U.S. Historical Perspective on Fair-Value Accounting

The current debate regarding Fair-Value Accounting is nothing new, for its origins date back to an earlier century.

In the nineteenth century, U.S. financial reporting followed what today would be called Fair-Value Accounting. At the turn of the century, investors demanded an income measurement that today we would term recurring, permanent, or sustainable income. As a result of this demand, the income statement and revenue-and-expense methodology were developed and became the backbone of financial accounting in the 20th century.

The problem, however, with the 20th century revenue-and-expense methodology was the difficulty of handling asset value trends and fluctuations. This resulted in the fiction that some assets and liabilities were never recognized; that some assets and liabilities were kept on the books at their original historic-cost values; that some assets and liabilities’ gains and losses were never recognized; and that income-smoothing operators were used to spread gains and losses across multiple periods—an arbitrary practice. This also resulted in the belief that either the balance sheet or the income statement can be accurate and valid, but not both.

The problem of handling asset value trends and fluctuations had not been resolved by the 1950s. Academic accountants, however, discovered J.R. Hicks’ Value and Capital, 2nd ed., published in 1946. Hicks was an economics professor at Oxford who won the Nobel Prize in economics in 1972.

In his book, Hicks discusses income, comparing two fundamental types of income: ex ante and ex post, under three levels of completeness. With regard to ex post income, he states, “Income No. 1 ex post equals … Consumption plus Capital accumulation.” (Hicks, p. 178) and “Income No. I ex post is not a subjective affair, like other kinds of income; it is almost completely objective.” (Hicks, pp. 178–179).

Because of these two statements, academic accountants wrote papers and books advocating “Hicksian” income measurements, giving birth to Fair-Value Accounting. Assuming no consumption, the first quote essentially defines fair-value income: the net change in assets and liabilities. The second quote appeals to the cultural desire for objectivity, with Fair-Value Accounting gaining further credibility because it was deemed to prevent a recurrence of the 1980s savings-and-loan crisis when balance sheets had significantly overvalued assets.

The result today is that most standard setters and academic accountants are “Hicksian,” arguing for Fair-Value Accounting, that asset and liability values should be estimated at the end of each period, and that the change in net assets is to be taken as net income.

The recent economic crisis, however, has called “Hicksian” Fair-Value Accounting into question, with the U.S. Congress ordering the Financial Accounting Standards Board (FASB) to roll back Fair-Value Accounting and Lord Turner, head of the British Financial Services Authority, citing Fair-Value Accounting as a cause of the market collapse in 2008. What has gone wrong?

First of all, going back to the 1950s, academic accountants and standard setters have misunderstood J.R. Hicks. In the paragraph after the one quoted above, Hicks rejects Income No. I ex post, the net income of Fair-Value Accounting: “…it can have no relevance to present decisions. The income which is relevant to conduct must always exclude windfall gains.” (Hicks, p. 179).

(For additional insights regarding the misunderstanding by standard setters, see (1)
FASB/IASB Revisiting the Concepts: a comment on Hicks and the concept of ‘income’ in the conceptual framework and (2) The Conceptual Framework: Revisiting the Basics A comment on Hicks and the concept of ‘income’ in the conceptual framework.

Second, the problem of handling asset value trends and fluctuations has been ignored for too long. Ideally, this problem would have been solved a century ago, but it was not. The 20th century revenue-and-expense paradigm has become obsolete and unworkable, and Fair-Value Accounting has recently demonstrated its major deficiencies. The problem of handling asset value trends and fluctuations must be solved now for the economy has immeasurably advanced beyond the two prior financial accounting paradigms.

EarningsPower Accounting™ is a possible solution to handling asset value trends and fluctuations so that both the income statement and balance sheet can be valid and accurate.