Please Mind The GAAP Between The Historical Cost And The Fair Value Onur SERAKIBI Tax

Inpector, Finance Ministry of Turkey

The term fair value reporting reflects a financial reporting standard which aims to present financial statements to be measured by fair value as a valuation technique rather than with their historical cost. Those concepts of fair value and historical cost are some of the basic instruments which help to measure changes in financial condition of the entities. Since the objective of financial reporting is to provide financial information about the entity that is useful in making financial decisions accounting regulators mostly develop and adopt accounting standards based on this approach. The fair value reporting is a popular argument among not only in accounting professionals but finance professionals as well.The results of valuating some elements of balance sheet by fair value accounting (FVA) or historical cost accounting (HCA)can affect the financial conditions of the entities in the first place which is very usual but the problem and the basis of the debate relies on the latter which ll be examined at the further stages of this essay. Before starting to make some definitions and comments on both HCA and FVA its obvious that today the majority of the policy and decision makers are on the side of FVA.This does not mean that HCA is useless at all but it is just old fashioned.Nowadays the desire to see the real values of balance sheet and make decisions on that way is a much more popular approach than HCA.This approach is also very important in reducing the conflicts between principals and agents and being prepared to the unexpected financial crisis.The greater good of the community forces the decision makers to take some measure in order to prevent global economic crisis before it starts.So in this essay the advantages of the FVA will be mentioned in more detailed than the advantages of the HCA. Today majority of the financial statements are prepared in accordance with two major accounting frameworks such as International Financial Reporting

Standards (IFRS) and Generally Accepted Accounting Principles in the United States (US GAAP). Even though they had tried to revise the conceptual framework and accounting standards to achieve a single measurement basis (fair value),they have considered the conceptual framework and accounting standards based on the mixed measurement approach since the occurrence of the financial crisis in 2008.1 Before pointing the vews of the promoters and the protestors of the fair value measurment some brief history and the detailed definition of this valuation method will be given at the folowing parts of the essay. Along with new financial reporting innovations in sporadic areas, there is a steady process of change of a basic accounting paradigm in order to satisfy the needs of users of financial accounting.The will of reverse the pattern of declining relevance of financial information prepare a solid surface for the old historical cost accounting paradigm to be replaced by the new fair value accounting paradigm by the the efforts of accounting standards setting bodies 2 The ad hoc history of the conception and application of 'fair value'

measurement within financial reporting reaches back to 1980s.Then the term was widely applied within the context of acquisition accounting as a basis for the allocation of entry values to acquired assets.3 Fair value accounting was proposed as a reform to ensure that financial statements are relevant and reliable as a means of preventing future crises in the financial institution's industry and the resulting economic burden to taxpayers. From the very begining stages of the fair value accounting and historical cost accounting debates SEC actively encouraged the accounting profession to shift away from an accounting system based on historical costs to a fair value accounting system.4
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Kusano, M.(2012). Does the Balance Sheet Approach Improve the Usefulness of Accounting Information,p.144 2 Barlev, B. & Haddad, J.R. (2003). Fair Value Accounting And The Management Of The Firm p.383 3 Power, M. (2010). Fair value accounting, financial economics and the transformation of reliabilityp.197

The considerable debate on the advantages and disadvantages of moving towards a full mark to market accounting system for financial institutions has been triggered by the move of the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) to make changes in this direction as part of an attempt to globalize accounting standards.5

In accounting and economics fair value is a rational and unbiased estimate of the potential market price of a good, service or asset. The objective factors of fair value are acquisition/production/distribution costs, replacement costs or costs of close substitutes while its subjective factors are risk characteristics, cost of and return on capital and individually perceived utility.6 Both IFRS7 and US GAAP8 define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This definition highlights several aspects that inevitably involve accounting discretion. First, this definition recognizes that fair value is of a would be nature. The transaction to sell the asset or to transfer the liability is a hypothetical transaction as of the measurement date. It is the would be exit price, not the documented entry price or the carrying value of the underlying asset. Secondly, it emphasizes that fair value is a market based measurement, not an entity specific measurement. Therefore, fair values should be determined based on the assumptions that market participants would use in valuing the asset or liability.9

