Information by fair value accounting: fair is foul and foul is fair*

Prof. Dr. Thomas Schildbach, Passau**

1. The Problem

Financial accounting seems to be very close to a global breakthrough. Varieties of national

accounting regulations and traditions regarded as dysfunctional and antiquated by the spirit of
time in accounting are gradually displaced by Anglo-Saxon accounting Standards US-GAAP
and IFRS heading for convergence towards “a single set of high quality understandable and
enforceable global accounting standards”.1 The world appears to be fascinated by this vision
of harmonisation, by the impression of consequent professionalism in standard setting and by
the exciting dynamic of change.

Actually the great esteem for the modern Anglo-Saxon accounting standards is mainly in-
duced by the progress in market information expected to result from the concentration on in-
formation as the only purpose of financial accounting and from the revolutionary fair value
concept. The idea that financial accounting has to serve multiple functions – contracting,
stewardship, taxes, regulation, litigation as well as information2 – fell out of fashion though
important features – like conservatism – justified mainly by these other functions still survive.
Restricting financial accounting to serve information by one regulation for the whole world is
supposed to revolutionize the decision quality of the investors as well as the capability of
markets to find efficient prices and to allocate scarce resources. No longer up to date is also
the revenue and expense view. Its indeed vague matching concept is suspected to permit al-
most any credit balance not to be a liability and any debit balance to be an asset.3 In the ab-
sence of anything better the ancient asset and liability view was revived and refined by the
new fair value-concept. The ingenious name of this concept not only elevates it over all its
rivals, it also opens the minds to expect true and fair figures indicating measures of economic
wealth and changes in this economic wealth. Imaginations were particularly stimulated by the

*
Shakespeare, Macbeth, Act the First, Scene 1.
**
Professor of accounting, retired 2010, University of Passau.
1
IFRS, Preface to IFRSs 6a.
2
Holthausen/Watts (2001), 31.
3
Johnson (2004), 2.
 2

idea to choose “relevance”4 as one of the primary decision specific qualities or qualitative
characteristics.

The premature esteem of fair value accounting of course is justified only by the ideal proper-
ties of values in an unrealistic world of perfect and complete markets5 and by the hope that
the use of fair value can transfer these ideal properties into our cruel world of imperfections.
This paper is dedicated to the question whether in this world of imperfections fair value ac-
counting will improve decision usefulness of accounting information and extend the infor-
mation incorporated in prices by markets. It tries to find answers by pure logic only. Even in
the model world of perfect and complete markets, in which fair values do reflect all value-
relevant information, fair value accounting is unable to contribute to the information of the
market or of the market participants. The reason is that the information offered by these val-
ues is already known to the market and to all individuals acting there. Transferred to a world
of imperfections the inability will hardly vanish. In fair value accounting it is the market that
transforms information taken from non fair value sources into fair values. Accountants use
fair values or infer them from information corroborated by observable market data in order to
return synthetically combined fair values – affected by various imperfections and opaque both
in their derivation and character – back to the market. The information needed by the market
to find fair values or by the preparers of financial statements to estimate fair values is taken
for granted. Fair value accounting is concerned with the dissemination of fair values but not
with the provision of information input necessary to determine fair values. A main challenge
arises from the fact that in reality fair values often can not be observed properly. They may
need adjustments or they even have to be evaluated by using a “mark to model” approach.
Modern standard setters like FASB and IASB assume individuals to be well prepared to per-
form jobs like these or – in respect of the “highest and best use” premise – even more. Indi-
viduals capable to evaluate fair values using market information only and deriving individual
asset values from the values of asset groups as well as the markets they scan for information
will hardly gain knowledge from this kind of figures. Thus fair value-accounting is in great
danger of being completely unable to inform markets or market participants. In this case it is
the non fair, inferior or “foul” information that is fair with regard to the ability to inform mar-
kets and individuals. And the kind of reporting using the term “fair” nowadays is actually foul
since it does not contain any new information.

4
SFAC 2.46-.50; IFRS Framework .26-.28.
5
Barth/Landsman (1995), 97.
 3

The following paper analyses the contribution of fair value accounting to the knowledge of
markets and market participants in combination with the contribution of markets and market
participants to the evaluation of fair values in six steps. A closer look at some basic ideas
about the information input to the pricing process and the way this information is disseminat-
ed into the market is used in the next section to compare fair value accounting and historical
cost accounting concerning their specific approach of informing markets. Assuming an entity
whose assets and liabilities are all traded in active markets the following section is dedicated
to the properties of the prices available there judged by their capability to show their specific
contribution to the value of the business. The section after that analyses basically the same
problems for fair values not taken from active markets but derived from “mark to model”. The
consequences of strategies – like “mixes” of concepts, “safeguards”, biased interpretations of
accounting standards, political intervention or lax enforcement – designed to overcome diffi-
culties for fair value accounting arising from the imperfections of our world are the topics for
another section, followed by a section dealing with a specific side effect of fair value account-
ing: its contributions to the exacerbation of price volatility, speculative investment and the
danger of financial crisis. Given information of markets and market participants as the only
relevant task of accounting both fair value accounting and historical cost accounting have to
solve the same – in the strict sense of course insoluble – problems. A final comparison of the
main differences of the two solutions will bring the paper to an end.

2. Differences in the contributions of the two rival accounting concepts to market in-
formation

In economics the subjects acting are primarily interested in future cash flows. Assets therefore
can be characterized by the volume, the timing and the certainty of the future cash flows they
will probably make available for their owners. In order to price assets efficiently according to
the properties of the future cash flows they promise to generate and by this to allocate scarce
resources the market as representative of all the individuals trading in the market needs in-
formation useful to assess the future cash flows generated by the assets. The information is
supposed to enable the market to price identical future cash flows with identical prices and
sums of future cash flows with the sums of their prices.

The information used or produced in this process of assessing future cash flows and to price
the objects generating them can be divided into several classes. There is of course a vast va-
riety of potentially relevant input information to this process. Financial reporting is just one
element whose involvement in the information process – as we will see later – depends on the
 4

question whether it is prepared according to the asset and liability view or alternatively ac-
cording to the revenue and expense view. Accompanying statements like those of cash flows
or of changes in equity, notes or management’s discussion and analysis (MD&A) are others.
The bulk of information however is made up of data on diverse developments in overall
economy, in the industrial sectors or in cross-border activities, on current trends in prices,
wages, interest rates, attitudes towards risk and liquidity as well as information on the quality
or acceptance of the products generated by the objects to be priced for instance. This mass of
information is selectively gathered and consolidated by consultants, analysts and rating agen-
cies, who publish some of their results or offer them to the market.

