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1 UNIVERSITÄT ZU KÖLN UNIVERSITY OF COLOGNE Kölner Diskussionspapiere zu Bankwesen, Unternehmensfinanzierung, Rechnungswesen und Besteuerung Cologne Working Papers on Banking, Corporate Finance, Accounting and Taxation Working Paper 05/2005 * The Decision Usefulness of Fair Value Accounting – A Theoretical Perspective Joerg-Markus Hitz July 2005 * url: http://www.wiso.uni-koeln.de/workingpapers/bcfat/index.html

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UNIVERSITÄT ZU KÖLN UNIVERSITY OF COLOGNE

Kölner Diskussionspapiere zu Bankwesen,

Unternehmensfinanzierung, Rechnungswesen und Besteuerung

Cologne Working Papers on Banking, Corporate Finance,

Accounting and Taxation

Working Paper 05/2005*

The Decision Usefulness of Fair Value Accounting – A Theoretical Perspective

Joerg-Markus Hitz

July 2005

* url: http://www.wiso.uni-koeln.de/workingpapers/bcfat/index.html

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The Decision Usefulness of Fair Value Accounting – A Theoretical Perspective

Joerg-Markus Hitz

Seminar für Allgemeine BWL und Wirtschaftsprüfung,

Universität zu Köln, Albert-Magnus-Platz, 50923 Köln

Tel.:+49 221 470 3089; Fax: +49 221 470 5165

[email protected]

Abstract: Regulators such as the SEC and standard-setting bodies such as the FASB and the

IASB argue the case for the conceptual supremacy of fair value accounting vis-à-vis the

traditional transaction-based model, notably on the relevance dimension. Recent standards on

financial instruments and certain non-financial items adopt the new measurement paradigm.

This paper takes issue with the notion of superior decision usefulness of a fair value-based

reporting system, with an emphasis on the theoretical soundness of the arguments put forward

by regulators and standard-setting bodies. The research is based on the premise that

conceptual reasoning not only represents a worthwile approach to accounting research, but is

of particular importance for the a priori evaluation of accounting alternatives from a standard-

setting perspective. Two approaches to decision usefulness are considered, the measurement

or valuation perspective and the information economics perspective. Findings indicate that the

decision relevance of fair value reporting can be constructed from both perspectives, yet the

conceptual case is not strong. Notably, the hypotheses underlying standard-setting’s shift

towards a fair value-based model turn out to be theoretically weak. One immediate

implication of the research – a condition for the further implementation of fair value

accounting – is the need to clarify standard setters’ notion of accounting income, its presumed

contribution to decision relevancy and its disaggregation.

Key words : Fair value accounting; fair value paradigm; information perspective;

measurement perspective; earnings volatility

JEL Classification: M41

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1 Introduction

This paper is motivated by the ongoing shift of financial reporting standards for listed

companies towards fair value reporting, notably the increasing importance of fair value as an

accounting measurement attribute. Since the mid nineteen-eighties, FASB and IASB have

systematically substituted market-based measures for cost-based measures. Starting out as a

specific remedy for the inequities of the reporting model for certain financial instruments, fair

value has manifested itself as the dominant measurement paradigm for financial instruments

and, more recently, for non-financial items, e.g. goodwill under SFAS 142 and IAS 36, or

investment property under IAS 40. The cost- and transaction-based reporting model is in

decline, a new market-value and event-based model on the rise, with dramatic implications for

the role and properties of balance sheet measurement and accounting income.

This shift in measurement paradigms is driven by the assumption of superior

relevance of market-based measures. Both FASB and IASB stress the capacity of market

prices to incorporate in an efficient, objective manner market consensus expectations about

future cash flows. Opponents of fair value measurement on the other hand criticize the

questionable reliability of fair value measures, especially those based on management’s

expectations and calculations, when sufficient market prices are not available. Especially the

implementation of fair value as a balance sheet measure is subject to intense discussion and

debate. The ongoing controversy about fair value accounting for financial instruments, as

recently highlighted by the rejection of IAS 39 (revised 2003) for full EU endorsement,

illustrates both conceptual issues such as the alleged distortion of earnings and technical

issues like the scope of fair value hedging. Apparently, the debate is far from resolved.

Prior empirical research on fair value accounting is mostly limited to financial

instruments. Results so far support the incremental value relevance of fair value disclosures

for securities (Petroni and Wahlen, 1995; Barth, Beaver and Landsman, 1996; Eccher,

Ramesh and Thiagarajan, 1996; Nelson, 1996) and derivatives (Venkatachalam, 1996) held

by banks and insurance companies. Park, Park and Ro (1999) find value relevance of

recognized fair values for available-for-sale securities under SFAS 115. While all these

studies focus financial sector firms, Simko (1999) with a cross-industrial sample finds no

significant sign of incremental value relevance for SFAS 107 disclosures, which is attributed

to the insignificance of financial activities for these firms. With respect to other financial

instruments, notably loans held by banks, results differ, which can be interpreted as lack of

reliability due to private information. On the other hand, Beaver and Venkatachalm (2000)

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find value relevance for the discretionary component of loan fair values. The notion of

perceived insufficient reliability is especially critical for non-financial instruments. Evidence

so far rests on parallels from market-value regimes in Australia and the U.K. and must be

considered cautiously. As an example, Barth and Clinch (1998) find value relevance for the

remeasurement differences of non-current assets under Australian GAAP, yet further

specification shows significant results only for negative amounts, i.e. asset write-ups are not

value-relevant. Summarizing the extant empirical literature, the relevance of fair value

measurement can only be supported for securities traded on highly liquid markets, while the

evidence reinforces the importance of the reliability argument both for financial and non-

financial assets.

Analytical research so far is mostly silent on the properties and desirability of fair

value measurement. While the superiority of market values is unassailable under conditions of

complete and perfect markets, the contribution of fair value in a realistic setting is unclear

(Barth and Landsman, 1995, Beaver, 1998). Exit value, entry value and value in use are not

identical in a world of asymmetric information, transaction costs and rents; there is no

aggreement on which alternative is the preferable measurement attribute from a conceptual

perspective. Notably, the existing literature does not take issue with the theoretical

assumptions and hypotheses underlying the fair value paradigm as articulated by standard

setters.

This paper assumes that there is a demand for conceptual reasoning on accounting

issues, especially with respect to standard-setting questions. Since the contribution of

empirical research is inevitably small for the a priori evaluation of reporting alternatives,

theoretical hypotheses and evaluations are required to assist standard setters in their task. We

therefore consider the properties and contribution of fair value reporting to decision

usefulness from two conceptual viewpoints, the measurement and the information

perspective, with a special emphasis on the evaluation of the paradigmatic assumptions

underlying regulators’ endorsement of fair value measurement.

One major result of this paper is that the conceptual foundations of the fair value

paradigm cannot be unequivocally supported by theoretical reasoning. The paradigmatic

assumptions are especially weak for model-based estimation of fair value and thus for

valuation of non-financial positions. With regard to fair value as an accounting measure,

standard setters do not present any specific case. Notably, no concept of fair value income is

offered, despite the growing use of fair value in income determination. Application of

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different notions of decision useful income leads to different perceptions of the usefulness of

fair value income and thus emphasizes the need to clarify and elaborate the concept of fair

value accounting prior to further implementation.

The remainder of the paper is organized as follows. Section 2 describes the concept

and proliferation of fair value reporting, with special emphasis on the paradigmatic

assumptions underlying standard setters’ reasoning. Section 3 develops the methodology used

for our conceptual analysis of the contribution of fair value reporting to decision usefulness.

In section 4, this methodology is applied to disaggregated reporting of fair value, whereas

section 5 explores the use of fair value for balance sheet and income measurement. Section 6

concludes the basic results and points at areas for further research.

2 Fair value accounting – a shift in standard-setting paradigms

2.1 Fair value in FASB and IASB accounting standards

2.1.1 Fair value

Despite different wording, the definitions and meanings of the term “fair value” are basically

equivalent in FASB and IASB pronouncements. The general FASB definition can be found in

SFAC No. 7, which describes fair value as “the amount at which that asset (or liability) could

be bought (or incurred) or sold (or settled) in a current transaction between willing parties,

that is, other than in a forced or liquidation sale“ (Glossary). The IASB framework at present

has no definition of fair value, yet a uniform definition can be found on the standards level:

“Fair value is the amount for which an asset could be exchanged, or a liability settled,

between knowledgeable, willing parties in an arm’s length transaction” (e.g. IAS 39, par. 9;

IAS 41, par. 8; IFRS 3, Appendix A; IFRS 4, Appendix A). Taking into account the relevant

interpretations, the FASB/IASB concept of fair value can be defined as specific hypothetical

market price under idealised conditions. More precisely, fair value is the exit market price that

would result under close-to-ideal market conditions, in a transaction between knowledgeable,

independent and economically rational parties, who interact on the basis of an identical

information set (complete information). The sharp distinction of fair value and value in use

clarifies that fair value measurement is not to include specific competitive advantages, i.e. no

private skills and no private information (SFAC No. 7, par. 24 a; JWG, 2000, par. 4.5).

