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07_JAF667316 582..591 Journal of Accounting, Auditing & Finance 2016, Vol. 31(4) 582–591 �The Author(s) 2016 Reprints and permissions: sagepub.com/journalsPermissions.nav DOI: 10.1177/0148558X16667316 jaf.sagepub.com The Pros and Cons of Fair Value Accounting in a Globalized Economy: A Never Ending Debate Antonio Marra Abstract Fair Value Accounting is not a new concept, either in business decisions or in financial report- ing. Nonetheless, due to big changes that took place over the last 20 to 30 years in the worldwide economy and the influence of the 2007 financial crisis, it has reemerged as one of the ‘‘hottest topics’’ on the agenda of Accounting Standards setters both under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standard (IFRS). Current research seems well balanced across the pros and cons of fair value, lending ammunition both to those ‘‘in favor’’ and to the ‘‘opponents’’ of fair value accounting. Subjectivity, estimates, and managerial discretion permeate the concept, defini- tion, and measurements of fair value, leaving such measurements open to an aggressive use of judgment and estimates. However, fair value accounting is more closely related to the needs of a globalized and information-based economy and is likely to grow in importance and use in the future. This article discusses evidence and summarizes some current papers on the informational impact of fair value measurements on market participants. Keyword Fair Value, Fair Value Accounting, Fair Value Measurement Introduction The concept of Fair Value is not new: It dates back at least to the past century (Zyla, 2012) and its application to accounting is increasing in scope (Barth, 2006). Nonetheless, opinions on Fair Value are conflicting (Laux & Leuz, 2009) and there is considerable room for documenting and analyzing the trade-offs resulting from the application of fair value in different economic settings. In favor, the main argument is that the Fair Value reporting fulfills the need for more decision-useful financial information given the increasing com- plexity of a globalized and innovation-based economy (Barth, 2006; Zyla, 2012). Some others, instead, see the use of fair values on balance sheet as controversial because they require model-based estimates using management’s expectations and projections as inputs (among others, Hughes & Tett, 2008; McCreevy, 2008; Penman, 2007). This article 1Universitá Bocconi Milano Italy Corresponding Author: Antonio Marra, Universita’ Bocconi Milano Italy. Email:
[email protected] Article presents evidence concerning the strengths and weaknesses of fair value accounting, both in general and on the basis of a set of papers selected for presentation at the Journal of Accounting, Auditing, and Finance (JAAF) conference in India.1 On their side, the Securities and Exchanges Commission (SEC), the Financial Accounting Standard Board (FASB), the International Accounting Standard Board (IASB), and other reg- ulators have revealed, through actions, their moderate, but unambiguous, preference for reporting fair values. Over the last decades, standard setters have issued many new guidelines for the measurement, recognition, and the disclosure of fair value estimates for assets and liabilities (Barth, Landsman, & Wahlen, 1995). Starting with an initial focus on financial instruments, the FASB and the IASB have progressively considered fair value as a possible measurement attribute in almost every standard, including revenue recognition, business com- binations, insurance contracts, and in the conceptual framework, as well (Barth, 2006). This gradual process of widening the scope of fair value measurements ran into a critical storm during the financial crisis of 2008. Many scholars argued that the use of fair values increased pro-cyclicality leading to market bubbles and crashes and suggested that it was better to use historical costs (Allen & Carletti, 2008). Others, however, suggested that sales-type accounting for derivatives was the true underlying reason for distorted financial statements (Bryan, Lilien, & Sarath, 2010). In any case, there were serious critical ques- tions raised about the market consequences of reporting assets and liabilities at fair value. Current research on the consequences of fair value continues to be inconclusive and dis- agreement on the topic exists, both theoretical and empirical. The relevance of fair value measurement is largely grounded on the concept of market efficiency. In recent years, effi- cient market theory has been challenged and, of course, if markets are inefficient, even Level 1 valuations become suspect.2 Nonetheless, even acknowledging fair value account- ing drawbacks, a return to historical cost accounting is considered unlikely to happen almost unanimously and not to be the proper response to fair value concerns. For assets and liabilities that are not traded in liquid markets, (discretionary) managerial estimates become central to the measurement of fair values. However, a detached and uncritical analysis on fair value accounting suggests that this accounting change is simply the natural evolution of accounting standards which follows, and better serves, the evolution of assets and liabilities used in current economy, which has substantially changed in the last few decades. Changing Economy, Globalization, and Capital Markets: Toward Fair Value Accounting Fair Value Accounting is not a novelty as far as financial reporting requirements are con- cerned and the concept of Fair Value has been evolving for more than a century (Zyla, 2012). Indeed, in a U.S. Supreme Court case that dates back to the 19th century,3 we can find an enlightening discussion about concepts and meanings underlying Fair Value. To ascertain that