Fair Value
by Humphrey Nash

Abstract

Fair value is the attribute that will guide the use of present values in future accounting developments and pronouncements.   The use of present values is most welcome; the use of fair value is not.  This article explains why and sounds the alarm.

Introduction

In recent years the Financial Accounting Standards Board (FASB) has researched, developed, and promoted the use of Present Value of Expected Cash Flows (PVECF) as a measure of economic value.   FASB has done a commendable job of introducing the concept of expected cash flow based on probability-weighted outcomes.   FASB has also illuminated the concept of present value as a sum of interest discounted expected cash flows.

In order for a measure to be relevant it must represent some observable attribute.   For PVECF the attribute recently proposed is fair value.   This attribute is what PVECF is intended to represent and hence fair value provides theoretical guidance in calculating PVECF or judging whether or not PVECF is appropriately representative.

The adoption of a PVECF attribute is critical to the future of accounting, accountants, and accounting organizations.   It is vital to get it right.

In its exposure draft Using Cash Information and Present Value in Accounting Measurements, FASB has defined Fair Value to be,

"The amount at which the 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."

If there is an active market for the asset ( or liability) then the observed market price is a fair value and a PVECF measure should approximate or be that price.   If no active market exists then a similar PVECF should be employed to inpute an appropriate market price.   If PVECF meets this goal it is then said to have satisfied the fair value attribute.

The definition of fair value seems reasonable and it is difficult, perhaps un-American, to challenge a term like "fair value".   In fact, I like the term and I support both the concept of fairness and the concept of value.   The only thing I have a problem with is the interpretation of the definition.

What Fair Value Is Not

Fair value is one of several competing attributes of PVECF.   FASB cites two others in its exposure draft, namely, entity-specific value (similar to value in use) and cost accumulation value (a terrible term).   FASB distinguishes these two attributes from one another and from the fair value.   Without going into detail, I believe that entity-specific and cost accumulation are, in practice, identical concepts.

The table below is taken from the FASB exposure draft and compares fair value with cost accumulation.

The choice of attribute has created some controversy among the FASB board members.   At least two members (the Dissenters) strongly favor the cost accumulation attribute and their views are well represented within the exposure draft.   Despite the lack of agreement, FASB has tentatively chosen fair value.

"In future standard-setting deliberations, the Board expects to adopt fair value as the measurement attribute when applying present value techniques in the initial and fresh-start measurement of assets and liabilities."

The Dissenters have no quarrel with PVECF, which they seem to like, only with fair value as an attribute of PVECF.   It is stated that they support fair value under certain circumstances, but I think that statement is a mischaracterization, in that it appears they support fair value only when it coincides with cost accumulation, for example, in the case of an actively traded financial instrument held short-term.   In general the Dissenters

"... agree with that description of fair value and with the notion that fair value is an estimate of a current price, even though current settlement may not be possible.   However, they do not consider market-based assumptions to be relevant if the entity does not intend to acquire a non-financial asset or settle a non-financial liability in a current transaction. "

They further hold that,

"Using fair value to measure non-financial assets and liabilities has troublesome recognition implications. " (for example, recognizing non-existent liabilities)

and that,

Using fair value to measure non-financial assets and liabilities also produces income statements that are confusing and less useful than those produced by a cost-accumulation approach.

The crux of the controversy boils done to a simple observation: fair value is not value-based.   It is price based and would be better labeled "fair price".   This follows directly from the definition; "fair price" is the amount at which that asset can be bought in a current transaction between willing parties.

Is there a difference between price and value?   It depends.   In the case of an actively traded financial instrument held short-term, there is no difference.   In the case of the seller of an asset there is no difference.   For the buyer of an asset to be held or used, there is a difference, often quite large.

Why is there a difference?   The answer is that the buyer of an asset has an economic or comparative advantage in using that asset.   The asset is worth more to the entity than the price; this motivates the purchase in the first place.   The value to the buyer of a rational purchase exceeds the price or cost.   If the measurement of value is the goal then fair value as, an attribute of PVECF, should not be used.