Cornett, M.M. & Zabihollah Rezaee, Z. & Tehranian, H. (1996). An investigation of capital market reactions to pronouncements on fair value accounting,p.120 5 Allena, F. & Carletti, E. (2008). Mark-to-market accounting and liquidity pricing, p.358 6 Wikipedia, (2013). Fair Value,(online). Available at: http://en.wikipedia.org/wiki/Fair_value, (accesed)12.03.2012 7 IASB, (2011). IFRS 13:Appendix A, 8 FASB, (2010). Statement of Financial Accounting St. No. 157 9 Cheng, K. (2012). Accounting Discretion and Fair Value Reporting: A Study of US Banks,Fair Value Reporting of Mortgage-Backed-Securities,p.534

In its pure form, fair value accounting involves reporting assets and liabilities on the balance sheet at fair value and recognizing changes in fair value as gains and losses in the income statement. When market prices are used to determine fair value, fair value accounting is also called mark to market accounting.10 Accounting for assets at fair value and accounting for them at book value are polar extremes. In an economic perspective accountants and regulators have long grappled with the problem of whether and how changes in the market value of assets should be incorporated into accounting reports.The main difference between two concept rely on that fair value accounting looks to changes in the market value balance sheet to indicate changes in the financial condition of a firm, while historic cost accounting looks to realizations of cash flow to measure changes in financial condition.11 The above term to measure is the process of determining the monetary amounts at which the elements of the nancial statements are to be recognised and carried in the balance sheet and income statement. 12 In the measurment by historical cost; assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.13 Fair value accounting is a way to measure assets and liabilities that appear on a companys balance sheet. When quoted prices in active markets for identical assets or liabilities are available, they have to be used as the measurement for fair value as Level 1 inputs. If not, Level 2 or Level 3 inputs should be used. Level 2 applies to cases for which there are observable inputs, which includes quoted prices
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Laux, C. & Leuz, C. (2010). Did Fair-Value Accounting Contribute to the Financial Crisis?, p.93 Heaton, J.C. & Lucas, D. & McDonald, R.L. (2010). Is mark-to-market accounting destabilizing? Analysis and implications for policy, pp.65 12 IASB, (2010). Conceptual framework for financial reporting , para.4.54 13 IASB, (2010). Conceptual framework for financial reporting , para.4.55

for similar assets or liabilities in active markets,quoted prices from identical or similar assets in inactive markets, and other relevant market data. Level 3 inputs are unobservable inputs (e.g., model assumptions). They should be used to derive a fair value if observable inputs are not available, which is commonly referred to as a mark to model approach.14 The below table shows the conclusions from a respected study in fair value accounting.The advantages and disadvantages of fair value accounting are briefly listed in two separated columns.Those basic characteristics of fair value accounting will be discussed at the folowing parts of the essay. Table 1. Fair values and qualitative characteristics of accounting information15 Advantages Disadvantages Fair values are relevant because they reflect present economic conditions relating to economic resources and obligations, i.e., the Lack a clear definition of fair value conditions under which financial statement users will make their decisions. Fair values can be faithful representation of assets and liabilities, because they reflect risk Lack verifiability and probability-weighted assessments of expected future cash inflows and outflows The ability for management to affect fair Fair values are unbiased and therefore neutral value estimates Potential circularity of reflecting fair values Fair values are timely because they reflect in financial statements when the objective is changes in economic conditions when those to provide financial statement users with conditions change information to make economic decisions that include assessing the value of the entity Fair values are comparable because the fair value of any particular asset or liability depends only on the characteristics of the asset or liability, not on the characteristics of the entity that holds the asset or liability or when it was acquired. Fair values enhance

