To start this discussion off with a quote from one of the articles that I found concerning this
issue. This was said by Charles Lee, an accounting professor at Stanford: "But the purpose of
accounting isn’t to make those forecasts, he insists. The purpose is to give shareholders the
tools they need to make their own forecasts."
Professors Lee's argument, and I agree, is that accounting should give an accurate
representation of what has happened, not force stakeholders to try to predict what will
happen. Fair value accounting requires forecasts on what the future returns will be. This is
great if a company is coming out of a slump, and seeing a lot of economic prosperity, but not
so great for companies that have surged, and are now settling into a more realistic cycle. As
written in the article, “The market has come to rely on accountants as the keepers of economic
history,” Lee declares. “As an investor, when I turn to financial statements, I want a
trustworthy and interpretable account of what took place. As soon as we start to anticipate
future exchanges, we are in a world of speculation. And unfortunately, given dysfunctional
managerial incentives and other moral hazard problems, it is often a world of fiction.” In
other words, this could give companies the opportunity to "cook the books" and make future
forecasts look much rosier than that they are. This, in turn, can mislead investors, who rely on
financial statements to show an accurate record of the company's financial stability. Yes,
investors are interested in a company's future potential, but it is up to them to make those
decisions, not up to financial statements to say what could have been, what may have been,
and not what is.
Fair value accounting is a controversial topic, and rightfully so I believe. My article by
Karthik Ramanna of Harvard Business Review, raises some interesting points. Fair value
accounting only entered the mainstream again over the past few decades. Fair value
accounting was blamed for the 1929 collapse, banned by the SEC until the 70’s, and then
blamed again for crashes since, most notably the 2008 collapse. Cost accounting is certainly
more conservative, whereas fair value accounting allows for manipulation of data (Ramanna,
2013).
Fair value can appear to make sense in certain instances. If an equity investment with a
$100,000 cost basis experiences enough capital appreciation to value the asset at $400,000,
we are missing out on reporting $300,000 in assets that, on paper at least, we have. The
problem arises when this investment experiences a 40% loss like we saw in 2008 in the equity
markets, and it looks like a company lost nearly half of its assets in a matter of weeks. This
can wreak havoc on financial reporting and judging only the balance sheet, can make things
look a lot bleaker than they are. Using cost accounting would avoid this scenario entirely,
though at the cost of being a very conservative approach (Ramanna, 2013).
As a personal example, I know most people probably look at their brokerage accounts and
just see a number. They think they “have” that number, so when the market corrects and they
lose 15% of their net worth in a couple weeks, they panic. Did we ever actually have that
money, though? Ultimately, we do not gain or lose anything until we sell. When people panic
and liquidate their life savings, they do lose money, because they make those unrealized
losses real. Looking at our cost basis might be a better indicator of the state of panic than
looking at how an overinflated stock we bought years ago fell 15%, still leaving us in the
black. The same scenario can be applied to large cap companies listed on the S&P500. When
asset valuations drop under fair value, it can look like the sky is falling and make investors
panic, which ripples throughout the market at large. Under cost accounting, we practice the
fact that we have not gained or lost anything unless we sold our asset, regardless of valuation,
and the most reliable method is cost.
To help alleviate the issues of fair market value, the FASB issued Staff Position No. 157-3
which determinates “the Fair Value of a Financial Asset When the Market for That Asset Is
Not Active.” (McCollum, 2008). SFAS 157 uses 3 valuation techniques to help determine
accurate fair market values which are:
Market Approach - "The market approach uses prices and other relevant information
generated by market transactions involving identical or comparable assets or liabilities
(including a business). For example, valuation techniques consistent with the market
approach often use market multiples derived from a set of comparables." (Zabel, 2009).
Income Approach - "The income approach uses valuation techniques to convert future
amounts (for example, cash flows or earnings) to a single present amount (discounted). The
measurement is based on the value indicated by current market expectations about those
future amounts." (Zabel, 2009).
Fair value accounting uses current market values as the basis for recognizing certain assets
and liabilities. Fair value accounting makes financial reporting more uncertain due to the lack
of economic history. I have found the article “Charles Lee: Why Fair-Value Accounting Isn’t
Fair”. The author has explained the reason why fair value accounting is used, which is “to
promote transparency, reformers have pushed banks and all other companies to embrace “fair-
value” accounting” (Andrews, 2014). However, Professor Lee argued that fair-value
accounting confuses the core purpose of rigorous accounting to provide accurate economic
transaction records history.
Accounting is to report on the financial information of the company’s performance and
financial position accurately and transparently under GAAP. It also “provides investors with a
language and tools to make their forecasts of future earnings growth”. But, Fair value
accounting is not going to help. I prefer to use cost accounting for a company's financial
reporting. Cost accounting is more useful than fair value accounting to keep track of asset
history, not to forecast future prices.
According to Greenberg, Fair value accounting (FVA) refers to the practice of updating the
valuation of assets or securities on a regular basis, ideally by reference to current prices for
similar assets or securities established in the context of a liquid market; historical cost
accounting (HCA) instead records the value of an asset as the price at which it was originally
purchased. Neither FVA nor HCA is objectively "better" than the other. Instead, both
accounting approaches can provide useful information for different contexts when applied
rigorously, but when they are implemented poorly or when regulatory oversight is weak, both
FVA and HCA can produce misleading information that can increase systemic risk across the
financial sector.