The estimation of fair value follows a three-tier hierarchy. The governing principle

is primacy of market-based measures, i.e. the refutable notion that market prices oder market

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data are more suitable and informative than internal estimates. Thus, market prices represent

the best estimate of fair value, if market conditions satisfy the fair value definition. The

relevant “quality” of market prices is assessed on the basis of the active-market-criterion, i.e.

regular trading of the item on a sufficiently liquid market is required for market prices to

qualify as fair-value-estimates.1 If market prices do not exhibit sufficient information quality

or are not available, the second level of the estimation hierarchy requires to consider

(modified) market prices of comparable items, where comparability naturally refers to the

cash flow profile. Only when such prices cannot be used either, marking to market fails and

fair value is to be estimated using internal estimates and calulations. This marking to model,

the use of accepted, theoretically sound pricing methods, represents a technique of last resort.

Ample guidance exists on valuation techniques for financial instruments, and accepted

methods can be found in the market place. For non-financial items, fair value estimation rests

on a present value approach. SFAC 7 and, with modifications, IAS 36, develop the principles

and methods for such measurements. Notably, they adopt an “economic” view on

measurement clearly grounded in modern neo-classical finance theory, and distinguish

traditional from expected cash flow approaches.

In summary, fair value represents a specific current value, i.e. exit value under

idealised conditions. Measurement follows a strict three-tier-process, with a preference for

marking to marking vis-à-vis marking to model. Fundamental properties of fair value are the

highly idealised market conditions required and the primacy of market-based measures. One

inevitable characteristic of any economic valuation is the lack of verifiability, which the fair

value concept attempts to mitigate with its emphasis on (objective/verifiable) market

valuation. Thus, the reliability of fair value estimates declines with each level of the

hierarchy, especially with the shift away from marking to market.

1 While FASB standards refer to the active-market-criterion without further elaboration, IFRS offer a standard definition, according to which “an active market is a market in which all the following conditions exist: (a) the items traded within the market are homogeneous; (b) willing buyers and sellers can normally be found at any time; and (c) prices are available to the public.” (IAS 36, par. 6; IAS 38, par. 8; IAS 41, par. 8). From a normative viewpoint, this criterion seems unappropriate, since it refers to the “time dimension” of liquidity, i.e. the speed, with which a transaction partner can be found, rather than the “price dimension”, i.e. the price reaction to the transaction, which represents the theoretically valid indicator of information quality. See also section 4.3.1 for these results.

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2.1.2 Implementation of fair value in existing accounting standards

The systematic shift towards fair value measurement, the initiation of the fair value paradigm,

is inexorably linked to the accounting for financial instruments and the specific problems

involved. The triggering event was the Savings-and-Loans-debacle in the U.S. during the

nineteen-eighties, which resulted in regulatory action by the SEC, which among other things

advised FASB to develop a standard on accounting for certain debt securities at their market

value instead of amortized cost. The underlying notion was that historical cost accounting had

hindered proper identification of the financial status of S&L’s; notorious practices were the

designation of securities as investments in order not to write down the carrying amount, and

the realisation of gains on securities trading above their book values (“cherry picking” or

“gains trading”) (Cole, 1992; Wyatt, 1991; White, 2003). Despite its limited scope, this

initiative represented a major evolution in accounting thought on the regulatory level.2

The immediate reaction in the wake of the S&L crisis represents the starting point

for the implementation of fair value measurement and the evolution of the fair value paradigm

both in FASB and IASB standards. Starting as a special rule for certain securities, fair value

measurement was soon identified as the most relevant attribute for financial instruments. Full

fair value accounting for financial instruments was advocated by the IASC in its 1997

discussion paper, which represented the basis for the Joint Working Group Draft Standard in

2000. Paralleling this process was the gradual implementation of fair value for nonfinancial

items, where SFAC 7 on the present value measurement of fair value constituted a landmark

conceptual step. Thus, the implementation of fair value accounting represents a gradual,

ongoing process, whose current status shall be summarized briefly.

Both US-GAAP and IFRS require the disclosure of fair value for basically all

financial instruments (IAS 32, SFAS 107). Rules on fair value accounting for financial

instruments are also equivalent, with one notable exception. IAS 39 and SFAS 115, 133

require trading securities and derivatives held for trading or as part of a fair value hedge to be

measured at fair value with revaluation gains and losses taken directly to income. Available-

for-sale-securities are also carried at fair value, but gains beyond the historical cost ceiling are

recognized as other comprehensive income until realization takes place. In both regimes,

2 Former FASB member Arthur Wyatt refers to it as “possibly the most significant initiative in accounting principles development in over 50 years.” (Wyatt (1991), p. 80), a notion emphasized by the testimony of SEC General Counsel James Doty to the U.S. Senate, who made it clear that “the time has run out on ‘once-upon-a-time-accounting’”.

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financial obligations, except derivatives, are in principle accounted for at cost, equally

securities held-to-maturity. This mixed model approach is an expression of standard setters’

reluctance and interested parties’ resistance to implementation of full fair value accounting,

despite a consensus on its conceptual merits. IASB has taken a big step into this direction with

the 2003 revision of IAS 39, which introduces the “fair value option”, the option to designate

any financial instrument as “measured at fair value through profit and loss” at inception.

However, objections especially from bank regulators, notably the European Central Bank,

have resulted only in a partial endorsement by the EU and in an Exposure Draft proposing to

limit the fair value option to such instruments for which fair value can be reliably measured.

Unlike for financial instruments, the implementation of fair value as measurement

attribute for non-financial items is quite different in US-GAAP vis-à-vis IFRS accounting.

Notably, FASB standards at present require fair value exclusively as a measure for

impairment losses, i.e. invariably preclude the recognition of fair value gains beyond the cost

ceiling. Specifically, fair value represents the relevant impairment measure for goodwill

acquired in a business combination, certain intangible assets (SFAS 142) and long-term-assets

(SFAS 144). IAS 36 requires similar impairment rules, with recoverable amount, i.e. the

higher of value in use and fair value less cost to sell, as the relevant measurement attribute.

Yet, for fair value accounting, IFRS standards go far beyond FASB provisions. The

revaluation model, which can be chosen for measurement of property, plant, and equipment

(IAS 16) and of actively traded intangibles (IAS 38) requires full fair value measurement,

with gains beyond the carrying amount taken to other comprehensive income, yet depreciation

measured on the basis of revalued amounts. The fair value model provided optionally for

investment property (IAS 40) and compulsory for biological assets (IAS 41) even requires full

fair value accounting with gains and losses directly taken to income.

In summary, IFRS implement the fair value paradigm more aggressively. While the

FASB obviously takes a cautious stance especially on fair value measurement for non-

financial items, the IASB assumes a more progressive role and implements the fair value

paradigm in a more consequent manner, accepting the deconstruction of the twin pillars of the

historical cost model, cost-based measurement and transaction-based income recognition. The

discussion on accounting for insurance contracts, where IASB intends to provide a full fair

value accounting in the second phase, illustrates the board's commitment to fair value

measurement, thus underscoring the impetus and determination of the development.

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2.2 Paradigmatic foundations and the debate on fair value accounting

The move towards fair value accounting is frequently characterized as a shift in paradigms

(e.g. Barlev and Haddad 2003). We share this notion and believe that this process is based on

firm beliefs and assumptions and thus needs to be taken seriously, with evaluation beginning

at the roots of the development. Therefore, the paradigmatic foundations of fair value

accounting shall be briefly elaborated as a starting point for conceptual evaluation.

A paradigm can be defined as a set of values and beliefs shared by a specific

community. Thomas S. Kuhn in his “Structure of Scientific Revolutions” extensively

discusses this term in the context of scientific methodology and develops his influential theory

of the process and drivers of paradigm shifts. Accordingly, with respect to financial reporting,

a paradigm shall be defined as a set of shared beliefs on the objectives of financial reporting

and on the accounting principles by which these can be achieved. It is grounded in firm

assumptions, and characteristically requires a theoretical foundation or vindication.

Specifically, a measurement paradigm represents a consensus on the measurement attributes

required to achieve the reporting objective in question. Once a financial reporting paradigm is

adopted by regulatory institutions, it becomes the guiding principle for accounting regulation,

i.e. standard-setting.

The move towards fair value measurement results from the adoption of the fair value

paradigm by standard-setting bodies such as FASB and IASB. The initiating event was the

Savings-and-Loans-Crisis referred to previously, which laid open the deficiencies – or, in

Kuhns terminology, the anomalies – of the present reporting system based on the historical

cost/matching paradigm. This model, whose roots are usually traced to the Paton and Littleton

(1940) monograph, seemingly was incapable of coping with financial instruments and the

business models of information-era/service-oriented firms founded on intangible assets. On

the standard-setting level, these problems and the conceptual debate had already resulted in

the adoption of an asset-liability approach instead of the traditional revenue-expense

approach, yet without daring to move towards current value measurement (Storey, 1999). The

financial instruments debate triggered by the S&L crisis represents the critical event initiating

the “revolution”, i.e. the shift from the historical cost paradigm towards the fair value

paradigm.

