As discussed in Chapter two, the Conceptual Frameworks developed by both the FASB and the IASB are based on the principle of decision-usefulness. This is highlighted in the primary quality that accounting information must be useful for decision-making and for it to be useful, such information must be relevant. As explained by Hitz (2007), standard setters have taken an economic view of measurement and this favours the fair value paradigm that utilises the market price as the relevant metric. The reason that market price is assumed to be relevant is because of the efficient market hypothesis - at least at the semi-strong form level (Hitz, 2007). In simple terms, the efficient markets hypothesis states that a market in which prices fully reflect all available information is
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regarded as efficient (Sharpe, 1964; Fama, 1970, 1991; Praetz, 1975). The market price is believed to reflect available information based on the “information aggregation hypothesis” which says that the market price aggregates in an efficient and unbiased manner the expectations of investors in the market concerning the cash flow patterns of the assets and liabilities appearing on a firm’s financial statements (Hitz, 2007). Ball and Brown (1968: 160-161) summarise this idea in the following terms:
“An impressive body of theory supports the proposition that capital markets are both efficient and unbiased in that if information is useful in forming capital asset prices, then the market will adjust asset prices to that information quickly and without leaving any opportunity for further abnormal gain. If, as the evidence indicates, security prices do in fact adjust rapidly to new information as it becomes available, then changes in security prices will reflect the flow of information to the market. An observed revision of stock prices associated with the release of the income report would thus provide evidence that the information reflected in income numbers is useful.”
Thus, under the semi-strong form of the efficient markets hypothesis, the market price of a firm’s equity will reflect the fair values of its assets and liabilities as summarised in its published financial statements. This simple idea has had a profound impact on the theoretical framework which informs the value relevance models that have been employed by researchers and others to test for the impact of fair value disclosures. This model is usually motivated in terms of the following simple valuation identity:
MVEt =
i=1 N MVAit -
i=1 M MVLit ……… (1)93
Here MVEt is the market value of equity at time t, MVAitrepresents the market value of asset i at time t, N is the number of asset classifications appearing on the firm’s balance sheet at time t (Eccher, et al., 1996; Barth, 1991; Barth, 1994), MVLit represents the market value of liability i at time t and M is the number of liability classifications appearing on the firm’s balance sheet at time t. The basis for this approach is that the present value of the expected future cash flows of a firm can be represented by aggregating the individual market values of its assets minus its liabilities.
This approach is also emphasized in how fair value is defined conceptually by both the IASB and the FASB as the “exit price” of a firm’s individual asset and liability classifications which in turn, should equate to a firm’s market price. The evidence for this is extensive in the U.S. banking industry as banks have been required to disclose the estimates of the fair values of their financial assets and liabilities since 1992, following the introduction of SFAS 107. Since a bank’s balance sheet consists mostly of financial instruments, we can restate equation 1 in terms of their fair value estimates under SFAS 107 as follows:
MVEt =
i=1 N aitFVAit -
i=1 M bitFVLit……… (2)where FVAit is the fair value of asset i at time t, FVLit is the fair value of liability i at time t and the market’s valuation coefficients based on the banks’ reported fair values are measured by ait and bit, respectively. The market’s valuation coefficients measure the way the market values the estimated fair values disclosed by banks as such disclosures may not be taken at face value by market participants. Moreover, this model can be expanded as a result of the levels classification based on the fair value hierarchy
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introduced by SFAS 157 in November, 2007. Thus, when the above model is modified in order to take account of the levels classification we have:
MVEt =
i=1 N1 a1itL1FVAit +
i=1 N2 a2itL2FVAit +
i=1 N3 a3itL3FVAit -
i=1 M1 b1itL1FVLit -
i=1 M2 b2itL2FVLit -
i=1 M3 b3itL3FVLit ……….. (3)where L1FVAit is the level 1 fair value asset i (based on quoted prices) at time t and N1 is the number of level 1 asset classifications, L2FVAit is the level 2 fair value asset i (based on identical asset prices) at time t and N2 is the number of assets classified level 2, and L3FVAit is the level 3 fair value asset i (based on modelled prices) at time t and N3 is the number of level 3 asset classifications. Moreover, L1FVLit is the level 1 fair value liability i (based on quoted prices) at time t and M1 is the number of level 1 liability classifications, L2FVLit is the level 2 fair value liability i (based on identical liability prices) at time t and M2 is the number of level 2 liability classifications and L3FVLit is the level 3 fair value liability i (based on modelled prices) at time t and M3 is the number of level 3 liability classifications. Finally, a1it, a2it, a3it, b1it, b2itand b3it, are the valuation coefficients for each level of fair value asset and liability classification, respectively. As previously noted in chapter two, the FASB brought in the levels classification because it believed there were issues regarding the reliability of some fair value estimates. Hence, we can expect that the valuation coefficients a1itto b3it, would differ in accordance with the levels classification of the fair value estimates. In other words, level 1 fair value estimates would be expected to have a valuation coefficient close to 1 while level 3 fair value estimates may have a valuation coefficient
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that is significantly different from 1. The fair value estimates are expected to utilise the market values of the individual assets and liabilities as inputs in the estimation process as much as possible in order to abide by the spirit of the exit price definition of fair values. However, some of these estimates are subject to managerial discretion and measurement errors. This in turn means that the moral hazard of managerial incentives could be manifested in the estimation process.