global financial crisis of 2007-2008.
Many of those detractors are lobbying for the suspension of fair value accounting and some are even calling for a return to pure historical cost accounting, especially for large, publicly traded financial institutions such as banks. While there is likely some truth in the accusation that fair value accounting has played a role in influencing market and consumer behavior, it is inappropriate to demand or expect the accounting profession to be responsible for establishing accounting policies that seek to do so.
The psychological and behavioral effects of fair value accounting, even if not welcomed, do not outweigh the benefits of having the more relevant, representationally faithful information provided by the proper use of fair value measures. We would argue that fair value accounting, notwithstanding the criticisms, is in fact an appropriate financial reporting choice in light of the desired qualitative characteristics of financial reporting, as outlined in recently promulgated SFAC No. 8, the Financial Accounting Standards Board’s updated concepts statement setting forth the objectives, purposes and qualitative characteristics of general purpose financial reporting.
That concept statement provides that the objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.
The role of the accounting profession is to report that information objectively, and not to select or skew such data based on the expected or desired behavioral or psychological impacts that it will have on users of financial statements and consumers.
An important, but distinct, issue surrounding the reporting of fair value information relates to the quality of the resulting financial statements, and this is largely a matter to be dealt with by auditors. There is little question that auditing fair value information can present serious challenges, as recently underscored by the Public Company Accounting Oversight Board’s release of its inspection findings for 2010 public company financial reports. Disturbingly, audit deficiencies of various kinds have increased markedly from the PCAOB’s findings in 2008 and 2009. But more apropos to the fair value debate, deficiencies relating to fair value accounting and disclosures, and the closely related accounting for asset impairments, accounted for about 45 percent of all the deficiencies identified by the PCAOB’s auditors. Thus, separate and apart from the question of the usefulness of fair value information, addressed in the following paragraphs, is the parallel concern about audit quality, which seemingly must be addressed by appropriate bodies (the Auditing Standards Board, the PCAOB, and the professional education industry).
We recommend the development and adoption of a remedying, incremental disclosure as a requirement of GAAP financial reporting. Specifically, there should be disclosures of the historical volatilities of the fair values of reported assets and liabilities, providing financial statement users with the context within which to evaluate the fair values of assets and liabilities presented on the face of the current statement of financial position. Hopefully, the presentation of such information would mitigate the psychological impact upon behavior that has been attributed to perceived changes in unrealized gains and losses.
Issues in Fair Value Accounting
Concerns associated with the effects of mark-to-market include, but are not limited to, how to determine fair value when markets are illiquid, and how to assess and control the perceived wealth effect, the perceived risk effect, and the perceived leverage effect on consumer and financial institution behavior. Wealth effect is an economic term that refers to the increase (or decrease) in spending associated with an increase (or decrease) in real wealth and/or perceived wealth. When increases in actual wealth are realized, the wealth effect can be thought of as an appropriate consumer response; when increases or decreases in wealth are merely perceived (i.e., unrealized), the wealth effect becomes a much less appropriate response.
The perceived risk effect, as described by Gina McMahon in a February 2011 article in CPA Journal, is an economic phenomenon in which prices are affected by perceived changes in risk, and these then lead to further changes in price. For example, as unrealized gains increase, the perception of risk decreases; investments appear to be safer, and the associated risk assessments are also lowered, causing the required risk premium to decrease as well.
McMahon also explains the perceived leverage effect as a by-product of fair value accounting. The perceived leverage effect refers to the increase in leverage as a result of perceived increases in wealth and the leveraging up of the balance sheet due to that perceived increase in assets. If decisions are then taken to deploy the newly generated asset values, this may leave the entity vulnerable when values decline, as they ultimately may do given the cyclicality of economic phenomena.
If asset prices decrease, the balance sheet may be left in an excessively leveraged position. (Consider what happened when defined benefit plans became over-funded during stock price run-ups, leading sponsors to reduce additional contributions or to even withdraw excess assets, only to quickly be found to be under-funded during the next stock market cycle.)
The Function of Accounting Standard-Setting and the Role of Accounting
SFAC No. 8 provides that the objective of financial reporting is to provide to existing and potential investors, lenders and other creditors information that is useful in making decisions about providing resources to the entity. In order to be useful, the information must be relevant and faithfully represent what it purports to denote. Relevant means the information must be capable of making a difference in a decision by helping users form predictions about the outcomes of past, present and future events or to confirm or correct expectations.