The fair value paradigm rests on the the decision usefulness paradigm, which was

only established with the formation of the FASB and the conceptual framework project,

which drew from the Trueblood report. Thus, unlike the historical cost model, fair value

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measurement rests conceptually on a clearly stated reporting objective: the provision of

information to investors to enable them to asses the amounts, timing and uncertainty of future

cash flows from an investment in a firm’s shares or debt securities (SFAC 1, par. 37; IASB

framework, par. 15). More specifically, the fair value paradigm rests on two theoretical

assumptions. The first and most fundamental assumption is that (hypothetical) market prices

aggregate in an efficient and virtually unbiased manner the consensus expectations of

investors in the market concerning the cash flow pattern of the security (information

aggregation hypothesis):

„An observed market price encompasses the consensus view of all marketplace participants about an asset or liability’s utility, future cash flows, the uncertainties surrounding those cash flows, and the amount that marketplace participants demand for bearing those uncertainties.” (SFAC No. 7, par. 26).3

With these informational properties, market prices incorporate exactly the information

demanded by investors, which financial reporting should convey. According to the second

paradigmatic assumption, investors can extract these implicit consensus expectations from

market prices in order to revise and improve their own projections (information inference

hypothesis). Market price information thus directly satisfies the assumed informational needs

of investors and therefore contributes in an ideal manner to financial reporting’s decision

usefulness objective. In an important step, SFAC 7 generalizes this reasoning for any market

value satisfying the fair value definition. That is, synthetically generated market prices are

also considered to have these desirable informational properties. The FASB therefore arrives

at a fundamental conclusion:

„For measurements at initial recognition or fresh-start measurements, fair value provides the most complete and representationally faithful measurement of the economic characteristics of an asset or a liability.” (SFAC 7, par. 36)

Standard-setting bodies establish elaborately the conceptual supremacy of fair value

measurement with reference to theoretical economic reasoning embodied in the two

fundamental paradigmatic assumptions. With the adoption of SFAC 7, the FASB lends

“constitutional character” to the fair value measurement objective: Following the normative

function of the conceptual framework, fair value measurement is an alternative to be

considered in any future standard-setting initiative. Since the arguments put forward in favor

of fair value refer to its relevance, i.e. the correspondence of reported information and

3 For equivalent conjectures in IASB standards see for example IAS 32, par. 87; IAS 36, par. BCZ11; IAS 40, par. 40, B36.

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required information, reliability concerns are the prime argument capable of declining fair

value measurement in future projects, especially where balance sheet recognition is

concerned.

The implementation of the fair value paradigm has ever since been a contentious

issue. While many aggree on the benefits of fair value disclosures, opinions differ especially

with regard to fair value measurement of recognized items and the treatment of revaluation

gains and losses. While these discussions involve many specific issues with respect to the

items in question, the fundamental questions of the fair value debate can be summarized as

follows (see e.g. Barth, 2000: 18-22; Wyatt, 1991: 84):

- Does fair value represent decision useful information? Is there a valid theoretical

background to standard setters’ paradigmatic assumptions?

- Should fair values be disclosed, or is there a conceptual case for recognition in basic

financial statements?

- Are revaluation gains from fair valuation regular components of income or should

they be recognized outside earnings?

- What are the basic properties of fair value income and its contribution to the decision

usefulness objective?

The aim of the following chapters is to contribute some conceptual thoughts to these

questions. Of notable concern is the fair value paradigm and the underlying assumptions,

which represents the intellectual basis for the presumed relevance of fair value accounting.

The scientific evaluation of the paradigm hinges critically on the validity of these

paradigmatic assumptions, a path which this paper, in contrast to the previous literature, will

take. In doing so, we consider both a measurement and an information perspective.

3 Research methodology: Measurement and information perspectives

on the a priori evaluation of accounting concepts

3.1 Measurement perspective

The so-called measurement perspective represents the traditional view on the information

function of financial reporting, especially of financial accounting. It is rooted in the

neoclassical theory of value and income developed by economists such as Hicks, Fisher and

Lindahl (for an overview see Liang, 2001). The fundamental notion underlying the

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measurement perspective is that accounting should directly measure and report the basic

information required by investors, which is the value of the firm, or at least a fraction of it.

Thus, firm valuation is delegated to the reporting entity. Under the measurement perspective,

stocks like assets, liabilities and equity and flows like income are measures well-defined and

exhibit an economic character.

In an ideal world of complete and perfect markets, disclosure of the market values

for all the firm’s assets and liabilities directly reports firm value and thus the desired investor

information. Earnings equal economic income. Obviously, the measurement perspective is

deeply rooted in such a scenario (Barth, 2000: 15; Beaver, 1998: 4, 76). Here, decision useful

information is information on the contribution of assets and liabilities to enterprise value.

Thus, the benchmark measurement attribute is value in use.

For a realistic setting, however, neither value nor income are well-defined concepts

and the orthodox measurement perspective runs into difficulties (Beaver and Demski, 1979).

Yet, the measurement approach is influential for real-world accounting, a fact witnessed by

the traditional, unchallenged use of the terminology of valuation in accounting (Barth, 2000:

15-18; Beaver, 1998: 76). Therefore, we distinguish the orthodox measurement perspective

from its real-world corrollary, the “decision-model-approach” (Beaver and Demski, 1974:

177). Here, the decision problem of a typical investor is regarded in order to directly delineate

information demands. For purposes of this paper, the decision problem is reduced to security

valuation. Therefore, investors demand information that directly feeds into their present-value

calculus. Under this variant of the measurement perspective, decision useful information is

(aggregated) information on future cash flows and their risikiness.

3.2 Information perspective

The measurement perspective underlies the a-priori-research conducted roughly until the

nineteen-sixties (Liang, 2001: 224-29). Criticisms of the restrictive assumptions of this view

on “informative” reporting were aggravated by the development of information economics,

which lead to the famous “impossibility result” for normative accounting principles (Demski,

1973; Beaver and Demski, 1979) and resulted in the establishment of a new research

paradigm, the information perspective.

In information economics, useful information is defined in an abstract manner as

information capable of transforming a-priori-expectations (beliefs) into a-posteriori-

expectations, which induces revisions and therefore improvements of decisions. In the latter

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case, an information system has information content; if the benefits of the improved decisions

exceed the price of the information procurement and processing, the information system has

information value. Comparison of information systems is conducted based on their fineness,

i.e. their capability to partition the event space.

From the information perspective, financial reporting represents but one information

system competing with others.4 Since information matters only in its capability to revise

expectations, the form of its presentation does not matter. Thus, specific accounting

representations such as balance sheets, captions and categories such as assets, liabilities etc.

are irrelevant, since only the content of the information transmitted is of interest.

The rise of the information perspective is usually associated with the growing

importance of empirical accounting research (Beaver, 1998). Yet, information perspective

criteria can also be extracted and used for the purpose of conceptual evaluation. In this paper,

two variants of decision usefulness from an information perspective shall be distinguished.

Information content refers to the “newness” of accounting information and is assumed for

such information that is first released to the semi-efficient stock market via financial reporting

and is valuation relevant, i.e. capable of altering investors’ expectations with respect to the

valuation of the firm. Value-relevance-research recognizes a second, less rigid form of

decision usefulness: the function of financial statements to aggregate in an efficient manner

valuation-relevant information regardless of its information content, thus providing cost-

efficient capital markets information (Barth, 2000: 16; Beaver, 2002: 461). Aggregation of

value-relevant information will therefore be considered as the second variant of decision

useful information production under the information perspective. It is assumed, when (1) the

data in question would exhibit information content were they not known in public, and (2) the

provision of these data via financial reporting can be reconstructed as cost-efficient

information aggregation.

3.3 Usefulness of theoretical reasoning

This analysis sets out from the conviction that there is potential use to conceptual reasoning

on the desirability of financial reporting alternatives, i.e. that there is a case for a-priori

economic analysis. Thus, the impossibility result is not accepted: The denial of the usefulness

4 A thorough textbook description of the information economics approach to financial reporting is given by Christensen/Demski (2003).

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of applying conceptual criteria on the grounds of the specifity of individual decision contexts

employs a Paretian notion of economic efficiency which is not suitable for economic analysis.

Economic analysis requires an assessment of the welfare implications of different alternatives

which can only be properly assessed on the basis of Kaldor-Hicks-efficiency. This means that

there is a case for analysing reporting alternatives on the basis of conceptual criteria if they

can be reconstructed as hypothetical consensus of the majority of constituents (Cushing,

1977).

For the following analysis, we assume that measurement and information

perspectives approaches represent conceivable views of decision usefulness from an investor

perspective. One advantage of this approach is that it represents a-priori research and

therefore produces results on hypothetical reporting alternatives prior to implementation.

Empirical research, on the contrary, in most cases represents a-posteriori research and is thus

of limited use for questions of accounting regulation. Therefore, conceptual reasoning

represents a worthwile, methodologically sound approach. It is of special interest to regulators

and standard-setting bodies: Without making final judgements or recommendations, a-priori

results on the contribution of alternative regulations to conceivable measures of decision

usefulness improves standard setters’ knowledge and is therefore capable of improving

standard-setting decisions.

