Describe Financial Statements and Accounting Methods Used

  

Address the following questions. Your research efforts should provide you with the knowledge, understanding, and insight, to respond and enable you to:Present and describe the components of the balance sheet. Use illustrative numerical examples to clarify the discussion. Highlight what you feel are the four most important accounting methods used for the development of this statement.Present and describe the components of the income statement. Use illustrative numerical examples to clarify the discussion. Highlight what you feel are the four most important accounting methods used for the development of this statement.Review the Penman (2007) article and describe the nature of the research questions and the primary conclusions advanced.Support your paper with a minimum of five (5) external resources In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included.Length: 5-7 pages not including title and reference pagesYour paper should demonstrate thoughtful consideration of the ideas and concepts presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards.
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Accounting and Business Research Special Issue: International Accounting Policy Forum. pp. 33-44. 2007
33
Financial reporting quality: is fair value
a plus or a minus?
Stephen H. Penman*
Recent deliberations by both the International
Accounting Standards Board (IASB) and the
Financial Accounting Standard Board (FASB) in
the United States have focused on how fair values
of assets and liabilities should be measured. The
issue of when, rather than how, fair value measurement should be applied is still far from resolved,
however. Fair values have been mandated for
some assets and liabilities under both IASB and
FASB standards, but it is fair to say that principles
governing the applicability of fair values have yet
to be articulated: when is fair value accounting appropriate and when is it not? Or, in terms of my
charge for this paper, under what circumstances is
fair value a plus or a minus?
To prepare for my task, I made a survey of public statements made for and against fair value accounting by a variety of standard setters,
regulators, analysts, and preparers. The stated ‘minuses’ typically point to the dangers of fair value
estimates from marking to model rather than marking to market, concerns about introducing ‘excess
volatility’ into earnings, and feedback effects (on
banks’ lending practices, for example) that could
damage a business and, indeed, heighten systematic risk. A few antagonists question whether fair
values (for bank assets and liabilities, for example)
really capture the economics of a business (in fostering core deposits and making loans). In counterpoint, the proponents of fair value argue that fair
value is a superior economic measure to historical
cost. Consider the following arguments, often advanced as ‘pluses’:
• With the passage of time, historical prices become irrelevant in assessing an entity’s current
financial position. Prices provide up-to-date information about the value of assets.
• Investors are concerned with value, not costs, so
report fair values.
1. Some preliminaries
*The author is at the Graduate School of Business,
Columbia University, shp38@columbia.edu This paper draws
on some of the themes in a White Paper prepared for the
Center for Excellence in Accounting and Security Analysis
(CEASA) at Columbia Business School. See D. Nissim and S.
Penman, The Boundaries of Fair Value Accounting, White
Paper No. 2 (Center for Excellence in Accounting and
Security Analysis, Columbia University, 2007). Comments received at the Information for Better Markets Conference have
been helpful as has a close reading of the manuscript by
Martin Walker and Pauline Weetman.
• Fair value accounting reports assets and liabilities in the way that an economist would look at
them; fair values reflect true economic substance.
• Fair value accounting reports economic income:
in accordance with the widely accepted Hicksian
definition of income as a change in wealth, the
change in fair value of net assets on the balance
sheet yields income. Fair value accounting is a
solution to the accountant’s problem of income
measurement, and is to be preferred to the hundreds of rules underlying historical cost income.
• Fair value is a market-based measure that is not
affected by factors specific to a particular entity;
accordingly it represents an unbiased measurement that is consistent from period to period and
across entities.
So self-evident do these points seem to be that
fair value accounting is often just presumed to be
‘more relevant’. The words, ‘fair value’ sound
good (who could be against ice-cream and fair
value?!) while ‘historical cost’ sounds, well, passé.
As it turns, out, however, each of these statements
becomes qualified under scrutiny. Can economic
argument lead to constructive arguments for implementing fair value accounting?
Pluses and minuses can only be evaluated against
an alternative, so I will take the approach of asking
if (or under what conditions) fair value accounting
is an improvement over historical cost accounting.
In discussions about fair value, people often proceed at cross-purposes, so a few points need to be
clear before we proceed.
