Using Fair Value Earnings to Assess Firm Value

Mary E. Barth
Graduate School of Business
Stanford University
Stanford, CA, 94305
mbarth@stanford.edu.

Wayne R. Landsman
Kenan-Flagler Business School
University of North Carolina at Chapel Hill,
Chapel Hill, NC 27599
wayne_landsman@unc.edu.

April 2018

We appreciate comments from Steve Cooper, Petrus Ferreira, Leslie Hodder, Jim Leisenring,
Warren McGregor, Steve Stubben, seminar participants at the Cambridge University Financial
Accounting Symposium, and an anonymous reviewer. We acknowledge funding from the
Center for Finance and Accounting Research at UNC-Chapel Hill.

Electronic copy available at: https://ssrn.com/abstract=3103842

 Using Fair Value Earnings to Assess Firm Value

Abstract

Whether fair value accounting should be used in financial reporting has been the subject of
debate for many years. A key dimension to this debate is whether fair value earnings can
provide information to financial statement users that is helpful in making their economic
decisions. A criticism of fair value accounting is the contention that fair value earnings simply
reflects “shocks” to value, and thus cannot be used to assess firm value. We show how fair value
earnings can be disaggregated into components that can be used to assess firm value, as well as
components that provide information about various types to shocks to value, e.g., effects of
changes in expected cash flows.

Electronic copy available at: https://ssrn.com/abstract=3103842

 Using Fair Value Earnings to Assess Firm Value

1. Introduction

Whether and the extent to which fair value accounting should be used in financial

reporting has been the subject of debate for many years. The Financial Accounting Standards

Board (FASB) and the International Accounting Standards Board (IASB) 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.”1 Fair value earnings is the

difference between the fair values of the firm’s net assets at the end and beginning of the

reporting period, adjusted for capital contributions and distributions. Although there are many

dimensions to the debate, a key one is whether fair value earnings can provide information to

financial statement users that is helpful in making their economic decisions, including valuing

the firm. Black (1980) observes that even though accountants do not profess to create an

earnings amount that can be used to measure value, they have done a remarkably good job of

doing so. Black refers to this as the “magic” in earnings. We reveal Black’s (1980) magic in fair

value earnings by showing how fair value earnings can provide relevant information to investors

in valuing the firm.

Black’s (1980) notion of earnings as measuring value is consistent with the theoretical

construct of permanent earnings, which is the amount that, if divided by the firm’s cost of

capital, yields the value of the firm. A key criticism of fair value accounting is the contention

that fair value earnings does not provide a measure of permanent earnings, and simply reflects

“shocks” to value. However, this criticism fails to take account of the information embedded in

the changes in fair value. In particular, as we demonstrate, fair value earnings can be

1
FASB, Accounting Standards Codification (ASC) Topic 820.

Electronic copy available at: https://ssrn.com/abstract=3103842

disaggregated into components that can be used to assess firm value, as well as components that

provide information about various types to shocks to value, e.g., effects of changes in expected

cash flows. This disaggregation is possible because fair value earnings embodies the expected

return on the firm’s assets, as well as changes in expectations of future cash flows and risk.

Although we demonstrate the disaggregation of fair value earnings into components can

be informative for valuation, we leave it to standard setters to determine whether the

disaggregation should be included in financial reports and, if so, whether it should be presented

as additional disclosure, or should be incorporated into or used in place of the statement of

comprehensive income as currently formatted. Although fair value earnings components also

can be useful for assessing managerial performance, we leave it to contracting parties to

determine the extent to which fair value or historical cost-based earnings—or particular

components thereof—is appropriate to include in managerial compensation contracts, or any

other contracts.

The remainder of this paper is organized as follows. Section 2 describes how earnings

can provide information useful in valuing the firm, explains how disaggregation of fair value

earnings into its components accomplishes this goal, and identifies two issues that complicate

implementation of this disaggregation for a real firm. Section 3 compares fair value earnings to

historical cost-based earnings, and Section 4 identifies other practical implementation issues that

can impede fair value earnings from revealing information about value. Section 5 offers

concluding remarks.

2
2. Fair Value Earnings and Valuation

2.1 Earnings for Valuation

In his 1980 Financial Analysts Journal article, Fischer Black observes that financial

statements users, including analysts, stockholders, creditors, managers, tax authorities, and

economists, prefer an earnings amount that can be used to measure firm value, not change in

value (Black, 1980). Black offers the illustration of analysts, who seek an earnings amount they

can multiply by a standard price-earnings ratio to arrive at an estimate of the firm’s value.

