210 PAIH 2 Theory ami accounting practice

Fair value or false accountingby Anthony Rayman

Forget Enron; forget WorldCom; forget Parmalat. Dishonest accounting can do enormousdamage - but nowhere near as much as the honest variety.

'Fair value accounting' is the most recent example. The title sounds wonderful, butits promotion by the International Accounting Standards Board (lASB)threatens to bringthe profession into even greater disrepute by institutional ising false accounting on aglobal scale.

According to lAS39, Financial Instruments: Recognition and Measurement, financialinstruments are to be stated at their 'fair value' - defined as 'the amount for which anasset could be exchanged, or a liability settled, between knowledgeable, willing partiesin an arm's length transaction'.'If the market for a financial instrument is not active, an entity establishes a fair value

by using a valuation technique ... [including] discounted cash flow analysis and optionpricing models,' says lAS 39. 'A gain or loss on a financial asset or financial liabilityclassified as at fair value through profit or loss shall be recognised in profit or loss.'

As far as financial instruments are concerned, fair value accounting is notable for itscloseness 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,lAS 39 looks like a passport to the promised land of 'truth and fairness of view'.

Before leaping on to this particular bandwagon, however, it may be a good idea to tryit out on a test-track - an economic utopia of perfectly competitive markets.

The beauty of an economic utopia is that it provides the most favourable conditions forfair value accounting: the change in recorded equity based on 'fair value' coincides withthe academic ideal of 'present value growth' as J measure of economic performance.

The following article strongly criticises the notion of fair values and the measurementoffinancial assets under lAS 39/AASB 139.

Additional readingsAl-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,

pp.265-79.

RequiredPrepare journal entries to record the events, as well as the income statement for Year 10and balance sheet as at 31 December Year 10, under the exit price method. Assume thedebenture is not part of capital and is a financial investment.

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A cau tionarv taleWith the (perfect) market rate of interest at 8% per annum, the Fair Value Companyinvests the whole of its investors' capital of 100m in 'financial instruments'. Theseare various equity shareholdings with expected cash dividends totalling 0 m pa. Thecompany has no other assets or liabilities.

Suppose an 'event' occurs - perhaps fear of a previously unexpected economicrecession. Suppose this event causes (1) the market expectation of the annual dividendsto be revised downwards to 5.5 m, and (2) the monetary authority to lower the rateof interest to 5% pa. As a consequence, the market value of the company's financialinstruments rises from {8 mlO.08 =1100 rn to {S.S mlO.OS =1 110 m.

The 1 0 m increase in the 'fair value' of the company's 'financial instruments' is basedon 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, themarket value of the company's share capital also rises from 1 00 m to 110m. Investorsin the Fair Value Company therefore have the opportunity of selling their shares andspending 1 0 m more than before.

From every point of view, it looks like an open-and-shut case in favour of lAS 39 andreporting a gain of 1 0 m - but appearances can be deceptive.

Only if investors actually take the opportunity of realising the market value andspending it immediately, are they able to spend 10 m more than they could beforethe 'event'. If they save for one year before actually spending, the extra spending madepossible by the 'event' is only 7.5 m; and the equivalent present sum (at S% pal at thebalance 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 'fairvalue'. If all the investors intend to save for eight years, the 'event' reduces the amountavailable for spending by 22.6 m. To cover this shortfall, the compensation that wouldbe 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 1 Sm, 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. Thebelief in the relevance of 'value change' as a measure of financial performance is theresult of a fallacy deeply entrenched in the conventional academic wisdom.

The present-value fallacyAt an)' given moment, a higher market value is unquestionably preferable to a lowermarket value. Irrespective of subjective preferences, 110 m will (through borrowingor 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 differentmoments. That is why it does not necessarily follow that a 10 rn increase in marketvalue over a period represents a gain. The fallacy underlying the IASB's standard onfair value accounting lies in following the conventional wisdom and assuming that itdoes.

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, itis sufficient to demonstrate that the academic ideal is false and that growth in presentvalue (= 'fair' market value) is not reliable as a measure of economic performance.

(For readers with the patience to endure a spot of general economic equilibriumanalysis complete with Fisher diagrams, a rigorous proof is available in the author'sbook on accounting reform: Accounting Standards: True or False? london: Routledge,2006.)

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CHAPTER fI Accounting measurement systems 211

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PART 2 Jheorv and .1n:ouoting pr.1C1icp

Questions1. How are assetsand liabilities measuredunder lAS39?2. What impact according to the author, will fair value accounting have on the balance

sheetand income statement?3. What measurementrequirement of historical cost accounting is violated?4. Isa change in assetvalue an increasein wealth or income?Are they the same?5. What do you think fundamental value in accounting should be?Refer to the debate

regardingvalue in useand value in exchangeoutlined in this chapter when answeringthis question.

The accounting implicationsThe moral of the story is that there is nothing wrong with fair values in the balancesheet; 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 financialposition, the disclosure of fair values is a development to be welcomed - as anindication of the available market opportunities. On the balance sheet of the Fair ValueCompany after the 'event', no figure has a greater claim to relevance as a measure ofthe net assets than their fair value of 11 0 m.

But opportunities are not the same as actual transactions. The very fact that an itemappears 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 'valuechange' may simply be the difference between hypothetical opportunities that haveactually been discarded. What is in question, therefore, is the relevance of fair value forreporting financial performance.

An accounting standard which generates a fair value 'gain' of 10 m in response toa fall in the expected annual returns from the Fair Value Company's net assets from8 m to 5.5 m does not inspire confidence. The 'event' is responsible for an increasein fair value of the company's net assets from 100 m to 110 m. A gain of 10mis a 'true and fair view' of the result on one assumption only: that the fair value isrealised and actually consumed at the balance sheet date. The most common reasonfor investing, however, is to save for the future. Of all the assumptions that couldhave been chosen, immediate consumption is the least likely. It is ruled out almostby definition.

Many savers and pensioners in the UK have become materially worse off as a directconsequence of events that would be reported in 'fair value' accounts as substantial'gains'. The propagation of the market-value fallacy has made a substantial contributionto 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 Companyhas fallen from 8% pa to 5'12% pa .. IAS 39 requires the accounts to report a gain of10 m equal to 10%on capital. This is in clear breach of Englishcriminal law: 'Whereaperson ... in furnishing information for any purpose produces ... any account ... whichto his knowledge is or may be misleading, false or deceptive in a material particular; heshall, on conviction on indictment, be liable to imprisonment for a term not exceedingseven years' (s17, Theft Act 1960).

lAS 39 is calculated to bring the profession into disrepute. But who is reallyresponsible - those who do their best to operate, with honesty and integrity, inaccordance with the standards- or the IASBwhich setsthem?Source: Excerptsfrom Accountancy, October 2004, pp, 82-:1.