1.1. What is fair value?
Three notions of fair value accounting enter the
discussion, and one must be clear which is being
entertained.
34
ACCOUNTING AND BUSINESS RESEARCH
1. Fair value variously applied in a ‘mixed attribute model’:
In this treatment, fair value is used alternatively with historical cost for the same asset or liability but at different times; the accounting is
primarily historical cost accounting, but fair
values are applied under certain conditions.
Examples are fair values applied in fresh-start
accounting (that then proceeds under historical
cost accounting), impairment from historical
cost to fair value (really a form of fresh-start
accounting), using fair values to establish historical cost (for barter transactions and donations, for example) or in the allocation of
purchase price (between goodwill and tangible
assets, for example), and reference to fair value
to discipline estimates under historical cost accounting.
2. Fair value continually applied as entry value:
Assets are revalued at their replacement cost,
with current costs then recorded in the income
statement, with unrealised (holding) gains and
losses also recognised. Revenue recognition
and matching is maintained but income, based
on current costs, is said to be a better indicator
of the future and not path-dependent.
3. Fair value continually applied as exit value:
Assets and liabilities are remarked each period
to current exit price, with unrealised gains and
losses from the remarking recorded as part of
(comprehensive) income.
The pluses and minuses of fair value in applica1 For example, impairment to fair value under application
(1) fresh-starts the matching of expenses to future revenues
when there is a downward revision in future revenues anticipated, that is, cost have expired. Application (2) matches current costs rather than historical costs to (current) revenues.
FASB Statement 33 (now suspended) was an experiment with
application (2), but those issues are not part of the current debate. See Statement of Financial Accounting Standards No.
33, Financial Reporting and Changing Prices (Norwalk,
Conn.: FASB, September 1979).
2 See Statement of Financial Accounting Standards No. 157,
Fair Value Measurements (Norwalk, Conn.: FASB, September
2006), paras 5–15 and Discussion paper, Fair Value
Measurements Part 1: Invitation to Comment (London: IASB,
November 2006).
3 Statement 157 is explicit in stating that the standard deals
with the measurement of fair value (when fair value measurements are applicable), not with the issue of when fair value
measurements are applicable. IASB discussion documents
have the same flavour. However, the application question is
very much open and (presumably) part of the conceptual
framework agenda.
4 Under application (3), some assets or liabilities might be
carried at fair value (continually) while others are carried at
historical cost (continually). So, marketable securities might
be marked to market, with inventories at historical cost. This
form of a ‘mixed attribute model’ differs from moving between fair value and historical cost for the same asset and liability.
tions (1) and (2) can be debated, but note that both
are really modified cost accounting; both maintain
standard revenue recognition – applying exit
prices to recognise value from business activity
only on actual exit of the product or service to the
market – but with modifications to the expense
matching.1 Application 3 applies exit values to
continually remark assets and liabilities but without actual exit (realisation).
The FASB, in its recent Statement 157, Fair
Value Measurements endorses fair value as exit
value, with a seeming nod from the IASB subject
to some minor reservations:2
‘Fair value is the price that would be received to
sell an asset or paid to transfer a liability in an
orderly transaction between market participants
at the measurement date.’
While the IASB and FASB presumably envision
exit values being applied to determine fair value in
the mixed attribute model (1), I will limit my comments to fair value applied in (3).3 It is the recognition of exit values without an historical exit
transaction that places this fair value accounting in
such contrast to historical cost accounting. The
top-line notion of revenue disappears, and income
is simply the change in fair values on the balance
sheet. Accordingly, the accounting issues are quite
different. Continually remarking equity investments to fair value rather than using the equity
method involves different issues from impairing
equity method investments for a permanent loss
under mixed attribute accounting. And so with
marking inventories, core deposits, bank loans, insurance contracts, debt, and so on to fair value on
a continual basis. ‘Fair value accounting’ as envisioned in application (3) is a potential shift in paradigm.4