Accordingly, he asserts that the ideal set of accounting rules is one that yields a constant price-

earnings ratio. He observes that even though accountants measure earnings in terms of changes

in amounts of recognized assets and liabilities, and therefore do not profess to create an earnings

amount that measures value, they have done a remarkably good job of doing so. In particular,

Black (1980) shows that the variability of equity book value to price ratios is greater than that of

earnings to price ratios, both across firms and over time, which suggests that earnings provides a

better estimate of value than does equity book value. He refers to this as “the magic in

earnings.”2

Black’s (1980) notion of earnings as measuring value is consistent with the theoretical

construct of permanent earnings (Miller and Modigliani, 1966; Beaver, 1998). Permanent

earnings is the amount that, if divided by the firm’s cost of capital, yields the value of the firm.

Black’s (1980) notion also is consistent with the professed objective of analysts’ Street earnings,

which is the portion of accounting earnings that has the characteristics of permanent earnings.

That is, Street earnings is professed to be accounting earnings stripped of its non-permanent

components, and hence can be used to measure value. Sustainable, core, operating, and

2
Although Black (1980) does not address whether historical cost or fair value earnings provides a superior estimate
of value, he observes (p. 20) that there is no circularity in using changes in asset values to measure earnings, and
then using earnings to estimate equity value as long as equity value is not used in estimating asset values.

3
recurring earnings also are consistent with the notion of permanent earnings.3 Unfortunately,

because these terms, as well as Street earnings, are not well defined, these measures of earnings

are subjective and ad hoc.

That earnings—or some transform of it—can measure value is particularly surprising in

light of the fact that the FASB and IASB concepts statements define earnings in terms of changes

in amounts of recognized assets and liabilities. As Storey and Storey (1998) explains, earnings is

not defined in terms of revenues and expenses because standard setters have been unable to

develop “rigorous, coherent, and consistent definitions of revenues and expenses that refer to

underlying events rather than the recognition process itself” (p. 84). As Bullen and Crook (2005)

points out, critics of the asset and liability view of earnings measurement who favor the revenue

and expense view have been challenged by the FASB, beginning with the 1976 Discussion

Memorandum, Scope and Implications of the Conceptual Framework Project (FASB, 1976), to

define revenue, expense, or earnings directly without reference to assets or liabilities or recourse

to highly subjective terminology such as proper matching. “Some tried, in letters, articles, and

public meetings with the FASB, but none could meet the challenge” (p. 7).4 The lack of such

definitions of revenues and expenses led standard setters to develop conceptual frameworks that

define earnings in terms of changes in assets and liabilities rather than revenues and expenses.5

3
Relatedly, Dichev et al. (2013) states that financial statement preparers also regard earnings that is sustainable and
repeatable as being high quality, and identifies the absence of one-time items and long-term estimates as
characteristics of such earnings.
4
Others have tried subsequently, but also with little success. For example, Dichev and Penman (2007) identifies as
a major feature of financial reporting a clear theoretical and practical distinction between operating and financing
activities, but does not offer such a distinction. Dichev and Penman (2007) identifies the matching principle as
another major feature, but offers no definition and recognizes the difficulties in interpreting and implementing such
a principle.
5
The US Securities and Exchange Commission (SEC, 2003) agrees that the revenue and expense view is
inappropriate for use in standard setting, and that “the asset/liability approach most appropriately anchors the
standard setting process by providing the strongest conceptual mapping to the underlying economic reality.” The
SEC believes that without this mapping the revenue and expense approach is “ad hoc and incoherent.”

4
 The notion of earnings being a change in net asset amounts is similar to the economists’

notion of earnings being the change in wealth (Hicks, 1946). Consistent with the Concepts

Statements, we use the term fair value earnings to refer to changes in values of recognized assets

and liabilities measured at fair value, adjusted for net capital contributions. Critics of fair value

contend that fair value earnings cannot possibly meet the goal of earnings as a measure of value

because changes in fair value are simply “shocks” and not permanent earnings (e.g., Christie,

1992; Hitz, 2007; Penman, 2007; Dichev, 2008). Hence, fair values can only provide a noisy

measure of value. However, we believe this view fails to take account of the information

embedded in the changes in fair value. In particular, fair value earnings can be disaggregated

into components to provide a measure of earnings as value that is not ad hoc and subjective.