To expand upon this point, decisions made by these individuals are dependent upon expected returns on the instruments in which they are invested or considering investing in, including those held as assets of entities whose shares are to be acquired. In order to inform their decision-making, users of financial information need information that will assist in developing expectations about, and assessing prospects for, the amount, timing and uncertainty of future net cash inflows to the entity.
Calling on accounting professionals, as preparers and auditors, and the FASB, in its role as accounting standards setter, to serve as arbiters of consumer behavior flies in the face of the objective of financial reporting as set forth in SFAC No. 8. The appropriate role of financial reporting is to report on economic activity and financial position, not to influence market activity and consumer behavior.
The Role of FAS 157
FAS 157, issued in 2006, which is now codified in ASC 820, served to remove much of the ambiguity involved in fair value reporting by providing a standard definition of fair value, establishing a framework for measuring fair value, and expanding the disclosure requirements for fair value measurements.
The Financial Accounting Standards Board defined fair value in FAS 157 as 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; i.e., it is the “exit” price of an asset or liability. FAS 157 sanctioned valuation techniques that are consistent with the market approach, income approach, and/or cost to measure fair value.
Further, the standard provides a three-tiered hierarchy related to the inputs of the valuation techniques used to measure fair value. The stated aim of this hierarchy is to increase the consistency and comparability in fair value measurements and the related disclosures provided in the financial statements. The fair value hierarchy provides that the highest priority of inputs (level 1) consist of quoted prices in active markets for identical assets or liabilities and the lowest priority of inputs are unobservable inputs (level 3).
Expanded Disclosure to Counter Misperceptions about Volatility
Mark-to-market’s pro-cyclical effects—that is, its propensity to influence financial decision making and/or consumer behavior via the wealth, risk, and leverage effects—could be remedied or ameliorated by a modest expansion of the current disclosure requirements. We suggest implementing a volatility disclosure requirement, distilled from the historical fluctuations in fair values of the assets and liabilities appearing on the entity’s most recent statement of financial position, as a strategy that might mitigate the upward or downward influence of the wealth effect.
Some amount of volatility in financial reporting is expected, and is normal when using fair value accounting, since the fair value approach essentially captures sentiments about the expected future cash flows of assets and liabilities, and these are derived from and sensitive to a range of economic, psychological and political factors. Since these value determinants in the real world are capricious and ever-changing, inherent volatility is rightfully what financial statements should reflect. Fair value accounting does not present an accounting problem, as many would argue; to the contrary, the fair value approach is conceptually the best alignment with the ultimate objective of providing useful information.
Fair value by itself does not create volatility, although some market reactions to information may exacerbate an upward or downward cycle. Improved communications about the reasons for, and the historical context surrounding, current volatilities could ameliorate this phenomenon. Strong market responses and increased volatility are appropriate when warranted by the underlying facts, such as when the market digests information in Form 8-K filings with the SEC, if they indicate the occurrence of a material event that is likely to alter the reporting entity’s expectations for future cash flows. More muted reactions would be apropos when the triggering events are temporal in nature. Better information, including disclosures such as narrative discussion, where useful, of past volatility, should assist users in distinguishing between the two.
ASC 820 already requires disclosures about the sensitivity of key assumptions used in the computation of fair value. In light of the objectives of financial reporting, expanding the disclosure requirements to include a historically based, and thus verifiable, volatility measurement should be understood as a superior alternative to a return to historical cost accounting, which does not provide decision-relevant information even if superficially comforting in its illusory stability.
Empirical research by Ursel Baumann and Erlend Nier has been conducted which investigates the relationship between the volatility of a bank’s stock price and the amount of information the bank discloses to the market. Based on evidence from their study in the September 2004 issue of Economic Policy Review, Baumann and Nier concluded that “banks that disclose more information on key items show lower measures of stock volatility than do banks that disclose less information.”
Reverting to a historical cost-based accounting methodology in order to mask volatility does not serve the best interest of financial statement users, nor would it align with or serve the objectives of financial reporting. A better option for mitigating the alleged pro-cyclical effects of fair value accounting is expanded disclosures showing the historical volatility of associated assets and liabilities.
Natasha Perssico, MBA, is an associate, and Barry Jay Epstein, Ph.D., CPA, CFF, is director of the forensic accounting and litigation consulting practice in the Chicago office of SS&G, Inc., a public accounting and consulting firm. Dr. Epstein is the author of the Warren, Gorham & Lamont Handbook of Accounting and Auditing, and was for many years the lead co-author of Wiley GAAP, Wiley IFRS, and Wiley IFRS Policies and Procedures. Dr. Epstein has authored or co-authored many professional books and articles, and has lectured in the U.S. and abroad. He can be contacted at