Should value be the goal?   If we want to make rational economic decisions, we must measure value.   If we want to exploit comparative advantage, we must measure value.   If we want accounting to be more forward looking, we must measure value.   If we want to use PVECF, we must measure value.

Fair value is a price based concept.   It continues the historical cost perspective of traditional accounting.   This retrospective view is at odds with the prospective view of PVECF.   To assign a retrospective attribute to a prospective measure is inconsistent and self-defeating.

An Alternative View

The Dissenters have provided an alternative to fair value.   This alternative, to its credit, is value oriented.   But cost accumulation is incomplete or, at least, not explicitly complete.   "To provide relevant information in financial reporting, present value must represent some observable measurement attribute of assets or liabilities."   Fair value represents observed price (PVECF to the seller), but has no connection to PVECF to the buyer.   Fair value observes, but observes the wrong thing.   What is the observable attribute of the cost accumulation approach?   What value does it represent?   What value should it represent?

A clue to what it is, or should be, can be found in the basic purpose of accounting and financial reporting.   Accounting and financial reporting is intended to be relevant to shareholders and their representatives (management, analysts and portfolio managers).   The value they are concerned with is shareholder value.   This value is readily observable in the capital markets.    PVECF should have shareholder value as the observable attribute.

Prospective Accounting

The draft proposal Accounting For The Future (AFTF) outlines a prospective accounting model based on shareholder value as the observable attribute of PVECF.   AFTF provides a relevant attribute, but also provides specific disciplined technology to ensure that the attribute is satisfied.   Fair value does not provide a relevant attribute and provides little methodology and little discipline.

AFTF resembles cost accumulation.   In the Comparison Table AFTF would be identical to cost accumulation, except for the final two items.   AFTF uses an embedded historical cost of (equity) capital rather than an embedded debt rate.   This AFTF cost of capital implicitly includes a provision for capital market risk and uncertainty.

Suggestion

Interpret fair value to be,

"The capital market amount at which the 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."

The fair value of the company is the market capitalization.   The total price of the company stock is the total value to the company because the company is the seller.

Indictment of Fair Value

The criticisms below present a summary of the many faults of fair value as an attribute of PVECF.

1.  Fair value omits intangibles, especially assets.   These values are dominant today and can't be ignored.

2.  Active market values exist or they don't exist.   If they exist, there is little use for PVECF.   If they don't exist, it will be very difficult to determine or verify the fair value of an asset or a liability.   Fair value is observable only in those cases where it is not needed.

3.  The fair value of an asset is the value to the seller not to the buyer.   The value to the buyer must reflect the comparative advantage that the buyer has, otherwise that advantage withers.

4.  Only in pathological cases is the value equal to the price, for example, in the case of a financial asset held for short term trade or in the case of forced liquidation.   In these cases all alternatives to fair value would also equate value to price to reflect the real cash flows.

5.  Fair market value is unsuitable for decisions.   Decisions (for a publicly traded company) are made with the goal of adding value.   Measuring cost or liquidation values is not oriented towards this goal.

6.  The fair value concept is more strained for liabilities than for assets.   "Buying liabilities" even sounds perverse.   For an ongoing enterprise it is doubtful that liabilities can be fully discharged to a third party.

7.  Fair value would tend to diminish assets and increase liabilities compared with current accounting practice.   This may discourage prudent risk taking and stifle economic progress.

8.  As defined, the fair value of component assets and component liabilities will not add up to the fair value of the total company.   This value, the capital market fair value, is well defined by an active stock market.   If the component measures don't add up to a well established total then those measures must be redefined.

9.  PVECF is patently incompatible with fair value since expectations are prospective from the entity's perspective whereas prices are retrospective and are from the seller's perspective.

10.  Fair value does not provide procedures, discipline, or uniformity.   Fair value provides no guidance in determining expected cash flows or discount rates.   Unless a fair market value is observable there will be no discipline on "value" assignments.   Interest rates, risk and uncertainty premiums, projected cash flows may vary with each asset or liability.