2.2 Fair Value Earnings for Valuation

The fair value of an asset—or liability—embodies the expected return on the asset, as

well current expectations of future cash flows and risk. Thus, assuming expected net capital

contributions is zero, asset fair value can be characterized as a random walk with a drift:

E(FVt) = er + FVt−1, (1)

where FVt is the fair value of an asset at reporting date t, E is the expectations operator, and er is

the drift term, which is the dollar expected return on the asset for period t. Fair value earnings is

the difference between the fair values of the firm’s net assets at the end and beginning of the

period, adjusted for actual net capital contributions, NCC.6 In the context of a single asset firm,

fair value earnings is (FVt – FVt−1) – NCC, i.e., change in the asset’s fair value, and comprises

the expected return, er, plus the unexpected change in fair value, i.e., the “shock.” The expected

return, er, is permanent earnings. The shock comprises changes in expected cash flows and risk,

6
Equation (1) can be modified to allow for non-zero expected net capital contributions by including –E(NCC) on the
right-hand side of the equation.

5
as well as realizations of cash flows and risk that differ from expectations (Barth, 2014). Thus,

disaggregating change in fair value into its expected return and shock components permits fair

value earnings to reveal both change in value and value.

To illustrate how disaggregation of change in fair value can reveal firm value and

potentially informative components of change in value, Figure 1 begins with a simple example in

which the firm has a single asset.7 The asset is expected to generate a $1,000 per year perpetual

cash flow with a discount rate of 10%, and thus its initial fair value is $10,000 ($1,000/0.1).

Assume that during the year the cash flow expectation is realized, i.e., the firm receives the

$1,000 cash flow, and there is no change in expectations regarding future cash flow or the

discount rate. The simple example and the examples that follow assume the firm pays out all

cash receipts as dividends to equityholders. Thus, the asset’s end-of-year fair value also is

$10,000 ($1,000/0.1). The firm’s fair value earnings is $1,000, which is the difference between

the asset’s end-of-year fair value, $10,000, and the asset’s beginning-of-year fair value, $10,000,

plus the collection of the $1,000 cash flow, i.e., $1,000 = $10,000 – $10,000 + $1,000. In this

setting of beginning-of-year expectations being met and no changes in expectations during the

year, the $1,000 fair value earnings reveals the value of the asset in that fair value earnings,

$1,000, divided by the end-of-year cost of capital, 10%, equals the asset’s value, $10,000. In this

simple setting, total fair value earnings reveals value, and because all unexpected components

equal zero there is no need to disaggregate fair value earnings to reveal value.

Figure 2 extends the example in Figure 1 in three ways related to unexpected events,

including realizations that differ from expectations and changes in expectations. First, realized

cash flow for the year is $1,150, which is $150 greater than the expected cash flow of $1,000.

7
See section 2.3 for discussion of two complicating issues for more complex firms, i.e., those with multiple assets,
some of which may be unrecognized.

6
Second, because of the unexpected increase in cash flow, at the end of the year the firm revises

its expectations regarding future cash flow to be a perpetuity of $1,200 instead of $1,000. Third,

the firm also revises downward its assessment of the risk associated with the asset and, thus,

revises downward the discount rate from 10% to 9%. Thus, the top section of Figure 2 shows

that the asset’s end-of-year fair value is $13,333, which is the expected $1,200 per year perpetual

cash flow divided by the 9% discount rate. The firm’s fair value earnings is $4,483, which is the

difference between the asset’s end-of-year fair value, $13,333, and the asset’s beginning-of-year

fair value, $10,000, plus the collection of the $1,150 cash flow, i.e., $4,483 = $13,333 – $10,000

+ $1,150.8

In this setting, the $4,483 fair value earnings does not reveal the value of the firm in that

fair value earnings, i.e., $4,483, divided by the end-of-year cost of capital, 9%, equals $49,811,

which is not equal to the asset’s fair value of $13,333. As the bottom section of Figure 2 shows,

one possible disaggregation of fair value earnings is based on the beginning-of-year expected

return, er, of $1,000. The unexpected components comprise the unexpected decrease in risk as

reflected by the decrease in expected return from 10% to 9% of $1,111 = $1,000/0.09 –

