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210 PAIH 2 Theory ami accounting practice

Fairvalue or false accounting

by Anthony Rayman
Forget Enron; forget WorldCom; forget Parmalat. Dishonest accounting can do enormous
damage - but nowhere near as much as the honest variety.
'Fair value accounting' is the most recent example. The title sounds wonderful, but
itspromotion by the International Accounting Standards Board (lASB)threatens to bring
the profession into even greater disrepute by institutional ising false accounting on a
global scale.
According to lAS39, Financial Instruments: Recognition and Measurement, financial
instruments are to be stated at their 'fair value' - defined as 'the amount for which an
asset could be exchanged, or a liability settled, between knowledgeable, willing parties
inan arm's length transaction'.
'If the market for a financial instrument isnot active, an entity establishes a fair value
by using a valuation technique ... [including] discounted cashflow analysis and option
pricing models,' says lAS39. 'A gain or loss on a financial asset or financial liability
classified as at fair value through profit or loss shall be recognised inprofit or loss.'
As far as financial instruments are concerned, fair value accounting is notable for its
closeness to the long-cherished academic ideal of 'income as present value growth'.
What possible objection can there be to fair value accounting? On the face of it,
lAS39 looks likea passport to the promised land of 'truth and fairness of view'.
Beforeleaping on to this particular bandwagon, however, itmay be agood idea to try
it out on a test-track - an economic utopia of perfectly competitive markets.
Thebeauty of an economic utopia isthat itprovides themost favourable conditions for
fair value accounting: the change inrecorded equity based on 'fair value' coincides with
the academic ideal of 'present value growth' as J measure of economic performance.
The following article strongly criticises the notion of fair values and the measurement
offinancial assets under lAS39/AASB 139.
Additional readings
Al-Hogail, AA,&Previts, GI 200 I, 'Raymond J. Chambers' contributions to the development
of accounting thought', Accounting Historians Journal, vol. 28, no. 2, pp. 1-30.
Barton, A 2000, 'Reflections of an Australian contemporary: the complementarity of entry
and exit price current value accounting systems.' Abacus, vol. 36, no. 3, pp. 298-312.
Chambers, R 1975, 'Accounting for inflation - the case for continuously contemporary
accounting', Australian Accountant, December.
Carlon, S. Mladenovic, R, Loftus. L Palm, C. Kimmel, I'D, Kieso. DE, &Weygandt, II.
2009, Accounting: building business shills. 3rd edition, Iohn Wiley &Sons Australia, Ltd.
Miller, M, &Loftus. I2000, 'Measurement entering the 21st century: A clear or blocked
road ahead?', Australian Accounting Review, vol. 10, no. 2, Iuly, pp. 4-18.
Ryan, I 2000, 'Measurement - or market?', Charter, vol. 71, no. II, December, pp. 56-7.
Staubus, GT 2004, Two views of accounting measurement', AbaC!ls, vol. 40, no. 3,
Prepare journal entries to record the events, as well as the income statement for Year 10
and balance sheet as at 31 December Year 10, under the exit price method. Assume the
debenture is not part of capital and is a financial investment.
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A cau tionarv tale
With the (perfect) market rate of interest at 8% per annum, the Fair Value Company
invests the whole of its investors' capital of 100m in 'financial instruments'. These
are various equity shareholdings with expected cash dividends totalling 0 m pa. The
company has no other assets or liabilities.
Suppose an 'event' occurs - perhaps fear of a previously unexpected economic
recession. Suppose this event causes (1) the market expectation of the annual dividends
to be revised downwards to 5.5 m, and (2) the monetary authority to lower the rate
of interest to 5% pa. As a consequence, the market value of the company's financial
instruments rises from {8 mlO.08 =1100 rn to {S.S mlO.OS =1110 m.
The 10m increase in the 'fair value' of the company's 'financial instruments' is based
on observable market prices. According to lAS 39, it is to be reported as a 'gain'.
Since these financial instruments are the whole of the company's net assets, the
market value of the company's share capital also rises from 100 m to 110m. Investors
in the Fair Value Company therefore have the opportunity of selling their shares and
spending 10 m more than before.
From every point of view, it looks like an open-and-shut case in favour of lAS 39and
reporting a gain of 10 m - but appearances can be deceptive.
Only if investors actually take the opportunity of realising the market value and
spending it immediately, are they able to spend 10 m more than they could before
the 'event'. If they save for one year before actually spending, the extra spending made
possible by the 'event' is only 7.5 m; and the equivalent present sum (at S% pal at the
balance sheet date is 7.1 m.
The effect of the 'event' on investors depends on how long they choose to save.