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Laux, C. & Leuz, C. (2009). The crisis of fair-value accounting: Making sense of the recent debate, p.827 15 Barth, M.E. (2007) Standard-setting measurement issues and the relevance of research, p.7

consistency because they reflect the same type of information in every period Where market prices reflect all value relevant information a significant advantage of fair value accounting rises as market price (fair value) equals value in use only under the perfect and the complete markets assumption.Accordingly, if we recognize all assets and liabilities on the balance sheet and measure them at market price (fair value),the book value of net assets reports the market value of equity. So under perfect and complete markets, investors do not need to estimate equity value because the balance sheet reports the equity value through the fair value accounting.16 One of the major arguments coming from fair value accounting

defenders is about its accuracy and relevancy in the comparasion with historical cost accounting in measuring a firm's current ability to redeploy its resources. Fluctuations in interest rates can change the financial conditions.Since fair value accounting can reflects every little movements in prices it reduces the alleged gains trading problem of selling high quality assets to realize gains while retaining poor quality assets to avoid recognizing losses. 17 Some proponents argue that due to the ability of providing timely information, fair values for assets or liabilities can increase transparency and encourage prompt corrective actions. 18 The savings and loan crisis in the US would be a good example for the benefits of using fair value reporting since historic cost accounting masked the problem by allowing losses to show up gradually through negative net interest income in that period.A fair value accounting approach would have helped to reveal to regulators and investors that these institutions had problems

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Kusano, M.(2012). Does the Balance Sheet Approach Improve the Usefulness of Accounting Information,p.145 17 Cornett, M.M. & Zabihollah Rezaee, Z. & Tehranian, H. (1996). An investigation of capital market reactions to pronouncements on fair value accounting,p.120 18 Laux, C. & Leuz, C. (2009). The crisis of fair-value accounting: Making sense of the recent debate, p.827-828

and this may have helped to prompt changes earlier than actually occurred and that would have allowed the problem to be reversed at a lower fiscal cost.19 Another advantage of fair value reporting is its approach to agent principal conflict. The most significant problems that may arise from agency relationships are moral hazard and adverse selection. Both problems are caused by information asymmetry, Moral hazard occurs when the ex post behaviour of the agent is not appropriate, i.e. the agent with more information about its actions has an incentive to behave not in line with the principalsinterest. On the contrary, in adverse selection models,the principal is not informed about a certain characteristic of the agent. 20The principal-agent conflict is enhanced by HCA. The HCA obscures real economic values and generates hidden-reserves .During certain periods, hiddenreserves had been favorably accepted by managers and by financial analysts, since the concept of reserves is conservatism taken to an extreme. A manager who has to report a decline in the firms net income may find that his/her job is jeopardized. Managers may take advantage of the conservative characteristic of HCA and can initiate an accounting change in depreciation (amortization) of operating (intangible) assets, restate assets that are reported in the balance sheet at lower than their cost net of depreciation, change the estimation of doubtful debts, and sell undervalued assets.Whereas the first three actions involve only a cosmetic change, the fourth involves a real and costly act that may be in contrast with the shareholders basic goals.While HCA can cause severe damages to the shareholders FVA reveals the current values, prevents obscurity, and decreases costs of the principal-agent conflict by allowing shareholders to evaluate the outcome of their managers decisions regarding selection of assets and liabilities for current operations, selection of assets and liabilities for hedging, operational activities, and hedging activities.. 21 Under both US GAAP and IFRS, fair values are most frequently used for financial assets and liabilities even though there is a mixed attribute model with a
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Allena, F. & Carletti, E. (2008). Mark-to-market accounting and liquidity pricing, Journal of Accounting and Economics, p.376 20 Ciliberti, F. & Haan, J.D. & Groot, G.D. & Pontrandolfo, P. (2011). CSR codes and the principalagent problem in supply chains: four case studies , p.886 21 Barlev, B. & Haddad, J.R. (2003). Fair Value Accounting And The Management Of The Firm p.383

multitude of rules stipulating that some items are reported at fair value and others are reported at historical cost. Another important point is depending on their classification unrealized gains and losses of items that are reported at fair value may or may not affect net income.According to FAS 115 both trading securities and available for-sale securities must be reported in the balance sheet at their fair value while in the income statement, unrealized gains and losses and changes in these values, are recognized for trading securities only. In contrast, financial instruments that are held to maturity are reported at amortized costs but fair values could be used in determining impairments for these items. In addition, fair values are used for disclosures in the notes to the financial statements. 22 Table 2. The following paradigm illustrates the points discussed above23

