© 1995 American Accounting AssociationAccounting HorizonsVol. 9 No. 4December 1995pp. 97-107

COMMENTARY

Mary E. Barth and Wayne R. Landsman

Mary E. Barth is Associate Professor of Accounting at Stanford University, and WayneR. Landsman is Professor of Accountancy at the University of North Carolina at ChapelHill.

Fundamental Issues Related to Using Fair ValueAccounting for Financial Reporting

SYNOPSIS: This paper discusses fundamental issues relating to implementation of fair value ac-counting. We conclude that in settings economically equivalent to perfect and complete markets, afair value accounting-based balance sheet reflects all value-relevant information, the income state-ment is redundant, income realization is not valuation-relevant, and intangible assets relating tomanagement skill, asset synergies, or options are reflected fully in the balance sheet. In settingswith more realistic market assumptions, fair value is not well-defined, resulting in three value con-structs, entry and exit values and value-in-use. Because these are unobservable, implementation offair value accounting requires their estimation, potentially introducing estimation error. Unless esti-mation error is severe, value-in-use is the appropriate construct for firm valuation for going con-cerns because it captures total firm value associated with an asset. Also, neither the balance sheetnor income statement reflects fully all value-relevant information and income realization potentiallycan be valuation-relevant, although management discretion can detract from its relevance. We pointout that fair value accounting concepts apply equally to assets and liabilities. Finally, our discussionreveals no basis for recognizing in income only realized gains and losses, and that the concepts ofcore earnings and fair value accounting are unrelated.

I. INTRODUCTIONThe Financial Accounting Standards

Board (FASB) recently has issued severalstandards requiring recognition or disclosureof fair value estimates for assets and liabili-ties, principally financial instruments (e.g.,Statements of Financial Accounting Stan-dards (SFAS) 87,105,107,115,119, and 121).In addition, many of their current agendaitems and discussion documents address rec-ognition and measurement issues relating tofair value accounting (e.g., Discussion Memo-randa Recognition and Measurement of Finan-cial Instruments and Distinguishing BetweenLiability and Equity Instruments and Ac-counting for Instruments with Characteristicsof Both). Before implementing fair value ac-

counting on a more comprehensive basis, thereis a need to explore its basic characteristics.

This paper is a response to suggestions bythe FASB that academics are in a position tocontribute to its standard setting process byviewing financial reporting issues in a broadercontext than that associated with addressingspecific issues raised in their discussion docu-

We are indebted to the members of tbe Financial Ac-counting Standards Committee of tbe American Account-ing Association, 1992 to 1995: D. Collins, G. M. Croocb,J. Elliott, T. Frecka, J. Gribble, E. ImbofF, C. McDonald,S. Penman, D. G. Searfoss, J. Smitb, R. Stephens, andT. Warfield; our frequent co-autbor. Bill Beaver; mem-bers of tbe Financial Accounting Standards Board; andJ. Wablen for belpful discussions and comments. Ofcourse, any errors and omissions rest solely witb us.

98 Accounting Horizons / December 1995

ments (see FASB Status Report, August 21,1995). Thus, our goal is to investigate sev-eral fundamental issues related to using fairvalue accounting for financial reporting.^ Inparticular, we address the following questions.• What is meant by fair value?• In realistic settings where fair value is not

well-defined, are accounting measuresbased on one concept of fair value morevalue-relevant than those based on otherconcepts?

• How do fair value-based financial state-ments relate to firm value? In particular,does a fair value-based income statementprovide value-relevant information beyondthat provided by a fair value-based balancesheet?

• What are the implications for firm valua-tion of private information and estimationerror in fair values?

