A question currently faced by the accounting profession, particularly in light of the mortgage meltdown, is whether to use fair value or historical cost for the reporting of assets and liabilities. It is argued that for accounting information to be useful for decision making, it should embody the two primary qualities of relevance and reliability. Fair value or historical cost on their own are not likely to achieve both characteristics. In practice, there seems to be an inherent trade-off between these two characteristics. The information which is most relevant is quite often less reliable, depending upon the nature of the item being measured. The information which is the most reliable usually tends to be that which is less relevant. Perhaps, an integration of the two measurement bases may be necessary. Both the IASB and FASB support the use of fair value and are moving away from historical cost and more towards fair value in the financial reporting standards. This means we are unlikely to go back to the strict use of traditional historical-cost based accounting despite the issues we face with fair-value accounting.

It is argued that reporting assets and liabilities at their fair value provides more relevant information for investment decisions than historical cost. Under fair-value accounting, when there is an active and liquid market for the asset or liability, mark-to-market reporting can be used. This provides extremely relevant information because it requires a downward adjustment when the market value of investments decline, thereby revealing problems more quickly. As an example, the savings and loan crisis may have been avoided had fair-value accounting been used. The crisis developed when variable interest rates paid on deposits exceeded the fixed interest rates charged on mortgages. Accounting under historical cost allowed resulting losses to be reported gradually over time, where fair-value rules would have required earlier recognition3. Lastly, use of the lower of cost or market rule does not provide relevant accounting reports when fair value significantly exceeds historical cost.

Fair value certainly provides relevant information for decision making, when the information is also reliable. Reliability may be difficult to achieve when we are dealing with hypothetical transactions that are not objectively measurable. This is the situation we face once we move away from the mark-to-market approach when determining fair value. Determining fair value for securities with no active markets using level 3 inputs is extremely difficult, and may therefore adversely affect the reliability and relevance of financial reports.

It is argued that the lower cost or market rule could be effectively adapted, making reports both relevant and reliable. When fair values exceed costs by a material amount, information related to increases in the value of assets could be provided in footnotes or pro forma statements. In other words, the reliability and relevance of historical-cost financial reports could be enhanced by providing fair value information through footnote disclosures or pro forma statements, while the assets are measured using traditional historical cost. Perhaps a nice balance to achieve both greater relevance and greater reliability.

Some financial models indicate that using fair value to report financial instruments at market value leads financial institutions to react to market changes in ways they would not normally act. For example, falling prices in an unstable market may worsen market stability. This is because companies tend to react to falling prices by rushing out to sell their assets before their competitors. In comparison, the use of historical-cost information by financial institutions tends to dampen the financial business cycle and, as a consequence, adds stability to the financial markets. Market stability and the nature of the financial business cycle play a large role in the determination of market prices and therefore have an impact upon the relevance and reliability of accounting information produced.

Obtaining fair values that are reliable can be elusive, particularly for market based instruments that lack objective substance, such as subprime debt obligations. The move to fair value accounting requires inclusion of more hypothetical transactions in the financial statements, which allowed subprime lenders to recognise income well before it was actually earned or received.4 This increases the risk of overstatement of accrual based income not realised in actual transactions. Zoe-Vonna Palmrose, former deputy chief accountant for professional practice at SEC, saw parallels between the subprime lending debacle in 2007 and the stock market crash of 1929. She noted that fair value accounting was popular in the 1920s but was banned by SEC for a number of decades after the stock market crash in 1929.

In a market bubble, values may be overstated and bubble values will not be realisable if many participants in the market decide to sell those assets at the same time. Consequently, financial statements incorporating fair values of assets and liabilities in unstable or illiquid markets are not likely to be relevant or reliable for the purpose of decision usefulness. This problem can be illustrated in subprime lending. When markets for subprime-backed securities were active, applying the market value at which securities were traded might have appeared reasonable and fair. However, the market for subprime securities was not stable and active for long. In the absence of an active and liquid market, how does one establish assumptions for developing estimates for fair values for delinquent loans in a declining market. It is particularly difficult to determine fair values in a speculative and high risk environment like the subprime lending market. Much of the risk due to deceptive practices used in lending to those who did not have the means to repay, encouraging borrowers to take loans with variable interest rates and securitising mortgage loans to relieve lenders of credit risk. Fair value rules require much judgement when adjusting or modifying initially recorded costs for reporting financial assets, including mortgage-backed instruments. The rules may be viewed as weak or ambiguous. We therefore end up suffering in terms of the compromise to relevance and reliability.

Questions

1,In practice, which measurement base, historical cost or fair value would provide the most relevant and reliable accounting information? Draw on the facts presented in the situation above, as well as your knowledge of the global financial crisis, to justify your response.

2,Discuss the role of market stability and the financial business cycle in determining the relevance and reliability of the accounting information produced.