According to William Issac, a financial crisis ensued in 2008 seemingly from controversial
accounting rules enforced by the federal government. The rules in question were the so-called
fair value accounting rules, led by the GASB. The author informs readers that while fair value
seems fair to some, others feel the opposite. This battle of right or wrong pushed the SEC to
improve fair market values. While this was occurring, the GASB made moves to loosen the
framework surrounding fair value regardless of skepticism from onlookers.
In my opinion, the author Justin Marlowe has been able to portray that there are two sides to
this story, which is something I strongly believe in. Everyone sees the same situation through
a different set of eyes thus having different takeaways and different opinions of the matter. I
prefer to use cost accounting rather than fair value accounting though, as I have become
accustomed to using it. Perhaps if I were more accustomed the other, I would have opposing
views. But I prefer to stick with what I am comfortable with, which is cost accounting.
Fair value accounting is essentially what an asset is priced at based on the current economy
and market. This is different than cost accounting which is the cost of the asset you are
purchasing or selling at the time the transaction occurs. Fair value accounting is facing a lot of
scrutiny for past economic downturns as the people who utilize this type of accounting can
price things unfairly. When the economy is trending down a bank can purchase a piece of
land for cheap and then wait for the economy is raising to list this land at a much higher rate.
It can be used to trick investors into thinking they are working with a very profitable company
when the company is changing the price to a new market value to increase profits. The article
I read explains that some companies use fair value marketing to actualize profits sooner for
the company and these can be turned into bonuses for members of the company. I do agree
with the author that this type of accounting can harm the economy and is utilized mostly by
companies that want to try and look at profitable as possible as fast as possible. I personally
would prefer cost accounting, because it is more accurate when looking at profits. It shows a
clearer picture of what an asset is worth and leaves a clear trail of how the helps or harms
your company.
Fair values are used for financial reporting requirements, asset allocation, incentive
compensation, portfolio construction, beneficiary transactions, among other purposes.
According to Larsen (2020), due to public market volatility, the expanding uncertainty and
unknown duration, and the ultimate economic impact of COVID-19 creates a situation where
it is more difficult to apply judgment in determining fair value, especially during the crisis
during the first two quarters of 2020. Although, fair value must be evaluated constantly and
objectively even in a highly subjective and constant changing environment. Estimating fair
value requires significant informed judgment in the best of times. The current economic
environment requires enhanced consideration of individual facts and circumstances with a
rapidly changing macro-overlay. Following robust established valuation processes, exercising
informed judgment, and following the concepts outlined in the AICPA PE/VC Guide, will
help demonstrate the rigor applied and the reasonableness of the judgments used in estimating
fair value at all measurement dates. In the current environment with increased risk and
uncertainty, investors need more than ever for fair value judgments to be sound.” On the
contrary, I agree with this article because despite the pandemic fair value has changed over
the last several decades.
The impact on the value of a specific investment should reflect a market participant’s
consideration of uncertainty in the macro environment. Uncertainty has increased, and
therefore a market participant would take the increased uncertainty and greater risk into
account when determining the amount, they would pay for an investment. The fair value
accounting method lists assets in their most liquid form. In addition, this provides
shareholders with a better estimate of how much an asset costs based on current prices instead
of constant prices making financial statements more accurate. Importantly, a fair value
measurement does not allow hindsight and considers information that was known or
knowable as of the measurement date by a market participant.
For this discussion, I read two separate articles to get a broader idea of the views on the fair
value controversy. The authors of each article were split on the concept of fair value. They
believe that fair value accounting is the best option, but there is still plenty of room for better
guidelines.
The article 'Fair Value or Fraudulent Misrepresentation' discusses a fine line between the two
things, and it falls on the accountants to ensure that the heads of the company are not
overinflating their numbers. The authors point out that fair value is straightforward to
determine on most assets, but it is on the unique or non-liquid assets where the trouble comes
in. Since fair value is determined by the expected market price at a given time, choosing what
this asset is worth can be difficult if you have a unique asset. The temptation to inflate or
misrepresent an asset can be substantial if there is not a large enough base to help with
calculating a realistic number. On this point, the authors point out that the best rule is to ask,
"What would a third party honestly pay for this."
The second article, 'Fair Value Under Fire,' similarly discusses the issue but with the focus on
the fact that fair value allows for transparency while at the same time does not protect the
average person from companies that have overextended their estimates on the assets. The
problem with this is that if the future market does not match their inflated expectations but
instead comes in massively short, the stockholders have suddenly lost money that didn't exist.
