RESEARCH CORNER

Market-value accounting standards and the market for accounting standards

Over the last two decades, there has been a gradual but continuous march toward fair value or market value accounting. In recent years, this movement has gathered momentum with the US Financial Accounting Standards Board (FASB), culminating in the pending standard "Fair Value Measurements " which is expected to be effective at the end of 2006, and "The fair value option for financial assets and financial liabilities" a corresponding exposure draft. This ED states that a second-phase standard would extend fair value measurement to non-financial assets and liabilities.

According to Ross Watts, a world-renowned professor from the MIT Sloan School of Management, this change will weaken the foundations of accounting standards and threaten the survival of GAAP-based financial reporting. In his April 21st research workshop at the Sauder School of Business, Professor Watts presented a convincing set of arguments based on the evolution of accounting standards over several centuries.*

In brief, prior to formalization by standards bodies, generally accepted accounting standards-in the true sense of the term-were developed in response to market forces and legal realities; and as a corporate governance mechanism, accounting has developed a transactions-based approach using historical values and a balance between timely reporting and conservatism. For example, accounting principles allow revenues to be recorded toward the end (but not at the end) of the operating cycle, barring exceptional circumstances (bad credit risk = later recognition; contracted prices = earlier). Managers' limited tenure, planning horizon, and liability require that owners compensate them on verifiable and conservative performance reports; and the limited liability of corporations and individuals requires that bankers lend on the basis of conservative, verifiable numbers.

Professor Watts argues that fair value accounting for non-financial items will disrupt the market-derived equilibrium of GAAP. For instance, one manifestation of fair value accounting is revenue recognition at the earliest point of the operating cycle: the conception of a business idea (i.e. recording the net present value of a new project). Jeff Skilling of Enron advocated such accounting, and we all know how that story ended. Fair value accounting involves too much uncertainty about the future resolution of events and invites abuse by those managers who are unscrupulous. As a result, Watts predicts that accounting standards based on fair value will be abandoned by the market, as users demand a different set of accounting reports.

Those who champion fair value reporting say it will provide more relevant financial statements; ironically, such standards would likely to lead to their own irrelevancy.