Renowned Economists' Perspectives on Fair-Value Accounting

While today's accounting boards, accounting academics, and many economists argue for Fair-Value Accounting, there appears to be no solid academic justification for such accounting, other than a misunderstanding of J.R. Hicks, as discussed in the companion paper U.S. Historical Perspective on Fair-value Accounting, also available on this website. In Fair-Value Accounting, assets and liabilities are marked-to-market, with gains and losses passing through the income statement, impacting net income.

Besides Fair-Value Accounting, a second accounting concept has existed for about a century, termed here Recurring, Permanent, or Sustainable Accounting, in which the objective is to estimate recurring, permanent, or sustainable net income. Recurring Accounting represents an ideal, and the revenue-and-expense paradigm of the twentieth century is an attempt to reach this ideal but is plagued by the difficulties of handling asset value trends and fluctuations (See U.S. Historical Perspective on Fair-value Accounting).

The difference between the two types of accounting is that fair-value net income includes one-time windfall gains and losses, while recurring net income attempts to exclude such single events.

In our literature scan of renowned and Nobel laureate economists, we found none who explicitly support Fair-Value Accounting, some who are seemingly agnostic about the topic, and three who explicitly reject Fair-Value Accounting and argue for recurring net income. Below, the three economists are quoted, with commentary provided.

J.R. Hicks won the Nobel prize in economics in 1972. He is the leading authority cited by the accounting boards and academic accountants to justify Fair-Value Accounting, but he actually championed Recurring Accounting. In his book, Value and Capital, published in 1946, he states:

"Income No. I is thus the maximum amount which can be spent during a period if there is to be an expectation of maintaining intact the capital value of prospective receipts (in money terms). This is probably the definition which most people do implicitly use in their private affairs." (Hicks, p. 173)

"The income he can calculate is not the true income he seeks; the income he seeks cannot be calculated. From this dilemma there is only one way out; it is of course the way that has to be taken in practice. He must take his objective magnitude, the Social Income ex post, and proceed to adjust it, in some way that seems plausible or reasonable, for those changes in capital values which look as if they have had the character of windfalls." (Hicks, p. 179)

In the first quotation, Professor Hicks does not concern himself with change in net assets as being income. Rather, he is focused on income as being what can be consumed, while preserving the capital base. Hicks is arguing for recurring income since recurring income embeds the concept of extraction, while keeping the capital base intact.

In the second quotation, Hicks recognizes the practical difficulty of determining recurring income but, in effect, says that windfalls need to be removed from capital-value changes in order to isolate recurring income.

The accounting boards and accounting academics, in their misinterpretation of Hicks, assert that the change in net assets constitutes income as recommended by Hicks, arguing, for example, that if net assets increase from $1,000 to $1,090, then the $90 difference can be consumed, while leaving the capital base intact. This, however, makes the reference point the start of the last period rather than the end of the current period, the current moment. To borrow and apply Hicks' language: "On the general principle of 'bygones are bygones', it [the $1,000 value at the start of the last period] can have no relevance to present decisions." With $1,090 in hand, the question is how much can be consumed, with the expectation that the residual will appreciate back to $1,090 over the course of the upcoming period. (Use 4% as the four-year risk-free rate in the demo on this website to see how this case is handled by EarningsPower Accounting™).

This incorrect interpretation by the accounting boards and academics is highlighted by considering that the capital base changes from $1,000 to $872. Under Fair-Value Accounting, there is a loss of $128; but there is no estimate regarding what can be consumed, with the expectation that the residual will appreciate back to $872. Hence, Fair-Value Accounting completely misses Hicks' perspective. (Use 10% as the four-year risk-free rate in the demo on this website to see how this case is handled by EarningsPower Accounting).

Hicks develops more advanced concepts of income entailing anticipated interest rate and price level changes, but such advanced considerations leave intact the main point here: that Hicks was focused on recurring income.

F.A. Hayek won the Nobel Prize in economics in 1974. He echoes the focus of determining what can be consumed, while leaving the capital base intact, and determining recurring income when writing:

"Whether the particular unforeseen change is favorable or unfavorable to him, this will mean that as soon as he learns about its occurrence or imminence, he will have to change his rate of consumption to the level at which it can now be permanently kept. If, for instance, his receipts increase in consequence of the change by £210, the rate of return which he can obtain on reinvestment is 5 percent, he must consume only £10, and must reinvest the remaining £200, which at 5 percent will give him the same return in every future year. Such windfall profits are, therefore, not income in the sense that their consumption is compatible with 'maintaining capital intact'. Nor need consumption be reduced by the amount of corresponding windfall losses. In both cases, only the current interest on the (positive or negative) capital gains ought to be counted as income." (Hayek, F. A. (2007). The Pure Theory of Capital, Volume XII. Chicago, IL: University of Chicago Press. pp. 286-87)

Fischer Black was a co-developer of the famous Black-Scholes option-valuation method and would have shared the Nobel prize in economics with Robert Merton and Myron Scholes had he been alive. In an indirect manner, he echoes the focus of determining what can be consumed, while leaving the capital base intact, and determining recurring income when writing:

"Users of financial statements—analysts, stockholders, creditors, managers, tax authorities and even economists—really want an earnings figure that measures value [i.e., Recurring net income], not the change in value [Fair-Value net income/comprehensive income]. Analysts, for example, want an earnings number they can multiply by a standard price-earnings ratio to arrive at an estimate of the firm's value. (Black, F. (1980) “The Magic in Earnings: Economic Earnings Versus Accounting Earnings,” Financial Analysts Journal, vol. 36, pp.19)

In Black's perspective, which EarningsPower Accounting shares, net income should be directly usable in price-to-earnings ratio analysis. He states this implicitly in the last sentence by saying that accounting should yield an earnings number that can be multiplied to obtain an estimate of a firm's value. Such an earnings number must be a recurring income number, exclusive of current one-time windfalls. If the earnings number included one-time windfalls, then the valuation would incorrectly presume that the one-time windfalls would recur.

Black also explicitly rejects Fair-Value Accounting when writing:

"Economists, on the other hand, usually say that earnings should be related to change in value, and this view has lately been gaining acceptance among accountants. The move to include gains and losses due to changes in currency values in full in the earnings statement for the year in which they occur represented acceptance of the economist's view of value. It was soon discovered, however, that inclusion made a firm's earning figures more erratic and less useful as a measure of how the firm was doing." (Black, p. 20; bold italics his)

In conclusion, given what Hicks, Hayek, and Black wrote, Fair-Value Accounting actually goes against leading economic thought, and it appears that there is no leading economic thought arguing for Fair-Value Accounting. Given the ferocious and continuous complaint about Fair-Value Accounting, the dilemma between having either the balance sheet or the income statement accurate and valid, but not both, must be solved. EarningsPower Accounting is a solution.