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5.3 Case Study

The trend toward fair value accounting

The debateCritics contend that GAAP is seriously flawed. Some in the accounting profession go so

far as to pronounce financial statements almost completely irrelevant to the financial

analyst community. The fact that the maret value of publicly traded firms on the !ew"or Stoc #$change is an average of five time their asset values serves to highlight this

deficiency. %any reformers& including 'AS( chairman )obert *er+& believe that fair

value accounting must be part of the anwer to maing financial statements more relevantand useful. Advocates of fair value accounting say it would give users of financial

statements a far clearer picture of the economic state of a company.

(ut switching from historical cost to fair value re,uires enormous effort. -aluing assets inthe absence of active marets can be very subective& maing financial statementsless

reliable. /n fact& disputes can arise over the very definition of certain assets and liabilities.

The cru$ of the fair value debate is this0 each hide agrees that relevance and reliability areimportant& but fair value advocates emphasi+e relevance& while historical cost advocates

place greater weight on reliability.

)elevance versus )eliability

The pertinent conceptual guidance for maing trade1offs between relevance andreliability is provided by 'AS( Concept Statement !o 2& ualitative Characteristics of

Accounting information. /t provides guidance for maing standard1setting decisions

aimed at producing information useful to investors and creditors. Concepts Statement

!o.2 states0

The ,ualities that distinguish 4better 6more useful7 information from 4inferior 6lessusefull7 information are primarily the ,ualities of relevance and reliability... The obectiveof accounting policy decisions is to produce accounting information that is relevant to the

purposes to be served and is reliable.

Critics of fair value generally believe that reliability should be the dominant characteristic

of financial statement measures. (ut the 'AS( has re,uired greater use of fair value

measurements in financial statements because it perceives that information as more

relevant to investors and creditors than historical cost information. /n that regard& the'AS( has not accepted the view that reliability should outweigh relevance for financial

statement measures.

Some critics also interpret reliability as having a meaning that differs in at least certain

respects from how that term is defined in the 'AS(8s Conceptual 'ramewor. Some

critics e,uate reliability with precision& and others view it principally in term ofverifiability. *owever& Concepts Statement !o.2 defines reliability as 4 the ,uality of

information that assures that information is reasonably free from error or bias and

faithfully represents what it purports to represent. with respect to measures& it states that

4 the reliability of a measure rests on the faithfulness with which it represent& what it

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purports to represent& coupled with an assurance for the user& which come through

verification& that it has that representational ,uality. thus& the principal components of

reliability are representational faithfulness and verifiability.

Although there are reliability concern associated with fair value measures& particularly

when such measures may not be able to be observed in active marets and greaterreliance must be placed on estimates of those measures& present1day financial statements

are replete with estimates that are viewed as being sufficiently reliable. /ndeed& present1

day measures of many assets and liabilities 6and changes in them7 are based on estimates&for e$ample& the collectibility of receivables& salability of inventories& useful lives of

e,uipment& amounts and timing of future cash flows from investments& or lielihood of

loss in tort or environmental litigation.

#ven though the precision of calculated measures such as those in depreciation

accounting is not open to ,uestion is not open to ,uestion since they can be calculated

down to the penny& the reliability of those measures is open to ,uestion. Precision&

therefore& is not a component of of reliability under Concepts Statement !o.2. /n fact&concepts statement !o.2 e$pressly states that reliability does not imply certainty or

precision& and adds that any pretension to those ,ualities if they do not e$ist is a negationof reliability.

uestions9. :hat you thin is the fundamental problem with financial statements based upon the

historic cost measurement principle used under ;S GAAP.