An Economic Analysis of Fair Value: Accounting as a Vector of Crisis

prisme15Prisme N°15 August 2009

Vincent Bignon, Yuri Biondi & Xavier Ragot

Prisme N°15 August 2009 (537.1 KiB)


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. In July 2002, the European Parliament’s adoption of new accounting standards for quoted companies, which took effect 1 January 2005, oriented European accounting towards the new principle of fair value. Its introduction has imposed the determination of the value of assets by the present value of the expected profits that these assets can generate. It has involved 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.

The financial crisis that began in the summer of 2007 confirms the intrinsic flaws of the fair-value accounting model. It did not help to prevent the crisis, but rather deepened it. Accounting must be an instrument of control and regulation, independent of the market and centred on the firm as an enterprise entity, without following daily market values. Accounting must thus establish itself as a central institution of market economies, essential to the functioning of the markets and in accordance with the public interest.