• Is income realization valuation-relevant?As does the Committee on Accounting andAuditing Measurement, 1989-1990 (Barrettet al. 1991), we assume that fair values con-ceptually are relevant to financial statementusers in assessing firm value, and define a fi-nancial statement item to be value-relevantif the information it reflects helps financialstatement users to assess firm value. We de-fine financial statement users broadly to in-clude creditors and others in addition to eq-uity investors. Although the FASB also dealswith questions of recognition, i.e., determina-tion of which financial statement items shouldbe recognized, we assume that all assets andliabilities that potentially are recognizableunder the present accounting model— includ-ing those that currently are not recognizedsuch as brand names and research and devel-opment assets—are recognized. However, thisassumption should not alter the basic tenorof the conclusions we draw.

We base part of our analysis of fair valueaccounting on an example in two settings, asimple setting in which fair values are obtain-able fi"om actively traded markets and a morerealistic setting where these assumptions arerelaxed.^ We also address two financial report-ing issues with which the FASB is concerned.

fair value accounting for liabilities and the im-plications of fair value accounting for State-ment of Financial Accounting Concepts ofearnings and comprehensive income and thealternative concept of core earnings that pres-ently is being discussed by the FASB (seeAICPA Committee Report 1993).

Our major conclusions are the following.Only in a simple setting economically equiva-lent to perfect and complete markets do thefollowing conditions hold: (1) fair value is well-defined; (2) a fair value-based balance sheetreflects all value-relevant information; (3) afair value-based income statement is redun-dant to valuation; and (4) income realizationis irrelevant to valuation. In more realistic set-tings, standard setters must choose among

1 Although the views presented here are our own, tbeyare based heavily on discussions we have had as mem-bers of the Financial Accounting Standards Commit-tee of the American Accounting Association over tbepast three years, wbicb in its comment letters consis-tently bas been supportive of fair value accounting(see Accounting Horizons, September 1993 tbrougbJune 1995 for several examples). We also benefitedgreatly from insigbts arising from joint research withBill Beaver on fair value accounting (e.g., Barth et al.1992, 1993, 1995a, and 1995b). Tbe ideas presentedhere also are based on tbe literature addressing is-sues relating directly to fair value accounting (e.g..Beaver et al. 1982; Beaver and Landsman 1983; Bea-ver and Ryan 1985; Bublitz et al. 1985; Magliolo 1986;Bernard and Ruland 1987; Harris and Oblson 1987;Beaver et al. 1992; Bartb 1994; Barth, Landsman andWahlen 1995; Bernard et al. 1995; Eccher et al. 1995;Nelson 1995; Petroni and Wahlen 1995). In addition,many of tbe conclusions we reacb bave been reacbedby otbers (see, e.g., Barrett et al. 1991).

^ Altbougb tbe FASB's present fair value accounting fo-cus is on financial instruments, our discussion appliesto all assets because, as noted below, tbe most impor-tant attribute of an asset as it relates to fair valueaccounting is wbether an estimate of its fair value iseasily obtainable, either because active markets existfor it or tbere are accepted tecbniques for estimatingits fair value, and not wbether it is a financial ornonfinancial asset. Nonetbeless, in practice, often itis more difficult to obtain fair values for nonfinancialassets because tbey typically are not actively tradednor are there accepted tecbniques for estimating theirfair values.

^ In tbe more realistic setting, measurement error infair value estimates exists, affecting tbeir relevance(Beaver et al. 1982; Beaver and Landsman 1983;Bartb 1991; Cboi et al. 1993; Barth 1994; and Bartbet al. 1995a). Tbrougbout, we use tbe terms estima-tion error and measurement error intercbangeably.

Fundamental Issues Related to Using Fair Value Accounting for Financial Reporting 99

three value constructs, entry and exit valuesand value-in-use. In such settings, neither thebalance sheet nor the income statement re-flects fully all value-relevant information and,if estimation error is not severe, value-in-usereflects flrm value under the going concernassumption more fully than other fair valueconstructs. Moreover, the presence of estima-tion error and private information enablesincome realization potentially to be valuation-relevant.

