Fundamental Issues Related to Using Fair Value Accounting for Financial Reporting.

Abstract This paper discusses fundamental issues relating to implementation of fair value accounting. We conclude that in settings economically equivalent to perfect and complete markets, a fair value accounting-based balance sheet reflects all value-relevant information, the income statement is redundant, income realization is not valuation-relevant, and intangible assets relating to management skill, asset synergies, or options are reflected fully in the balance sheet. In settings with more realistic market assumptions, fair value is not well-defined, resulting in three value constructs, entry and exit values and value-in-use. Because these are unobservable, implementation of fair value accounting requires their estimation, potentially introducing estimation error. Unless estimation error is severe, value-in-use is the appropriate construct for firm valuation for going concerns because it captures total firm value associated with an asset. Also, neither the balance sheet nor income statement reflects fully all value-relevant information and income realization potentially can be valuation-relevant, although management discretion can detract from its relevance. We point out that fair value accounting concepts apply equally to assets and liabilities. Finally, our discussion reveals no basis for recognizing in income only realized gains and losses, and that the concepts of core earnings and fair value accounting are unrelated.