$1,000/0.1, the unexpected increase in expected cash flow from $1,000 to $1,200 of $2,222 =

$200/0.09, and the unexpected increase in cash flow from $1,000 to $1,150 of $150.9

8
The simple example, which includes a cash flow perpetuity assumption, could be generalized to permit expected
cash flows to differ per period and for the asset to have a finite life. For example, the example could allow for the
asset to have a finite life and be replaced at the end of its life with another asset funded by a capital contribution.
However, such generalizations would not affect the insights we draw from either the setting in which all
expectations are realized or the setting in which expectations are not met and change. To the extent that firm value
differs from the value of the single asset, e.g., the firm has an unrecognized growth option, the discussion in section
2.3 relating to unrecognized net assets applies.
9
Another possible disaggregation is an unexpected increase in expected cash flow of $2,000 and an unexpected
decrease in expected return of $1,333, which assigns the $222 interaction between them to the decrease in expected
return. The disaggregation in the bottom section of Figure 2 assigns the interaction to the increase in expected cash
flow. Nonetheless, the beginning-of-year expected return is $1,000 regardless of how the interaction is assigned.

7
Unfortunately, none of the components, including the beginning-of-year expected return, yields

earnings as value.

However, Figure 3 offers an alternative disaggregation of the $4,483 fair value earnings

that can be used to assess firm value. In contrast to Figure 2, this disaggregation is based on the

end-of-year expected return, discount rate, and expected cash flow rather than beginning-of-year.

In particular, the end-of-year expected return based on the end-of-year asset fair value of $13,333

and discount rate of 9% is $1,200 and the cash flow of $1,150 is $50 less than the end-of-year

expected $1,200 cash flow. As in Figure 2, the unexpected decrease in expected return is $1,111

and the unexpected increase in expected cash flow is $2,222, i.e., these two unexpected amounts

are computed relative to beginning-of-year expectations. Figure 4 reveals that combining the

information in Figures 2 and 3 can yield yet another alternative disaggregation that provides

additional insights by disaggregating the $1,200 expected return in Figure 3 into the beginning-

of-year expected return of $1,000 and the revision to the expected return of $200.

The Figure 4 disaggregation provides several earnings components with characteristics

that embody features of earnings desired by many financial statements users. First, the $1,200

end-of-year expected return can be characterized as permanent, sustainable, or recurring

earnings. Second, the $1,000 beginning-of-year expected return can be characterized as

expected earnings that is a benchmark against which to compare current year performance, i.e.,

earnings of $4,483. Third, the remaining unexpected components can be characterized as non-

recurring items. These disaggregated components are not arbitrary, but rather reflect changes in

fair value that are grounded in economic valuation concepts. For example, the $1,111 fair value

gain is attributable to the decrease in the risk associated with the asset’s cash flow.10

10
Penman (2007) makes a similar observation that fair value accounting can reveal information about risk that is not
apparent from historical cost-based accounting.

8
 Fair value critics might assert that such a disaggregation is neither practical nor

implementable. However, the information required to construct the disaggregation underlies all

fair value estimates and therefore changes in the estimates. This information is needed to

estimate fair value, particularly in the case of Level 3 fair values. To the extent that firms

estimate fair values based on market prices, i.e., Level 1 and perhaps some Level 2 fair values,

the prices are summary statistics reflecting these components. Presumably, even in the case of

Level 1 and Level 2 fair values, financial statement preparers are in a position to estimate

reliably the various disaggregated components. Moreover, requiring disclosure of this

disaggregation can enhance reliability of fair value estimates because financial statement users

can use the disclosures to scrutinize and challenge the validity of the preparers’ assumptions

(Aboody, Barth, and Kasznik, 2006).

2.3 Complicating Issues for More Complex Firms

The illustration in section 2.2 is based on a simplified example of a single asset firm

when the asset is measured at fair value. Real firms are more complex, which raises two

complicating issues, neither of which is unique to fair value. The first is how best to present the

disaggregated fair value earnings component information in aggregate for multi-asset and

liability firms. Presumably, earnings components relating to unexpected changes in value are not

perfectly correlated across all assets and liabilities. As a result, some of the changes in value can

be offsetting, which can result in a loss of information if the components are aggregated in the

presentation.