Finally implemented is this information by the market participants. Generally inspired by

their business model they use information in order to look for opportunities improving their
situation. Of course their business models can be very different – ranging from pure specula-
tive to depending practically only on the special way of combining assets – and the models
can with good reason turn out to be successful or detrimental. In any case apart from financial
instruments it will generally be impossible to assign expectations of future cash flows to indi-
vidual assets. In a world of – at least based on random – efficient prices it is even hard to
specify the abnormal future cash flow expected to be generated by a speculative investment.
Even if there is good reason to believe in the existence of mispricing one can never be sure
and one can never know how long it will take the market to realize this error so that the profit
can be cashed. Moreover with regard to the “heads I win, tails You lose” game there is defi-
nitely good reason to doubt whether speculation and some risky kinds of arbitrage are justifi-
able business models for enterprises with owners of limited personal liability only. In a busi-
ness model aiming at revenues generated by the products of asset combination it is basically
impossible to split up the revenues of the “cash generating units”6 to the different assets used
up or engaged in the production process. Without individual cash flows in the past there can
of course be no individual expected future cash flows and no individual values based on such
expected future cash flows. The use of baking ingredients, energy, an oven and the work of a
baker results in cash flows from the sale of bread, cakes and pastries for example. These cash
flows however can not be allocated to the individual ingredients, to the energy, the oven and
to the work of the baker in order to determine the economic values of these combination in-
puts. Hence the amount of cash acceptable for a market participant in a deal to buy or sell a
specific combination-use-asset is located in a wide range of prices spanning from the margin-
al proceeds achievable in a fire sale transaction to the value driven by the synergies attainable

6
IAS 36.6.
 5

in a combination where only this special asset is missing. Factors like the amount of pressure
arising from shortage of time or liquidity on the one hand and like the availability of alterna-
tives on the other play a vital role for the actual relevance of these values.

Readiness for transaction under specific conditions deduced from the business model, from
the information analysed and from the expectations influenced by this information carries the
information of the active individuals into the market. The limits in which the individuals
ready for transaction are willing to enter into contracts form the basis for the determination of
prices by markets. The resulting prices are the outputs of this information founded pricing
process. They are decisive which of the planned transactions are executed and they determine
their conditions. Though of course interesting for the individuals they will not inform the
market since it was the market who created them.

Future cash flows expected to be generated by a business can not be observed and reported
reliably. Therefore historical cost accounting looks for a way to rearrange historical cash
flows without changing their overall volume (“clean surplus”). The idea is to look for a new
timing that – to the extent possible – increases the predictive value of the historical cash flow
figures. Thus in countries like Germany where pension plans are not funded future pension
payments are anticipated and purchase prices of fixed assets subject to wear and tear are dis-
tributed over their expected useful lives while ordinary revenues and expenses are separated
from extraordinary gains and losses. Of course there will be a never ending discussion about
the best way of rearranging and classifying historical cash flows. Moreover the matching con-
cept used will always be vague to some extend. But the result conforms both with the exclu-
sive relevance of future cash flows and with the alleged mission of financial accounting. The
figures are supposed to support the efforts to estimate future cash flows generated by a busi-
ness without keeping the users away from forming their own opinions and they are prepared
by persons with at least good knowledge to do this job. The fact that latitudes in estimation or
even free choices may be used to mask performance is qualified by the opportunity to coun-
teract the bias taking advantage of the details in the financial statements and of other infor-
mation. The strategy of tightening accounting standards however is problematic since it will
only increase costly real earnings management or even manipulation.7

Historical cost accounting according to the revenue and expense view with the focus on the
profit and loss statement does not only have an old tradition founded by Schmalenbach8 it is

7
Graham/Harvey/Rajgopal (2005); Ewert/Wagenhofer (2005).
8
Schmalenbach (1926).
 6

also backed by the FASB in SFAC 1: “Information about enterprise earnings based on accrual
accounting generally provides a better indication of an enterprise’s present and continuing
ability to generate favourable cash flows than information limited to the financial effects of
cash receipts and payments.”9 Also “considerable research documents that historical cost in-
formation forecasts future earnings rather well on average”.10 According to the relevant litera-
ture the valuation of core operations of business enterprises is not resulting from a piece meal
valuation and aggregation of individual values of line items. Instead it is based on one of the
common representations of future cash flows (future dividends, free cash flows or – in com-
bination with book value – residual incomes) which are all founded mainly on income state-
ment data and discounted by appropriate costs of capital.11

Fair value accounting according to the asset and liability view follows a quite opposite strate-
gy. The balance sheet is in the limelight and the information task is interpreted as showing the
economic wealth embodied in a business piece-meal “by accounting for assets and liabilities
in the balance sheet at fair value”12 Information by fair value balance sheets seems to be very
easy: the vector listing the quantities of the different assets and liabilities held by a business is
multiplied by the vector of the related fair values. However since these fair values or – except
for “the reporting entity’s own data” under level 313 – the information necessary for the mark
to model valuation are delivered from there the market is source rather than recipient of in-
formation. Then the actual knowledge added by fair value accounting is the list of assets and
liabilities processed into an overall value by use of the individual fair values. Under real in-
stead of ideal conditions though it is always complicated to define assets and liabilities
whether accounting regulation or presentation of economic value is concerned. Actually the
problems of defining assets or liabilities and of valuing them with reference to an overall val-
ue of combinations are interrelated. Reporting on business combinations by the acquisition
method bears witness to this. But strange to say fair value accounting does not bother about
this question. Unfortunately both ways out are unsatisfactory. Traditional definitions of assets
and liabilities14 will not lead to an overall value of a business because the value additivity
property is not valid. The opposite strategy starting with the overall value of the business and

9
SFAC 1, Highlights, dot No. 9.
10
Nissim/Penman (2008), 16.
11
Soffer/Soffer (2003); Penman (2007).
12
Nissim/Penman (2008), 13.
13
SFAS 157.30
14
“I know what an asset is. I can see one, I can touch one, or I can see representations of one.
I also know what liabilities are”, Linsmeier in Nissim/Penman (2008), 61.
 7

splitting it up into values of assets and liabilities is not only inappropriately expensive15 but it
also makes the concept of piece meal valuation an absurdity. It is impossible to find the value
of a painting by multiplying the vector listing the quantities of the colours used by the vector
of the current prices of these colours. Actually the approach will lead to a grotesque estimate.
If the value of this painting is estimated directly it does not really make sense anymore to di-
vide the overall value into the values of the colours and the residual value – positive or nega-
tive – of the work of art.

Apart from the balance sheet fair value accounting is completely unable to inform markets or
market participants. Calculated according to ideal fair value accounting “earnings are unin-
formative about future earnings and about value; earnings are changes in value and as such do
not predict future value changes, nor do they inform about value (value ‘follows a random
walk’, as it is said)”.16 If fair value earnings – as Nissim and Penman assert – inform about
risk,17 this risk is definitely not the risk of a going concern. It is rather the risk of a speculator
whose view is quite different outside the ideal world and who will rather be interested in the
risks and returns of individual assets or of special portfolios reducing risk. Whether fair value
based “earnings report the stewardship of management in adding value for shareholders”18 is
not quite clear especially from the perspective of a going concern, since “earnings (changes in
value) is a random shock that has no growth” and since “earnings do not repeat in any pre-
dictable fashion”.19

Dependent on well informed markets able to deliver accurate fair values fair value accounting
should be interested to ensure that the market is supplied with the information it needs to per-
form this task. In fact fair value accounting is completely free from worries in this respect.
Taking the existence of fair values for granted the only concern is dedicated to the use of fair
values and their aggregation to assess the value of a business. Markets needs for information
suitable to find future cash flow based fair values are disregarded and unknown. Without re-
gard of the information available to markets in order to price assets and liabilities it is prob-
lematic to assume that “A quoted price in an active market provides the most reliable evi-
dence of fair value”.20 The adoption of fair value accounting for example will edge out its
rival historical cost accounting with probable consequences for the quality of the fair values.