4 Decision usefulness of fair value as a measurement attribute

4.1 Measurement perspective

The first part of the analysis considers the decision usefulness of the fair value measure itself.

That is, the form of fair value disclosure and aggregation is not considered. This abstract

perspective can be thought of as the disclosure of the fair values for all assets and liabilities an

enterprise holds. It allows for the evaluation of the informational properties of fair value. Plus,

it is consistent with the view taken by the fair value paradigm: Both the fundamental

information aggregation and the information inference hypotheses regard fair value per se

rather than questions of (aggregated) fair value accounting or even fair value income.

As a starting point, an orthodox measurement perspective is taken, with mixed results. In a

world of complete and perfect markets, fair value equals market value equals value in use

(Barth and Landsman, 1995; Beaver, 1998). The sum of fair values for all the firm’s assets

and liabilities (N positions) thus constitutes a precise measure of firm value and is therefore

decision useful:

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∑∑==

==N

1n

nt

N

1n

ntt FVVIUV .

Obviously, fair value represents an ideal measurement attribute under these conditions. Many

proponents of fair value measurement have, at least implicitly, in mind such a scenario. Yet,

this setting not only represents an idealised world, it also does not have a role for financial

reporting: By definition, complete information can be taken at no cost from the market

(Bromwich, 1977: 592; Ronen, 1974: 147). Financial reporting, however, is an institution

created by the deficiencies of real world markets, notably asymmetric information and

transaction costs.

As for the neoclassical scenario, the measurement perspective in a real world

scenario of incomplete and imperfect markets requires investors to agree on one concept of

value. Only if value is identically defined and thus independent of individual preferences and

beliefs can the valuation task be delegated to the financial reports, i.e. the reporting entity.

Such an agreement on the value concept is only accomplished when separation of

consumption and investment decisions is feasible: In that case, investors base their decisions

on the present value of cash flows only and need no information on their timing, amounts and

uncertainty, since they establish their preferred cash flow and consumption pattern via capital

market transactions. Finance theory shows that such irrelevance of individual preferences is

given when markets satisfy the spanning and the competitivity criteria (Grossman and Stiglitz,

1977; DeAngelo, 1981). Spanning prevails on a well-developed capital market which allows

cash flows from non-financial investments to be duplicated and thus insured. Individual

preferences concerning risk and timing are reflected in state prices which determine value.

The competitivity assumption requires that neither investments in non-financial positions nor

capital market transactions have an impact on state prices. Spanning and competitivity thus

are required for the present-value-criterion and therefore the shareholder-value-objective to

hold.

Real-world conditions can generally be expected to roughly fulfill these separation

criteria, except for “exotic” investment projects that create cash flows which cannot be

hedged via capital market transactions. Value in use thus still represents the benchmark

measurement attribute from a measurement perspective. However, fair value as a specific

market value concept will normally not equal value in use. Additionally, no market prices

exist for many assets, especially not for intangibles constituting competitive advantages.

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Whereas firm value conceptually equals the sum of the values in use for all identifiable assets

and liabilities, the respective fair valuation systematically underestimates firm value:

.11

t

N

n

nt

N

n

ntt gFVVIUV +== ∑∑

==

Unlike market value, a positions’s value in use incorporates two components, the asset or

liability in question plus a fraction of intangible assets, i.e. management skill. On the firm

value level, the sum of these unidentifiable (not separable) intangibles equals goodwill (g)

which accounts for the difference between firm value and market values of assets and

liabilities.

At this point, the conceptual case for fair value measurement from a measurement

perspective can only be made for a idealised scenario of complete and perfect markets which

has no demand for financial reporting. Even if well-developed markets are assumed for a real-

world-setting, fair value measurement under such conditions leads so systematic

undervaluation of a firm since market values do not incorporate a firm’s competitive

advantages resulting from specific intangible assets. The case for fair value measurement is

thus weak.

Yet, if we look at fair value measurement from a less restrictive decision-model-

approach and consider not whether fair value measurement can produce an unbiased measure

of firm value, but whether it can facilitate or improve individual valuations, a case can be

made. Precisely, for activities not associated with rents, which do not interact with the firm’s

other activities, valuation can be separated. Investors can combine the fair values of these

activities and the present value of cash flows from other activities (c) in order to arrive at firm

value:

[ ]∑∑

+=τ−τ

τ

= ++=

T

1tt

tM

1n

ntt )'k1(

cEFVV

This separation model illustrates how fair value information can improve decision making

and is thus decision useful, if it allows for cheaper – a part of the valuation task is delegated to

the reporting entity – and/or for more precise valuation, if higher quality cash flow projections

can be reached for the remaining activities. This approach is well established in financial

analysis (Penman, 2004: 455) and provides the case e.g. for fair value reporting for

investment property and, if one is inclined to assume separability, for financial activities. Yet,

it not only requires separability and zero rents for the activities in question, but also high

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information quality of fair value: Fair value can only substitute subjective projections if it

represents an unbiased measure of the present value of future cash flows, i.e. the validity of

the information aggregation assumption underlying the fair value paradigm is vital. This will

be further explored once the information perspective has been considered.

4.2 Information perspective

From an information perspective, fair value’s contribution to decision usefulness is not

evaluated on the basis of its convergence with value in use, but on its capability to alter

expectations and thus revise decisions, or to efficiently aggregate value-relevant information.

Starting with the narrow concept of useful information, information content, the analysis

brings up a straight-forward result: Since fair value, by definition, is only to include

information publicly available in the market place, it cannot by itself revise expectations of

market participants and therefore has no information content, let alone information value.

This is especially true for fair values estimated via marking-to-market, i.e. market prices.

Conceptually, it also applies to synthetical fair values generated by internal models, since the

principle of market-based-measurement requires to use market data and to emulate market

expectations. However, in practice internal estimates and assumptions, i.e. private

management information, are incorporated into such fair values, leading to the awkward result

that information content can only be achieved where fair value estimation violates the

conceptual foundation of market-based measurement. Of course, these results are of a

theoretical nature, since fair value measurement is applied to the entity-specific resources and

obligations, information which is inherently private and thus of potential information content.

Yet, the fact that for a scenario of full disclosure of an entity’s assets and liabilities, full fair

value measurement creates no additional information content since market participants can

perform such a market valuation themselves points to a certain contradictiveness of the fair

value concept.

However, the usefulness of fair value measurement may be reconstructed from a

broad information perspective, if fair value in an efficient manner aggregates value relevant

information. Since the question whether financial reporting constitutes the efficient means for

reporting such information is hard to evaluate in a stringent manner, the central issue is

whether fair value information is potentially value relevant. As pointed out, value relevance is

assessed by the hypothetical question whether the respective information were capable of

altering investors beliefs and action on publication if it were not publicly available.

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Therefore, similar to the decision-model-approach, the ultimate evaluation of fair

value rests on its informational properties, the question of what kind of information it

transports and whether this information is of valuation relevance / potential information

content. This evaluation obviously corresponds with the theoretical validity of the fair value

paradigm and shall be assessed in the next section, which differentiates the two sources of fair

value estimates, market prices and marking to model.

4.3 Informational properties of fair value

4.3.1 Marking to market

The interpretation of market price as the present value of future cash flows is well accepted in

economics and finance. Yet, it is not descriptive of the nature of the expectations

incorporated. More specifically, it is not clear what kind of information, i.e. what information

set is processed and in what manner. Thus, the analysis of the informational properties of fair

value as a market price is inextricably linked to the question of market efficiency. While the

generic definitions are attributed to the seminal work of Fama (1970), a more specific concept

shall be used for the purposes of this paper. The so-called Fama-Rubinstein-efficiency

emphasizes the notion of “consensus expectations” which is central to the fair value

paradigm. Accordingly, a market where naturally market participants hold heterogeneous

expectations is efficient with respect to a specific information set. This information set can be

conceptualized as consensus expectations, i.e. the set of homogeneous expectations that, if

held by all market participants, would result in the identical price like the one witnessed in the

presence of heterogenous expectations. That is, prices evolve as if each investor held the

identical information set, that is consensus expectations (Rubinstein, 1975: 818). This concept

of information efficiency confirms that any market price can, in principle, be reconstructed as

an aggregate of consensus expectations (Verrecchia, 1979: 960).

The relevant question now concerns the nature of this information set. Specifically,

the assumption traditionally held in economics that market prices efficiently aggregate the

private information dispersed in the market place (v. Hayek, 1945: 526) needs further

examination. That is, the informational quality of fair value as market price and thus the

validity of the paradigmatic information aggregation assumption rests on the extent to which

investors’ private information is factored into the market price, i.e. on the degree of market

information efficiency in the strong Fama sense. The modern theory of asset pricing under

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asymmetric information, notably rational expectations equilibria and strategic trader models,

give valuable insights into this question.