1.2. Fair value to whom?
As with any policy issue, prescriptions cannot be
made without an understanding of the objectives
of the exercise. To whom are we reporting? Whose
pluses and whose minuses? Different users may
demand different accounting reports, and confusion reigns if issues are discussed at cross purposes. A shareholder might recognise a gain from a
fall in the market value of debt as creditworthiness
deteriorates, but not the creditor. Bank shareholders might wish to see bank deposits at fair value,
but not the depositors. A bank regulator would also
be concerned about reporting deposits at less than
face value if such reporting affected depositors’
confidence in the banking system. While an investor might welcome the information about
volatility that fair value accounting reveals, not so
a central banker who might be concerned about
feedback effects on systematic risk. A bank regulator might be concerned about marking up banks’
Special Issue: International Accounting Policy Forum. 2007
capital during speculative times with the resulting
incentive for profligate lending.5
In this talk, I take a shareholder perspective:
what are the pluses and minuses of using fair value
accounting (rather than historical cost accounting)
for reporting to shareholders? This, I submit, is
hardly controversial; the shareholders are the owners to whom management and auditors report. But
it does mean that, if standard setters have a broader set of constituents in mind, with an objective of
general purpose financial reporting, then they may
see the issues differently.
1.3. My approach
Normative statements about accounting issues
are often statements of the author’s received wisdom combined with some a priori thinking: here is
what I think about the matter, says the author, supported by some inductive and deductive logic. This
approach, applied in the ‘accounting theory’ era of
the 1950s to the 1970s, gave us numerous prescriptions but little resolution. It would be helpful to
refer to concrete research results for answers, but
theoretical and empirical research has not delivered
a definite resolution either. Recent accountingbased valuation theory has given us some insight to
which I will refer later. Empirical research (of the
type discussed by Wayne Landsman) documents
correlations between fair value measurements and
stock prices that are useful for understanding
whether fair values are ‘relevant to investors’. But
it does not give us much of a handle on the policy
question of whether fair values should be reported
in place of historical cost accounting (which, research shows, is also relevant to investors).6
My approach, I must confess, is largely a priori.
But I hope to get some bite by taking what might
be referred to as a demand approach. Accounting,
as I see it, is a product and products are a matter of
design. The design – and the quality of the product
– should be judged on how well it serves the customer. So, with the customer identified as the
shareholder (above), I ask which product features
– fair value or historical cost – help (or frustrate)
the customer. Unfortunately, inferring demand
from statements made in the current regulatory environment is difficult, given that regulation affects
behaviour. We do observe the voluntary application of fair value accounting (without the coercion
of regulation) in some situations – unregulated
hedge funds use fair value accounting, for example
– and so we can defer to ‘the market’ for lessons.
Such observations are limited, however, so I resort
to a priori analysis. But I do so with an eye to the
shareholder; I presume that shareholders require
accounting information for two purposes:
1. Valuation. Shareholders use accounting information to inform them about the (fair) value of
the equity: What is the equity worth?
35
2. Stewardship. Shareholders use accounting information to assess the stewardship of management, the owners’ employees: How efficient
have managers been in making investments
and conducting operations to add value for
shareholders?
More concretely, I force an orientation to practical tasks for which information is demanded: To
what extent does fair value accounting aid or frustrate the tasks of equity valuation and monitoring
managers’ stewardship? This focus, also, is hardly
controversial. The first task is that of the equity analyst, the second the pursuit of those involved in
corporate governance on behalf of shareholders.
In view of the above, many of the points I make
below are not particularly original. I want to be a
little more analytical than simply listing the standard litany of complaints about and statements in
favour of fair value accounting. But, in doing so,
some well-worn points come to the surface. By
presenting them in a more organised framework,
my hope is that they will be more imperative.
1.4. Information for better markets
It is often said that financial reporting should have
the objective of providing all relevant information
to capital markets. So (it follows), if both historical
cost information and fair values are relevant, both
should be reported. Nothing here subtracts from that
position (if one wants to adopt it). The issue is
which measurement basis should go through the
discipline of the accounting system to determine the
summary, bottom-line numbers, earnings and book
value on which investors and analysts focus (for
whatever bounded rationality reason). Alternatives
to the accounting information (within the system)
can, of course, be supplied in footnotes, much like
some fair value information is now disclosed.