Despite all advantages of fair value accounting

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there are still some

opositions to the above arguments.The most significant objections on fair value

Laux, C. & Leuz, C. (2009). The crisis of fair-value accounting: Making sense of the recent debate, p.827 23 Tsitsianis, N. (2013). International Accounting Lecture Notes ,

accounting focuses in the fact of fair value accounting increases volatility of reported earnings and capital and it would likely cause financial institutions to become short term oriented as short term securities are subject to less price fluctuations. According to those opponents fair value measures are not objective at all.24Also in times of crisis prices in illiquid markets may not reflect future earning power and this can lead to unnecessary liquidation. 25 For instance in 2008 RBS was required to write down $8bn of loans to households that had gone bad but also 33bn of goodwill.These adjustments so large that the bank was effectively forced into insolvency and needed bailing out by the UK government.26 Some other opponents claim that for assets which are held to maturity fair value is not relevant and potentially misleading and prices could be distorted by market inefficiencies.They also claims that fair value accounting contributes to the procyclicality of the financial system.For instance it can provoke contagion in financial markets when banks have to sell assets at a price below the fundamental value and that the price from these sales becomes relevant to other institutions that are required by fair value accounting to valuate their assets to market.27

The table below is taken from Tesco PLC annual reports and it shows the comprehensive income statement under the valuation method of fair value. It can present the assets and the liabilites in a more realistic format as well as the gains and the losses.28 Table 3.Group Statement of Comprehensive Income - TESCO
Change in fair value of available-for-sale financial assets and investments Currency Translation differences
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2012 13 (22)

2011 2 (344)

Cornett, M.M. & Zabihollah Rezaee, Z. & Tehranian, H. (1996). An investigation of capital market reactions to pronouncements on fair value accounting, p.120 25 Franklin Allena, Elena Carletti,Mark-to-market accounting and liquidity pricing, Journal of Accounting and Economics 45 (2008) 376 26 Tsitsianis, N. (2013). International Accounting Lecture Notes . 27 Laux, C. & Leuz, C. (2009). The crisis of fair-value accounting: Making sense of the recent debate, p.827-828,829 28 Tsitsianis, N. (2013). International Accounting Lecture Notes .

Gains(losses) on defined pension schemes Gains (Losses) on Cash Flow ) Net Fair Value Gains (Losses Reclassified and reported in the Group Income Statement Tax relating to components of other Comprehensive Income for the year Total Other Comprehensive Income for the year Profit for the year Total Comprehensive Income for the year Attributable to: Owners of the parent Non-Controlling Interest Total Comprehensive Income to Equity Shareholders arises from: Continued Operations Discontinued Operations

(498) 241 (142) 73 (335) 2,814 2,479 2,466 13 2,479 2,607 (141) 2,466

595 (22) 8 (153) 86 2671 2,757 2,746 11 2,757 2,851 (105) 2,746

The most significant point in valuating the assets and the liabilites by fair value is to provide useful information to the external users of entities.The shareholders and the managers of the entities can reach the desired financial tables in any format in anytime but the stakeholders can not.So by the force of US GAAP and IFRS presenting the financial tables in same format all over the world can provide more transparency and clear information to the markets and help stakeholders to prevent their savings from dangers.

In the conclusion part of the essay it can be argued that fair value reporting can reflect current market conditions and provide more transparency to the markets while it can cause subjectivity due to the reliability in illiquid markets and cause volatility which introduces uncertainty to the markets. 29In over all the advantages of the FVA is much more higher than its disadvantages.For instance it is very useful before making an investment in stock market to know the real value of the company or to see the updated price of the land that is remaining with its historical cost in the balance sheet of the company for years.In that example the depreciated price of the land would be too low and investors if they re not chartered accountant could not realise the current price of the land since they were just misinformed by the HCA.So it can be argued that fair value accounting and fair value presentation are very
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Tsitsianis, N. (2013). International Accounting Lecture Notes .

