Fair Value as a Relevant Metric: A Theoretical Investigation
56 Pages Posted: 26 Jan 2006
Date Written: January 2006
Supporters of fair value accounting claim that this metric has two central advantages, including that it is a relevant measure and that it accurately reflects the underlying economic condition of a firm. In this paper I investigate the robustness of these presumed advantages by undertaking three related analyses. First, I develop a theoretical framework to identify the necessary and sufficient conditions for market price (as a fair value metric) to be relevant. Second, I develop an economic model to examine the two claims. I show that, when markets are in disequilibrium, the market price of an asset alone does not reliably allow a user to infer a firm's long-term value. If the user also has information regarding a firm's economic profits, market price could be relevant. Third, I construct computer simulations of the economic model and find that reported accounting profits do not have the same predictive power as economic profits. I also find that there exists a non-trivial relationship between accounting profits and fair value that could help a user to identify a firm's long-term value. Thus the usefulness of fair value depends on users' understanding of this relationship.
Keywords: fair value, historical costs, relevant and reliability
JEL Classification: G12, M41, M44
Suggested Citation: Suggested Citation