Fair-value accounting: what's so fair?
Historical-cost accounting intentionally puts the onus on conservative measurement so that the worst-possible scenario will be reported as the financial position. Fair-value accounting allows managers to present more "good" information to investors, effectively ignoring the concept of conservatism.
For transparency's sake, investors who are interested in the fair value of a company can use a cost-to-market ratio and create their own fair-value report (basing it on the investor's own judgments). The management's financial report and its auditors should not be in a position to decide about the fair-value judgment on behalf of the investors.
Yigal Rechtman, CPA, CFE, CITP, CISM
New York, N.Y.
The author responds:
I understand the concern that a shift toward fair-value accounting might violate the accounting tenet of conservatism. In responding, I would like to discuss three issues related to the reader's concerns: the relevance of historical-cost versus fair-value accounting; the meaning of conservative reporting in FASB's viewpoint; and the role of conservatism in fair-value reporting.
Relevance of historical-cost accounting versus fair-value accounting. The current system of historical-cost reporting is not meeting the needs of investors. According to NYU professor Baruch Lev, the relationship between market values and book values of companies on the S & P 500 was approximately 1:1 in the late 1970s and early 1980s. Today that relationship is approximately 6:1. The historical-cost system, created during a time of fixed-asset-based companies that obtained financing primarily from creditors, does not provide a good representation of value in our knowledge-based economy. Reporting our best estimate of the current values of assets and liabilities and disclosing information about ranges of possible outcomes seems to provide more complete information than simply relying on historical-cost financial information that is conservative and reliable but not very relevant!
Most financial statement preparers, standards setters, and users would concur that the primary characteristic of financial information is that it should be useful in the decision-making process. The two primary characteristics that contribute to usefulness are relevance and reliability. Our article discussed these characteristics at length, and, to summarize, it is frequently necessary to trade relevance for reliability. In the ideal world, we would like to increase relevance--the ability of information to affect a decision--and increase reliability--the fair representation of the financial information reported. New accounting standards and proposals place greater emphasis on providing relevant financial information to users, perhaps at the expense of reliability. This shift is evident in FASB's recent activities that increase the use of fair-value accounting. A recent example of FASB's focus on fair value is the exposure draft on business combinations.
The definition of conservatism in an accounting environment. Where does conservatism fit into the primary accounting qualities of relevance and reliability? In practice, the idea of conservatism has been altered from FASB's original intention. Statement of Financial Accounting Concept 2 defines conservatism as "a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately considered." This suggests that if the reliability of a measurement is not certain, the preparer should carefully consider how uncertainty would affect users' decisions and, thus, how information about the uncertainty should be portrayed. This definition does not imply that financial statements should always be pessimistic. The role of conservatism is for preparers to acknowledge that risks and uncertainties are present in financial information and to adequately account for those risks in the information that is presented to decision makers.
Conservatism in a fair-value environment. Based on the above discussion, how does conservatism impact the current movement toward measuring assets and liabilities at fair value? In an environment clearly moving toward fair-value measurements, the importance of conservatism, as originally intended by FASB, may be even more important than in an historical-cost environment. Specifically, conservatism was meant to encourage accountants to consider the uncertainties surrounding their measurements and the impact those uncertainties and risks might have on decision makers. This is critical in today's marketplace.
In a fair-value environment, financial statement amounts are determined by using estimates of discount rates, cash-flow streams, income streams, and others to establish the fair value of a particular asset or liability. When choosing between alternative assumptions, accountants should be conservative and consider the inherent uncertainties and risks of the asset or liability they are measuring. Furthermore, after establishing the best estimate of current value, the uncertainty and risks inherent in the fair-value estimates should be reported through detailed disclosures about the assumptions used and the range of possible outcomes if alternate assumptions were used. This is the approach followed in the fair-value-measurements exposure draft. The objective of the exposure draft is to improve the consistency and comparability of fair-value measurements and to require increased disclosures so that investors can adjust the reported values as they see appropriate. This process provides relevant financial statements with detailed information that would allow users to assess risks and thus allow them to create more-conservative estimates of corporate value.
To summarize, the current system of financial reporting frequently seems to focus on providing reliable information that is conservative, if not pessimistic, in nature. This focus on reliable information has resulted in an accounting system that produces financial information that is frequently not relevant to investors and other users of financial information. FASB's current focus on fair-value accounting would provide users with much more relevant information that may not be as reliable. One critical component of this new system is that preparers will have to be vigilant in disclosing information about the assumptions made to determine values, and report the uncertainties involved in those assumptions. Thus, accounting is shifting the focus of conservatism from reporting the worst-case scenario to providing detailed information about assumptions and uncertainties surrounding those assumptions, so that users can make informed decisions about corporate measures of fair value.
Rebecca Toppe Shortridge, PhD, CPA
Northern Illinois University, DeKalb, Ill.