Fair value accounting versus cost accounting has been a controversial issue for years. The
article I chose is "Is It Fair to Blame Fair Value Accounting for the Financial Crisis?". You
can review the article at: https://hbr.org/2009/11/is-it-fair-to-blame-fair-value-accounting-for-
the-financial-crisis. In the article the author states we must recognize that there is no single
best way to value the assets of financial institutions. Some assets may be more accurately
measured under fair value accounting, while others may be better measured under the
historical cost approach (Pozen, 2009). d I agree with the author; I do not believe one approach
is more accurate than the other, I believe it depends on the asset. The author suggest three
recommendations for realistic reporting; Enhance creditability of marking to model, unlink
accounting and capital requirements, and calculate earnings per share both ways (Pozen,
2009). I agree that we can make these accounting complexities clearer by adopting a
multidimensional approach to financial reporting. d
When it comes to fair value versus cost accounting, I am on the fence. d I see where fair value
accounting is beneficial for some assets where you would want to reflect the current market
value, but I also see where cost accounting is a more straight forward and simplified approach.
the article The Case for Fair Value Accounting by Edmund L. Andrews. In reviewing the
article, the statement that I kept in mind was What’s the purpose of accounting? Well
according to another article “The purpose of accounting” its purpose is to accumulate and
report on financial information about the performance, financial position, and cash flows of a
business. This information is then used to reach decisions about how to manage the business,
or invest in it, or lend money to it (Bragg, 2022). With that I mind, as I read The Case for Fair
Value Accounting, I could see the point being made. d If the purpose of accounting is to report
on financial information and use that information to make decisions about a business, whether
it's to lend money or invest, wouldn’t you want the most up-to-date information?
The interviewee of this article Mary E. Barth talks about too much focus being put on
historical costs, how misleading this can be, and how tenuous the link to original cost is, so
much so that it’s almost an accident when historical-cost accounting practices correlate with a
company’s underlying value. With one of the biggest objections to fair value accounting
approach is that it's based on estimates, rather than “hard facts,” and those estimates could
easily be erroneous or intentionally manipulated. I would have to agree with Ms. Barth’s
rebuttal to this when she says that anything can be “massaged” and “manipulated” to fit the
direction that management wants to go. So, to me, the argument that fair value doesn’t present
“hard facts” and can easily be misleading doesn’t work. I couldn’t tell you how many times I
read in our book that we use estimates for one situation or the other because there’s no way of
getting the actual figures.
As a user of financial statements, I would have to go with fair value because it’s more
representative of the value of an asset that historical costs. Fair value is tested annually for
impairments, while historical cost is not tested for impairment loss and remains the same
throughout the life of the asset. And if the time value of money tells us anything, it's that the
value of a dollar today is not the same as the value of that dollar 5, 10 or 20 years from now.
For this week’s discussion, I chose an article called “Financial Reporting Another Fair Value
Controversy” from Strategic Finance magazine. The author in this article focuses mainly on
the implications of company debts when using Fair Value Accounting. d He discusses in detail
the net effect on the income statement as well as perception from creditors when a company
that is experiencing financial difficulties, is able to depress the appearance of their debt by
reporting a gain on their income statement, by resolving their debt at a lower cost, and
maintaining their credit worthiness.
I agree with the author’s opinions in this article. Not only can there be a significant
differentiation between two companies in the same financial situation, with one using Cost
Accounting and one using Fair Value Accounting, but companies aren’t going to realize a
loss intentionally, appearing less financially stable, and Fair Value gives them the opportunity
to realize the gain when the debt is less than the amortized cost. The lack of consistency in
the financials for a company using Fair Value Accounting makes it difficult to attain fair
market comparisons.
As a user of financial statements, I prefer Cost Accounting. In my opinion, there are too
many variables in Fair Value Accounting that leave the financial statements more open to
interpretation, than the facts that can be found in the financial statements of a company using
Cost Accounting.
Pounder, B. (Ed.). (2012, November). Financial Reporting Another Fair Value Controversy.
Retrieved March 24, 2022, from https://sfmagazine.com/wp-
content/uploads/sfarchive/2012/11/FINANCIAL-REPORTING-Another-Fair-Value-
Controversy.pdf
Article reference: Edmund L. Andrews, Andrews, E. L., Barth, M. E., & Landsman, W. R.
(2019, May 16). The case for Fair Value Accounting. Stanford Graduate School of Business.
Retrieved from https://www.gsb.stanford.edu/insights/case-fair-value-accounting
Bragg, S. (2022, March 15). The purpose of accounting. AccountingTools. Retrieved from
https://www.accountingtools.com/articles/what-is-the-purpose-of-accounting.html
Greenberg, Michael D., Eric Helland, Noreen Clancy, and James N. Dertouzos, Fair Value
Accounting, Historical Cost Accounting, and Systemic Risk: Policy Issues and Options for
Strengthening Valuation and Reducing Risk. Santa Monica, CA: RAND Corporation, 2013.
https://www.rand.org/pubs/research_reports/RR370.html.
Andrews, Edmund. (2014). Charles Lee: Why fair-value accounting is not Fair. Insights by
Stanford Business. https://www.gsb.stanford.edu/insights/charles-lee-why-fair-value-
accounting-isnt-fair
Cost Approach - "The cost approach is based on the amount that currently would be required
to replace the service capacity of an asset (often referred to as current replacement cost)."
(Zabel, 2009).
Zabel, R.R. (2009). SFAS 157: What Is Its Purpose? Robins Kaplan LLP. https://www.
robinskaplan.com/resources/articles/sfas-157-what-is-its-purpose.
Ramanna, K. (2013). Why 'fair value' is the rule: How a controversial accounting approach
gained support. Why 'Fair Value' Is the Rule: How a Controversial Accounting Approach
Gained Support - Article - Faculty & Research - Harvard Business School. Retrieved March
23, 2022, from https://www.hbs.edu/faculty/Pages/item.aspx?num=44233
https://www.gsb.stanford.edu/insights/charles-lee-why-fair-value-accounting-isnt-fair