The stockholders believe they had more equity in an asset than what was honestly there, and
the company has no way of making it up.
I believe that fair and historical costs each have a good argument when it comes to short-term
assets. It's on longer-term or rarely traded assets where the problems begin to rise. For
historical costing, the plus is that you know exactly what the asset once was worth, but this
does not account for inflated, depreciation, wear, etc. When logging it on the books, the
historical cost may well misrepresent the asset's actual value at the time of the statement.
When the asset is traded or sold, you can adjust your books for the gain or loss on the asset
using the actual price that it was sold for. The profit or loss is just not realized until this point
which can make some investors upset if they do not see a return sooner. On the side of fair
value accounting, this allows an analyst to view trends and predict the future of the market
and use this data to determine the asset's value. This is where I agree with both articles on the
problem with fair value, especially when discussing something as fluid as the stock market.
There need to be firmer rules as to how companies determine what the fair value of their
assets are. In my opinion, the fair value costing creates a greater potential for a house of cards
situation for a company and subsequent shareholders. I believe that historical accounting is
the more honest accounting method, it just takes longer to see profits or losses.
I chose an article written by CFE, CPA, CIE Gerry Zack from May/June 2016. In the article
Zack describes how fair value accounting can be manipulated by businesses in order to
receive a financial gain. Zack makes a very substantial comment in his article, stating “the
greater the required use of judgment, the greater the risk of fraud”. He explains that fair value
accounting requires a strong use of judgement to accurately report assets. However, because
of this judgement it leaves a large gap for businesses to use this accounting concept
fraudulently.
Mr. Zack paraphrases an enforcement release from the SEC from January 2016 pertaining to
Miller Energy Resources Inc. This company acquired Alaskan Oil and gas assets from a court
approved auction. Miller paid $2.25 million for the assets and assumed $2 million in
liabilities from a company that was in the process of bankruptcy. When the company filed
there quarterly financial statements ending January 31, 2010, they reported a value of $480
million for the assets. This significantly increased the book value, which then increased their
overall net income. This increase in income resulted in Miller’s stock price going from a low
of $0.60 on December 10, 2009, to $6.60 by March 31,2010.
I do agree with the authors stance, that fair value accounting leaves a Gray area where
companies are able to manipulate their books to receive a financial gain. This to me is
unethical reporting because this is not reporting in an honest way. When you manipulate the
value of assets, you are violating many of the GAAP Principles, such as the Principle of
Sincerity. This principle states “The accountant strives to provide an accurate and impartial
depiction of a company’s financial situation” (Fernando, 2022). By reporting assets at a fair
value, it does not fully disclose the assets value, as any change in the economy could affect
the value of the asset. Therefore, this would not be accurately reporting the company’s
financial health.
References
Fernando, J. (2022, March 17). Generally accepted accounting principles (GAAP).
Investopedia. Retrieved March 24, 2022, from
https://www.investopedia.com/terms/g/gaap.asp
Zack, G. (2016, May). Fraud magazine. Fraud Magazine. Retrieved March 24, 2022, from
https://www.fraud-magazine.com/article.aspx?id=4294992681
As a bonus, I found another article that was a great read on how the GAAP use of fair value
and the IFSB use historical cost can cause differences in the numbers a company reports.
https://hbr.org/2016/07/where-financial-reporting-still-falls-short
Keenan, L. (201, March 1). Fair Value or Fraudulent Misrepresentation? FRA.
https://www.forensicrisk.com/fair-value-or-fraudulent-misrepresentation/
Sutton, M. (2020, April 29). Fair Value Under Fire. UWorld Roger CPA Review.
https://accounting.uworld.com/blog/cpa-review/fair-value-under-fire/
Larsen, D. (2020). Measuring Fair Value in Times of Significant Uncertainty: Valuation
Insights First Quarter 2020. Duff & Phelps.
https://www.duffandphelps.com/insights/publications/valuation-insights/valuation-
insightssecond-quarter-2020/measuring-fair-value-times-significant-uncertainty.
https://hbr.org/2013/03/why-fair-value-is-the-rule
Marlowe, J. (2015, December). Is 'Fair Value' Accounting Actually Fair? Retrieved from
https://www.governing.com/archive/gov-fair-value-accounting.html