One possible solution to this form of information loss is to present separately positive and

negative changes in value for the components. This approach is similar to the current

requirement to present separately gross unrealized gains and gross unrealized losses on available-

9
for-sale securities. However, even if the sign of the component value change for a group of

assets or liabilities is the same, there can be a loss of information regarding the extent to which

particular assets in the group are sensitive to the source of the value change. For example, an

increase in the discount rate can result in an average loss in value for the group of assets, but

presentation as a group can mask the fact that one (or more) of the assets sustained a substantial

loss in value. Possible solutions to this form of information loss is to group assets and liabilities

based on asset life or liability term or based on particular risks to which they are exposed.11

A second complicating issue is that not all assets and liabilities are recognized.

Unrecognized assets include, e.g., internally generated intangible assets, assembled workforce,

and synergies among assets (Barth and Landsman, 1995; Barth, 2014). As a result, fair value

earnings does not include changes in value for all the firm’s assets and liabilities. In the simple

example of a single asset firm in section 2.2, the statement of financial position reveals the value

of the asset and hence the value of the firm, which makes income measurement redundant (see

Beaver and Demski, 1979).12 In real firms, income measurement is not redundant because

earnings provides information about not only recognized assets and liabilities, but also

unrecognized assets and liabilities. In this case, a disaggregation of fair value earnings based on

the simple weighted average of the expected returns for the firm’s recognized assets and

liabilities does not include the expected return associated with unrecognized assets and liabilities.

A partial solution to this problem as it relates to synergies among assets is to recognize

synergistic assets on a portfolio basis. For example, suppose a firm has two assets, each of

11
Despite there being aggregation issues arising from presentation of unexpected value change components, there is,
in principle, no issue regarding presentation of the expected return components if there are no synergies among the
firm’s assets and liabilities. This is because the aggregate expected return is simply the weighted average of the
expected returns for the firm’s assets and liabilities.
12
More generally, when all assets and liabilities are measured at fair value, income measurement is also redundant if
a firm’s assets and liabilities have uncorrelated value changes, i.e., there are no synergies.

10
which has a fair value of $100, but together they create synergies of $50, and thus the portfolio

comprising the two assets has a fair value of $250. In this case, a disaggregation of fair value

earnings based on an expected return that treats the two assets on a portfolio basis does include

the expected return associated with their synergies.13 Because such synergies arise when the

firm manages the assets and liabilities together, presumably the firm has the information

necessary to provide a portfolio-based expected return.

More generally, there is no clear solution to how to obtain a measure of earnings—

regardless of the system of measurement—that can be used in isolation to assess firm value in

the presence of unrecognized assets. For example, in the context of the example in the right-

most column of Figure 2, assume there is a second, unrecognized, asset and cash flow collected

during the year is $1,650 rather than $1,150, which implies unexpected cash inflow is $650 and

total earnings is $4,983; all other amounts are the same. In Figures 3 and 4, the unexpected cash

inflow is $450 and, again, total earnings is $4,983. In Figures 3 and 4, the $1,200 expected

return can be used to estimate the value of the recognized asset. However, it is necessary to

employ some other valuation technique, e.g., residual income, to value the unrecognized asset

and hence to estimate firm value.14 The need to estimate the value of the unrecognized asset

applies regardless of the measurement basis, i.e., fair value or historical cost, for the recognized

asset.

The disaggregation of earnings into expected return and various unexpected value change

components can be presented as an additional disclosure or can be incorporated into or used in

13
There is another complicating issue of how to allocate value changes among synergistic assets. See Barth,
Landsman, and Rendleman (1998, 2000). To the extent that the synergistic assets are viewed as a portfolio, the
allocation issue is less of a concern.
14
Unrecognized assets and liabilities are a limiting case for recognized assets and liabilities not measured at fair
value. Thus, the need to use some other valuation technique to estimate the value of an unrecognized asset also
applies to a recognized asset not measured at fair value.

11
place of the statement of comprehensive income as currently formatted. To the extent that a

large proportion of a firm’s value is attributable to unrecognized assets and liabilities, a stronger

case could be made for presenting the disaggregation as an additional disclosure. More

generally, adopting this disaggregation approach would require re-thinking other aspects of the

financial reporting package. For example, the solution to the aggregation issues highlighted

above that leads to aggregating assets and liabilities in the earnings disaggregation described in

Figure 4 also could improve the way in which assets and liabilities are aggregated in the

statement of financial position. However, we leave it to standard setters to determine whether

the disaggregation should be included in financial reports and, if so, how.