This paper is organized as follows. Sectiontwo defines fair value. Section three presentsthe example we use to illustrate our pointsand evaluates the role of fair value account-ing in the simple setting. Section four extendsour analysis to the more realistic setting. Sec-tion five discusses fair value accounting forliabilities and section six discusses the impli-cations of fair value accounting for the con-cepts of earnings, comprehensive income, andcore earnings. Section seven summarizes andconcludes the paper.

II. WHAT IS FAIR VALUE?In SFAS 107, the FASB defines fair value

as the amount at which an asset could be ex-changed in a current transaction between will-ing parties, other than in a forced liquidationor sale. However, this definition of fair valueis limiting because, except in settings that areeconomically equivalent to perfect and com-plete markets, fair value is not well-definedand alternative fair value constructs, entryvalue, exit value, and value-in-use, are likelyto differ (see Beaver 1987). Entry value is anasset's acquisition price or, if relative priceschange, an asset's replacement cost; exit valueis the price at which an asset could be sold orliquidated; value-in-use is the incrementalfirm value attributable to an asset (see Bea-ver and Landsman 1983; Beaver 1987).

Because the FASB is concerned with finan-cial reporting of a firm's assets in place andnot assets to be acquired, their definition offair value should be interpreted fi:om the per-spective of a seller. Thus, their fair value con-cept is exit value. Moreover, it relates only toexchange transactions in which, by construc-tion, the seller's exit value equals the buyer's

entry value. More importantly, because theirdefinition is not stated with reference to aparticular economic setting, fair value in othersituations is not defined. In particular, thedefinition makes no mention of a value-in-useconcept of fair value for assets without activeexchange markets, and is silent on what pri-vate information the buyer and seller eachhave. As discussed in section four, estimatesof value-in-use can provide estimates of thevalue of intangible assets arising from man-agement skill—a dimension of which includesprivate information, asset synergies, and op-tions, including growth options and the optionto put the firm's assets to creditors. For easeof exposition, throughout we refer to these in-tangible assets as management skill.

m. EXAMPLE AND SIMPLE SETTINGOur simple setting is economically equiva-

lent to perfect and complete markets. In thissetting, fair value unambiguously equals mar-ket value, and hence there are no measure-ment issues regarding an asset's fair value,and market values reflect all value-relevantinformation, i.e., there is no private informa-tion. We use the following three period ex-ample to illustrate our points. Consider twoall equity firms. Firm A and Firm B, whoseassets are actively traded and worth initially$100. Without loss of generality, assume thatthere are no new equity issues by either firmduring the three year period. Table 1 summa-rizes these firms' activities over the threeyears and represents the balance sheet andincome statement for each under fair valueaccounting.

Assume that Firm As assets grow to $110in value in period 2, and then either fall to$100 or rise to $120 in two alternative statesfor period 3: 3A and 3B. Firm A's income

Period12

3A3B

TABLE 1Firm A

Assets$100

110100120

Income$ -

10-10

10

FirmBAssets

$100100100100

Income$ -

000

100 Accounting Horizons / December 1995

equals the year-to-year change in these val-ues. In contrast, assume the value of Firm B'sassets is constant at $100 and, accordingly, itsincome equals zero in each period.

Because the value of Firm B's assets neverchanges, and consequently income alwaysequals zero, it is irrelevant whether the firmturns over a fraction of its assets or merelyholds its initial portfolio. In contrast. Firm A'sassets rise to $110 in period 2, which is re-flected hy a $10 gain— realized or unrealized—in the period 2 income of $10. The period 2financial statements reveal that Firm A hasmore assets than Firm B, and that this differ-ence arises solely because of changes in thevalue of its assets, and not by acquiring addi-tional assets. At the end of period 3, first as-sume that Firm A's assets drop in value to$100, i.e., state 3A occurs. The $10 loss indi-cates that either the firm's managers failedto sell its appreciated assets before the declinein value or they sold the initial assets and ac-quired other assets that declined in value. Itis not relevant to firm valuation whether theperiod 3 loss is realized or unrealized. Alter-natively, assume that state 3B occurs andFirm A's assets rise in value to $120. The $10gain is reflected in the income statement and,as in state 3A, it is valuation-irrelevantwhether the period 3B's gain is attributableto the initial assets or to assets acquired dur-ing period 2.