Application of the theory of rational expectations to asset pricing emphasizes the

dual role of prices: Not only does the price system in equilibrium balance supply and demand

and clear the market; it also represents a source of information for market participants, who

extract from market prices knowledge about other investors’ private information. Thus, a

major result of this strand of research is the information content of market prices: Investors

with individual expectations (private information sets) will act differently if they also survey

market prices, that is the additional market price information is capable of inducing revisions

in investment decisions (Grossman, 1981: 549-54). A second important result concerns the

degree of informational efficiency, i.e. the information set that can be inferred from market

prices. The Grossman-paradox illustrates that perfectly informative, “fully revealing” prices

cannot exist in an equilibrium with costly information acquisition, because perfect inference

from prices eliminates incentives for private information collection, which in turn reduces the

informativeness of prices (Grossman, 1976). The implication is that only where additional

noise inhibits the quality of prices as sufficient statistics for consensus expectations will

incentives for information acquisition prevail. This leads to the paradox result that the

biasedness of the price system is a condition for its informativeness; market efficiency in the

strong sense cannot be accomplished. Noisy rational expectations equilibria recognize these

precepts and show that, given stochastic noise, the informational quality of market prices, i.e.

the degree of private investor information diffusion and aggregation, increases with reduced

investor risk aversion and with the precision of their private information, whereas it is reduced

with the cost of private information acquisition and with noise (Grossman and Stiglitz, 1980;

Diamond and Verrecchia, 1981; Hellwig, 1980; Verrecchia, 1982).

A different theoretical branch, the so-called strategic trader models, yield additional

results on the determinants of market prices’ information quality. Here, the focus lies on the

strategic implications of the use of private information by insiders, especially on the factors

which determine the speed and amount at which such insiders give their information into the

market and have it factored into the price system. In a seminal model, Kyle (1985) shows that

in Bayes-Nash-equilibrium, the “aggressiveness” of the insider’s use of his private

information critically depends on the amount of non-information-based trading, which

provides noise and thus camouflage for the insider. Market makers, on the other hand,

anticipate the insider’s strategy and make price adjustments that are inversely correlated with

the amount of noise trading, i.e. the possibility to compensate losses from trading with the

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insider with gains from trading with uninformed market participants. This result leads to the

important implication that the market liquidity in its price dimension, i.e. the price reaction to

an order, results endogeneously as a reaction to insider trading and is thus a theoretically

sound indicator of adverse selection or information quality of the price system (Kyle, 1985;

Glosten and Milgrom, 1985). Follow-up models refine these results and demonstrate that the

quality of market prices increases with the competition among insiders and the precision of

their private information, and decreases with their risk aversion and with the volume of noise

trading (Kyle, 1984; Holden and Subrahmanyam, 1992; Subrahmanyam, 1991; Vives, 1995).

The theory of asset pricing under asymmetric information thus yields several

insights into the informational properties of fair value estimated as market price. At the outset,

the Grossman paradox shows that this fair value cannot be fully informative: unbiased

consensus expectations cannot be inferred. Theoretical models illustrate the factors that

determine the quality of partially revealing market prices. More recent insights from

behavioral finance theory suggest that additional to noise, irrational market behavior is a

factor reducing the information quality of market prices (Shleifer ,2000). Thus, the

paradigmatic information aggregation assumption holds roughly only for specific assets

traded on organized, highly liquid markets. For positions not traded on organized exchanges,

markets can be characterized as search markets (Krainer and LeRoy, 2002). Under these

circumstances, market prices normally cannot be interpreted in the paradigmatic sense, since

they result from specific transactions between two parties and rather indicate value in use than

aggregate the consensus expectations of numerous market participants.

As for the second paradigmatic hypothesis, rational expectations equilibrium models

reconstruct the “learning from prices” assumption, according to which investors infer

information about the probability distribution of cash flows. However, this conditioning of

expectations rests on strict assumptions, especially normal distribution of cash flows, which

are not descriptive of reality. In fact, one price can be the result of an infinite number of cash

flow profiles. The notion of infering precise information on the timing, amounts and

uncertainty of consensus cash flow expectations is thus not very realistic; the revision of a

subjective present value estimate sure is.

Given the mixed findings on the theoretical validity of the fair value paradigm, the

implications for the decision usefulness of market price reporting needs consideration. The

result that market prices have information content in that their disclosure induces revision of

decisions exclusively based on individual information sets demonstrates the valuation

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relevance of market price information for the respective positions. Applying this result to

aggregated reporting, the disclosure of a sum of market prices for homogeneous positions, e.g.

fair value of trading securities, conveys information relevant for the valuation of the firm as a

whole. Investors learn about the consensus present value for the positions in question and can

thus extract useful information from financial reports. Therefore, given sufficient information

quality, the decision usefulness of (aggregated) market price disclosures can be reconstructed

from the broad information perspective. As pointed out, information content, i.e. decision

usefulness in the strict information economic sense, is questionable for publicly available

market prices given the disaggregated disclosure of a firm’s assets and liabilities.

From a measurement decision-model perspective, requirements for market prices to

represent useful information are more restrictive since the information quality needs to be

higher than or at least equal to the quality of the investors’ individual projections, which are

substituted by market price information in a separation calculus. Obviously, the decision to

substitute one’s own projections for a biased aggregated consensus forecast is context-specific

and critically depends on the private information set and the cost structure of the investor in

question. Yet, tentative reasoning suggests that only prices for positions traded on highly

liquid markets should be traded, with no hints to investor sentiment or irrationally motivated

biasedness. Similar to the information perspective, the case for substitution seems weak with

respect to prices for positions not traded on organized markets, and can normally only be

made based on cost considerations rather than based on the notion of improved estimation

quality.

4.3.2 Marking to model

With the move from market price valuation to the modelling of a synthetic market value, fair

value becomes a hypothetical market price under ideal rather than idealised conditions. This is

due to the neoclassical character, the strict assumptions underlying contemporary pricing

models. The CAPM is representative of these models and illustrates the ideal character of

resulting estimates. It is the foundation of present value calculations and is explicitly

suggested by FASB and IASB as valuation method. Underlying the CAPM are the

assumptions of perfect and complete markets, notably no transaction costs and perfect

information. Thus, the valuation methods underlying fair value modelling usually do not take

into account the influence of information asymmetry on market pricing, which is of course

due to the infant state of this line of research (O’Hara, 2003: 1336). Plus, they assume

equilibrium states, while financial reporting is a result of disequilibrium situations (Peasnell,

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1977: 164). In brief, valuation methodology rests on strict assumption not descriptive of

reality that lead to systematic overvaluation of assets vis-à-vis “real” market prices. This

biasedness is aggravated by standard setters’ pragmatic guidance on marking-to-model, which

allows for the ignorance of risk, i.e. for risk neutral valuation where the reporting firm can

demonstrate that the estimation of risk premia is only feasible with undue costs (SFAC 7, par.

62; FASB, 1999, par. 82).

A second fundamental informational feature of synthetic fair value is the lack of

verifiability and, thus, of reliability. This is characteristic of any economic valuation, which

axiomatically rests on projections and expectations of the future. Since such prospective data

represents soft information, only plausibility and consistency judgements can be made.

Despite the inevitability of the decline of reliability down the estimation hierarchy, existing

guidance on marking-to-model does not cope with it in an appropriate manner. Although the

emphasis on market data represents a suitable reaction to the loss of verifiability, the lack of

specificity and of prescriptiveness, for example for risk measurement or for cash flow

projections, creates numerous loopholes, opportunities for the exercise of management

judgement and discretion and thus for earnings management (Benston et. al., 2003: 39).5

Therefore, the traditional argument that fair value reporting reduces incentives and

opportunities for management discretion seems to focus market price valuation rather than

marking-to-model. It does not hold for the majority of non-financial assets which cannot be

marked to market, questioning the reliability of the fair value concept as a whole.

While the reliability issue is grave, from the perspectives taken here the issue of

information aggregation is equally important. A straightforward result is that model-based fair

value cannot, by definition, represent an aggregate of expectations spread in the market place:

Since valuation rests on the information set of one person or one organisation, this fair value

loses its capacity to efficiently collect and aggregate consensus expectations on the cash flows

of the relevant position. The paradigmatic information aggregation assumption fails, and so

does the theoretical case for fair value reporting. Rather than market information, model-

based fair value incorporates management’s private information and assumptions, that is

value in use.

5 For example, SFAC 7 discusses various methods for calculation of risk premia, such as portfolio theory and arbitrage pricing, yet simultaneously critizises their descriptiveness with reference to behavioral pricing (par. 62-71), thus giving no final guidance. Even more, par. 62 allows for discounting with a risk free rate of interest only if no reliable estimate of the risk premium can be made. The recent Exposure Draft on fair value measurement (FASB (2004)) does not alleviate theses concerns.

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From a measurement, decision-model perspective this result forbids the qualification

of fair value as an estimate of fundamental value. The investor rather needs to trade off the

benefits of private information incorporation into such fair values against the danger of

systematic biasedness due to earnings management. Again, no definite results emerge, yet the

overall suitability of such estimates as replacements for individual investor expectations is

reduced, the case for decision usefulness rather weak.

