An Economic Analysis of Fair Value

prisme4Prisme N°4 March 2004

Vincent Bignon, Yuri Biondi & Xavier Ragot

Prisme N°4 March 2004 (234.0 KiB)

In July 2002, the European Parliament’s adoption of new accounting standards for quoted companies, to take effect from January 1, 2005, oriented European accounting towards a new principle, that of fair value. Hitherto, European legislation took its essential inspiration from the logic of historical cost: the valuation of balance sheet assets was grounded in the depreciated historical cost of their acquisition. The introduction of the principle of fair value will impose the determination of the value of assets by the present value of the expected profits that these assets can generate. It involves establishing the value of each asset according to its future contribution to the profit of the business.

Contemporary research, however, does not have as its ultimate goal the replacement of historical cost by fair value. Recent work analysing business production processes plead, on the contrary, for limitation of its usage. Three concepts summarize this work: asymmetry of information, complementarities, and specificities of assets employed. Firms create wealth by making assets complementary, because they add to these assets characteristics specific to the production process deployed.
These supplementary characteristics have no market value, and thus the value of each asset for a firm is always greater than its resale value. Consequently, the specificity of an asset is defined by the difference between its value for the firm and its market value. In order to preserve the competitive advantage flowing from this combination of specific assets, it is necessary to keep this type of information secret: hence, there exists an asymmetry of information between the firm and its environment.

In this context, the criterion of fair value poses important problems of asset valuation: the specificity and complementarity of assets force accountants to use valuation models in order to determine asset values. Financial analysts have recourse to such models in order to value businesses. The use of these models for accounting purposes does not, however, ensure the reliability of accounts; in effect, small changes in the assumptions can lead to large variations in the results. The purpose of accounting is rather to constitute a source of independent information, in a form that is relevant to valuation by financial markets.

In addition to the valuation problem, the principle of fair value may introduce the problem of financial volatility into accounting. The existence of excessive financial market volatility, which is demonstrable theoretically and empirically, creates superfluous risk and tends to reduce the investment capacity of firms. Lastly, fair value reinforces financial criteria to the detriment of the other valuation criteria of management teams. All stakeholders in the business, including shareholders and institutional investors, risk being its victims.

It is difficult to affirm that the net contribution of fair value to the improvement of accounting standards is positive. If far from ideal, the logic of historical cost appears as the least worst option in the presence of informational asymmetries, complementarities and specificities.