The Value of Accounting
Posted: 19 Jul 2012
Date Written: October 21, 2011
Fair value estimates of debt and equity securities play an increasingly important role in the economy. For example, International Financial Reporting Standards require companies to report many of their investments at fair value on the balance sheet or to use fair values in goodwill impairment tests. Further, the funding status of pension plans is typically assessed as the difference between the fair values of pension plan assets and pension plan commitments. In many of these situations the use of fair value estimates results in economic decisions being dependent on valuation. That is, fair value adjustments to the carrying amounts of banks’ investment portfolios affect their regulatory capital, forcing them to restructure their assets and liabilities in some extreme cases. Similarly, the fair value of pension assets affects decisions on pension funding, premiums and payouts. Although the exact use and implications of fair values may vary across these examples, what they have in common is that they stress the importance of having available accurate fair value estimates.Commonly, regulators and standard setters such as the International Accounting Standards Board express a strong preference for using quoted market prices as the basis for fair value, seemingly focusing on the reliability of fair value estimates. In this inaugural address, I discuss such use of market prices in measuring fair values and benchmark the price-based approach against fundamental valuation approaches, such as multiples-based and full-information-based valuation. I also reflect on the dominance of market prices and returns in business risk measurement, as used, for example, in practical applications of the capital asset pricing model, and discuss why a risk measurement approach that makes use of fundamental (accounting) information could serve as a useful alternative or complement.
Keywords: accounting, fair value, fundamental analysis, mispricing, business valuation, equity risk measurement
JEL Classification: M41, M00
Suggested Citation: Suggested Citation