FAIR VALUE ACCOUNTING has changed the way financial information is presented. Where once financial statements were based primarily on historical costs, under certain circumstances, fair value is often the basis of measurement for reporting for both financial and nonfinancial assets and liabilities. Measuring fair value often requires experience and judgment, and it has the potential to introduce bias into financial statements. A trend toward increasing the amount of financial statement information presented or disclosed at fair value persists under U.S. generally accepted accounting standards (GAAP) and International Financial Reporting Standards (IFRS). The trend away from historical costs, which has been the bedrock of traditional accounting, toward fair value accounting has been challenging for preparers, auditors, standards setters, and regulators.
Fair value accounting is a financial reporting approach that requires or permits entities to measure and report assets at the price assets would sell and liabilities at the estimated price that a holder would have to pay in order to discharge the liability. The term fair value accounting not only refers to the initial measurement but can also refer to subsequent changes in fair value from period to period and the treatment of unrealized gains and losses in the financial statements. Therefore, fair value accounting affects the reported amounts for assets and liabilities in the balance sheet and affects the reported amounts for unrealized gains or losses shown in the income statement or in the other comprehensive income section of shareholders' equity. In financial reporting, fair value accounting is often applied to financial instruments such as investments in stocks, bonds, an entity's own debt obligations, and derivative instruments like options, swaps, and futures. When unadjusted or adjusted market prices are the basis for fair value estimates of financial assets and liabilities, the process is often called mark‐to‐market accounting.
Fair value accounting is applicable to nonfinancial assets and liabilities as well, but in more limited circumstances. For instance, when an entity is acquired in a business combination, all balance sheet assets and liabilities are recorded at fair value. Subsequent to the acquisition date, fair value is the basis for testing acquired goodwill for impairment. Likewise, fair value is the benchmark when testing property, plant, and equipment and amortizable intangible assets for impairment.
Fair value measurement is the process for determining the fair value of financial and nonfinancial assets and liabilities when fair value accounting is required or permitted. Therefore, fair value measurement is broader than mark‐to‐market accounting. It encompasses estimating fair value based on market prices as well as estimating fair value using valuation models. The Financial Accounting Standards Boards (FASB) Accounting Standards Codification (ASC) 820, Fair Value Measurement, provides authoritative guidance for measuring the fair value of assets, liabilities, and equity interests when fair value accounting is required or permitted in other accounting standards. The International Accounting Standards Board (IASB) has an identical standard, IFRS 13, Fair Value Measurements.
Advocates of fair value accounting believe that fair value best represents the financial position of the entity and provides more relevant information to the users of the financial information. Detractors believe that fair values are unreliable because they are difficult to estimate. Critics also believe that reporting temporary losses is misleading when they are likely to reverse, and those critics believe that reported losses adversely affect market prices and market risk.1
In spite of the criticism, fair value accounting has become more prominent in financial statement presentation and will continue to be a fundamental basis for accounting in the future.
In December 2018, the IASB published a postimplementation review of IFRS 13, Fair Value Measurements, which is conducted periodically by both the IASB and the FASB to determine whether accounting standards are working as intended. In a summary of their findings, the IASB concluded the following:
- “The information required by IFRS 13 is useful to users of financial statements.
- Some areas of IFRS 13 present implementation challenges, largely in areas requiring judgment. However, evidence suggests that practice is developing to resolve these challenges.
- No unexpected costs have arisen from application of IFRS 13.2
The IASB further concluded that the findings of the postimplementation review on fair value measurements should be incorporated into the project about better communication in financial reporting. The Board also concluded that it needed to better liaise with the valuation profession, including monitoring new developments with valuation specialists.
WHY THE TREND TOWARD FAIR VALUE ACCOUNTING?
In recent years, there has been an increasing trend toward the use of fair value accounting in financial reporting. Even when fair value accounting is not required and financial statements are prepared using some other measurement basis, there is a likelihood that related disclosures will require the presentation of fair value information. Several factors are influencing the trend toward fair value accounting: the growing economic importance of intellectual property, globalization, and investors' desire for financial statements that are more relevant and transparent.
The Changing Economy
The economy in the United States has undergone tremendous changes over the past quarter‐century due to a rapid rate of technological innovation. The explosion in the use of personal computers and digital media has created whole industries that did not previously exist. One product of technological innovation that contributed to economic change is the commercialization of the Internet, which resulted in what some call the information revolution. The result of this technological and economic change is that a significant portion of the U.S. economy shifted from bricks‐and‐mortar businesses to information‐based businesses.
This economic change has led to a growing recognition that the value driver of many business entities lies within their intellectual property, not just in their inventory, plant, and equipment. Financial statement users also recognize that intellectual property has not been effectively measured under traditional cost‐based accounting practices. The reason is that existing accounting principles require internally created intellectual property to be expensed as research and development.
Ocean Tomo, an intellectual capital merchant banking firm, produces an Annual Study of Intangible Asset Market Value that breaks down the Standard & Poor (S&P) 500's equity market value into an implied intangible asset value and a tangible asset value. In 2015, tangible and financial assets generated approximately 13 percent of the S&P 500's market value. While tangible and financial assets are reflected on company balance sheets, the remaining 87 percent of value attributable to intangible assets is often not recognized at all.3
The market‐to‐book ratio for the S&P 500 as of December 31, 2018, was approximately 2.944
This ratio indicates that only about a third of the value of the market capitalization on average is recognized by current accounting standards. This value gap has increased in recent years, highlighting the increasing importance of intangible assets (including intellectual property) in the overall market capitalization of publicly traded companies.
The International Monetary Fund defines economic globalization
as “a historical process; the result of human innovation and technological process. It refers to the increasing integration of economies around the world, particularly through the movement of goods, services and capital across borders.” Globalization has accelerated since the 1980s as a result of technological advances that made international financial and trading transactions easier and quicker.5
This increasing globalization of business has created a need for consistent accounting standards across national boundaries.
The FASB and the IASB recognize that users of financial statements would benefit from having one set of international accounting standards that could be used for domestic and international, cross‐border financial reporting. As a result, both organizations have been working for several years to jointly create accounting standards and to converge U.S. GAAP with ...