The move toward fair value accounting has engendered intense debate. Both supporters and detractors of fair value accounting have been equally vocal in airing their views. The major advantages of fair value accounting are as follows:
Reflects current information. There is no denying that fair value accounting reflects current information regarding the value of assets and liabilities on the balance sheet. In contrast, historical cost information can be outdated, giving rise to what may be termed “hidden” assets or liabilities. For example, the assets of many manufacturing companies are seriously understated because the current market value of their real estate holdings is not reflected on the balance sheet. This is obviously the most important advantage of fair value accounting over the historical cost model. By reflecting more current information, fair value accounting is argued to be more relevant for decision making.
Consistent measurement criteria. Another advantage that the standard setters stress is that fair value accounting provides the only conceptually consistent measurement criteria for assets and liabilities. At present, financial accounting follows a mish-mash of approaches that is termed the mixed attribute model. For example, fixed assets such as land and building are measured using historical cost, but financial assets such as marketable securities are recorded at current market prices. Even for the same item, inconsistent criteria are used because of conservatism; for example, inventory is usually valued at cost unless market value drops below cost, in which case it gets measured at market value. Under fair value accounting, it is hoped that all assets and liabilities will be measured using a consistent and conceptually appealing criterion.
Comparability. Because of consistency in the manner in which assets and liabilities are measured, it is argued that fair value accounting will improve comparability, that is, the ability to compare financial statements of different firms.
No conservative bias. Fair value accounting is expected to eliminate the conservative bias that currently exists in accounting. Eliminating conservatism is expected to improve reliability because of neutrality, that is, reporting information without any bias.
More useful for equity analysis. One complaint of traditional accounting is that it is largely oriented to provide information useful for credit analysis. For example, the use of conservative historical costs is more designed to provide an estimate of a business’s downside risk than evaluate its upside potential. Many argue that adopting the fair value model will make accounting more useful for equity analysis
The major disadvantages of fair value accounting include the following:
Lower objectivity. The major criticism against fair value accounting is that it is less reliable because it often lacks objectivity. This issue is crucially linked to the type of inputs that are used. While nobody can question the objectivity of Level 1 inputs, the same cannot be said about Level 3 inputs. Because Level 3 inputs are unobservable and based on assumptions made by managers, many fear that the extensive use of Level 3 inputs especially for operating assets and liabilities—will lower the reliability of financial statement information.
Susceptibility to manipulation. Closely linked to lower objectivity is the concern that fair value accounting would considerably increase the ability of managers to manipulate financial statements. Again, this issue is closely linked to the use of Level 3 inputs—it is more difficult to manipulate fair values when Level 1 or Level 2 inputs are used.
Use of Level 3 inputs. Because Level 3 inputs are less objective, a crucial issue that will determine the reliability of fair value accounting is the extent to which Level 3 inputs will need to be used. The recent credit crisis in the United States has shown that even for financial assets or liabilities, many companies have had to resort to extensively using Level 3 inputs because of poor liquidity in the credit markets. The need to use Level 3 inputs is obviously expected to be greater for operating assets and liabilities. If Level 3 inputs are widely used, then many believe that the fair value accounting model will reduce the reliability of the financial statements.
Lack of conservatism
Reflects current information. There is no denying that fair value accounting reflects current information regarding the value of assets and liabilities on the balance sheet. In contrast, historical cost information can be outdated, giving rise to what may be termed “hidden” assets or liabilities. For example, the assets of many manufacturing companies are seriously understated because the current market value of their real estate holdings is not reflected on the balance sheet. This is obviously the most important advantage of fair value accounting over the historical cost model. By reflecting more current information, fair value accounting is argued to be more relevant for decision making.
Consistent measurement criteria. Another advantage that the standard setters stress is that fair value accounting provides the only conceptually consistent measurement criteria for assets and liabilities. At present, financial accounting follows a mish-mash of approaches that is termed the mixed attribute model. For example, fixed assets such as land and building are measured using historical cost, but financial assets such as marketable securities are recorded at current market prices. Even for the same item, inconsistent criteria are used because of conservatism; for example, inventory is usually valued at cost unless market value drops below cost, in which case it gets measured at market value. Under fair value accounting, it is hoped that all assets and liabilities will be measured using a consistent and conceptually appealing criterion.
Comparability. Because of consistency in the manner in which assets and liabilities are measured, it is argued that fair value accounting will improve comparability, that is, the ability to compare financial statements of different firms.
No conservative bias. Fair value accounting is expected to eliminate the conservative bias that currently exists in accounting. Eliminating conservatism is expected to improve reliability because of neutrality, that is, reporting information without any bias.
More useful for equity analysis. One complaint of traditional accounting is that it is largely oriented to provide information useful for credit analysis. For example, the use of conservative historical costs is more designed to provide an estimate of a business’s downside risk than evaluate its upside potential. Many argue that adopting the fair value model will make accounting more useful for equity analysis
The major disadvantages of fair value accounting include the following:
Lower objectivity. The major criticism against fair value accounting is that it is less reliable because it often lacks objectivity. This issue is crucially linked to the type of inputs that are used. While nobody can question the objectivity of Level 1 inputs, the same cannot be said about Level 3 inputs. Because Level 3 inputs are unobservable and based on assumptions made by managers, many fear that the extensive use of Level 3 inputs especially for operating assets and liabilities—will lower the reliability of financial statement information.
Susceptibility to manipulation. Closely linked to lower objectivity is the concern that fair value accounting would considerably increase the ability of managers to manipulate financial statements. Again, this issue is closely linked to the use of Level 3 inputs—it is more difficult to manipulate fair values when Level 1 or Level 2 inputs are used.
Use of Level 3 inputs. Because Level 3 inputs are less objective, a crucial issue that will determine the reliability of fair value accounting is the extent to which Level 3 inputs will need to be used. The recent credit crisis in the United States has shown that even for financial assets or liabilities, many companies have had to resort to extensively using Level 3 inputs because of poor liquidity in the credit markets. The need to use Level 3 inputs is obviously expected to be greater for operating assets and liabilities. If Level 3 inputs are widely used, then many believe that the fair value accounting model will reduce the reliability of the financial statements.
Lack of conservatism
There are many academics and practitioners who prefer conservative accounting. The two main advantages of conservatism are that (1) it naturally offsets the optimistic bias on the part of management to report higher income or higher net assets, and (2) it is important for credit analysis and debt contracting because creditors prefer financial statements that highlight downside risk. These supporters of conservative accounting are alarmed that adopting the fair value model which purports to be unbiased will cause financial statements to be prepared aggressively, therefore reducing its usefulness to creditors, who are one of the most important set of users of financial information.
Excessive income volatility
One of the most serious concerns from adopting the fair value model is that of excessive income volatility. As we noted earlier, under the fair value accounting model income is simply the net change in value of assets and liabilities. Because assets (or liabilities) are typically large in relation to income and because fair values can change significantly across time, changes in fair values of assets can cause reported income to become excessively volatile. Much of this volatility is attributable to swings in the fair value of assets and liabilities rather than changes in the underlying profitability of the business’s operations, so it is feared that income will become less useful for analysis. Standard setters are aware of this problem and have embarked on a project for changing financial statement presentation, which will consider also reporting intermediate income measures that reflect the firms operations
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