AN ANALYSIS OF THE FAIR VALUE CONTROVERSY

Abstract

During the recent financial crisis fair value accounting received its share of the blame for the meltdown. There were those that argued that the measurement system used in fair value accounting was not related to cash flow, worked well in an orderly market but not in a market requiring forced liquidation, did not clearly spell out that financial instruments should have been valued at Level 3 inputs instead of Level 1 inputs in a seized market, and created an arena in which accountants were not fully equipped to participate. People also questioned exactly what was to be depicted by fair value accounting—the market value of the entity or the success or failure of management in operating the business. Then there were others that argued that the financial meltdown was caused by a host of factors totally unrelated to fair value accounting. These factors included financial illiteracy, excessive leverage, rampant speculation, relaxed lending standards, mortgage innovations, failed regulation, unqualified borrowers, contagion in the market, and greedy investment bankers/institutional investors. Fair value accounting may have exacerbated the problem but, it was argued, served only as a scoreboard. However, it appears that the contribution of fair value accounting to the mortgage crisis was more the result of the fact that accountants, auditors, and investors were uneducated or undereducated with regard to fair value accounting. Fair value accounting has only been on the scene since 2006. As such only a handful of those in the financial arena have a firm grasp on fair value accounting. Most of the people in the financial community studied the traditional accounting model—the accrual basis model that is grounded in cash. Fair value accounting changes the recognition and measurement criteria that financial statement users are accustomed. Fair value accounting is not grounded in cash. Management ran the business as if the unrealized gains arising via fair value accounting were realized in the form of cash. Fair value accounting obscured the intrinsic value of the firm in favor of the market value, failed to adequately reflect the stewardship function of management, and stakeholders were ill prepared to adequately analyze the performance of an entity using fair value accounting. The fact is that fair value accounting is now only being fully absorbed into college curriculums. Finance textbooks are at least a decade behind with regard to the changing nature of financial statements, still teaching the same old performance metrics that may not apply to current financial statements. The only financial statement that transcends fair value accounting and the traditional accounting model is the cash flow statement. There should be increased emphasis placed on the cash flow statement, both in practice and in education. Maybe the cash flow statement should be moved to the front of the financial statements instead of the rear. The numerous financial ratios that have been developed for the cash flow statement are mostly only used by auditors. These ratios should make their way into textbooks and stakeholders also need to become acquainted with these analytical tools.

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