Is Fair Value Accounting Fair?

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to get an overall view of the informativeness of FVA, this paper mainly focuses on the two major users of financial statements, the investor and creditor.

2.1 Relevance of Fair Value Accounting

The most informational value added part is relevancy, because the balance sheet (or statement of financial position) stated according to book value tends to provide information based on cost, while it would be based on current value when it is stated in accordance with FVA. As proponents argue: ‘Investors are concerned with value, not costs, so report fair value’ (Penman, 2012). The relevancy is important for the overall informativeness of the financial statement.

A way to assess the relevance of FS and its disclosures is to measure its step-by-step association with share prices. For different categories of bank assets and liabilities within the financial statement, FVA tends to provide more useful information. First of all, investment securities are incrementally informative relative to their book values in explaining share prices (Barth M. a., 1996). Furthermore, loans fair value are also incrementally informative relative to their book values in explaining share prices (Barth M. a., 1996). This is due to the fact that their fair values reflect information about the default and interest rate risk. Investors are, as a result of exercising discretion of loans, able to see whether a manager of an unhealthy bank is trying to appear look healthier. Lastly, Bank’s derivatives fair values explain variation in bank share prices (Venkatachalam, 1996).

As tangible fixed assets are likely to fall into level 3 of the fair value hierarchy, explained in the introduction, these assets are more prone to a substantial amount of management’s discretion compared to assets such as financials. According to Easton et all. (1993), asset revaluations of tangible long-lived assets have descriptive influence comparative to earnings and variation in earnings. Regarding the managerial discretion, there is little evidence suggesting that the relevance of appraiser-based revaluation compared to director-based estimates is negligible (Landsman, 2007). However, when focusing on appraiser, external appraisers’ revaluations estimates are more informative than internal appraisers’ revaluations estimates. This is not really surprising, yet depending on the category of asset, revaluation estimates should be made by those having the best information in order to be reliable. That is the reason why a lot of companies are more likely to use external appraisals to estimate revaluations about land and buildings but plant, equipment and intangible assets by directors. In contrast to fair values of tangible fixed assets, evidence for the informativeness of FVA for intangible assets is still controversial.

2.2 Transparency of Fair Value Accounting

A second important informational value added part is transparency. If information is more transparent to the investors, more efficient allocation of resources is possible, and hence increases capital market’s efficiency.

Volatility is argued as one of the disadvantages of fair value, although this is not necessarily a disadvantage. As Sundgren (2013) argues: Investors, lenders and creditors are probably interested in the quantity, timing and uncertainty of the forecasts of future net cash inflows to a company. Variations in fair value may include information about the uncertainty of future cash inflows which in turn indicate higher risk. However, there is a lot of controversy regarding this subject, which will be discussed later.

Bleck & Liu (2007) describe the problem as follows: HCA is similar to granting a free call option to the manager. If the firm’s performance is good (e.g., its market price is high), the manager can choose to sell, making the book value reflect the asset’s market price. Quite the opposite, if the asset’s market value is low, he can keep the asset and account a book value equivalent to the asset’s initial cost. Hence, however the manager has a “baseline” in the book value, which is the initial cost. All at once, he can benefit from the project’s positive side. This is the typical feature of a call option. In other words, management’s discretion and latitude has an substantial impact on the transparency.

So, the transparency level tend to be higher under FVA. Signaling more information about the current situation will benefit investors in making their estimates and decisions of capital allocation.

2.3 Comparability of Fair Value Accounting

A third important informational value added part is comparability. As we know, the world is emerging, international trade is increasing, cultures are spreading etcetera. In short, the world becomes intensively connected, so does the capital market. In order to let the capital market work efficient, in other words, to let the firms attract investors from foreign countries, and on the other side, let investors allocate their resources in foreign businesses, internationally comparable financial statements and hence internationally financial standard setters are needed. The FASB defines comparability as: ‘the quality of information that enables users to identify similarities in and differences between two sets of economic ’phenomena”. To fulfill this demand for comparability, FVA can play an important role. Barlev et al. (2007) claim that comparability of local and international accounting information is achievable under the paradigm of FVA, but not under that of the HCA paradigm. They argue this by stating that FVA provides accounting data at the time when the comparison is made, and therefore comparable and relevant. The comparison is not affected by timing differences, changes in purchasing, power of local currencies, changes in local price structures and other influential difference in circumstances regarding comparability around the world (Barlev & Haddad, 2007).

Concluding, especially for investors and creditors FVA tends to be more informational compared to book value. For bank’s assets and liabilities there is an association with share prices after controlling for market information, hence fair value level inputs 1, 2 and 3. However, it should be highlighted that there are also other users of FS for which it might be not so informative or even worse leading to dysfunctional information of FS. Furthermore, the use of FVA has a positive effect on the amalgamation of capital markets. Especially, FVA is enhancing the transparency to investors, the comparability between financial statements of businesses and relevancy of the value of assets.

3. Disadvantages of Fair Value

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