#2973 - Stream 3 Reading Fair Values, Imaginary Prices, Mystical Markets - Financial Accounting, Analysis and Valuation

Accruals give some indication of managerial expectations about the future

A sufficient understanding of fair value measurements of assets and liabilities is that they are based on actual estimates of specific market values

The appeal of fair value is that there is the perception that it increases the social value of accounting information

• It minimizes the freedom for managerial manipulation

However, reliability may come at high cost as surely investors are interested in expected opportunities to earn profits above normal returns – super profits - as seen by management

They are supposedly objective, as actual market prices are empirical phenomena, publicly available and can be verified by all

However, additional assumptions are required that may not sit easily with the world in which accounting exists

Even the FASB draft on Fair Value Measurement (FASB 2004) does not contain a full case for fair values, being mainly concerned with problems in the measurement of fair values

There is a reluctance to discuss formally the rationale of fair value

• This is also the case with the IASB

  • Standards utilizing fair value do not provide either a rationale or theoretical case for using fair value measurement

Fair values are estimates of the market prices which would be obtained in contracts (transactions) between buyers and sellers of individual accounting items if these items were either to be sold on the market (exit prices) or replaced on the market (entry prices) even when such markets do not exist

Transaction costs do not enter into estimates of fair value prices

• Because going concerns will at any given time not generally plan to either sell or replace their entire set of assets and their liabilities portfolio

  • Therefore will not incur transaction costs at the time of accounting measurement

• Another argument is that such costs are not recoverable in the market anyway

Principle that fair values should not incorporate entity-specific views

It is not yet clear whether alterations in market values and estimates of market values incorporated into financial reports will be priced by the market in the same way as the accounting results flowing from corporate transacations

• There is however, substantial evidence that fair values may be value relevant, i.e. have an effect on stock prices in some circumstances (Barth and Landsman, 1995)

As a result, fair values may differ from transaction prices in actual markets (even where markets are available)

USA Accounting Principles Board (APB) – 1973

• Fair value ‘should be determined by referring to the estimated realizable values in case of transactions of the same or similar, assets, quoted market prices, independent appraisals, estimated fair values of assets of services received in exchange and other available evidence’

  • This is referring to exit value

Current definitions include:

• FASB 1998 – The amount at which an asset could be bought or sold in a current transaction between willing parities, that is, other than a forced or liquidation sale

• FASB 2004 – The price at which an asset or liability could be exchanged in a current transaction between knowledgeable willing, unrelated parties

• IASC 1995 – The amount for which an asset could be exchanged, or a liability settled, in a current transaction between knowledgeable willing parties in an arm’s length transaction

The IASB to accept the third definition by FASB but feel that entry prices, may represent fair value in some cases

Market prices for many assets, especially intangibles, either do not exist or are not recognized in financial statements

FASB has felt it necessary to present a substantial number of assumptions that it sees as necessary to allow the definitions to work

• Have remained implicit in the IASB standards and much of its literature

Two crucial assumptions:

• Selling entity views should not form the basis of fair values

• Irrespective of market imperfections and market failure, it is possible to simulate the market prices acceptable in determining fair values

When no suitable markets exist, additional assumptions are needed to determine the character of the imaginary markets to be assumed to exist

How do you remove the super-profits incorporated into the prices charged by a monopoly supplier of assets? (Bromwich, 1977)

Is there any reason to assume that the managers of companies are able or willing to estimate fair values?

Other assumptions include:

• Market participants are assumed to act prudently

• Buyers must actually be interested in the precise asset in question

If fair values involve arm’s-length transactions, market participants cannot be...