3. Comparison of Fair Value Earnings to Historical Cost-based Earnings

Penman (2007) provides an analysis of whether fair value accounting enhances or

diminishes financial reporting quality relative to historical cost accounting. This analysis

articulates several concerns held by fair value accounting critics. Unfortunately, it is difficult to

judge the merits of the conclusions reached because historical cost accounting is not well

defined. Financial statements that are prepared in accordance with US accounting standards

often are characterized as historical cost financial statements. However, unlike fair value, there

is no clear definition of historical cost that applies to all assets and liabilities. For example,

inventories generally are measured at lower of cost and net realizable value (ASC Topic 330).

Property, plant, and equipment is measured as the cost of acquiring the asset including the costs

necessarily incurred to bring it to the condition and location necessary for its intended use, minus

depreciation and impairment, if any, plus any adjustment attributable to applying fair value

hedge accounting (ASC Topic 360). Long-term debt typically is measured as the amount of

proceeds plus or minus amortization of discount or premium relative to par, adjusted for

12
restructured terms, if any, but not for changes in credit risk, even those associated with

recognized asset impairment (ASC Topic 470).

Despite lack of a clear definition of historical cost accounting, Penman (2007) proposes

several benefits of historical cost earnings. The first is that historical cost earnings can be used

to develop an estimate of value but fair value earnings cannot. The reasoning starts with the

observation that historical cost earnings can forecast future historical cost earnings, and assumes

that future historical cost earnings approximates permanent earnings. Thus, by applying the

appropriate multiple, current historical cost earnings can be used to value the firm. However, it

is unclear how this is achieved given the lack of a clear definition of historical cost accounting.

In contrast to historical cost-based earnings, fair value earnings is characterized as being

simply a shock to value, and hence it cannot be used to forecast permanent earnings. However,

as section 2.2 explains, our analysis reveals that fair value earnings comprises more than a shock

to value and a component of it can be used to value the firm. In addition, as section 2.3 explains,

fair value earnings can provide a measure of permanent earnings that includes synergies

associated with assets treated on a portfolio basis.

As section 2.3 also explains, in the presence of unrecognized net assets, neither fair value

nor historical cost-based earnings can provide complete information that can be used to obtain a

measure of permanent earnings. However, historical cost-based earnings has an additional

source of incompleteness that arises from the difference between historical cost-based measures

and fair values for recognized assets (see footnote 14). Thus, regardless of the measurement

basis, the information earnings provides is not redundant to the information asset and liability

measures provide. Feltham and Ohlson (1995) makes a similar observation by showing that the

greater is the proportion of “financial” assets—those measured at fair value—a firm has relative

13
to “operating” assets—those measured at historical cost, the smaller is the proportion of firm

value that needs to be estimated based on residual income.

The second proposed benefit is that historical cost earnings provides information about

value added by the firm but fair value earnings does not. In particular, proponents of historical

cost accounting view earnings as reporting the value-added by the firm from buying inputs,

combining them according to the firm’s business model, and selling the resulting product at a

price presumably greater than the sum of the input prices. Although it is likely that aggregate

historical cost earnings over the life of the firm measures the value added, or value lost, the

extent to which historical cost earnings in any particular period corresponds to value added

during that period is difficult to determine a priori. The extent likely depends on, among other

factors, the length of production and sales cycles of individual products, which likely vary across

products. It also depends on the particular historical cost accounting rules that apply to each of

the firm’s assets and liabilities. For example, the historical cost accounting rules that apply to

receivables depend in large part on the historical cost accounting rules that apply to revenue.

However, fair value earnings is designed to provide this information period by period, i.e., on a

timely basis (Willis, 1998). For example, fair value accounting for receivables would contribute

to a measure of earnings that reflects value added during the period.

