In January, the Financial Accounting Standards Board published an exposure draft called "The Fair Value Option for Financial Assets and Financial Liabilities." Despite its low-key launch, this draft has revolutionary implications.The proposed standard would permit managers to adopt fair value accounting for some financial assets and liabilities, but only if they want to. That's why the title refers to the fair value "option" - the choice is up to them.

Phase I makes this option available only for select assets and liabilities; Phase II will later expand it to others, but again as an option, not as a mandatory practice.


The board's main rationale - to make reported earnings less volatile - is probably counterintuitive to most. Traditionally, managers have resisted market values to avoid volatile earnings. To minimize their own risk of attesting to an amount that shortly might go up or down, auditors have also fled from values.

So, what's FASB thinking? The point is that piecemeal use of values produces unrealistic volatility as, for example, when values are used for investments but not for debt incurred to acquire them. Furthermore, the idea of hedging is to own things with divergent economic value - when one goes up, the other goes down. If market value is used for only one side, information about the risk mitigation provided by the other is omitted. Hence, by choosing to report both items at market, the counteracting value changes will flow through the income statement and, FASB believes, decrease the volatility of reported earnings.

A second rationale offered by the board is to converge U.S. principles on international standards, where this option has been available for some time.

Our response

As regular readers will anticipate, we favor any effort to substitute values for costs. The outcome has to be progress toward the ultimate goal of more informed and more efficient capital markets.

We also applaud convergence, but conditionally. It does no good to converge on a common standard that doesn't produce useful information. That's merely political expediency. Convergence on a better standard is a step toward meeting users' needs, and we like that. Our support, however, is a little reserved, as we'll explain momentarily.

Long-time readers will also expect us to be pleased that FASB has proposed voluntary value-based accounting. We have long argued that managers who try to meet the markets' needs for information will reap rewards as their capital costs fall as a result of reducing users' information risk. Voluntary value accounting is certain to please users who will no longer have to guess, search for or simply do without facts they need for their analyses.

As we see it, those who first provide what capital markets demand will be rewarded more handsomely than those who come along only when forced to. Those who voluntarily report values declare their desire to connect with users, while those who refuse to do so clearly signal their obsolete and misguided desire to trick markets into paying too much.

On the other hand ...

However, we are disappointed with the draft, mainly because some board members don't see economic reality through the same lens we use.

In particular, the draft discusses whether it's useful to report gains from falling liability values triggered by a borrower's declining creditworthiness. To explain, receivables from a slipping company decrease in value because of greater uncertainty about collectibility. While every accountant in the land will force creditors to recognize bad debt losses, only bankruptcies or formal restructurings currently allow debtors to recognize bad debt gains.

This asymmetry reflects the old entrenched tendency to mold reports to reflect what one wishes were true instead of reality. In fact, debtors are better off whenever liability values decline; however, that is only the good news side of the real bad news story. Intelligent statement users understand the bizarre nature of that income. If others are confused by this positive result emerging from the overall dismal situation, that's their problem and it should not be solved by keeping everyone else in the dark.

Another feature of the draft that bothers us is that it would be applied only to new assets and liabilities. Managers are not given the opportunity to bring their whole portfolios up to date all at once. Rather, they will have to wait until the old assets and liabilities are replaced by new ones. Until that transition is finished, financial statements will contain mixed numbers, even for those preparers who want to provide more useful information.

We understand FASB's compulsion for an orderly transition, but we're afraid that this faint-hearted approach does nothing but delay users' access to fair value information that is more reliable than what they can produce on their own. We think it only makes sense for managers to have the option to more fully implement value reporting to serve their users, instead of waiting until timorous accountants see the light.

Relevance can't be lost

We also chide FASB for not fully understanding its own Conceptual Framework, especially in view of the revision project that's underway.

Twice, the draft mentions relevance in a way that suggests that the board doesn't comprehend its meaning. Page iv states, "The board believes that fair value is more relevant to financial statement users than cost for assessing the current financial position of an entity, because fair value reflects the current cash equivalent of the entity's financial instruments, rather than the price of a past transaction." And page 8 says, "With the passage of time, historical prices become irrelevant in assessing an entity's current financial position."

While we wholeheartedly agree that old numbers lose usefulness with age, the board's explanation mischaracterizes the cause of that decline. It's not relevance that's lost, but reliability.

Specifically, we're persuaded that relevant information about all assets and liabilities reveals their cash flow potential, which is their ability to affect the amount, timing and uncertainty of the reporting entity's future cash flows. (Roughly what the board calls the current cash equivalent.)

If the marketplaces for those assets and liabilities are fully informed and efficient, then current prices will reflect a broad consensus on their present ability to affect future cash flows. Higher (or lower) market values will be associated with those items with a greater (or lesser) potential positive impact on the amount, timing and uncertainty of the cash flows. What this means is that the search in accounting is for reliable depictions of that relevant cash flow potential.

As we have described in other columns, the original framework reasonably observes that reliable information must be representationally faithful, verifiable and neutral. It's clear that market values are more reliable than costs, because they more faithfully represent current cash flow potential. Further, values are more verifiable than costs because they are observed in numerous independent transactions, not just one exchange involving the reporting entity.

Finally, values are neutral because they exist separate and apart from that entity. They change even if no one wants them to change, because they emerge from a process that is indifferent to who wins or loses. Part and parcel to this analysis is the presumption that market values are real numbers rooted in multiple observable events, not hypothetical wild-eyed guesses (think Enron).

Therefore, market values do not lose relevance as they get older. Their usefulness does decline, however, because they lose representational faithfulness and reliability. The solution to that problem is to continuously replace old market value numbers with new ones at every opportunity.

The real surprise is that market values are not more relevant than costs; rather, they are much more reliable than costs in terms of describing the current cash flow potential of assets and liabilities.

The bottom line

It's no surprise that we like FASB's proposal; more market value accounting is better than less, and voluntary reporting offers advantages over coerced reporting. Of course, that does not mean we're satisfied with the details or the rationale. But at this point, we're happy to find progress wherever we can, so we hope that the board follows through.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at

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