For investors intending to save for more than just over 31/2 years, the effect of the
fall in the rate of interest from 8% pa to S% pa outweighs the initial increase in 'fair
value'. If all the investors intend to save for eight years, the 'event' reduces the amount
available for spending by 22.6 m. To cover this shortfall, the compensation that would
be required at the balance sheet date (in order to accumulate at S% pa for eight years)
amounts to no less than 15.3 m.
If the consequence of the 'event' is 300,000 worse than being robbed of 1S m, is it
'true and fair' to report a gain of 10 m? Or is it fraudulent misrepresentation?
It is certainly misrepresentation, and it can be massive; but it is not intentional. The
belief in the relevance of 'value change' as a measure of financial performance is the
result of a fallacy deeply entrenched in the conventional academic wisdom.
The present-value fallacy
At an)' given moment, a higher market value is unquestionably preferable to a lower
market value. Irrespective of subjective preferences, 110 m will (through borrowing
or lending) support a higher level of spending of any chosen pattern than wi II 100 m.
But, as the table demonstrates, this is not always true of sums available at different
moments. That is why it does not necessarily follow that a 10 rn increase in market
value over a period represents a gain. The fallacy underlying the IASB's standard on
fair value accounting lies in following the conventional wisdom and assuming that it
The tale of the Fair Value Company is simply one particular example of the 'present-
value fallacy'. But, because it takes place on the test-track of an economic utopia, it
is sufficient to demonstrate that the academic ideal is false and that growth in present
value (= 'fair' market value) is not reliable as a measure of economic performance.
(For readers with the patience to endure a spot of general economic equilibrium
analysis complete with Fisher diagrams, a rigorous proof is available in the author's
book on accounting reform: Accounting Standards: True or False? london: Routledge,
CHAPTER fI Accounting measurement systems 211
, no. 3,
;andt, II,
lia. Ltd.
{of entry
.r Year 10
slime the
PART 2 J heorv and .1n:ouoting pr.1C1icp
1. How areassetsand liabilities measuredunder lAS39?
2. What impactaccording totheauthor, will fair valueaccounting haveonthebalance
sheetand incomestatement?
3. What measurementrequirement of historical costaccounting is violated?
4. Isa changeinassetvalue an increasein wealth or income? Arethey thesame?
5. What doyou think fundamental value in accounting should be?Referto thedebate
regardingvalueinuseandvalueinexchangeoutlined inthischapterwhenanswering
this question.
The accounting implications
The moral of the story is that there is nothing wrong with fair values in the balance
sheet; there is everything wrong with fair-value changes in the profit and loss account.
In a balance sheet intended to present a 'true and fair view' of a firm's financial
position, the disclosure of fair values is a development to be welcomed - as an
indication of the available market opportunities. On the balance sheet of the Fair Value
Company after the 'event', no figure has a greater claim to relevance as a measure of
the net assets than their fair value of 11 0 m.
But opportunities are not the same as actual transactions. The very fact that an item
appears in a balance sheet, means that by definition it has not been exchanged. Its 'fair'
market value represents a rejected opportunity.
The fundamental mistake is to report 'value change' as a 'gain or loss'. For 'value
change' may simply be the difference between hypothetical opportunities that have
actually been discarded. What is in question, therefore, is the relevance of fair value for
reporting financial performance.
An accounting standard which generates a fair value 'gain' of 10 m in response to
a fall in the expected annual returns from the Fair Value Company's net assets from
8 m to 5.5 m does not inspire confidence. The 'event' is responsible for an increase
in fair value of the company's net assets from 100 m to 110 m. A gain of 10m
is a 'true and fair view' of the result on one assumption only: that the fair value is
realised and actually consumed at the balance sheet date. The most common reason
for investing, however, is to save for the future. Of all the assumptions that could
have been chosen, immediate consumption is the least likely. It is ruled out almost
by definition.
Many savers and pensioners in the UK have become materially worse off as a direct
consequence of events that would be reported in 'fair value' accounts as substantial
'gains'. The propagation of the market-value fallacy has made a substantial contribution
to the housing bubble and the pensions crisis.
Truth in accounting?
As a result of the 'event', the rate of return on investment in the Fair Value Company
has fallen from 8% pa to 5'12% pa.. IAS 39 requires the accounts to report a gainof
10mequal to 10%on capital. This is inclear breachof Englishcriminal law: 'Wherea
person... in furnishing information foranypurposeproduces ... anyaccount ... which
to his knowledge is or may bemisleading, falseor deceptive in a material particular; he
shall, on conviction on indictment, beliable to imprisonment for a termnot exceeding
sevenyears' (s17, Theft Act 1960).
lAS 39 is calculated to bring the profession into disrepute. But who is really
responsible - those who do their best to operate, with honesty and integrity, in
accordance with the standards- or the IASBwhich setsthem?
Source: ExcerptsfromAccountancy, October 2004, pp, 82-:1.