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fundamental valuation scales for small and middle size investors since the large capacity investors could be more prepared to analysis the financial statements in a more professional way. After all the definitions and the comments coming from both sides it can be seen that much of the debate on fair value accounting versus historic cost accounting has focused on the trade offs between the two. Maybe an alternative would be to try to combine the best features from both.30The combination of a mixed valuation system would provide better results and prevent the undesired side effects of the FVA by using the HCA where it is appropriate.

Bibliography Allena, F. & Carletti, E. (2008). Mark-to-market accounting and liquidity pricing, Journal of Accounting and Economics, 45, pp.358378 Barlev, B. & Haddad, J.R. (2003). Fair Value Accounting And The Management Of The Firm, Critical Perspectives On Accounting , 14, pp.383415,p.383 Barth, M. & Landsman, W. (1995). 'Fundamental issues related to using fair value accounting for financial reporting'. Accounting Horizons, 9(4),pp.97-107. Barth, M.E. (2007) Standard-setting measurement issues and the relevance of research,Accounting and Business Research,Vol. 37, Nbr. 3, p.7 Bowen, R. M., DuCharme, L. & Shores,D.(1995).Stakeholders Implicit Claims and Accounting Method Choice, Journal of Accounting and Economics, Vol. 20, pp. 255295 Cheng, K. (2012). Accounting Discretion and Fair Value Reporting: A Study of US Banks Fair Value Reporting of Mortgage-Backed-Securities, Journal of Business Finance & Accounting, 39(5) & (6), pp.534-535 Ciliberti, F. & Haan, J.D. & Groot, G.D. & Pontrandolfo, P. (2011). CSR codes and the principal-agent problem in supply chains: four case studies , Journal of Cleaner Production,19, pp.885-894,p.886
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Allena, F. & Carletti, E. (2008). Mark-to-market accounting and liquidity pricing, p.376

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Cornett, M.M. & Zabihollah Rezaee, Z. & Tehranian, H. (1996). An investigation of capital market reactions to pronouncements on fair value accounting, Journal of Accounting and Economics, 22, pp.119-154 p.120 Eccher, A., Ramesh, K. & Thiagarajan, S. R., Fair Value Disclosures Bank Holding Companies, Journal of Accounting and Economics, Vol. 22, 1996, pp. 79117. Financial Accounting Standards Board, (2010). Statement of Financial Accounting Standards No. 157 ICAEW. (2006). Information for Better Markets:Measurement in Financial Reporting. London: Institute of Chartered Accountants in England and Wales. International Accounting Standards Board, (2011). IFRS 13:Appendix A, 12 May 2011 Heaton, J.C. & Lucas, D. & McDonald, R.L. (2010). Is mark-to-market accounting destabilizing? Analysis and implications for policy, Journal of Monetary Economics,57, pp.65 International Accounting Standards Board, (2010). Conceptual framework for financial reporting Kusano, M.(2012). Does the Balance Sheet Approach Improve the Usefulness of Accounting Information, The Japanese Accounting Review, 2), pp.139-152 ,p.144 Laux, C. & Leuz, C. (2009). The crisis of fair-value accounting: Making sense of the recent debate, Accounting, Organizations and Society, 34, pp.826-834 p.827 Laux, C. & Leuz, C. (2010). Did Fair-Value Accounting Contribute to the Financial Crisis?, Journal of Economic Perspectives,Volume 24, Number 1, pp.93118 Power, M. (2010). Fair value accounting, financial economics and the transformation of reliability,Accounting and Business Research, Vol. 40. No. 3 , pp.197-210 Power, M. (1992b). 'On the idea of a conceptual framework for financial reporting'. In M.J. Mumford and K.V. Tsitsianis, N. (2013). International Accounting Lecture Notes , Queen Mary University of London Wikipedia,(2013).FairValue,Available at: http://en.wikipedia.org/wiki/Fair_value, (accesed)12.03.2012

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