Table of Contents
Subject: Accounting | Level: Undergraduate | Word Count: ~1600 words | Referencing: Harvard
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Discuss whether fair value accounting improves or undermines the decision-usefulness of financial statements.
Financial statements are intended to provide information that is useful to a wide range of users making economic decisions about an entity, a principle embedded in the International Accounting Standards Board’s Conceptual Framework as the fundamental qualitative characteristic of decision-usefulness, itself comprising relevance and faithful representation (IASB, 2018). How assets and liabilities should be measured for this purpose remains one of the most contested questions in financial reporting, and nowhere is the debate sharper than in the contrast between historical cost, which records items at their original transaction price, and fair value, defined by IFRS 13 as 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 (IFRS Foundation, 2011).
This essay discusses whether fair value accounting improves or undermines the decision-usefulness of financial statements. It argues that fair value measurement enhances relevance considerably, particularly for actively traded financial instruments, but does so at a meaningful and context-dependent cost to reliability, comparability and stability, a cost that becomes most acute where markets are illiquid or under stress. The essay considers the case for and against fair value in turn, examines its implications for cross-firm comparability, and concludes by outlining the mixed-measurement approach that current international standards, and much of the academic literature, now favour over a straightforward choice between the two bases.
The principal argument in favour of fair value accounting is that it substantially improves the relevance of reported figures by reflecting current economic conditions rather than a potentially decades-old transaction price. Historical cost figures for long-held assets, such as investment property purchased many years previously, can diverge dramatically from any figure a rational investor would consider useful for assessing current solvency, performance or the entity’s capacity to meet its obligations. Barth, Landsman and Wahlen (1995), in an influential early study of the banking sector, found that fair value estimates of banks’ investment securities were more strongly associated with share prices than historical cost figures for the same items, providing empirical evidence that fair value information is genuinely value-relevant to capital market participants rather than merely theoretically appealing in the abstract.
This relevance advantage is particularly pronounced for financial instruments traded in active markets, where fair value can be observed directly as a quoted price, described in the fair value hierarchy as a Level 1 input under IFRS 13 (IFRS Foundation, 2011). For such instruments, fair value arguably improves decision-usefulness with little corresponding cost, since the market price is both highly relevant to users and, being independently observable, reasonably reliable and verifiable by auditors and users alike. Penman (2007) accordingly argues that the strongest case for fair value accounting exists precisely where markets are liquid and prices are objectively determinable, a condition satisfied by listed equities and government bonds but by no means universally true across a typical balance sheet, which also contains many items for which no such observable market exists.
A further, less frequently emphasised argument concerns stewardship rather than valuation alone. Historical cost figures for assets held over long periods can obscure the true economic performance of management, since a manager who has allowed an asset’s market value to fall substantially while its historical cost carrying amount remains unchanged reports no loss under a pure cost model, potentially misleading users about the quality of resource management during the period. Fair value, by contrast, forces timely recognition of both gains and losses as they arise economically, which some scholars argue produces a more faithful running record of management’s decisions and their consequences, even where the resulting figures are individually less precise than a historical transaction price (Barth, Landsman and Wahlen, 1995).
The case against fair value accounting centres on reliability rather than relevance. Where no active market exists, fair value must instead be estimated using valuation models and unobservable inputs, classified as Level 3 under the IFRS 13 hierarchy, introducing substantial management judgement and consequent scope for manipulation or, more commonly, honest but material estimation error (IFRS Foundation, 2011). Whittington (2008) argues that this reliance on modelled estimates undermines the faithful representation criterion central to decision-usefulness, since figures that cannot be independently verified are of limited value to users seeking to hold management accountable for stewardship of the entity’s resources. Power (2010) extends this critique, suggesting that fair value accounting effectively substitutes the discipline of financial economics and modelling expertise for the traditional, more directly verifiable discipline of transaction-based accounting, a substitution that arguably changes what reliability itself means within financial reporting.