A third proposed benefit is that historical cost earnings measures stewardship of

management in adding value to the firm. However, the extent to which historical cost earnings

provides this benefit also is difficult to determine a priori because historical cost earnings fails to

incorporate expected returns. To see this, consider a firm in which a manager purchases an asset

for 10 and sells it for 15, but the expected return based on the asset’s expected cash flows and

risk at the time of purchase was 8. Historical cost earnings of 5 obscures the notion that the

14
manager sold the asset for 3 less than expected, i.e., 15 instead of 18. As section 2.2 explains,

fair value earnings, with appropriate disaggregation, provides the expected return of 8 and

unexpected loss of 3.15 In the context of the example illustrated in Figure 4, the $1,000

beginning-of-year expected return on the asset can be used as a benchmark against which to

assess management stewardship. In this example, the asset’s return of $4,483 greatly exceeds its

beginning-of-year expected return of $1,000, which can be interpreted, at least in part, as

superior management performance (Willis, 1998).

Determining the extent to which fair value or historical cost-based earnings—or

particular components thereof—is appropriate to include in managerial compensation contracts,

or any other contracts, involves factors that we do not address. For example, as discussed in

section 4, there may be contracting motivations for application of conservative accounting.

4. Implementation Issues that Can Affect the Informativeness of Fair Value Earnings

In addition to the aggregation and unrecognized assets and liabilities issues discussed in

section 2.3, there are a variety of practical implementation issues that can impair the

informativeness of fair value earnings. First, because many fair values must be estimated, they

are subject to estimation error. If such error is large enough, then the disaggregation of fair value

earnings components we offer in section 2.2 will be uninformative to financial statement users.

Second, because managers may have incentives to manipulate fair value estimates, the resulting

estimates could be biased. In this circumstance, the disaggregation can provide misleading

information for valuation. Such issues are well understood (e.g., Landsman, 2007; Barth, 2014)

and therefore we do not elaborate on them here.

15
Penman (2007) recognizes that historical cost earnings has shortcomings for valuation, e.g., the failure to
recognize all intangible assets, but makes the observation that such shortcomings can be overcome by combining
information in earnings and equity book value. However, this observation applies equally to such potential
shortcomings of fair value earnings. See also section 2.3.

15
 More importantly, these issues are not peculiar to fair value accounting. First, virtually

all historical cost-based amounts require estimation, and it is unclear whether such estimates are

more or less free from error than fair values particularly because, as explained in section 3.1,

typically there is no objective of measurement for historical cost-based amounts after initial

recognition. Second, managers also have incentives to manage historical cost-based estimates,

and there is a large literature finding that such incentives lead to biased historical cost-based

accounting amounts (see, e.g., Healy and Wahlen, 1999, for a review). As a result, whether such

incentives lead to more misleading financial statement amounts based on fair value or historical

cost-based accounting is an open question.

The managerial incentives issues have led some to advocate conservative accounting as

an important characteristic of financial reporting and, as a result, to reject fair value accounting

(see, e.g., Watts, 2003). The logic underlying the desirability of conservatism rests upon the

belief that verifiability is of paramount importance in financial reporting. However, the FASB

and IASB concluded that verifiability is an enhancing characteristic of decision-useful

information, not a fundamental characteristic (FASB, 2010; IASB, 2010).16 Also underlying the

logic for the desirability of conservatism is the proposition that conservative amounts are more

verifiable than those based on fair value accounting. However, this proposition is inconsistent

with the fact that some conservative practices do not necessarily result in accounting amounts

that are verifiable. For example, banks measure loans at amortized cost adjusted for allowance

for loan losses, which are widely criticized for lacking verifiability.17 In addition, this

16
Relatedly, Lambert (2010) questions why accounting standard setters should develop standards to address agency
problems with managers, which underlie the notion that verifiability is of paramount importance in financial
reporting, and offers alternative mechanisms to address these problems. Lambert (2010) also questions how
conservatism should be applied given that verifiability is not dichotomous, e.g., “[i]f one item (or transaction) is
slightly less verifiable than another, do we apply slightly more conservatism to it?” (p. 293).
17
There is an extensive literature providing evidence that banks’ loan loss provisioning is influenced by incentives
to manage earnings and regulatory capital (e.g., Ahmed, Takeda, and Thomas (1999) and Wall and Koch (2000)).

16
proposition is inconsistent with the fact that some conservative practices are based on fair value

measures, e.g., asset impairment (ASC Topic 360).