15
“Separating goodwill into different components is a complete waste of time.”, PricewaterhouseCoopers
(2007), 11.
16
Nissim/Penman (2008), 13.
17
ibid.
18
ibid.
19
ibid.
20
SFAS 157.24.
 8

“Fair value accounting cannot displace historical cost accounting on which fair value is
based.”21 Serving exclusively to inform markets and market participants there is no improve-
ment in financial accounting if former information is wiped out, if the way information is car-
ried into markets is not regarded as interesting and if markets are supplied with their own in-
formation only: You can not fill up a bucket by pouring in water taken from this bucket.

As a result quite a number of reasons seem to indicate that piece meal fair value accounting
and information of markets do not go together well. For a final judgement of course further
investigation is necessary.

3. “Mark to market” and the assessment of the value of a business

“A quoted price in an active market provides the most reliable evidence of fair value and shall
be used to measure fair value whenever available”22 – subject to selected exceptions only.23
With active markets defined by the fact that “prices are available to the public”24 “from an
exchange, dealer, broker, industry group, pricing service or regulatory agency”25 fair value
accounting seems to be a children’s game. Since prices in perfect and complete markets are
quite different from those in real markets – especially if the information needed by these mar-
kets to find fair values is left as an open issue – things are a bit more complicated though.
Taking the task of accounting for value of a business for granted the following analysis con-
centrates on the contribution of prices in active markets to the assessment of overall values of
businesses.

In real markets there are neither homogeneous expectations of market participants nor stand-
ard business models and asset combinations where every asset is used according to a theoreti-
cal optimum for overall economy. Therefore the idea of a “consensus view of all market place
participants about an asset or liability’s utility (or) future cash flows”26 sounds strange. Assets
are rather combined in specific ways and used to serve individual business models which of
course are resulting from heterogeneous educations, talents and expectations. So even mas-
terminds who are familiar with all the different expectations concerning assets traded in a
market will distinguish between their own expectations and those which will probably deter-
mine the market prices. Heterogeneous expectations and business models resulting in individ-

21
Nissim/Penman (2008), 42.
22
SFAS 157.24; ED/2009/5.48.
23
SFAS 157.17, .26 und .C68; ED/2009/5.36 und 5.50.
24
IAS 36.6; 38.8; 41.8.
25
IAS 39. AG 71.
26
SFAC 7.26.
 9

ual price limits for potential transactions and carried into an active market are transformed
into a price by a rule specified for calculating prices, normally the principle of highest volume
traded. At the point where the marginal supplier and buyer meet the price corresponds to their
special limits and equals their individual value. For the other successful market participants
and for potential sellers unable to sell the asset they own the value of the asset is different. It
was lower for those who sold and it is higher for those who bought or who did not sell the
asset they own. The prices in active markets then express a “middle range” value characteris-
tic for the marginal supplier and buyer. For everybody else the individual “values in use”27 as
elements of a piece meal approach to assess the value of a business without leaving every-
thing of interest to goodwill or Badwill are different. Since real markets in contrast to ideals
in model worlds are sensitive both to the volumes offered or asked and the information con-
veyed to the market by planned activities the value can even be different for everybody. If for
instance a painting is sold by auction and nobody involved knows that it is a “Rubens” the
market will assign a bad price (similar of that assigned to subprime mortgage backed securi-
ties in the time of euphoria).

Except for investments in financial instruments prices in active markets for individual assets
can also not be founded on the future cash flows expected to be generated by these assets.
Since cash flows generated by asset combinations cannot be split up properly into the contri-
butions provided by the individual combination-use-assets engaged there can be neither corre-
sponding expected future cash flows nor individual values consequently based on future cash
flows only. This is also true for the individual values in use of investments for speculation.
Therefore prices in active markets for individual assets have to result from a more complicat-
ed system of value driving factors.

Whether assets are valued by use of historical cost, of “objective” fair values given by prices
in active markets or – to minimize the problem – of “subjective” values in use the sum of the-
se values will not lead to the overall value of the business for owners and creditors; there is no
value additivity property28 in our real world. Both “allocating the cost of an acquired entity to
assets acquired and liabilities assumed” according to the “Purchase Method” of SFAS 141
and “recognising and measuring the identifiable assets acquired, the liabilities assumed and
any non-controlling interest in the acquire” according to the “acquisition method” of IFRS 3
give ample proof of this in dealing with business combinations presented by individual fair
values. Even after the recognition of all intangible assets according to criteria specially tai-

27
IAS 36.6 and .30-.57; in favour of value in use, Bromwich (2004).
28
Beaver (1998), 39.
 10

lored to be used for business combinations there will normally remain either an “excess of
cost over the fair value of acquired net assets (goodwill)” or an “excess of fair value of ac-
quired net assets over cost” (badwill). Differences arising from almost every business combi-
nation indicate that fair value accounting faces even more shortcomings in presenting the val-
ue of a business because of the restrictive recognition of internally generated intangible assets
compared to those acquired in a business combination. Internally generated goodwills which
make piece meal valuation an absurdity may not be recognised under US-GAAP and IFRS
anyhow.29 According to evidence from business combinations the differences are material
even if intangibles are recognised generously.

In contrast to ideal markets real world prices even in active markets are imperfect and subject
to distortion. The logical minimum of imperfection is owed to the fact that efficiency has to
be established by search for inefficiencies and suitable action which is costly and has to be
remunerated by profits from arbitrage. By admitting that there is a “most advantageous mar-
ket”30 which “maximises the amount that would be received to sell the asset or minimises the
amount that would be paid to transfer the liability, after considering transaction costs and
transport costs”31 or “in which the entity would normally enter into a transaction for the asset
or liability”32 (or “a principle market”)33 – definitions aiming at different goals – FASB and
IASB concede the existence of imperfection. According to the results of Behavioral Finance
market inefficiencies are even more significant. There is ample evidence that instead of pursu-
ing a well diversified passive investment strategy investors violate fundamental postulates of
rationality in their trading: “they trade on noise rather than information”34 and follow irration-
al strategies being avers to sell stocks that have lost value and buy others just because there is
a recent history of rising prices or earnings for example. The history of the stock prices of
Royal Dutch relative to Shell between September 1980 and September 1995 – two shares par-
ticipating according to a fixed relation of 60 to 40 percent both in a joint cash flow and in the
power of control – contradicts the claim that prices in active markets equal value. In fact the
deviations from parity ranged from an underpricing by 35 percent to an overpricing by 10
percent of Royal Dutch relative to Shell.35 Moreover irrational behaviour and noise trading in
real markets are not uncorrelated so that the distortion influences are not neutralized but rather

