Fair Value Accounting

Abstract

The paper provides a genesis of fair value accounting (FVA) and reviews some research and empirical evidence that are relevant to the debate surrounding its use. We also comment on FVA’s role in the financial crisis: was it just the messenger of bad news or was it “procyclical,” contributing to the sad state of the economy in addition to reporting on it? We briefly characterize FVA as comprising three levels of valuation: level 1 for assets/liabilities for which market values are directly observable, level 2 for assets/liabilities for which market-derived inputs, but not prices, are observable and level 3 for assets/liabilities which value is derived from models. We conclude that the use of FVA by regulators was probably procyclical for level 1 FVA assets, i.e., those assets which accounting values were based upon directly observable market prices. In contrast, accounting values for FVA assets that were not actively traded (levels 2 and 3) probably lagged market developments and were likely biased in their valuation. Our analysis also suggests that the appropriateness of FVA-derived valuation is conditional upon market conditions (efficiency and liquidity), and that fundamental valuation drivers such as an asset/ liability underlying cash flows are still relevant valuation inputs despite the existence of concurrent market prices. The paper concludes with some observations regarding the role of auditors, regulators, standard-setters and investors regarding FVA-derived information.