5. Concluding Remarks

Whether and the extent to which fair value accounting should be used in financial

reporting has been the subject of debate for many years. Although there are many dimensions to

the debate, a key one is whether fair value earnings can provide information to financial

statement users that is helpful in making their economic decisions. Black (1980) observes that

even though accountants do not profess to create an earnings amount that approximates

permanent earnings, they have done a remarkably good job of doing so. Black refers to this as

the magic in earnings. A key criticism of fair value accounting is the contention that fair value

earnings is that it simply reflects “shocks” to value, not permanent earnings. However, this

criticism fails to take account of the information embedded in the changes in fair value. In

particular, fair value earnings can be disaggregated into components that can be used to assess

firm value, as well as components that provide information about various types to shocks to

value, e.g., effects of changes in expected cash flows. This disaggregation is possible because

fair value embodies expected return on the firm’s assets, as well current expectations of future

cash flows and risk. Thus, fair value earnings can be used to assess firm value.

17
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 Figure 1

Fair Value Earnings: All Expectations Realized and No Changes in Expectations

Asset fair value end of year: $1,000 per year at 10% $10,000
Asset fair value beg. of year: $1,000 per year at 10% 10,000
Change in fair value $0
Cash collected during the year 1,000
Fair value earnings $1,000

Expected return on asset: $10,000 at 10% $1,000

Unexpected decrease in expected return 0
Unexpected increase in expected cash flows 0
Unexpected cash inflow 0
Fair value earnings $1,000

This figure illustrates fair value earnings for a firm with a single asset that has expected cash
flows of $1,000 per year in perpetuity with a discount rate of 10%. During the year, the firm
collects $1,000, as expected, and there are no changes in expectations.

21
 Figure 2

Fair Value Earnings: Realizations Differ from Expectations and Changes in Expectations

Expected at
beg. of year Actual
Asset fair value end of year: $1,200 per year at 9% $10,000 $13,333
Asset fair value beg. of year: $1,000 per year at 10% 10,000 10,000
Change in fair value $0 $3,333
Cash collected during the year 1,000 1,150
Fair value earnings $1,000 $4,483

Expected return on asset: $10,000 at 10% $1,000 $1,000

Unexpected decrease in expected return: 10% to 9% 0 1,111
Unexpected increase in expected cash flows: $1,000 to $1,200 0 2,222
Unexpected cash inflow: $1,150 instead of $1,000 0 150
Fair value earnings $1,000 $4,483

This figure illustrates fair value earnings for a firm with a single asset that has expected cash
flows of $1,000 per year in perpetuity with a discount rate of 10%. During the year, the firm
collects $1,150, which exceeds expectations by $150. In addition, expected cash flows for
subsequent years increase by $200 per year to $1,200, and the discount rate decreases from 10%
to 9%.

22
 Figure 3

Disaggregation of Fair Value Earnings to Assess Firm Value

Expected return on asset: $13,333 at 9% $1,200

Unexpected decrease in expected return: 10% to 9% 1,111
Unexpected increase in expected cash flows: $1,000 to $1,200 2,222
Unexpected cash inflow: $1,150 instead of $1,200 –50
Fair value earnings $4,483

This figure provides an alternative disaggregation of fair value earnings illustrated in Figure 2 for
a firm with a single asset that has expected cash flows of $1,000 per year in perpetuity with a
discount rate of 10%. During the year, the firm collects $1,150, which exceeds beginning-of-
year expectations by $150, but is below end-of-year expectations by $50. In addition, expected
cash flows for subsequent years increase by $200 per year from $1,000 to $1,200, and the
discount rate decreases from 10% to 9%.

23
 Figure 4

Disaggregation of Fair Value Earnings to Assess Firm Value as well as to Provide a

Benchmark for Assessing Current-year Performance

Expected return on asset beg. of year $1,000

Update of expected annual cash flows 200
Expected return on asset end of year $1,200
Unexpected decrease in expected return: 10% to 9% 1,111
Unexpected increase in expected cash flows: $1,000 to $1,200 2,222
Unexpected cash inflow: $1,150 instead of $1,200 –50
Fair value earnings $4,483

This figure provides an alternative disaggregation of fair value earnings illustrated in Figure 2 for
a firm with a single asset that has expected cash flows of $1,000 per year in perpetuity with a
discount rate of 10%. During the year, the firm collects $1,150, which exceeds beginning-of-
year expectations by $150, but is below end-of-year expectations by $50. In addition, expected
cash flows for subsequent years increase by $200 per year from $1,000 to $1,200, and the
discount rate decreases from 10% to 9%.

24