29
SFAS 142.10; IAS 38.48.
30
SFAS 157.8; ED/2009/5.8.
31
ED/2009/5,8; similar SFAS 157.8.
32
ED/2009/5.10; similar SFAS 157.8.
33
SFAS 157.8; ED/2009/5.11.
34
Shleifer (2000), 10.
35
Shleifer (2000), 28 – 32.
 11

amplified by aggregation. Especially in combination with the performance concept of fair

value accounting widespread price to price feedback trading will fuel both euphoria and panic
in active markets.36 International standard setters are aware of this problem. As representa-
tives of fair values they accept prices derived from “orderly transactions”37 only. But while
just the negative extreme – “forced liquidation or distress sale”38 – is explicitly excluded there
is a wide range of uncertainty whether forced acquisition prices like those of the VW-share
end of October 2008 are also excluded and how to draw a line between orderly and not order-
ly transactions where prices need adjustments. While some exclude adjustments of prices as
long as transactions are still realized and as long as the transactions are not forced liquida-
tions, cases that are regarded as exceptionally rare,39 others are less restrictive. FASB and
IASB list four kinds of transaction prices that do not give evidence of fair values – related
parties transactions, transactions under duress caused e. g. by financial difficulty, transactions
including unstated rights and privileges or transaction costs and transactions not carried out in
the most advantageous market40 – and provide for adjustments if necessary both on Level 1
and 2 Inputs.41 In October 2008 an IASB Expert Advisory Panel even acknowledged the need
of significant adjustments to observable transaction prices to arrive at the price of an orderly
transaction.42 Thus even FASB and IASB concede divergences between prices in active mar-
kets and fair values. Recent experiences before and in the current crisis seem to suggest that
these differences may be material. Laux and Lenz for example summarize a paper by Coval et
al. by stating that “They find little evidence suggesting that the dramatic widening of the cred-
it spreads during the crisis is driven by fire sales; if anything, it corrected mispricing prior to
the crisis.”43

In summary there are numerous material reasons why prices in active markets can not serve as
elements of a piece meal aggregation of values leading to overall values of individual busi-
nesses. Under “fair weather conditions” they may add up to a torso whose relevance depends
on the degree of absence of creative and ingenuous quality of the business model. In times of
euphoria or panic even prices in active markets differ widely from values. Moreover only very

36
Shiller (2003).
37
SFAS 157.7; ED/2009/5.7.
38
SFAS 157.7; ED/2009/5.7; IAS 39. AG 69 and AG 72.
39
IDW (2007), 6; Lüdenbach/Freiberg (2008), 372.
40
SFAS 157.17 and C 68; ED/2009/5.36.
41
SFAS 157.26 and .29; ED/2009/5.47 and .52.
42
IASB (2008), Para 16.
43
Laux/Leuz (2009), 19.
 12

few assets compared to the masses existing are traded in active markets which according to
experience in the current crisis moreover can also turn to be inactive easily.

4. “Mark to model” and the assessment of the value of a business

“Mark to model” is another ingenious idea creating an impression of general applicability of

fair value accounting independent of the existence of active markets and even of their capabil-
ity to produce orderly transaction prices. Adjustments seem to turn unsuited prices in active
markets or resulting from individual transactions into fair values preventing criticism of bi-
ased fair values. Valuation techniques based on “assumptions that market participants would
use”44 – “shall maximize the use of observable inputs and minimize the use of unobservable
inputs”45 – give the feeling that fair values exist universally. Unfortunately these noble im-
pressions are just illusions. In fact the idea that all preparers of financial statements – with
IFRS for SME’s this is a huge number of persons – are able to estimate fair values is nothing
less than a revolution. Up to now there are two standard ways in economics to coordinate ac-
tivities: decentralized coordination by markets and hierarchical coordination by a central
planning authority like Gosplan in the former Soviet Union. Mark to model introduces a third
way. Every preparer of fair value financial statements is assumed to have enough information
to determine fair values capable both to show the inherent “wealth” to the owner and to solve
the problem of allocating scarce resources. With at least all preparers of financial statements
being capable to fulfil the functions of a central planning authority in the “soft” way of allo-
cating by prices all material problems of information and coordination in an economy should
be solved. Of course these miraculous capacities of preparers surprise particularly since fair
value accounting is only interested in spreading fair value figures but not in bringing infor-
mation besides fair values into the market. And it is incredible that just by switching to fair
value accounting problems that could not be solved by gigantic administrative bodies will be
solved by managers of SME’s in bywork. The idea that a considerable number of individuals
are able to determine fair values that markets were unable to find though – apart from the ex-
ceptions of level 3 inputs – the information they use are “the assumptions market participants
would use” is even more surprising.46 Thus mark to model is some kind of a dream vision.

The framework established by FASB and IFRS for measuring fair value confirms this impres-
sion. If problems are not simply ignored the regulation is confined to empty phrases, circular

44
SFAS 157.21.
45
SFAS 157.21.
46
Hayek (1948), 77 – 91.
 13

reasoning, qualities that are self evident and others that are problematic. Self evident is the
postulate to look for a price at the measurement date.47 Postulates like “orderly transaction”48
“independent, knowledgeable, able to transact and willing to transact”,49 concerning the mar-
ket participants for example are empty phrases. They mark different kinds of ideal conditions
stimulating an impression of perfection though everybody should know that perfection in the
above mentioned criteria is virtually unattainable in reality. Since it is also impossible to draw
a line of separation between acceptable and unacceptable degrees of perfection the criteria are
not really useful in the end. With empty phases as landmarks, several approved valuation
techniques that are at best coarsely outlined50 and vague guidelines regarding the intensity and
direction of the required search for information51 mark to model is rather marked to mystery,
maze or mist. Looking for a way out of this trouble FASB and IASB are trying to give orien-
tation to professional judgement but unfortunately they have to resort to circular reasoning.
Dealing with ranges of possible valuation results both SFAS 157.19 or .A13 and
ED/2009/5.39 offer the same solution: “A fair value measurement is the point within that
range that is most representative of fair value in the circumstances”.52 This solution will only
work if fair value is known before the measurement method is selected. It does not offer any
help to solve the measurement problem. It only gives evidence that given the individual cir-
cumstances and the knowledge of actual fair value the method has led to the same value,
which does not mean that the method will also work under different circumstances.

The assumption of “highest and best use” is problematic too. Introduced to abolish the ambi-
guity of the value of an asset if different ways of using it with different future cash flows were
admitted it does not refer to the way the asset will actually be used for the future and to the
value resulting from the intended use. Instead of values resulting from such considerations
(“values in use”) which go best with the assessment of an overall value of the business that
uses the assets mark to model focuses on the values assets have for the “champion”-user. But
while in a world of perfect and complete markets highest and best use is synonymous with
rationality it is nothing but a value driving bias for the majority of the businesses in the real
world taking advantage from different kinds of business models. The positive bias of the
highest and best use assumption does not only distort the synthetically deduced overall value
for all users except the champion but it is also inconsistent with the use of prices in active

47
SFAS 157.5; ED/2009/5.5.
48
SFAS 157.7; ED/2009/5.7.
49
SFAS 157.13; ED/2009/5.10.
50
SFAS 157.C 54.
51
ED/2009/5.28.
52
Similar ED/2009/5.B8.
 14

markets as fair values. While highest and best use deviates from individual use by regarding
champions only prices in active markets refer to the marginal buyer and seller which means
that individual use is replaced by the least profitable way the asset can be used by market par-
ticipants holding the asset. Both interpretations of fair value are contradictory.

best use = max {A,B}

A B

individual
„values in use“
by holders

price in active markets

individual
„values in use“
by non holders

C D

Transactions

Moreover Example 1 – “Asset Group” of Appendix A53 of the Implementation Guidance to

SFAS 157 throws discredit upon the whole fair value information concept. The example de-
scribes the way an asset C used in combination with the assets A and B has to be valued ac-
cording to the ideas of “in use” valuation combined with “highest and best use”. Different
buyers have different ways of using the asset in an asset group. Example 1 confronts two buy-
ers using the assets A, B and C in different ways with specific values both of the asset group
and of the assets in the group. The following values are assumed:

buyer S buyer F
asset A 360 300
asset B 260 200
asset C 30 100
asset group 650 600

53
SFAS 157.A8 and A9.
 15

According to the interpretation of “highest and best use” applied to this example the fair value
of C is 30 because this is its value resulting from the best use of the asset combination enclos-
ing C.

