Examine the effect of fair value accounting on volatility of
reported profits and equity. Discuss options for
improvement
Introduction
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
Fair value accounting requires assets and liabilities to be measured at their
current market value, rather than historical costs. The goal is to provide
users with a more accurate picture of a company's financial position and
performance based on prevailing market conditions. However, fair valuing
certain items also introduces volatility into reported profits and equity.
There are ongoing debates around whether fair value measurements
appropriate depict economic realities and whether this level of volatility is
desirable from the perspective of financial reporting and markets. Proponents
of fair value argue that it provides transparency while critics argue that
volatility does not necessarily reflect operational performance.
This essay examines how fair value accounting has impacted volatility in
reported profits and equity. It analyzes the sources and implications of fair
value volatility for different classes of financial instruments and non-financial
assets. The essay also discusses options proposed by various standard
setters and stakeholders to potentially reduce undesired accounting volatility
without compromising on relevance of reported numbers.
Fair Value Accounting Standards
The principle of fair value was gradually introduced in accounting standards
during the 1990s and 2000s through accounting rules like FASB Statements
107, 115, 124, 133, 157 and IFRS 7 and 13. Fair value is defined 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.
Fair value is required for trading securities, available for sale securities and
derivative financial instruments in both US GAAP and IFRS. In addition, US
GAAP also requires use of fair value option for certain financial assets and
liabilities. Under IFRS, investment properties and biological assets are also
carried at fair value.
Fair value may be determined through quoted prices in active markets,
valuation techniques incorporating market observable inputs or
unobservable inputs where there is no active market. Unrealized fair value
gains or losses, also called mark-to-market gains/losses, flow through profit
or loss except for certain equity investments classified as other
comprehensive income. The standards aim to provide decision-useful
information to investors.
Sources and Implications of Fair Value Volatility
Potential fair value volatility arises from a variety of sources including
interest rate fluctuations, credit spreads, equity prices, foreign exchange
rates and commodity prices. The degree and implications depend on the
class of instrument involved.
Trading securities: Their short-term holding nature exposes gains/losses to
frequent market price swings. While reflecting economic exposure, this
volatility may obscure operational performance.
Available for sale securities: Price volatility from macroeconomic factors
filters into profits despite no intent to sell. Unpredictability is problematic for
earnings guidance.
Derivatives: Fair values are highly sensitive to small interest/price changes
due to use of leveraged positions and valuation techniques. This introduces
noise.
Investment properties: Periodic valuations capture property market
sentiments but reported results may diverge from cash flows in interim
periods before actual transactions.
Equity investments at FVTOCI: While unrealized gains/losses bypass P&L, fair
value fluctuations directly impact other comprehensive income and equity.
This affects balance sheet-linked metrics and covenants.
Held to maturity bonds: If fair value option is elected, interest rate risk
exposures are magnified in income statement instead of being amortized
over time through maturity.
Management stock options: Valuation model inputs like expected volatility
introduce subjectivity into compensation costs recognized despite no cash
flows.
Critics argue that while fair value provides information, reported volatility
may sometimes exceed what is operationally meaningful or sustainable. It
could undermine financial statement credibility if not accompanied by
adequate explanations. Short-termist behavior by market participants
penalizing temporary fair value swings is also a concern.
Fair Value Volatility: Accounting vs Economic Realities
While fair value aims to reflect prevailing economic conditions, the
accounting recognition of fair value changes does not always synchronize
well with underlying economic events or performance realities. There are a
few potential disconnects:
1. Timing mismatch: Fair value gains/losses flow through P&L immediately
but economic impacts may not crystalize until asset sale or liability
settlement in future.
2. Non-cash/temporary volatility: Many fair value swings represent merely
'paper losses/gains' without real economic substance until cashing out of
positions.
3. Divergence of fair value and discounted cash flows: Fair value may depart
significantly from long-term fundamentals/cash generation ability especially
for financial distress situations.
4. Behavioral effects: Recognizing temporary fair value swings could create
adverse incentives like reluctance to hold long-term and pro-cyclical asset
sales at wrong points in time.
5. Lack of symmetry: Fair value gains/losses treatment is asymmetric, flowing
through P&L only in one direction whereas economic exposures are two-
sided.
6. Valuation inputs subjectivity: Fair values incorporating unobservable Level
3 inputs introduce undesirable estimation uncertainty into reported numbers.
Therefore, while fair value fulfills relevance criteria, the mismatch between
timing of accounting and economic impacts means volatility does not
necessarily portray quality of underlying business performance or economic
substance of events.
