Brave the new world

There has been a sea change in accounting’s orientation regarding valuing
assets and liabilities from an historical cost perspective to a fair value
perspective.

Today, fair value is the predominant measurement method. My review of the
accounting and finance literature suggests that, while fair value is frequently
found to be more relevant and timely than other measurement systems by investors
and users of financial statements (i.e. vis-à-vis historical cost), questions
remain about its perceived reliability.

While arguably more relevant, bona fide concerns have been raised over
whether fair value, because of the increase in required estimates and
assumptions, may introduce greater subjectivity and bias.

The risk is that if users of financial statements have concerns about
financial statement reliability, the end result will be that statements will
lose credibility with the very population they were intended to serve.

Obviously financial instruments are risky. It is possible that realised
values will differ from estimated fair values, even with perfect information,
complete transparency and neutrality.

Fair values can be based on observable inputs such as market quotes from an
organised exchange and from similar financial instruments. Those values are
generally not viewed with controversy.

However, inputs that a market participant would use when an asset or
liability lacks a ready market or when there are unobservable inputs, risk
increases that the value reported can deviate from fair value.

It is unlikely that accounting standards will ever retreat from a fair value
orientation.
Therefore, the burden faced by preparers of financial statements becomes one of
addressing concerns about minimising bias to ensure that the market place views
fair value estimates as both relevant and reliable.

While large broker dealers have invested in the infrastructure to comply with
fair value, not all investors have the infrastructure to create such complex
models. Valuation skills are critical in this environment.

Finally, you cannot trivialise the effort and risks involved in implementing
fair value accounting.

The objective of fair value is to provide financial statements that yield
greater relevance.

Accomplishing this objective will require companies, auditors and regulators
to understand the subtleties and complexities of valuing assets and liabilities,
where it is particularly hard to value them.

Larry Levine is a director in financial advisory
services at RSM McGladrey