Starting with the highest value of the asset group, which expressly reflects the synergies with-
in the group of asset used this way,54 and allocating it to the assets involved is incompatible
with the synthetic piece meal deduction of the value of an asset combination by adding the
values of the assets in this combination. It is the exact opposite way of regarding the valuation
problem. In addition the deduction of the asset values from the value of an asset group that
incorporates synergies postulating that the values of the assets add up to the value of the
group without any difference (goodwill, badwill) is impossible. This is especially true if the
values are supposed to reflect the future cash flows generated by the assets involved since
combination-use-assets do not generate individual cash flows.

Also the solution will only work if all users of the asset use it in the same combination with
other assets. In this case the main additional information for the market in a fair value balance
sheet – the combination of assets – is fixed and known to anybody who owns one of the as-
sets. In case of businesses consisting of one asset combination only it is just the volume of the
business that is revealed to the market.

Not all owners of an asset of course use it in the same combination with identical complemen-
tary assets. On the contrary an individual mix of assets according to the specific business
model and to the special conditions will be the norm. This individual mix – the vector listing
the quantities of the different assets and liabilities held by a business – has to be different if
fair value accounting wants to be in a position to supply additional information to the market.
Besides there also are unique assets which have to be valued according to the highest and best
use too. Under more realistic conditions like that highest and best use makes sense only, if
preparers of financial statements know the different ways the assets of the business are used
by other owners especially by those who found the best ways of using them. Following the
technique described in SFAS 157.A8 they must have an idea of the asset combinations real-
ized by the champion users and of the ways the overall values have to be allocated to the indi-
vidual assets involved. This inescapable implication of Example 1 and the highest and best
use assumption however means that all businesses owning an asset have to know the asset
combinations of the champion users of this asset. Consequently the values of the champion
businesses must be known to the market so that the fair value-financial statements of these

54
SFAS 157.A8a.
 16

businesses contain absolutely no new information. Financial statements of the other inferior
users may show unknown figures. But the market knows that they are inferior users and that
the values shown do not indicate the future cash flows generated by these inferior users but
rather those of the champions. Thus there is new information but it is not useful and the mar-
ket is well aware of this.

Even if preparers are assumed to strive for the best estimates of fair value mark to model will
turn out as a malicious kind of a maze. Since possession of information about values which is
superior to the information available to the market may be converted into profit it must be
difficult to find such information. Therefore superior information can not be held by a majori-
ty or even a big number of market participants without disseminating this information instan-
taneously to the market. These interrelations lead to another challenge for the highest and best
use assumption. The highest and best use of an asset results in the most advantageous future
cash flows because the bulk of the other owners of this kind of assets are either ignorant of
this outstanding kind of using the asset or unable to realize it. For somebody ignorant of or
unable to realize the highest and best use of an asset it must be quite difficult to estimate the
value of an asset based on this unknown or inaccessible way of using it. At least he can hardly
be called an expert to perform this job so that his estimates will rather have a low quality. If
on the other side all owners of an asset were aware of the highest and best use and also able to
switch over to it supply of the products resulting from the highest and best use would rise
while the supply of the products of inferior kinds of use would fall. As a result all kinds of
using the asset would result in the same benefits, highest and best use therefore would no
longer exist and estimating the value of the asset under such unrealistic conditions would be-
come even more difficult.

If transactions have dried up because the values assigned to an asset by the current owners
and potential sellers are incompatibly higher than those of the potential buyers mark to model
urged to use market corroborated information only has to work wonders. By using mark to
model it must be possible to overcome the differences of expectations between potential buy-
ers and sellers by reducing the uncertainties prevailing in the market and by anticipating the
consequences of a decline of the irrational aversion of owners to sell assets that have lost val-
ue.

Actually individuals provided with information superior to that of the market (e. g. a person
exclusively knowing that a painting offered by auction is a “Rubens”) will hardly pass over
their knowledge to the market. They will rather keep it secret and take action to profit from it
 17

no matter whether the knowledge resulted from luck, from ingenious vision or from hard
work.55 By acting of course prices in the market will be influenced in a way that absorbs the
additional information. But in this case it is the market, not the adjustment by the individual
or its mark to model based value that disseminates the superior information to the public. Of
course there are professionally qualified valuers.56 They earn their money by supporting the
preparers of financial statements to estimate fair values according to mark to model and to
chase away apprehensions concerning a distortion of the information conveyed to the market.
Accordingly the information they provide must not prove to be profitable by arbitrage. It ra-
ther has to give the impression of being well-founded and unbiased to the public while serv-
ing the interest of the management by making maximum use of the flexibilities offered by
regulation. And such experts do have both the motivation and the expertise to go to the limits.

Since preparers are either unable or understandably unwilling to supply the public with in-
formation superior to the market mark to model in the end just endows them with leeway in
estimating fair values. “Fair value is what you want the value to be. Pick a number.”57 Illus-
trated by figures taken from the actual Forms 20-F filed with the SEC and alternatively recal-
culated by changing some of the input variables, “all of which fall within the bounds of ac-
ceptability” Ernst & Young show that charges to income as required by IFRS 2 Share-based
Payment vary considerably: equally legitimate ways of presentation applied to four identical
basis data cover ranges up to 114 % of the amount of the original charges and up to 116 % of
the income reported to the SEC.58 Actually mark to model is even more generous. If observa-
ble market data of level 2 is not available unobservable inputs reflecting “the assumptions that
market participants would use in pricing the asset or liability” of level 359 is admitted as a
substitute. Thus independent of the input and valuation technique almost any value formally
derived from mark to model is raised to the peerage of fair value. Admitting any value means
that virtually nothing is excluded and fair values according to mark to model are boundless.
Unable to bind preparers to search for amounts “most representative of fair value in the cir-
cumstances”60 mark to model finally creates an eldorado for accounting policy which will be

55
Hedge-fund managers like John Paulson betting against subprime mortgages give evidence to their as-
sertion.
56
IAS 16.32.
57
The Wall Street Journal Europe, Nov., 8th, 2004, M8 with reference to Charles W. Mulford.
58
Ernst & Young (2004), 5.
59
SFAS 157.30; ED/2009/5.53.
60
SFAS 157.31; ED/2009/5.39.
 18

gratefully accepted by preparers. “Indeed, valuation techniques such as discounted cash flow
analysis are notorious for abuse; they can be used to justify a wide range of valuations.”61

All this puts users of mark to model based fair value accounting into a bad position. Figures
produced by preparers which are not only incapable to estimate fair values in the desired way
but also unaware of the relation between their estimates and the values looked for and which
in their personal interest cause bias to these figures are hardly informative for users. These
poor people are completely unable to disentangle the confusion resulting from inabilities and
creative accounting practices. Since all details concerning assumptions, valuation models or
inputs to the models and all influence of bias is aggregated in the values users are excluded
from adjusting the figures even if they are provided with superior information referring to
some details. Users are fobbed of with mysteries instead of understandable and transparent
information. Notes lighting up the backgrounds of the values – stipulated by extensive disclo-
sure regulation – can of course reduce these problems. However such disclosure is costly and
it diverts attention from valuing the business as a whole to the flood of individual values hid-
den in every balance sheet item. At best little progress in calculating the current values of the
colours forming a painting will result but not a real progress in valuing the painting.