Although some managers may be moreskilled at selecting investments than others,i.e., state 3B is more likely than 3Ato occur,the intangible value of management's skill inselecting investments is reflected fully in therecognized assets' fair value. Simply put, wellrun firms will have assets that are worthmore. Similarly, management skill is reflectedfully in the income statement, which includesboth realized and unrealized changes in fairvalues. Because in this setting an asset's fairvalue is unambiguous, the value of any sepa-rate asset related to management skill equalszero. In the more realistic setting discussedin section four, it is possible that the differ-ence between an asset's value-in-use and itsentry or exit value could reflect the value ofmanagement skill in selecting investments.

Note that in this simple setting the bal-ance sheet provides all value-relevant infor-mation because, hy assumption, fair valuesof all assets are well-defined and ohservahle.The income statement reveals only that theperiod-to-period change in value results fromchanges in value of assets held rather thanfrom acquisition of new assets. In this simplesetting, this distinction regarding the sourceof the value change is not necessary for valu-ation and, in fact, income measurement isredundant."*

In summary, if fair value accounting isapplied in the simple setting: (1) fair value iswell-defined; (2) the balance sheet reflects allvalue-relevant information and income mea-surement is redundant for valuation; (3) in-come realization is not valuation-relevant; and(4) any management skill is reflected fully inthe balance sheet. Section four shows that inmore realistic settings these three observa-tions are not necessarily descriptively valid.

IV. MORE REALISTIC SETTINGSWe now turn to more realistic settings in

which the assumptions of the simple settingare relaxed. In particular, we assume thatmarkets are not economically equivalent tothose that are perfect and complete. Thus notall assets are actively traded, resulting in thelack of availability of market prices for all as-sets, and fair values are not unambiguouslyunique, i.e., entry and exit values and value-in-use are not necessary equal. Implementa-tion of fair value accounting requires selectionof one of these three value constructs. How-ever, selection of one by standard setters asthe basis for financial statements does notresolve all implementation problems. Mostnotably, estimation issues remain because inmany cases these value constructs are notobservable. Estimation often is difficult for

•• Beaver (1987, especially 81-85) makes clear that theincome statement is derived from the balance sheetand not vice versa. In particular, one can constructincome either from firm value using an expected rateof return, or by calculating the difference in firm valuebetween two successive dates. Beaver (1987) refers tothe former (latter) income measure as ex ante (ex post)income.

Fundamental Issues Related to Using Fair Value Accounting for Financial Reporting 101

value-in-use because it involves, e.g., predic-tion of future cash flows, selection of an ap-propriate discount rate, and knowledge of as-set synergies. It also can be difficult for entryand exit values if transaction prices do notexist. Moreover, even when market prices ex-ist, the potential for private information in animperfect market can result in market pricesthat do not reflect all value-relevant informa-tion (Rajan and Sarath 1995).

Entry Value, Exit Value, orValue-in-Use?

The concepts of entry and exit values andvalue-in-use have a long history in the ac-counting literature (see, e.g., Edwards andBell 1961; Chamhers 1966; Sterling 1970), andBeaver and Demski (1979) make clear that itis the ahsence of perfect and complete mar-kets that results in these three values differ-ing. Thus, each can provide different informa-tion about an asset's value. At the time of ac-quisition, value-in-use will be no less thanentry value for it to be rational to buy the as-set. In contrast, exit value can be greater orless than a firm's value-in-use, or entry value,because it is established by others. Clearly, anasset's value-in-use can differ from firm tofirm.

