Special Issue: Fair Value in Financial Reporting, Auditing, and Tax Accounting
Casabona, Patrick A., Gornik-Tomaszewski, Sylwia, Review of Business
During most of the last century, standard setters emphasized historical cost accounting. Under this traditional accounting model, the income statement, which results from matching an entity's revenues with expenses during a period of time, was considered the primary financial statement conveying useful information about a company's performance and value to shareholders. The balance sheet was considered a by-product of the matching process, since it contained such categories as prepaid expenses, unearned revenues, accrued expenses, and accrued revenues. Financial statements prepared under the historical cost convention were and are still perceived by many today to be reliable, relatively easy to verify, and straightforward to understand.
Historical cost accounting was sufficient as long as a company's assets consisted mostly of identifiable tangible assets. With the increased prominence of intangible assets, such as intellectual capital, human resources, brand names, technology advances, or corporate culture, this accounting model resulted in under-valuing and under-recording assets that contributed significantly to the achievement of a company's strategic goals and objectives. For example, intangible assets that are recorded in the balance sheet--purchased copyrights, patents, and other legal rights--are recorded at historical cost. Other intangible assets, such as brand assets, assets arising from marketing and supplier relationships, and knowledge assets developed from research and development are not recorded at all. Consequently, great disparities between companies' book and market values have been observed, and the users of financial statements have pressed for more relevant fair-value information.
For the past decade, to improve the decision-making relevance of financial statements, the Financial Accounting Standards Board (FASB) has been adding more fair value recognition, measurement, and disclosure standards to the body of U.S. generally accepted accounting principles (U.S. GAAP). The International Accounting Standards Board (IASB) follows a similar approach. As a result, a mixed accounting model has been developed, which is still primarily based on historical cost but with an ever increasing application of fair value accounting. Consequently, a shift has occurred in recent years towards using the balance sheet as the primary financial statement conveying information to shareholders, and the income statement reporting economic income as simply the change in value over a period of time.
Although recent accounting standards reflect increasing acceptance of fair value as a measurement attribute, the shift towards the fair value accounting model has not been without controversies. Fair value accounting information continues to be criticized as being less reliable than historical cost, especially when based on subjective assumptions. Estimation errors introduce distortion not only into the balance sheet, but also into the income statement. Furthermore, unrealized changes in fair values from one period to the next, which must now be reported as gains and losses in financial statements, distort the results of operations, if and when they flow through the income statement each period. And finally, fair value accounting requires proper matching of assets and liabilities, which is even more difficult to implement than the matching of revenues and expenses under a historical cost model.
Existing empirical evidence does not resolve these controversies. Empirical findings suggest that the reliability of fair value estimates varies with the extent to which fair value estimates include publicly observed market-based versus management-produced information. The most consistent evidence regarding the reliability of fair value estimates is found for investment securities traded in active markets. The evidence regarding the reliability of other fair value estimates is rather limited. Furthermore, the empirical research on the reliability of fair value estimates is largely derived from the analysis of banks and other financial institutions for which financial instruments comprise core operating assets and liabilities. …