Fair Value Accounting
high confidence — compiled with source citation from the investment brain.
Fair Value Accounting
Fair Value Accounting
Fair value accounting is the effort to make balance-sheet book values a measure of current market or fair value rather than original cost. It sits at the collision point between accounting-quality and intrinsic-value: the question is whether an accounting statement should try to be a valuation. aswath-damodaran is the sharpest skeptic in this corpus; berkshire-hathaway and howard-marks add practitioner caveats.
The skeptic's case
Damodaran's lecture on the topic is titled Fair Value Accounting: Visionary Thinking or Oxymoron? and opens with the admission that gives the case its force: "Fair value accounting is now the path that true accountants want to follow. While those pushing for it may have the best of intentions, I am skeptical." He admits he does not know what fair value means, and neither, he argues, do the rule writers. His objection is that fair value is not a single number — it depends on whether one uses intrinsic or relative valuation, whether one values for a passive or active investor, and whether one is holding for cash flows or selling today. The same firm legitimately has five different fair values.
Why it does not deliver what its advocates promise
One claimed benefit is lower price volatility, since marked-to-market statements would better reflect value. Damodaran's evidence cuts the other way: "The acceptance of fair value accounting is going to do little to dampen stock price volatility. It may actually increase it." During the financial crisis the most volatile securities were precisely those of financial firms that marked to market, and the write-downs created a feedback loop — falling markets forced write-downs, which threatened capital ratios, which pushed prices down further.
The deeper problem is that accountants cannot be appraisers: "Accountants are not (and should not try to be) analysts, appraisers or evaluators." His four first principles for the standard-setters are deliberately modest: do no harm, don't overreach, keep it simple, less is more. See accounting-quality.
The history of the debate
The controversy is old. In his valuation survey, Damodaran notes that firms used to revalue assets at market value until 1934, when the SEC discouraged the practice to curb the manipulation that had become prevalent; the modern push is therefore partly a return to an abandoned ideal. "The move towards fair value accounting has not been universally welcomed even within the accounting community", with one camp arguing it better connects statements to value and the other that it increases the scope for manipulation.
The practitioner caveats
Buffett endorses mark-to-market in principle while rejecting a specific implementation: "We endorse mark-to-market accounting", he writes, before explaining why he believes the Black-Scholes formula produces strange results when the long-term variety are being valued. The distinction — the convention is right, but a formula that produces wild swings on long-dated contracts is not a fair measure of economic value — is the same complaint Damodaran levels at the concept of fair value itself.
Marks reaches the same conclusion from the market side, observing that the price Mr. Market offers "can diverge – sometimes wildly – from their fair value", so a fair value that merely chases market price inherits the market's mood. See mr-market. Marks grounds the same point in what mark-to-market actually does: it is public securities — "stocks and bonds" — that "mark to market regularly and are the assets that most enter my consciousness", so their quoted prices inherit investor psychology.
The common thread across all three voices: fair value is a useful input to valuation, but a dangerous substitute for it — the distinction that intrinsic-value exists to preserve.
Sources
damodaran/markdown/SFDayOne.mddamodaran/markdown/valuesurvey.mdberkshire-hathaway/Letters-Markdown/2008 - Letter to Shareholders.mdhoward-marks/Memos-Markdown/Mr. Market Miscalculates.mdhoward-marks/Memos-Markdown/The Calculus of Value.md