Although in principle the three values candiffer, the most important differences arethose between value-in-use and the other twobecause only value-in-use always reflects dif-ferential management skill, including exploit-ing synergies among assets. Thus, the differ-ences between value-in-use and exit and en-try values are measures of management skill.Consistent with the FASB's definition of fairvalue which focuses on exit value, we definethe value of management skill as the differ-ence between value-in-use and exit value.^Because value-in-use is the only measure thatalways captures total firm value associatedwith an asset and is consistent with the goingconcern tenet of GAAP, value-in-use should bethe focus of fair value accounting.' Eventhough intangible assets such as managementskill are excluded under the present account-ing model, there is ample evidence that shareprices reflect them (see, e.g., Fama and French

1995; Penman 1992; Bernard 1994; Barth etal. 1995b; Barth, ElUott, and Finn 1995; andRyan 1995). However, fair value accountingbased on value-in-use likely will be the mostdifficult to implement because estimatingvalue-in-use involves incorporating firm-spe-cific and potentially private information. It ispossible that measurement error could be sosevere for value-in-use that exit or entry valueestimates could be more value-relevant.

There are two, not necessarily mutuallyexclusive, types of measurement error. Thefirst is unsystematic error arising from gen-eral uncertainty, and the second is systematicerror arising from management exercising dis-cretion in determining the estimates. Mea-surement error affects the validity of claimsby some that managers' ability to manage in-come, and hence investors' perceptions of firmvalue, would be eliminated or reduced underfair value accounting (see, e.g., appendix A inSFAS 115). These claims are not necessarilyvalid because estimates of value-in-use arebased on managers' private information andthey are also subject to potentially severe es-timation error. By selectively revealing theirinformation, managers strategically can affectgains and losses recognized under fair valueaccounting. Even without private information.

^ Additional problems are introduced if fair value ac-counting is implemented on a piece-meal basis, withhedge accounting being a prominent example. Fre-quently, the hedged item is recognized at historicalcost, but the hedging instrument, which generally isa financial instrument, typically is off-balance sheet.Even if the hedging instrument were recognized atfair value, there is still a mismatch (a measurementanomaly in the FASB's terminology) unless the hedgeditem also is recognized at fair value.

^ Management skill need not be positive, i.e., poor man-agement of an asset can result in value-in-use lessthan entry or exit value if the manager's wage exceedshis marginal product. Moreover, although exit valuesreflect what others are willing to pay for an asset,entry values may reflect some of the value attribut-able to a firm's management skill to the extent thatthe firm is willing to pay up to its value-in-use. Ofcourse, actual entry and exit values depend on a vari-ety of factors including market competitiveness.

'' If the objective of financial statements is to reflect in-formation from other than a going concern perspec-tive, e.g., that of liquidation, then exit value shouldhe the focus. However, in the case of liquidation, value-in-use and exit value are the same.

102 Accounting Horizons /December 1995

the existence of general uncertainty about fairvalues results in a situation that permits man-agers to manage recognized fair values. Alsobecause of the existence of measurement er-ror, particularly that associated with manage-ment discretion, it is possible that separatedisclosure of the components of value-in-userelating to exit value and the intangible valueattributable to management skill providesmore value-relevant information than disclo-sure of only the total, i.e., aggregation can re-duce information. This is especially true ifmeasurement error differs for the two compo-nents, as one might expect in the situation justdescribed.

Existence of private information also com-plicates the measurement task because cur-rent market prices may not reflect managers'private information about asset values. Onecan view the existence of private informationas a dimension of management skill, such asthe ability to select assets. Private informa-tion can only be reflected in an asset's value-in-use, and not its entry or exit value.