Based on the illusions that masses of individuals are able to assess fair values while markets
are unable to do so and that those who actually have better information than the market pro-
vide this information to the public mark to model is unrealistic. Neither guidance by nice
sounding words only nor “champion”-conditions incompatible with the substance of prices in
active markets can show ways out of this dilemma. Inconsistency and vagueness of this ob-
noxious creature turn mark to model into mark to mystery, maze or mist with devastating con-
sequences for the information generated by this concept.

5. Consequences of strategies to overcome difficulties connected with the information

purpose of financial reporting

The asset and liability view as well as the revenue and expense view do not inform by provid-
ing figures which according to the information concept chosen are directly relevant for users.
Instead of values derived from overall free cash flows or flows to equity and appropriate cost
of capital FASB and IASB trust in a piece-meal concept of valuation while historical cash
flows rearranged in order to increase their predictive value substitute future cash flows within
the scope of historical cost accounting. The actual implementation of the fair value concept by

61
Nissim/Penman (2008), 36.
 19

US-GAAP and IFRS however does not realize this approximation consequently. Presumably
prompted by various reasons the leading standard setters have modified the substitute in many
ways.

Perhaps motivated by the considerable problems inherent in the mark to model approach gen-
eral use of fair value was replaced by a “mixed-attribute model” combining fair values and
historical cost to a complex selection of manifold methods. While according to the principle
of prudence generally only lower – for assets and higher for liabilities – fair values are able to
displace historical cost in the sense of a non-symmetrical use of fair values symmetrical fair
valuation is restricted to selected conditions many of which are actually not mandatory and
which are partly different in IFRS from US-GAAP. Full use of fair values with all changes in
value immediately included in profit or loss is confined to derivatives, to financial instruments
designated for trading purpose or at fair value through profit or loss,62 to a few special kinds
of inventories traded in an exchange63 or owned and designated to this valuation by a broker-
trader (IFRS only),64 also in IFRS only to biological assets and65 – as a choice and in IFRS
only – to investment property.66 Foreign currency monetary items are updated but only with
regard to the development in the exchange rate.67 Financial instruments designated as availa-
ble for sale are symmetrically adjusted to fair value but fair value changes are assigned to
equity and other comprehensive income as long as they are not caused by an impairment.68
IFRS extend this in a free choice to investments in subsidiaries, jointly controlled entities and
associates in separate financial statements.69 While changes in value which were not caused
by impairments or their reversals and which were assigned to equity and other comprehensive
income have to be recycled on derecognition of an available for sale asset70 the revaluation
method eligible under IFRS goes another way yet. Admitted to be used for property, plant and
equipment and for intangible assets traded in active markets revaluation leads to a corre-
sponding net of tax increase in equity that is not recycled but transferred from revaluation
surplus to retained earnings either spread over time according to wear and tear or fully on
derecognition.71

62
SFAS 115.12a; IAS 39.9, .46 and .55.
63
SFAC 5.84 e; IAS 2.3 (a).
64
IAS 2.3 (b).
65
IAS 41.12 and .26.
66
IAS 40.30, .33 and .35.
67
SFAS 52.15; IAS 21.23 (a).
68
SFAS 115.13; SFAS 130; IAS 39.55 (b).
69
IAS 27.38.
70
SFAS 115.13; SFAS 130.18; IAS 39.55 (b).
71
IAS 16.41.
 20

With this regulation and with banks and agricultural activity left aside the obligatory use of
fair values according to US-GAAP or IFRS is not important to any appreciable degree.72 Thus
the asset and liability view is not only a quite dubious vision but also just a pie in the sky.
According to figures aggregated from 10-K and 10-Q filings of large bank holding companies
and large investment banks this is even true for banks. Referring to figures of Laux and Leuz
(2009) covering the first quarter of 2007 to the first quarter of 2009 the fair value to total as-
sets-ratio ranges from 31 % to 34 % for large bank holding companies and from 43 % to 55 %
for three (first quarter 2009 two) large investment banks.73 Within the period of time regarded
the share of level 1 fair values is going down with quite constant but high level 2 fair values
for major investment banks and also high but increasing level 2 fair values for major bank
holding companies while level 3 fair values are growing strong for all banks at least till the
third quarter of 2008 but with an overall moderate importance of 7 % to 14 %.74 Assets pre-
sented at fair value by smaller bank holding companies cover approximately just 21 % of total
assets.75

Deficits in the presentation of overall value in a balance sheet are also due to the fact that in-
ternally generated intangible assets are largely ignored and unrecorded.76 In order to fulfil
their mission by supplying a complete accounting for value the promoters of the asset and
liability view have to find solutions to this problem which will fill the gap to a greater extent.
Up to now FASB and IASB follow different strategies both with little success. Under US-
GAAP different topics are picked up and solved individually. In this spirit there is regulation
for research and development costs,77 for exploration costs in the oil and gas industry,78 for
specific costs in the record and music industry,79 for costs of a title plant,80 for costs of inter-
nally generated software,81 for costs of broadcasters82 and of producers and distributors of
motion picture films83 and for costs of direct response advertising.84 Apart from internally
generated software this regulation does not really contribute to fill the gap because it is re-
strictive with regard to the solution for research and development cost and with regard to the

72
Küting/Zwirner/Reuter (2007).
73
Laux/Leuz (2009), 39.
74
ibid.
75
ibid, 37.
76
SFAS 142.10; IAS 38.48.
77
SFAS 2.
78
SFAS 19.
79
SFAS 50.
80
SFAS 61.
81
SFAS 86; SOP 98 – 1.
82
SFAS 63.
83
SFAS 139; SOP 00 – 2.
84
SOP 93 – 7.
 21

general relevance of the other topics dealt with. The IFRS-strategy rests on a differentiation
between research costs – which have to be expensed as incurred – and development costs –
which shall be recognised as an asset if six conditions are met.85 Since especially one of the
six conditions – the intention to complete the intangible asset86 – is subject to arbitrary discre-
tion, the duty to recognise development costs as an asset is in fact a free choice to do so. By
this it is up to the management whether the gap is partly filled or not. In any case the problem
of recognising intangible assets in the balance sheet is still an open issue particularly because
internally generated goodwills may not be recognised as assets under both standards.

The shortcomings both in valuation and in recognition of assets have significant consequences
not only for a fragmentary accounting for value but also for a manipulation of earnings due to
imminent violation of matching. In 2007 and 2008 especially U.S. American banks have pre-
sented profits resulting from an increase of the entity-specific credit risk borne by the entity’s
creditors which has led to a decrease both of the value of the claims of the creditors and of the
liabilities of the banks.87 Of course the increase in risk is also tied up with an even bigger loss
in value of the entity because the holders of equity are involved in this loss of value too. As
long as goodwill and other intangibles are not recognised however this loss in value does af-
fect mainly or only the assets and values outside the balance sheet. Thus an imaginary profit
is created.