A second, closely related concern is procyclicality. Laux and Leuz (2010) examine the role of fair value accounting during the 2007-08 global financial crisis and conclude that, while fair value accounting was not the primary cause of the crisis, mark-to-market losses on illiquid mortgage-backed securities forced some banks to recognise losses that overstated the securities’ ultimate realisable value in illiquid, panic-driven markets, contributing to further forced asset sales and price declines in a self-reinforcing downward spiral. Plantin, Sapra and Shin (2008) formalise this mechanism theoretically, showing that marking illiquid, long-term assets to a distressed short-term market price can generate excess volatility and contagion that would not arise under historical cost accounting, which simply defers unrealised losses until an asset is actually sold or genuinely impaired. Ryan (2008) offers a partially dissenting view, arguing that fair value losses during the crisis largely reflected genuine deterioration in expected future cash flows rather than purely a temporary liquidity discount, which complicates any simple, one-directional procyclicality narrative.
Decision-usefulness depends not only on the quality of a single firm’s figures but on comparability across firms and over time, a qualitative characteristic explicitly identified alongside relevance and faithful representation in the Conceptual Framework (IASB, 2018). Fair value accounting, particularly at Level 3 of the hierarchy, can undermine comparability because two firms holding economically similar illiquid assets may apply different valuation models, discount rates or underlying assumptions, producing materially different reported values for genuinely comparable positions and thereby frustrating like-for-like analysis. The Financial Reporting Council (2020) has highlighted inconsistent disclosure of valuation methodology as a recurring concern in its reviews of UK corporate reporting, noting that users often cannot readily assess how sensitive a reported fair value is to the underlying assumptions without additional voluntary disclosure that goes beyond the minimum required by the relevant standards.
This comparability concern has practical consequences for a range of decision-usefulness contexts beyond capital markets, including lending decisions, credit-rating assessments and merger and acquisition due diligence, all of which rely on being able to compare the reported position of one entity against another on a broadly consistent basis. Where valuation inputs and models differ substantially between otherwise similar firms, analysts and lenders must undertake additional adjustment work to restore comparability, effectively transferring cost from the preparer to the user of the financial statements, a shift that at least partially offsets the relevance gains that fair value is intended to deliver in the first place.
Much of the accounting literature now converges on a mixed-measurement view rather than treating the question as a binary choice between historical cost and fair value across the entire balance sheet. Penman (2007) argues that fair value is most decision-useful for financial assets held for trading, where market prices are observable and realisation is likely in the near term, while historical cost, supplemented by impairment testing, remains more decision-useful for operating assets held for long-term use within the business, where fair value estimates would be both unreliable, given the absence of an active market, and arguably of limited relevance to how value will actually be realised through continued operational use. Current international standards broadly reflect this compromise, applying fair value selectively to financial instruments, investment property and biological assets while retaining cost-based measurement, subject to regular impairment testing, for most property, plant and equipment and intangible assets (IASB, 2018).
On balance, fair value accounting neither straightforwardly improves nor undermines the decision-usefulness of financial statements; its effect depends heavily on the nature of the item being measured and the depth of the market in which it trades. For actively traded financial instruments, the evidence, from Barth, Landsman and Wahlen (1995) onward, indicates a clear net improvement in relevance with only modest cost to reliability, since prices are independently observable and verifiable. For illiquid assets valued using Level 3 models, however, the reliability, comparability and procyclicality concerns raised by Whittington (2008), Power (2010) and Plantin, Sapra and Shin (2008) are substantial enough that fair value can plausibly undermine, rather than enhance, decision-usefulness, particularly during periods of market stress when estimates are least reliable and most consequential. The most defensible position, and one consistent with current IFRS practice, is therefore a selective, mixed-measurement approach in which fair value is reserved for contexts where it can be reliably estimated, rather than applied indiscriminately as a universal measurement basis across the balance sheet.
| Characteristic | Historical Cost | Fair Value |
|---|---|---|
| Relevance to current decisions | Lower for long-held assets | Higher, reflects current conditions |
| Reliability / verifiability | High; based on actual transaction | High for Level 1, lower for Level 3 estimates |
| Earnings volatility | Lower | Higher, especially for Level 3 items |
| Suitability for actively traded instruments | Weak | Strong |
| Suitability for illiquid operating assets | Strong | Weak |
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