Options for Reducing Undesirable Fair Value Volatility
Various options have been debated and in some cases implemented by
accounting standard setters and regulators to potentially address concerns
around fair value income statement volatility, timing disconnects with
economic realities and over-reliance on estimates in measurement:
1. Recycling fair value changes to OCI: This treatment is allowed for certain
equity investments under both US GAAP and IFRS. It keeps volatility out of
earnings but still impacts equity via OCI.
2. Deferring recognition: Amortization of day-one gains, available-for-sale
reserve and macro hedging techniques serve this purpose to some degree
but involve complexity.
3. Widening P&L bandwidth: Allowing wider profit margins can accommodate
short-term volatility without frequent earnings restatements.
4. Additional disclosures: Disclosures around unrealized amounts,
sensitivities, risk hedging provide context without tweaking recognition
principles.
5. Carve-outs from fair value: IFRS 9 provides a business model-driven
classification bypassing fair value option for basic lending activities.
6. Enhanced guidance on estimates: IFRS 13 clarified practices around use of
quoted prices, valuation techniques, inputs to curb unwarranted fluctuations.
7. Anti-abuse measures: Aggressive/intentional exploitation of accounting
mismatches should be curtailed through clarified principles.
8. Reformulating liquidity hierarchies: Levels 1 and 2 may be defined to
encompass reliable techniques based on orderly assumptions even without
very liquid/observable markets.
9. Dual/separate reporting: Supplementary reporting focusing on cash flows,
underlying economics alongside fair value-centric reports mitigates fixation
on latter.
10. Stricter hedge accounting: More closely synchronizing accounting and
risk management through qualifying criteria for hedge accounting
techniques.
The IASB and FASB continue monitoring feedback and consensus to consider
further targeted changes where needed to balance fair value objectives
versus concerns related to transient volatility. Convergence remains crucial
to minimize diversity.
Level 3 Fair Value Estimates: Key Challenges
Fair value estimates for certain assets/liabilities depend substantially on
unobservable inputs requiring significant management judgment, classified
as Level 3 in the fair value hierarchy. Challenges pertaining specifically to
Level 3 estimates include:
- Sensitiveness to small input variations coupled with wide possible ranges
produce highly uncertain valuations.
- Lack of observable pricing creates challenges in calibrating models/inputs
appropriately and independently validating reasonableness.
- Degree of subjectivity undermines comparability and allows potential for
bias, errors, manipulation.
- Periodic 'mark-to-model' nature conflicts with concept of exit price between
informed parties.
- Dampening impact on reported results overstates income statement
precision amid uncertainty.
- Potential over-reliance on appraisals from limited firms without truly
open/competitive bidding.
Some options gaining traction to curb challenges pertaining to Level 3
estimates include
- Enhanced disclosures around inputs, valuation policies, sensitivities,
changes from prior periods.
- Stricter guidance/oversight around selection/independence of experts
valuing complex/infrequent instruments.
- Considering range of reasonably possible amounts instead of point
estimates to portray inherent uncertainties.
- Recycling unrealized changes directly to equity reserves under OCI
treatment instead of P&L.
- Simplifying/standardizing models for certain illiquid instruments based on
benchmark/index approximations.
Overall, reducing reliance and potential abuse of Level 3 estimates through
prudent recognition and enhanced transparency remains an ongoing priority
area.
Conclusion
While fair value accounting fulfills the objective of relevance, its
implementation has introduced unintended volatility into reported profits and
equity balances primarily due to timing mismatches with underlying
economic events. The degree and implications differ depending on the class
of instrument involved as well as reliance on potentially subjective Level 3
estimates in certain cases.
Standard setters and regulators have made efforts through principles-based
guidance, carve-outs and disclosure-focused solutions to balance concerns
regarding fair value income statement volatility without compromising its
qualitative benefits. Further convergence is important to streamline
acceptable practices globally.
Reducing over-dependence on Level 3 inputs through stringent oversight,
simplifying models for complex instruments and recycling changes directly to
equity also help address related challenges. At the same time,
supplementary non-fair value reporting focusing on cash flows and inherent
business performance provides useful context.
Overall, there remains an ongoing need to make adjustments cautiously
considering trade-offs between decision-usefulness and stability of reported
results. No ideal solution exists, but a balanced principles-based approach
incorporating feedback from diverse stakeholders can help accounting
standards evolve to better fulfill their objectives over time.