Seen in the cold light of day the mixed-attribute model reveals fair value accounting to be
distressed between Scylla and Charybdis. Complete accounting for value requires both com-
prehensive coverage of assets including goodwill and comprehensive use of current values,
values in use or fair values. Both duties result in insolvable problems because the overall val-
ue of a business can be founded neither on a piece meal definition of assets nor on individual
current values. In trying to avoid the problems by exclusion of a wide range of intangibles
from the balance sheet and by extensive renunciation of using mark to model-based fair val-
ues FASB and IASB of course knock the bottom out of the asset and liability concept. Eroded
by the mixture financial reporting according to the leading accounting standards falls between
two stools. The selective use of fair values “through profit or loss” destroys earnings while
restrictions of using fair values undermine the presentation of wealth. That the recognition of
all development costs as expenses and further reductions in the use of fair values for financial
instruments, for property, plant and equipment, for intangible assets and for biological assets

85
IAS 38.54 and .57.
86
IAS 38.57 (b).
87
Becker/Wiechens (2010), 235 and 236.
 22

are presented as a strength of IFRS for SME’s though the asset and liability concept is not
abandoned88 comes close to an embarrassment. Watering a concept will hardly result in an
improvement of its realization. Inappropriate in a similar way are attempts to justify the asset
and liability concepts by referring to several “safeguards” against marking to potentially dis-
torted prices or to prevent regional segregation of standards by stepping back in reaction to
political pressure.89 Opportunities to replace mark to market by mark to model and level 2
inputs by level 3 inputs will neither prevent the use of distorted prices in balance sheets nor
ensure the use of values with less distortion. Instead there will be more latitude for creative
accounting practices able to improve or – and more probable – to deteriorate the resulting
information. Especially private standard setters distinguished by their technical expertise to
serve public interests in all matters are in danger of loosing public confidence if they give in
to easily to political pressure. The history of the recent financial crisis shows little resistance
to this kind of pressure though this pressure aims at the very heart of the information function.
Often encouraged by influential representatives of banks powerful politicians urged the stand-
ard setters to reduce the need for devaluations of financial instruments. In something like a
race to the bottom FASB and IASB – accompanied by Japan – loosened their standards on
reclassification and devaluation of financial instruments in 2008 and 2009 within a few days
while periods of a half to one year are normal. “Fair-value accounting was not pushing values
unreasonably low; instead, it appears that banks were able to overstate their assets in a way
that did not help to build confidence.”90

Vision and reality of fair value accounting are worlds apart. Committed to inform the markets
by a complete accounting for value according to the asset and liability view FASB and IASB
as a rule actually stick to conservative historical cost accounting modified by the principle of
prudence. Symmetrical fair valuation and additional mandatory capitalization of intangible
assets play a role of little significance. According to current figures of US banks even the rev-
olutionary presentation of financial instruments did not lead to radical changes. Shocked by
harsh consequences of the recent financial crisis and by an accompanying shift in public opin-
ion revisions of IAS 39 are justified now by the chance of an extended use of historical cost
instead of fair value.91 Anyhow immediate softening of their standards was the reaction of the
leading standard setters to political pressure.

88
IASB (2009).
89
Schildbach (2008).
90
Laux/Leuz (2009), 13.
91
Frankfurter Allgemeine Zeitung, October 10th, 2009, 20; Financial Times Deutschland, October 10th,
2009, 16.
 23

6. The contribution of fair value accounting to financial crisis

Historical cost accounting according to the revenue and expense view and fair value account-
ing according to the asset and liability view have fundamentally different ideas about profit.
The revenue and expense view is dedicated to the vision of an indicator of current operating
performance trying to approximate its ideal: the information adjusted ex ante economic earn-
ings (“nachträglicher Idealgewinn”). In the case of success – which will hardly come true
mainly since future does not simply continue the past – the revenue and expense view shows
permanent earnings which are easily transferable to value if divided by the appropriate cost of
capital. Seen by the asset and liability view profit is the difference between the value of the
entity at the end of the period compared to that at the beginning. Perfect measurement of val-
ue taken for granted this profit will be equal to the ex post economic earnings which combines
ex ante economic earnings and a capital gain or loss (“Zinsen und Kapitalgewinn”). This prof-
it in the sense of a comprehensive income indicates the changes in wealth. Due to capital
gains and losses included which in markets of rational expectations result from pure random92
this type of profit differs from permanent earnings. In particular there is no way to directly
deduce current value without knowledge of the value at the beginning of the period.

A simple model and some figures might illustrate these rather academic ideas. In a multi-
period model-world of uncertainty it is up to chance to decide which state of the world will
occur at the end of the period. If the actually realized state of the world can be regarded as
best indicator of expectations concerning possible future developments and if the expected
rate of return is assumed to be a constant 10 % the different types of profit can be illustrated
easily on the basis of an arbitrary sequence of states of the world.

92
Nissim/Penman (2008), 13.
 24

economic value

4.000

3.500
300
3.000 〈- 500〉
〈+ 1.000〉 1.300 250 250
2.500 〈+500〉
200
〈± 0〉 200 - 250 〈- 1.000〉 + 750
2.000 〈+500〉
+ 700
200 150
1.500
- 850

1.000

500

0 1 2 3 4 5 6 time

information adjustet ex ante economic earnings („nachträglicher Idealgewinn“)

capital gain or loss („Kapitalgewinn)
information adjusted ex ante economic earnings plus capital gain or minus capital loss („Zinsen und Kapitalgewinn“)

Different profits induce different incentives. Traditional historical cost earnings which contain
capital gains only if assets have been sold profitably while due to the principle of prudence
they punish for losses in value immediately do not induce speculative action but rather deter
such plans. Management attention is drawn to operating profits resulting from asset combina-
tion according to a favourable business model. Modern fair value based profits however con-
tain both capital gains and losses immediately – either directly in profit or loss or – at least
temporarily – in equity and other comprehensive income only. Well-disposed towards chanc-
es of appreciations in value and supported both by the shareholder value movement and by a
rather short time horizon of management induced partly by short-sighted compensation plans
fair value based profits urge management to engage in speculative investments. This is espe-
cially true in times of bull markets and euphoria when price to price feedback trading is fasci-
nating increasing parts of society. Fair value accounting contributes to the boom not only by
the instant response of profit to value appreciation which is not impeded by price-reducing
sales in order to realize gains but also by the immediate increase of equity creating new op-
portunities of action. Moreover managers are strongly motivated to look for or even create
opportunities allowing to turn value appreciation into profits. The financial innovation of sub-
prime mortgages lent to borrowers previously and with good reason excluded from being
granted a loan and afterwards refinanced and tranched by sophisticated, multistage and
 25

opaque securitisations leading to the result that the final lenders do not have any idea both of
the risk they bear and of the specific collateral backing their claim is an excellent example.
Even the basis of the business – the hope for a long term appreciation of house prices93 – was
perceptibly wrong because inflation adjusted U.S. housing prices went through a sequence of
bubbles and crashes in the years 1975 to 2008 with the biggest bubble – homemade by the
subprime business – arising from 1997 to 2007.94

Value appreciation as the core element of profit was also the main driver of the subprime
bubble and – after its burst – of the crash. Subprime mortgages had a very special structure
invented to make them affordable to low-income households, to camouflage the risk, to create
a source of cash flow for the lenders and by this to get the business running.95 Borrowers were
attracted by a moderate “teaser” interest rate for two or three years with the prospect to re-
finance the mortgage with a new one adjusted to the fair value of the house if this value has
risen sufficiently. Turning fair value appreciation of the boom into a growing flow of cash by
refinancing old mortgages with new and bigger ones was the rousing idea of the subprime
business. Every two or three years mortgages not affordable to the lenders and all the bonds
and CDOs derived from them could be amortized and served with interest creating an impres-
sion of safety which paved the way for the sale of the new bonds and CDOs. In addition not
only the chain of managing banks were remunerated but also the lenders were allowed to use
the remaining surplus for consumption purpose instead of building up an equity stake.96