value, the original cost of constructions, the amount expended in permanent improvements, the amount of market value of its stocks and bonds, the present as compared to the original cost of construction, the probable earnings capacity of the property under particular rates prescribed by the statute, and the sum required to meet operating expenses, are all matters for consideration, and are to be given such weight as may be just and right in each case. We do not say that there may not be other matters to be regarded in estimating the value of the property. (Smyth v. Ames, 1898) Marra 583 As can be seen, this statement of the U.S. Supreme Court clearly refers to several Fair Value measurement concepts that are currently in place and embedded in most of the Accounting Standards at worldwide level such as market approach, economic value, expected income, and the application of judgment in many value assessments. Over time, the FASB, the IASB, and several other local Standard Setters have issued hundreds of statements that use Fair Value to measure companies’ resources. And, even when Fair Value is not required—and Financial Statements are prepared according to other measurement systems (such as historical cost)—there are chances that Fair Value disclosure related to some items will be required in the notes to the Financial Statements. The information revolution that has characterized the global economy over the last decades has accelerated the inclusion of Fair Value measurements into financial reporting. Changes such as Internet, computers, and media channels have determined a twofold shift in current economic activity: (a) innovation, which has generated industries that did not exist before and has moved the economy from a ‘‘hard’’ (brick) one to a ‘‘soft’’ (informa- tional)-based one and (b) rapid communication, which has enabled mobility of people, information, and capital across countries resulting in a globalized economy. Innovations have increased the awareness that value drivers of many business activities are embedded into intangible items (i.e., intellectual properties, rights, brands, etc.) and not just into tangible ones (such as inventories and Property Plant and Equipment [PPE]). In this framework, since the 1990s, users, policy makers, standard setters, and market partici- pants have figured out—at different speeds and stages, and with divergent outcomes—that Financial Statements might not have been able to properly measure companies’ values (Lev, 2000). The reason may be that accounting principles were mainly developed during the industrial age and do not reflect the needs of an economy where modes of production change very rapidly. Globalization, since the 1980s, made international financial market transactions and cross border investments much easier. The International Monetary Fund (IMF) defines eco- nomic globalization as ‘‘a historical process; the result of human innovation and technologi- cal process. It refers to the increasing integration of economies around the world, particularly through the movement of goods, services and capital across borders.’’ To allocate capital effi- ciently on a global scale, market prices should be the result of the proper assessment of all the available financial information pertinent to rapid decisions. Both the increased value of intangible assets in business and the greater need for information—which is relevant for acquiring or disposing these intangible assets—have led to a demand for Fair Value account- ing in financial statements. The ability to correctly evaluate critical accounting items such as intangible assets, and espe- cially goodwill, turns out to be of great importance in light of the fact that in December 2007, the constituents of the S&P 500 reported in their accounts e1.2 trillion in goodwill and e0.6 trillion in intangibles other than goodwill overall. On the same date, the constituents of the EU STOXX 600 reported e1.0 trillion in goodwill and e0.5 trillion in specific intangibles overall. (Bini & Penman, 2013) (P 11) The 2008 financial crisis accelerated the commitment of regulators, standard setters, and practitioners for providing decision-useful financial information regarding large and rapid changes in market values to all firms’ stakeholders. The introduction of new accounting standards that were more Fair Value oriented came also as a response to public opinion cri- ticisms to the ability of the accounting rules to prevent financial scandals. Combined 584 Journal of Accounting, Auditing & Finance together, these factors led to a reevaluation of asset and liability measurements that we explore in the next section. Fair Value Accounting: Definitions and Measurement Starting as a specific remedy for the inaccuracy of cost-based measures of certain financial instruments, fair value has become the dominant measurement paradigm for non-financial items as well (Hitz, 2007). Even the opponents of fair value recognize that cost- and trans- action-based reporting model is in decline, and a new market-value and event-based model is developing, with dramatic implications for the role and the measurement properties of balance sheet items and, thereby, accounting income. Despite different wordings, the definitions and meanings of the term fair value are basi- cally equivalent in FASB and IASB pronouncements.4 The general FASB definition on Section 820-10-05-1B of Topic 820—Fair Value Measurement—states that the objective of fair value measurement is, to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. The IASB framework, at present, does not include any official definition of fair value, yet a uniform definition can be found at standards level5: 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. The FASB/IASB considers fair value as a specific hypothetical