RSS feedsThere has been a sea change in accounting’s orientation regarding valuing assets and liabilities from an historical cost perspective to a fair value perspective.
Today, fair value is the predominant measurement method. My review of the accounting and finance literature suggests that, while fair value is frequently found to be more relevant and timely than other measurement systems by investors and users of financial statements (i.e. vis-à-vis historical cost), questions remain about its perceived reliability.
While arguably more relevant, bona fide concerns have been raised over whether fair value, because of the increase in required estimates and assumptions, may introduce greater subjectivity and bias.
The risk is that if users of financial statements have concerns about financial statement reliability, the end result will be that statements will lose credibility with the very population they were intended to serve.
Obviously financial instruments are risky. It is possible that realised values will differ from estimated fair values, even with perfect information, complete transparency and neutrality.
Fair values can be based on observable inputs such as market quotes from an organised exchange and from similar financial instruments. Those values are generally not viewed with controversy.
However, inputs that a market participant would use when an asset or liability lacks a ready market or when there are unobservable inputs, risk increases that the value reported can deviate from fair value.
It is unlikely that accounting standards will ever retreat from a fair value
orientation.
Therefore, the burden faced by preparers of financial statements becomes one of
addressing concerns about minimising bias to ensure that the market place views
fair value estimates as both relevant and reliable.
While large broker dealers have invested in the infrastructure to comply with fair value, not all investors have the infrastructure to create such complex models. Valuation skills are critical in this environment.
Finally, you cannot trivialise the effort and risks involved in implementing fair value accounting.
The objective of fair value is to provide financial statements that yield greater relevance.
Accomplishing this objective will require companies, auditors and regulators to understand the subtleties and complexities of valuing assets and liabilities, where it is particularly hard to value them.
Larry Levine is a director in financial advisory services at RSM McGladrey