Trouble began when demand for new houses weakened because a growing number of new
mortgages was used to amortize old ones but not to buy new houses. If value appreciation
falls short of the “teaser” interest rate the subprime business collapses entirely. With lenders
often unable to afford even moderate interest rates a breakdown of refinancing nearly cuts
down cash flow from subprime mortgages completely. This brings many holders of the bonds
and CDOs in big trouble because financing their investments by commercial papers was usu-
al. The options of the lenders trying to gain from the boom and to avoid losses by selling be-
fore the prices fall considerably did not work because with the burst of the bubble price reac-
tion was fast and drastic. Instead the implicit “heads I win, tails you loose”-options of the bor-
rowers to gain from the boom with chances to get rid of the mortgage by leaving the devalued
house to the bank and perhaps to repurchase it at a bargain price worked well. Direct depend-

93
„House prices were supposed to always go up.“ Gorton (2008), 49.
94
The Wall Street Journal Europe, April, 7th, 2009, 15.
95
Gorton (2008).
96
ibid.
 26

ence on the development of house prices and their extensive transformation into cash flows by
trust in fair values made the subprime business boom when prices were rising but it also made
it bust even faster when home prices were not rising any more. Bad news always rouse fears.
Sales induced by lack of liquidity or by immediate decline of equity – both typical for the fair
value driven subprime business – together with sales resulting from danger of further losses
will of course increase pressure on prices. Prices either fall significantly or vanish because
markets dry up. Fire sale prices as well as lack of prices bring mark to model and estimation
into play again which are inclined to exaggeration however tending to enthusiasm on sonny
days and to panic in hard times.

Favourable by reducing uncertainty and asymmetry of knowledge in any case all information
slightly boosts positive expectations by good news and negative expectations by bad news.
This tendency however is amplified considerably by changing from historical cost based ac-
counting to fair value accounting. If profits consist mainly of changes in value and manage-
ment compensation refers to such profits in a way that prospects to gain are combined with
the chance to leave the losses to others manager change their behaviour. Interested in hardly
anything but value appreciation they are not only willing to engage in risky speculation but
also highly motivated to develop business models which turn expectations of value apprecia-
tions swiftly into profit. The business of subprime mortgages and their multiple securitization
bears witness to that. At the beginning such a business feeds itself. Hope for rising prices – if
needed fuelled by loans – induces more demand, boosts observable prices and under fair val-
ue accounting also profits immediately. As long as the public is unaware of the risk it is easy
for the originators to sell their securities and for the buyers to finance their transactions. With
the burst of the bubble conditions change instantaneously since there are neither goodwills
nor due to fair valuation any hidden reserves. Accompanied by illiquidity caused by the “re-
vival” of risk the price collapse both in markets and models wipes out equity and makes loss-
es soar. In such a mess the obvious thing to do is to water the rules of fair valuation and esti-
mation hoping to relief the pain.

7. Conclusion

Informing markets and market participants is important only in realistic worlds of imperfect
knowledge but not in markets which are – or which are regarded to be – perfectly informed
already. Actually information plays an important part in such a world since superior infor-
mation in particular fields is the core of both the business models implemented by enterprises
and of the investment strategies of their investors and creditors which are not just perfectly
 27

diversified. Information in order to improve market efficiency and allocation of resources

however competes with the need of safeguarding secrecy necessary for those who create supe-
rior knowledge in order to reap the rewards of their endeavour for the innovators and their
financiers. Thus free access to the internal information system of an enterprise in order to
“level the playing field” is not a solution to the information-problem.

The objective of general purpose financial statements is to provide new information about the
providing entity97 no matter whether the overall value of the entity or its performance in the
past as one indicator of future profitableness is moved into the centre. Compared with this
objective fair value accounting according to its intention is a beneficiary of market infor-
mation rather than an information instrument. It assumes the existence of fair values trusting
in comprehensive knowledge of the market and if required in breathtaking capabilities of pre-
parers to adjust “unfair” market prices98 or to even evaluate missing ones. Perfect capability
to estimate values of assets in conformity to their highest and best use implies complete
knowledge of different ways of combining these assets, of using them according to the busi-
ness models possible and of the ways of allocating the overall values of the business to the
assets involved.99 As a consequence of the capabilities mentioned even asset combinations
used by the entities acting in a market are known to market participants so that the only thing
fair value balance sheets add to the values taken for granted are already known to the market
too. Incompetence to increase the knowledge of the market is finally established by the fact
that fair value accounting is in no way engaged to endow markets with the information they
need to determine fair values. Fair values then result from the utilization of not fair or “foul”
information. Moreover due to the highest and best use assumption estimated figures do not
conform to the entity reporting but to the champion-use of the assets valued. Of course the
“echoes” produced by fair value accounting in reality are far from the illusions created by the
theoretical concept and many details of the paper presented give reference for this.

Discrepancy between the theoretical concept and its imperfect conversion into real figures is
not the real problem particularly since all information concepts are far from being perfect. The
important and specific flaws of the fair value based concept of information have their roots in
illogicalities and in a less than half-hearted pursuit of the conceptual idea. Fair value account-
ing is not only fundamentally unable to supply markets with additional information its valua-
tion concept is also contradictory. Outside the theoretical world of perfect information there

97
IFRS Framework, 6 and 12.
98
SFAS 157.7 and .17; ED/2009/5.36.
99
SFAS 157 A 6 – A 12.
 28

are no objective fair values but only subjective values of assets. Thus the value of a business
can only be found by valuing the entire business according to the asset combination realized
and the business model strived for. Real world precludes the existence of individual cash flow
based values of combination-use assets as well as value additivity of individual asset values
leading to the value of the combination. Mark to model is the illusion that all preparers do not
only have knowledge and capability to estimate efficient prices every time markets fail to
determine such prices. They are also assumed to be willing to do so in spite of the benefits
they loose by disclosing instead of using their superior information and in spite of their moti-
vation of glossing over the facts. On top there are no reliable or even well defined methods of
estimation so that actually nearly every method and every information basis can be alleged to
lead to fair value while the only clear prescription – the highest and best use assumption – is
incompatible with the way prices are determined in active markets. US-GAAP and IFRS also
do not implement their valuation concept consistently. Their “mixed-attribute model” usually
combines few or some fair values linked to profit and equity in nearly every way imaginable
with a lot of historical cost, free choices and discretion. The problem of extending the asset
definition in a way that includes all material intangibles has not been solved. “Internally gen-
erated goodwill shall not be recognised as an asset.”100 Such a mix of concepts provokes the
danger that financial accounting will neither be useful to learn something about value nor
about performance.

Subject to imperfection too historical cost accounting according to the revenue and expense
view can at least contribute to the information of the market. The figures presented do not
only relate to the entity supplying them they can also be prepared only by this entity or by
persons with assess to its secret information and obliged to discretion. Investors and analysts
are invited to form opinions on the data and to come to their own expectations for the future.
But the concept does not need masterminds familiar with the consequences of all feasible uses
of assets combined by the entity they are interested in.

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 29

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