For example, consider the value of FirmA's assets at the end of period 2 in the example.Suppose Firm A's managers know that its as-sets will trade at $110 at the end of the nextperiod, but there is no transaction in period 2that reveals this amount. Assume this assetis not actively traded, e.g., it is a municipalbond, and has a market price of $100 in peri-ods 1 and 2. Thus, Firm A's managers possessprivate information and, based on this infor-mation, know the asset will soon trade at $110.The value-in-use to Firm A is $110, and forother flrms it is $100. Because other firms lackFirm A's private information, they are indif-ferent between holding the asset or selling ittoday for $100. Firm A can realize the $10 dif-ference between value-in-use and the marketprice of $10 simply by waiting until the restof the market learns Firm A's private infor-mation and the asset's market price moves to$110. Alternatively, they can establish tbeasset's value by selling it to an equally in-formed buyer, thereby recognizing tbe $10gain, or by credibly revealing their privateinformation to tbe market, wbicb will driveits market price up to $110. Tbe sale of tbe

asset and its associated realized gain is notwbat is informative. Ratber, it is tbe informa-tion tbat Firm A's managers reveal tbat en-ables tbem to obtain a buyer at $110. As apractical matter, selling tbe asset may be tbeonly credible way for a firm's managers to es-tablish tbe value of a particular asset aboutwbicb tbey bave private information.^

Is Income RealizationValuation-Relevant?

Altbougb in tbe simple setting income re-alization is redundant to firm valuation, in tbeabsence of perfect and complete markets andtbe presence of measurement error tbis is notnecessarily tbe case.^ Income realizations tbatoccur from asset transfers in arm's lengtbtransactions establisb entry value for tbebuyer, exit value for tbe seller, but not neces-sarily value-in-use for eitber party. Accord-ingly, separate disclosure by the seller of re-alized and unrealized gains and losses can pro-vide information about values-in-use for tboseremaining assets tbat are similar in natureto tbose sold. Estimation error enbances tbepotential for income realization to provide in-formation about asset values because entryand exit values are firmly establisbed forbuyer and seller. ° However, because manag-ers often bave incentives to realize selectively

® This example illustrates that even for financial as-sets value-in-use can differ across firms, especially ifthey are inactively traded. This conclusion appearsto contrast with that of Leisenring, Northcutt, andSwieringa (FASB Status Report, August 21, 1995),who assert that "value-in-use...of financial instru-ments should not vary from entity to entity..." Thereason for the apparent difference is that we admitthe possibility of market imperfections, most notablyprivate information, whereas they assume implicitlythat financial assets' markets essentially are equiva-lent to those that are perfect and complete. The ex-tent to which value-in-use for a financial instrumentdiffers across firms depends on the degree of marketimperfections.

5 Barth et al. (1993, 1995h) examine conditions underwhich halance sheet information is value-relevant in-cremental to income statement information and viceversa.

1° In the extreme, if all firm assets are sold, then theissues relating to management discretion do not existand the assets' fair values are firmly established atexit value hecause management has foregone any pos-sible value-in-use.

Fundamental Issues Related to Using Fair Value Accounting for Financial Reporting 103

gains or losses to influence assessments ofasset values by financial statement users, e.g.,"cherry-picking," realized amounts can pro-vide a biased picture of the value of the as-sets still held (Barth et al. 1990; Warfield andLinsmeier 1992; Barth 1994; Barth,Landsman and Wahlen 1995). Of course,knowing this, financial statement users arelikely to factor this into their value assess-ments. Thus, it is not clear whether knowingrealized gains and losses in addition to thesum of realized and unrealized gains andlosses increases the knowledge financial state-ment users have about the firm's assets' exitand entry values, let alone values-in-use.

In summary, in the more realistic settingof imperfect and incomplete markets: (1) fairvalue is not well-defined—i.e., entry and exitvalues and value-in-use can differ; (2) becauseeach of the three value constructs may beunobservable, implementation of fair valueaccounting requires their estimation, therebyintroducing the potential for measurement er-ror; (3) one primary difference between value-in-use and the other two constructs relates tothe intangible value of management skill; (4)fair value accounting should focus on value-in-use because it is the only measure that al-ways captures total firm value associated withan asset and is consistent with the going con-cern tenet of GAAP; (5) separate disclosure ofthe components of value-in-use potentially isinformative in the presence of measurementerror; (6) separate disclosure of realized andunrealized gains and losses can provide infor-mation about asset fair values that otherwisewould be unavailable if only the total weredisclosed, although there is information lossin the presence of measurement error and ifmanagers selectively realize gains and losses.