2. The conceptual merits of fair
value accounting versus historical
cost accounting
As with most accounting issues, it is important to
distinguish conceptual issues from those that have
5 Papers that deal with fair value from the view of the central banker and bank regulator include A. Enria et al., Fair
Value and Financial Stability Occasional Paper Series No. 13,
European Central Bank, April 2004; G. Plantin, H. Sapra, and
H. Shin, ‘Marking to market, liquidity, and financial stability’,
Monetary and Economic Studies (Special Edition), October
2005; K. Burkhardt and R. Strausz, ‘The effect of fair vs. book
value accounting on banks’, unpublished paper, Free
University of Berlin, April 2004; and ‘Fair value accounting
for financial instruments: some implications for bank regulation’, BIS Working paper No.209, August 2006.
6 Indeed, inferences from the empirical research are limited
because stock prices, from which ‘relevance’ is inferred, are determined from information under current accounting practices,
and those prices might be different under alternative practices.
36
ACCOUNTING AND BUSINESS RESEARCH
to do with measurement. Here I ‘conceptualise’
how both fair value accounting and historical cost
accounting would satisfy the valuation and stewardship goals of shareholder reporting, in principle
(if measurement were no problem). I then overlay
the concepts with measurement in Section 3.
2.1. The concepts behind fair value accounting
Putting aside measurement issues, fair value accounting conveys information about equity value
and managements’ stewardship by stating all assets and liabilities on the balance sheet as their
value to shareholders:7
• the balance sheet becomes the primary vehicle
for conveying information to shareholders;
• with all assets and liabilities recorded on the
balance sheet at fair value, the book value of equity reports the value of equity (the Price/Book
ratio = 1.0);
• the income (profit and loss) statement reports
‘economic income’ because it is simply the
change in value over a period;
• following the economic principle that current
changes in value do not predict future changes in
value, earnings cannot forecast future earnings.
But this is of no concern for valuation, because
the balance sheet provides the valuation;
• (unexpected) earnings, being a shock to value,
reports on the risk of the equity investment.
Volatility in earnings is informative for value at
risk;
• the P/E ratio is Price/Shock-to-value, that is, a
realisation of value at risk (with a very different
interpretation to that under historical cost);
• income reports the stewardship of management
in adding value for shareholders.
In short, the balance sheet satisfies the valuation
objective and the income statement provides information about risk exposure and management performance.
7
This idea is close to that of ‘value in use’ but with a focus
on the shareholder rather than on the entity. The value-in-use
concept (or its variant, ‘deprival value’) appears (for example)
in Accounting Standards Board, Statement of Principles for
Financial Reporting (London: ASB, 1999), Australian
Accounting Research Foundation, Accounting Theory
Monograph No. 10, Measurement in Financial Accounting
(AARF, 1998) and has long been part of the discussion, for example in J. Horton and R. Macve, ‘ ‘Fair value’ for financial
instruments: how erasing theory is leading to unworkable
global accounting standards for performance reporting’,
Australian Accounting Review 10 (July 2000): 26–39 and R.
Macve and G. Serafeim, ‘“Deprival value” vs “fair value”
measurement for contract liabilities in resolving the “revenue
recognition” conundrum: towards a general solution’.
Unpublished paper, London School of Economics, June 2006.
The accounting for investment funds – mutual
funds and hedge funds – applies this strict fair
value accounting, and investors are willing to trade
in and out of these funds at book value (‘net asset
value’) with the presumption that book value
equals value (with no gains and losses between
shareholders). Further, the income (returns) for
these funds is accepted as a comprehensive measure of the fund managers’ investment performance, both the investment success and the
volatility to which investors have been subjected.
The accounting is sufficient; one does not require
a balanced scorecard.
2.2. The concepts behind historical cost
accounting
Historical cost accounting is often misinterpreted in the debate, with the criticism that it reports a
balance sheet with old, historical costs rather than
current values. This statement is correct, but belies
an understanding about how historical cost works
for valuation and performance assessment. Under
historical cost accounting,
• the income statement is the primary vehicle for
conveying information about value to shareholders, not the balance sheet;
• earnings report how well the firm has performed
in arbitraging prices in input (supplier) markets
and output (customer) markets; that is, historical
cost earnings reports the value-added buying inputs at one price, transforming them according
to a business model, and selling them at another
price;

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