Since the fair value paradigm has an information-economic flavor, the collapse of

the paradigmatic information aggregation assumption, the impossibility to reproduce market

expectations and thus to simulate “informative” market prices, impairs the decision usefulness

of synthetic fair value from an information perspective. The reconstruction of fair value

reporting as an efficient aggregation of value-relevant information fails. Yet, model-based fair

value is capable of creating useful information in the strict, information content sense, when

credible communication of private management information takes place. Empirical evidence

suggests this is happening (Beaver and Venkatachalam, 2000; Barth and Clinch, 1998). This

leads to the result that fair value reporting on the marking-to-model level is only capable of

reconstruction when the fair value definition is violated and elements of value in use are

incorporated. Obviously, this effect refutes rather than confirms the paradigmatic foundations

of fair value measurement.

Summing up, the decision usefulness of disaggregated fair value information can be

reconstructed both from an information and a measurement perspective, yet only under

specific conditions. Notably, the paradigmatic foundations of fair value measurement appear

theoretically valid only for prices taken from organized, sufficiently liquid markets and can

therefore hardly be applied to reporting for non-financial items, which typically require

model-based estimation. Where market prices are used, additional concerns arise because

such measurement of assets and liabilities is based on publicly available information not

specific to the entity and thus increases reliability, yet deprives management of possibilities

for signalling private information. These results are, of course, of a very general and abstract

nature. The purpose of the next section is to look at the reporting issues involved, i.e. to

investigate aspects of the form of fair value reporting.

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5 Decision usefulness of fair value accounting

5.1 The case for fair value accounting

The form of reporting is irrelevant from a strict information perspective. Thus, when we focus

on such issues, we assume that especially recognition versus disclosure matters due to cost of

information acquisition and processing. Other reasons for the relevance of presentation are

contracting issues which are not addressed here. The theoretical case for the relevance of the

reporting form is supported by the empirical evidence in general and specifically for fair value

reporting (Ahmed, Kilic and Lobo, 2004; Beatty, Chamberlain and Magliolo, 1996).

The paradigmatic foundations of fair value measurement refer to fair value per se

and thus do not specify or support any specific form of aggregation or presentation. Notably,

no case is made for fair value accounting, since the disclosure of fair values would suffice to

benefit from the alleged informational properties. Yet, as pointed out, fair value is

increasingly being used for balance sheet and income measurement. Assuming a positive role

for historical cost based financial statements, notably for contracting reasons (Watts, 2003),

this implementation of fair value accounting therefore requires theoretical support beyond the

informational quality of fair value by itself. It is the task of the following section to analyse

the properties and potential decision usefulness of fair value accounting. Despite articulation,

we distinguish between balance sheet valuation and fair value income for expository reasons.

5.2 Fair value balance sheet

The move from historical cost accounting towards fair value accounting emphasizes an

economic approach to accounting measurement, where economic values are reported on the

balance sheet, partly estimated on the basis of theoretical pricing models. This emphasis on

the valuation function of the balance sheet, coupled with the paradigmatic foundations that

rest on a stocks perspective, illustrates the growing importance of the balance sheet as a stand-

alone instrument of investor information (Barker, 2004: 166; Razaee and Lee, 1995: 217). In

the terminology of accounting theory, the asset-liability approach and thus an informative role

of the balance sheet is strengthened vis-à-vis the traditional revenue-expense approach, which

is on the decline. An immediate implication of this is an increase in book value of equity: Fair

value accounting closes the gap between market valuation and historical cost of an asset or a

liability, thus eliminating hidden reserves.

As pointed out, the information perspective does not allow for evaluation of

different reporting formats. Therefore, this approach will not be used intensively here. The

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only implications are that, in accordance with the results of the previous sections, the high

degree of aggregation associated with balance sheet format reporting substantially inhibits the

inference of the underlying consensus present value, let alone the cash flow profiles. This is

especially true where fair values based on market prices and such based on modelling are

mixed together and, more severly, where heterogeneous positions valued at different

measurement attributes are summed up in one balance sheet caption. From a strict information

perspective, the high degree of information aggregation characteristic for balance sheet

measures thus leads to a negative assessment of potential decision usefulness.

Similarly, the prior results on the orthodox measurement perspective evaluation of

fair value measurement can be applied to balance sheet measurement, since they are

independent of aggregation. Book value of equity under fair value accounting does eliminate

hidden reserves for recognized assets and thus narrows the gap between accounting value and

enterprise value (market value of equity). Yet, for conceptual reasons, it cannot eliminate this

gap, which is constituted of two further elements: the fair values for identifiable, yet not

recognisable positions such as certain internally-generated assets (“recognition gap”), and the

fair values of the remaining, non identifiable factors incorporated into goodwill (“goodwill

gap”). Fair value accounting is neither conceived for nor capable of measuring directly the

value of the firm. The perception of book value under fair value accounting as a measure of

enterprise value is thus ill-founded.

The overall negative evaluation from a strict measurement perspective can once

more be modified using the less restrictive decision-model approach. By assuming clean-

surplus accounting and rewriting the cash-flow valuation model so far assumed as residual

income model, the notion of book value of equity as heuristic measure of a fraction of

enterprise “value” can be confirmed. The residual income valuation formula depicts firm

value as the sum of book value of equity plus the present value of future residual earnings

(Ohlson, 1995; Edwards and Bell, 1964). In doing so, it confirms the valuation relevance of

aggregated accounting data. Numerous proponents even argue the superiority of accounting-

based valuation, since it reduces the fraction of firm value to be estimated based on

projections, notably the terminal value problem, relieves the valuation task of the difficult

forecasting of dividends and thus “brings value forward in time” (Penman, 2004: 160;

Penman and Sougiannis, 1998; Penman, 1998). Although accounting valuation theory is silent

on the comparative advantages of different measurement attributes, this basic idea suggests

that fair value accounting is superior to historical cost accounting, since it “brings more value

on the balance sheet” and c.p. reduces the present value of residual earnings to be forecasted.

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Certainly, this represents a rather crude argument in need of further elaboration. Especially,

the predictive ability of earnings and residual earnings under different measurement regimes

is crucial and needs further exploration.

Thus, the increasing economic character of the balance sheet reduces the valuation

gap and insofar focuses the estimation problem on residual earnings valuation. Intuitive

reasoning suggests superior decision usefulness of fair value accounting from a decision-

model (measurement) perspective. Ultimate evaluation, however, rests on the informational

properties of fair value income, which will be the subject of the following section.

5.3 Fair value income

5.3.1 On the evaluation of income concepts

The discussion of fair value income in the literature and by regulators so far seems somewhat

paradox. The analysis of the properties and decision usefulness of fair value income is not

part of the fair value paradigm, which rests solely on a stock perspective. Scientific evaluation

is equally sparse, since most empirical studies focus the value relevance of fair value

dislcosures and analytical papers so far have not taken issue with fair value income. These

facts contrast starkly with the prominent role of earnings in the capital market, which is

normally equally reflected and recognized by the theoretical literature (Beaver, 1998: 38, 89-

124). Additionally, the most contentious aspects of the debate on fair value accounting center

on its implications for earnings. While the debate is in principle concerned with the

fundamental questions of recognition versus dislosure, the qualification of revaluation gains

and losses and the disaggregation of income (performance reporting), the practical, sometimes

even political discussion focuses on the volatility issue.

Opponents of fair value income claim that current valuation leads to increased

volatility of earnings, with negative implications for predictive ability (e.g. Christie, 1992: 87;

Poon, 2004: 40; Wilson and Rasch, 1998: 24). In a more subtle vein, it is argued that fair

value measurement for certain positions only will lead to “artificial” volatility and “distorted”

earnings, because revaluation gains and losses are economically compensated by the valuation

differences for positions not measured at fair value (“mismatching”) (e.g. Mauriello and

Erickson, 1995: 181; Beatty, 1995: 28). This argument was first discussed with the

introduction of SFAS 115, which does not allow fair valuation of financial liabilities, yet in a

compromise solution alleviates volatility concerns by reporting fair value differences for

available-for-sale securities outside earnings.

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Proponents of fair value income, on the other hand, stress its economic character and

argue that remeasurement gains and losses express “real economic volatility” (e.g. Sprouse,

1987: 88; Wyatt, 1991: 84). Plus, income realisation based on “objective” market values

allegedly deprives management of a device for earnings management (e.g. Barlev and

Haddad, 2003: 384, 395).

The volatility debate, which serves as a motivation for further analysis, poses two

problems. First, the notion that the move to fair value accounting generally leads to increased

earnings volatility is invalid. It rests on an isolated view on a single position and neglects

compensation effects when a number of positions, especially both assets and liabilities, are

remeasured at fair value. Therefore, volatility implications need to be considered separately

for each rule or standard in question. Second, evaluation of fair value vis-à-vis historical cost

concepts of income requires a notion of “appropriate volatility”, that is, a concept of

informative income (Gellein, 1986: 16). Yet, due to the impossibility theorem, there is no one,

universally accepted definition of income under conditions of imperfect and incomplete

markets (Beaver and Demski, 1979). More probematically, standard-setting bodies do not

take on their role, which is to make such welfare-relevant decisions: Neither FASB’s nor

IASB’s framework exhibits a clear definition of the income concept pursued, despite the

emphasis on the informational role of earnings (Barker, 2004: 158, 164).