V. FAIR VALUATION OFLIABILITIES

Thus far we have considered only all eq-uity firms, yet most firms have liabilities. Al-though valuation of liabilities conceptually isthe same as valuation of assets, it is troublingto some that as a firm's financial conditionworsens, tbe fair value of its liabilities de-

clines. Using debt as a representative liabil-ity, we provide two related explanations forwby this is appropriate.

The value of debt equals the discountedvalue of the cash fiows the issuer contractu-ally promises the debtholder. ^ The debt's dis-count rate depends on the riskiness of its is-suer. As the firm becomes less likely to honorits obligation, the debt becomes riskier, theappropriate discount rate becomes higher, andthe value of the debt decreases if the contrac-tual interest rate is not adjusted to refiect thedebt's riskiness. This is true whether or notthe debt is traded. This decrease in value is atransfer of wealth fi-om the debtholder to theissuing firm. Effectively, the debtholder con-tractually has committed to accept an inter-est rate that subsequently proves to be eco-nomically too low.

A related, and economically equivalent,explanation to understand why the value ofdebt declines as a firm's financial conditionworsens is to note that debt contains an op-tion held by the issuing firm to put the firm'sassets to the debtholder at a striking priceequal to the face value of the debt (Smith1976). This option is an economic asset of theissuing firm (Swieringa and Morse 1985;Barth, Landsman, and Rendleman 1995;Kimmel and Warfield 1995), the value ofwhich increases as the firm's financial condi-tion worsens, thereby decreasing the value ofits debt.

Under fair value accounting, in a periodin which the issuing firm's financial conditionworsens it recognizes in income as a credit thedecrease in its liabilities' fair values. Thiscredit represents the amount of wealth trans-ferred fi-om creditors to equityholders duringthe period. ^ As with assets, conditional on therelative amounts of measurement error asso-ciated with entry and exit values and value-in-use, fair value accounting for liabilities

1' For purposes of the discussion in this section, we as-sume that asset and liability values can be character-ized using a discounted cash flow approach. Althoughsuch a characterization of value may not hold, the con-clusions we draw largely are unaffected if other plau-sible characterizations are considered.

^^Revsine (1981) makes a similar point in the contextof inflation accounting.

104 Accounting Horizons / December 1995

should focus on value-in-use.^^ Although itappears that exit value may differ from value-in-use for some liabilities, such as those in-volving the provision of services instead ofcash, they may not differ depending onmanagement's actions. For example, in thecase of warranties an exit value is what thefirm would have to pay a third party to as-sume its obligation, and value-in-use is thevalue of the firm's services required to dis-charge its obligation. However, value-in-useequals exit value if management contractswith a third party to meet its obligation. Aswith assets, the case could be made for dis-closing estimates of liabilities' exit values andvalues-in-use if there is estimation error.

In summary, fair value accounting for li-abilities is conceptually no different than forassets. The decrease in liabilities' fair valuesarising from a deterioration of a firm's finan-cial condition represents the transfer of wealthfrom creditors to equityholders.

VI. COMPREHENSIVE INCOMEAND CORE EARNINGS

The FASB is concerned with how, if at all,fair value accounting relates to the conceptsof earnings and comprehensive income and thealternative concept of core earnings. A primarydistinction between earnings and comprehen-sive income discussed in the FASB's ConceptsStatements is that unrealized holding gainsand losses are candidates for comprehensiveincome but not earnings. Our discussion of fairvalue accounting in section four admits thepossibility that separate disclosure of realizedand unrealized gains and losses providesvalue-relevant information. However, our dis-cussion provides no basis for recognizing inincome only realized gains and losses. ^ Thisconclusion is consistent with that reached byLeisenring, Northcutt, and Swieringa (FASBStatus Report, August 21,1995) who concludethat changes in fair values should be reportedas a component of comprehensive incomerather than reported only in the balance sheetas part of owners' equity.