Evaluation of fair value income must therefore be conducted on the basis of

concepts that are conceivable from a standard-setting perspective, that is, concepts that can be

reconstructed as consensus criteria for the overwhelming majority of investors addressed.

Accounting theory discusses numerous notions of “informative” or “quality” earnings

(Schipper and Vincent, 2003). For purposes of this paper, the two concepts of economic

income and of persistent earnings shall be considered and applied to the conceptual cases of

pure fair value accounting (event-based income) and pure historical cost accounting

(transaction-based income).

5.3.2 Fair value as economic income (measurement perspective)

Economic income is usually associated with Hicks’ definition of income, according to which

“a person’s income is what he can consume during the week and still expect to be as well off

at the end of the week as he was at the beginning” (Hicks, 1946: 176). It is the change in firm

value during one period and thus a direct measure of individual welfare or consumption

potential. In a setting of certainty, economic income equals the interest on firm value at the

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beginning of the period. For uncertainty, this expected income is modified by an unexpected

component.

Since it requires a strict definition of value, economic income is well defined only in

a neoclassical setting. It is thus the income concept typically associated with an orthodox

measurement perspective (Beaver, 1998: 49, 57, 64-67). Yet, it is of conceptual merit even for

analysis of real-world income concepts, since it allows for comparative analysis of relevant

properties and emphasizes differences compared to ideal “earnings quality” (Schipper and

Vincent, 2003: 97). Therefore, some remarks shall be made on the conjecture that fair value

income represents a superior estimate of economic income since is rests on economic

valuation (i.e. market valuation). In doing so, we assume that rents, i.e. net present value, are

a component of economic income.6

Any concept of accounting income that satisfies the clean-surplus condition will

over time result in accumulated earnings that equal the cash flow surplus. Thus, for the whole

life of a firm, fair value income equals historical cost income equals economic income.

Differences are only inter-temporal and result from different degrees of delayed or biased

recognition of accounting income. For fair value income, recognition is less delayed, that is,

the gap between creation and accounting recognition of value is smaller than for historical

cost accounting. Income realization does not rest on market transactions but on market

valuation. Yet, even under fair value accounting, value differences attributable to

unrecognized intangibles and goodwill are not recognized until they result in cash

transactions. Thus, fair value income as one variant of an economic approach to income

measurement differs systematically from the concept of economic income (Hicksian income).

This is especially relevant for firms not in a steady state, that is for firms with increasing or

declining net assets (Zhang, 2000: 132).

Thus, fair value income represents no valid indicator of economic income, since,

given growth, both earnings measures differ systematically, where the differences increase

with the gap between firm value and the book value of equity. From a strict measurement

perspective, decision usefulness cannot be supported. Apparently, proponents of fair value

income who insist on its capability to depict “economic reality” implicitly employ such an

economic perspective on income measurement. However, the systematic differences indicate

that this argument is ill-founded, because mismatching occurs due to unrecognized assets and

6 For the distinction between economic income in a narrow sense and such “economic profit” see Christensen/Demski (2003), pp. 40, 50.

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goodwill and impairs fair value income’s capacity to express economic reality, since in such

cases it does not represent an acccurate measure of change in firm value. As it turns out, even

from an economic income perspective, earnings variations in a full fair value model

incorporate elements of “artificial volatility” and thus do not accurately portray economic

reality.

5.3.3 Predictive ability

While economic income already incorporates firm valuation and thus does not leave a

prediction task for investors, it is this formation of expectations about the future that is the

prime concern of investors in a realistic setting. The concept of predictive ability can therefore

be reconstructed as a conceivable consensus criterion for decision usefulness (Beaver,

Kennelly and Voss, 1968). It can be reconciled both with information and measurement

perspectives on decision usefulness, yet needs further elaboration. In accordance with notions

hinted at in the frameworks,7 above all for its prevalence in valuation practice and accounting

theory (Beaver, 1999: 163; Schipper and Vincent, 2004: 99), predictive value shall be

measured by the degree of earnings persistence.

Earnings persistence refers to the degree to which present earnings persist into the

future. The concept thus assumes that investors conduct valuations based on estimates of

future earnings. The residual income model provides one rationale for this assumption. In a

more precise specification, earnings persistence is defined by the autocorrelation of

unexpected earnings components (Lipe, 1990: 50, 52). As two extreme points of theoretical

reference, permanent and transitory earnings can be distinguished. While a permanent

earnings shock is assumed to persist in equal amount for all future periods, transitory earnings

shocks have no implications for future earnings at all (zero autocorrelation) (Ohlson, 1999;

Ramakrishnan and Thomas, 1998).

Opponents of fair value accounting who resort to the volatility issue typically have

an income concept of earnings persistence in mind, when they claim that introduction of fair

value accounting creates volatility due to erratic market value movements that deprive

accounting income of its predictive ability. This notion in many cases stems from the

traditional conjecture in accounting theory that focussing either income statement or balance

sheet results in a decline in information quality of the opposite reporting instrument. Thus, it

7 Although, as pointed out, the frameworks elaborate no concept of informative earnings, several paragraphs hint at the concept of persistent earnings. See e.g. SFAC 1, par. 44; SFAC 5, par. 31; IASB Framework, par. 28.

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is argued, the focus of fair value accounting on balance sheet information comes at the price

of a loss in the informativeness of the income statement (e.g. Christie, 1992: 95, 101). The

validity of this conjecture is to be evaluated, starting on the level of single positions held at

fair value.

The assumption of erratic, non persistent moves in asset values is a traditional

subject of debate in the literature on efficient (capital) markets. Specifically, the

characterization of asset values as following a Martingale-process lends vindication to the

conjecture of decreasing earnings persistence. Values (prices) follow a Martingale-process if

today’s value represents the best estimate, i.e. expected value, of the future value: Et [Vt+1] =

Vt. The well-known random walk property satisfies this definition (LeRoy, 1989: 1589). For

an asset following a Martingale, the fair game property of efficient markets theory applies. It

states that for a given information set, no abnormal return can be made on an efficient market

by using that information. More specifically, with respect to the fair value concept, which

rests on the assumption of efficiency in the semi-strong sense, the expected abnormal return

of using publicly available information for asset valuation is zero. This means that any

deviation from expected value, i.e. current value, is by definition unexpected, and there is an

equal chance of positive and negative deviations. This is the result of the Samuelson theorem,

which presents a strong case against the usefulness of fair value income: Since today’s value

incorporates all relevant information, any deviation from it cannot be predicted (Samuelson,

1965, 1973). Differences between expected return and realized return, i.e. “unexpected fair

value income”, are unpredictable and uncorrelated, thus purely transitory.

However, a closer look suggests that the Martingale property cannot be generalized

for any market value or market price, since the fair game property refers to the return on an

asset, which consists of both a revaluation and a cash flow component. Only when the

expected return on the asset equals the expected cash flow will any deviation from today’s

value be transitory, i.e. unexpected. That is, for assets whose cash flow patterns do not satisfy

this property – this will be the case for any asset subject to deterioration –, the expected value

follows a trend, with deviations from this trend occuring randomly. That is, the change in fair

value consists of an expected and an unexpected component (fair value shock). For an

expected (market) rate of return k and cash flows c, the change in fair value can be

decomposed:

[ ]444 3444 21444 3444 21shock fair value

t1tt

fair valuein change expected

t1t1t1tt )FV(EFV)c(EFVkFVFV −−−− −+−×=−

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Therefore, the conjecture of random movements in fair value is too crude a qualification,

since it applies only to a fraction of the revaluation difference. This is further illustrated by

looking at fair value income, which is defined as the change is fair value plus the cash flow

realized. Realized fair value income equally consists of an expected and an unexpected

fraction:

[ ] ( )[ ]444 3444 2144 344 2143421shock fair value

1

shock flowcash

1

income fair value expected

1

1

|)|( −−−

Ω−+Ω−+×=+−=

ttttttt

tttFVt

FVEFVcEcFVkcFVFVx

The unexpected cash flow component is strictly transitory, because fair value is independent

of the current cash flow realization. Yet, the fair value shock is partly persistent, since it

directly bears on current fair value which by itself is multiplied with the market return to yield

expected income. Additionally, systematic deviations from expected fair value income occur

when the position is associated with rents. If the firm can use the position in a favorable way

compared to the market or has private information concerning its prospective cash flows, the

“unexpected” component of fair value income will be correlated and thus have predictive

ability.

Summing up, the Samuelson theorem presents a theoretic backing for the conjecture

of random moves in fair value and thus the distortion of income’s predictive ability. Yet, at a

second glance, it needs to be applied cautiously. It turns out that changes in fair value can

indeed be correlated in time, despite market efficiency. A fair value income measure which

incorporates the cash flow component will exhibit certain persistence, since fair value shocks

bear on expected return.

These results, however, concern single assets only and are not of a comparative

nature. Thus, the next step is to compare fair value accounting income to the transaction-

based concept. Since such earnings numbers are the result of a complex measurement process

and also include revenues and gains stemming from transactions and events not recognized on

the balance sheet, a thorough investigation is not attempted. Yet, important points can be

made with reference to a stylized scenario, where a single-asset firm is assumed that produces

one good for a limited number of periods and sells it at uniform numbers, capitalizing on a

competitive advantage that enables the firm to demand above-market prices.

For a situation where all expectations are precisely fullfilled, fair value income will,

in time, decline. Despite uniform cash flows, the interest component of fair value, which

offsets the cash flow component, will decline, leading to an increase in “fair value

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depreciation”. Transaction-based income, on the other hand, is uniform due to straight-line

depreciation and thus presents a more adequate picture of enterprise performance. On the

other hand, fair value residual income is constant in time and depicts the competitive

advantage, i.e. the fraction of sales that is earned on top of market expectations. Transaction-

based residual income increases in time and thus seems less accurate. These, however, are

rather crude qualifications that only serve as a starting point. Predictive ability matters where

expectations are not fulfilled, i.e. where economic shocks occur. Therefore, the implications

of a sales shock and an interest rate shock are pondered.

A sales shock, the increase in products produced and sold due to an unexpected rise

in demand, results in an unexpected increase for both event-based fair value income and the

transaction-based historical cost income. Insofar, both concepts reflect the “good news”.

Since historical cost income returns to a steady path in the following period, it suggests

greater persistence. Notably, a persistent sales shock will result in a fully persistent income

shock, since the additional revenue will reoccur over the following periods. Clearly, this

property of historical income is what many proponents of transaction-based income

recognition have in mind, because fair value income is less stabile: It exhibits a one-time

shock in the period of the economic shock and then declines in the following periods. If one

shares the strict definition of useful income as persistent income, a case can be made for

transaction-based accounting. Put differently, the volatility criticism can be supported from

this perspective.

However, a second glance at the time-series behavior of the two earnings numbers

shows a property of fair value income so far hardly encountered in the literature. Since

transaction-based income will only recognize the effects of the economic shock on current

period’s sales, it cannot discriminate one-time shocks from lasting, i.e. persistent effects. This

lack of responsiveness contrasts sharply with fair value income, which will c.p. react the

stronger, the more persistent the economic shock. More precisely, since the fair value shock

captures the revisions of cash flow expectations for all future periods, it will correlate with the

persistence of the sales shock. The fair value shock as a component of fair value income,

unlike unexpected historical cost income, discriminates the persistence of economic shocks

and thus allows for a more precise state partition. That is, despite its lack of persistence in the

traditional definition, fair value income represents the finer information system than historical

cost income.

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This property is further demonstrated by considering a lasting interest rate shock,

the unexpected negative shift of the term structure of interest rates, which modifies cost of

capital and therefore the discount factor underlying the fair value of the firm’s asset. This

represents an eonomic event that alters the company’s value, yet leaves the cash flows

unchanged. Historical cost income therefore completely neglects this event, whereas fair

value income rises unexpectedly. Whereas transaction based income again is more steady and

persistent, the rise in fair value income is followed by declines due to the interest rate effect,

i.e. negatively autocorrelated. Yet, unlike historical cost, fair value income signals the

occurrence of a valuation relevant event and thus transports more information.

In conclusion, the fundamental conjectures against the predictive ability of fair value

income can be supported if one employs the traditional concept of earnings persistence. Fair

value income incorporates economic shocks more extensively, since their implications for all

future periods are immediately recognized, and more completely, because cash-flow-irrelevant

shocks are also recognized. This greater responsiveness to valuation relevant events impairs

the steadiness of the earnings number, that is the autocorrelation of earnings (shocks). Yet, in

informing more precisely and more thoroughly about these relevant events, it represents the

finer information system. Put differently, fair value income incorporates more information

than transaction-based income, whose stability may be deceptive: the persistence of historical

cost income appears far more “artificial” than the “volatility” of fair value income.

Our analysis of fair value income illustrates that the positions taken and conjectures

made on its desirability rest on specific notions of informative income. Since economic

income and persistent income represent two different income concepts, many arguments

against and in favor of fair value accounting cannot be compared, i.e. they are

incommensurable. Thus, final conclusions and evaluations of desirability cannot be reached.

Yet, the discussion points at an important insufficiency underlying the debate and the shift to

fair value accounting. Up to this present day, accounting standard-setters fail to communicate

the income concept that is pursued with the implementation of fair value measurement.

Discussion so far suggests that they have none, which severly inhibits future progress and

consistency in standard-setting. The results here indicate that the relevant concept is not one

of earnings persistence, which serves as problematic vindication for the transaction-based

model (revenue-expense approach). Rather, residual income seems a path worthwile of deeper

exploration. Coupled with the merits of “bringing value forward in time”, one advantage of

fair value income is that it focuses economic rents and is less disturbed by effects of delayed

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recognition. Future research into the properties and quality of fair value residual income

appears promising.

6 Conclusions and Implications

This paper examines the potential decision usefulness of fair value reporting from two

conceptual viewpoints, the measurement and the information perspective. As a point of

reference, the paradigmatic assumptions underlying the move to market valuation are

extracted from standard setters’ pronouncements. The analysis of the fair value measure

shows that decision usefulness can be reconstructed for fair value as a price taken from liquid

markets. The conceptual case for marking to model, on the other hand, is less strong. Notably,

the paradigmatic assumptions do not hold for the fair value of most non-financial assets,

putting into question the theoretical backing for fair value reporting and its universal use as

preferred measurement attribute. In a second step, fair value accounting is analysed. Standard

setters offer no reasoning as to the desirability and implementation of fair value as a balance

sheet and income measure. Most strikingly, no income concept is given. Application of a

traditional measure of predictive ability, earnings persistence, suggests the relative inferiority

of fair value income vis-à-vis transaction-based income and therefore lends support to

criticisms of unrepresentative income volatility. However, further examination demonstrates

that fair value income is a superior indicator of the occurrence and persistence of valuation

relevant economic events, leaving an unclear picture. There are at least three immediate

implications of this research for standard-setting:

(1) There is a theoretical case for the disclosure of prices taken from organized,

sufficiently liquid markets, since these allow for the rough inference of the market’s

consensus expectations concerning amounts, timing and uncertainty of future cash flows. Fair

value disclosures for traded financial instruments can thus be supported. Given the conceptual

merits as to income determination, full fair value accounting for financial instruments appears

as the superior path, despite reliability concerns for non-publicly-traded instruments and

distortions vis-à-vis the economic income model.

(2) Since fair value measurements based on valuation models do not inform about

consensus expectations, the conceptual backing for fair valuation of non-financial items

appears ill-founded. Additionally, empirical evidence supports the notion of grave reliability

concerns for fair values not taken from active markets. At present, there is no conceptual case

for generalising the fair value paradigm to non-financial items such as property, plant and

equipment or even intangibles.

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(3) The special case against incorporating fair value measures into the core financial

statement is further supported by the vagueness of the income concept thus pursued.

Theoretical reasoning demonstrates that the relative superiority of fair-value vis-á-vis

transaction-based income varies critically with the notion of predictive ability applied. As

long a standard-setters are hesitant to elaborate their notion of fair value income and its

contribution to decision usefulness, the transaction-based income concept should be sustained

for non-financial items.

The results affirm the need for a definition of useful income which standard setters

so far have failed to develop. The fundamental discussion of financial reporting quality

triggered by the Enron failure, which among other things resulted in a committment to more

“principle-based” standard-setting and a joint conceptual framework project undertaken by

FASB and IASB, represents a unique opportunity for standard setters to remedy this

fundamental deficiency. Conceptual, normative accounting research can lend valuable support

to this task. Since fair value income as an economic concept puts more emphasis on balance

sheet valuation and implies a more economic concept of income, residual income valuation

appears as a particularly promising concept for further exploration.

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Kölner Diskussionspapiere zu Bankwesen, Unternehmensfinanzierung,

Rechnungswesen und Besteuerung

Cologne Working Papers on Banking, Corporate Finance, Accounting and Taxation

Hrsg./ed.:

Thomas Hartmann-Wendels, Seminar für ABWL und Bankbetriebslehre, Universität zu Köln

Norbert Herzig , Seminar für ABWL und betriebswirtschaftliche Steuerlehre, Universität zu Köln

Dieter Hess, Seminar für ABWL und Unternehmensfinanzen, Universität zu Köln

Carsten Homburg, Seminar für ABWL und Unternehmensfinanzen, Universität zu Köln

Christoph Kuhner, Seminar für ABWL und für Wirtschaftsprüfung, Universität zu Köln

Wirtschafts- und Sozialwissenschaftliche Fakultät, Universität zu Köln

Albertus-Magnus-Platz, 50923 Köln

Bisher erschienene Beiträge / Contributions:

01/2005 Hautsch, Nikolaus Hess, Dieter

Bayesian Learning in Financial Markets – Testing for the Relevance of Information Precision in Price Discovery

02/2005 Kuhner, Christoph Interessenkonftlikte aus Sicht der Betriebswirtschaftslehre

03/2005 Kuhner, Christoph Zur Zukunft der Kapitalerhaltung durch bilanzielle Ausschüttungssperren im Gesellschaftsrecht der Staaten Europas

04/2005 Hitz, Joerg-Markus The Decision Usefulness of Fair Value Accounting – A Theoretical Perspective