IVIany contend that financial statementusers can glean more value-relevant informa-tion from an income statement based on a con-

cept of core earnings. Although core earningsis not precisely defined, it appears to refer topartitioning income into two major compo-nents: one relating to income provided by afirm's ongoing operating activities, and an-other relating to income provided by gains andlosses on primarily nonoperating assets. Coreearnings resembles the concept of permanentearnings discussed in the academic litera-ture.^^ It is possible that a partition of incomebased on operating versus nonoperating ac-tivities is informative if operating earningshave different valuation implications thannonoperating earnings, e.g., different riskcharacteristics, resulting in investors apply-ing different weights to the two componentswhen valuing the firm.^^ However, fair valueaccounting and the concept of core earningsare unrelated in that the former relates toaccounting measurement and the latter re-lates to disaggregation of recognized amounts.Thus, standard setters should consider theconcept of core earnings apart from their con-sideration of fair value accounting.

In summary, fair value accounting pro-vides no basis for recognizing in income onlyrealized gains and losses. Although the con-cept of core earnings may provide value-rel-evant information to financial statement us-ers, the concepts of core earnings and fairvalue accounting are unrelated.

VII. CONCLUSIONThis paper discusses fundamental issues

relating to implementation of fair value ac-

1 Entry value is a less common concept with liabilitiesthan it is with assets. It refers to the price a firm wouldpay to acquire its present obligations.

* It is an open empirical question whether disclosureand recognition have different valuation implications(see Imhoff et al. 1993; Bernard and Schipper 1994;and Barth and Sweeney 1995).

'^ Studies investigating permanent earnings include,among others. Beaver and Morse (1978), Beaver etal. (1980), Lipe (1986), Beaver (1987), Kormendi andLipe (1987), Collins and Kothari (1989), Cornell andLandsman (1989), Easton and Zmijewski (1989),Ramakrishnan and Thomas (1991), Barth et al. (1992,1993), and Barth, Elliott, and Finn (1995).

1 Analogously, separate disclosure of income, sales, andassets by geographic and business segments may pro-vide additional value-relevant information than thatprovided by reporting aggregate amounts.

Fundamental Issues Related to Using Fair Value Accounting for Financial Reporting 105

counting. We conclude that in the simple set-ting economically equivalent to perfect andcomplete markets, a fair value accounting-based balance sheet reflects all value-relevantinformation, the income statement is redun-dant, income realization is not relevant tovaluation, and any intangible asset relatingto management skill, asset synergies, or op-tions is reflected fully in the balance sheet.However, in settings in which the market as-sumptions are more realistic, fair value is notwell-defined, giving rise to three value con-structs, entry value, exit value, and value-in-use. Because none of these is always observ-able, implementation of fair value accountingrequires their estimation, thereby introducingthe potential for estimation error. Unless es-timation error is severe, value-in-use is moreappropriate for firm valuation for going con-

cerns than the other two constructs becauseit is the only construct that captures total firmvalue associated with an asset, including in-tangibles relating to management skill. Alsoin the more realistic setting, neither the bal-ance sheet nor income statement reflects fullyall value-relevant information and income re-alization potentially can be valuation-rel-evant, although management discretion candetract fi*om its relevance. We also point outthat fair value accounting concepts applyequally to assets and liabilities. Finally, ourdiscussion of fair value accounting reveals nobasis for recognizing in income only realizedgains and losses, and that although the con-cept of core earnings may provide value-rel-evant information to financial statement us-ers, the concepts of core earnings and fairvalue accounting are unrelated.

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