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 The Routledge Companion to Fair
Value and Financial Reporting

Although a great deal has been written about fair value, there has been no systematic attempt to
bring together experts on the subject and analyse it thoroughly from all perspectives. Until now if
someone, be it student, accountant or analyst, wanted to find out about fair value, there has been
no single comprehensive source to which they could turn.
At last here is a book that has brought together chapters from international academic and
professional experts writing on different aspects of using current market values in financial
reporting. The companion has three sections:

• Section I analyses the use of fair value in International Financial Reporting Standards and the
US standard SFAS 157 Fair Value Measurement and sets out the case for and against.
• Section II looks at fair value from a number of different theoretical perspectives: possible
future uses, alternative measurement paradigms, how it compares with other valuation models.
• Section III examines fair value accounting in practice, including audit, financial instruments,
impairments, an investment banking perspective, approaches to fair value in Japan and the
USA, and Enron’s use of fair value.

The Routledge Companion to Fair Value and Financial Reporting will become the standard
worldwide reference work on this controversial topic, providing professionals, students and aca-
demics with a unique resource.

Peter Walton Ph.D. FCCA is a researcher and journalist specialising in international accounting.
He is a director of the ESSEC-KPMG Financial Reporting Chair at ESSEC Business School and
editor of World Accounting Report (published by informa) and Accounting in Europe (published
by Taylor & Francis).
The Routledge Companion
to Fair Value and Financial
Reporting

Edited by
Peter Walton
First published 2007
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN
Simultaneously published in the USA and Canada
by Routledge
270 Madison Avenue, New York NY 10016
Routledge is an imprint of the Taylor and Francis Group, an informa business
© 2007 Peter Walton for editorial selection and material; individual contributors, their own
contribution
Typeset in Times by RefineCatch Ltd
Printed and bound in Great Britain by
The Cromwell Press, Trowbridge, Wiltshire
All rights reserved. No part of this book may be reprinted or reproduced or utilised in any
form or by any electronic, mechanical or other means, now known or hereafter invented,
including photocopying and recording, or in any information storage or retrieval system,
without permission in writing from the publishers.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
The Routledge companion to fair value and financial reporting / edited by Peter Walton.
p. cm.
“Simultaneously published in the USA and Canada.”
Includes bibliographical references and index.
ISBN 0–415–42356–2
1. Financial statements. 2. Fair value—Accounting—Standards. 3. International business
enterprises—Accounting—Standards. I. Walton, Peter J. II. Title: Fair value and financial reporting.
HF5681.B2R68 2007
657′.3—dc22
2006100799

ISBN10: 0–415–42356–2 (hbk)

ISBN13: 978–0–415–42356–4 (hbk)
 Contents

List of illustrations viii

List of contributors x
Preface xvii
Acknowledgements xviii

Section I: Introduction 1

1 The nature of fair value 3

Peter Walton

2 The use of fair value in IFRS 9

David Cairns

3 What SFAS 157 does, and does not, accomplish 24

Alfred M. King

4 The case for fair value 32

Ian P. N. Hague

5 Fair values: imaginary prices and mystical markets – a clarificatory review 46

Michael Bromwich

Section II: Theoretical analysis 69

6 Recent history of fair value 71

David Alexander

v
CONTENTS

7 Fair value and valuation models 91

Anne Cazavan-Jeny

8 Whither fair value accounting? The future of fair value 103

Warren McGregor

9 Between a rock and a hard place? 115

Andrew Lennard

10 Fair value and capital markets 123

Franck Missonier-Piera

11 Fair value: the right measurement basis? An Australian perspective 132

Kevin M. Stevenson

12 Measurement in accounting and fair value 152

Petri Vehmanen

13 CCA – an unsuccessful attempt to change the measurement basis 173

Peter Walton

14 Alternatives to fair value 181

Geoffrey Whittington

15 The relevance and reliability of fair value measurement 196

Allister Wilson

16 The fair value principle and its impact on debt and equity: theoretical traditions,
conceptual models and analysis of existing IFRS 210
Jens Wüstemann and Jannis Bischof

Section III: Fair value in practice 231

17 Fair value accounting: a cautionary tale from Enron 233

George J. Benston

18 The insurance industry and fair value 247

Gabi Ebbers

19 Fair value measurement for corporate entities, insurance companies and retail banks:
an investment banker’s perspective 265
Dean Galligan

20 Fair value and the auditor 278

Raphaël Jacquemard

vi
 CONTENTS

21 Fair value accounting in the USA 300

Robert E. Jensen

22 A Japanese perspective on fair value 321

Kenichi Akiba and Takashi Matabe

23 Pension accounting and fair value 340

Christopher J. Napier

24 Fair value under IFRSs: issues for developing countries and SMEs 350
Paul Pacter

25 Fair value and financial instruments 370

Andrew Spooner

26 Use of fair values in impairment testing 385

Caroline Woodward

Index 393

vii
List of illustrations

Figures

6.1 Measurement bases including fair value 78

6.2 Measurement bases including fair value (author) 78
11.1 Edwards and Bell income statement 137
15.1 Fair value hierarchy 203
20.1 Building a DCF valuation 284
20.2 Excess earnings method 285
20.3 Relief from royalty method 285
25.1 Common type of hedging activity 377
25.2 Scenarios 1 and 2 381
25.3 Scenario 3 381

Tables

2.1 The use of fair value in the initial measurement of transactions 15

2.2 The use of fair value in the allocation of the initial amount of compound
transactions to their constituent parts 17
2.3 The use of fair value in subsequent measurement 19
2.4 Subsequent measurement of assets in IFRS consolidated financial
statements 20
2.5 Subsequent measurement of liabilities in IFRS consolidated financial
statements 21
2.6 The use of fair value in the determination of the impairment of assets 22
4.1 Summary of benefits of fair value 42
5.1 Core fair value assumptions 53
6.1 An array of value concepts 72
6.2 Suggested articulation of the 24 concepts from Table 6.1 73

viii
 L I S T O F I L L U S T R AT I O N S

6.3 IASB definitions of fair value 74

11.1 Relationships of values and deprival value 140
11.2 Amended deprival value 148
14.1 Selection of deprival values 187
15.1 Company data relating to employee share options 205
17.1 Enron Corporation and subsidiaries consolidated income statement (2000) 240
18.1 Main CFO Forum principles for a future insurance accounting model 256
19.1 Display in the income statement 270
20.1 Differences between valuation approaches 283
20.2 CAPM discount rate 285
20.3 Appropriate valuation models 286
20.4 Summary of substantive tests 288
22.1 Relationship between type and results of investments released from risks 323
22.2 Form of asset/type of investment 323
22.3 Type of investment and outcome 325
22.4 Accounting for hedges 328
22.5 Summary of hedging analysis 330
22.6 Consistency of use 332
24.1 China’s new accounting standards 366
25.1 Common types of financial instrument – balance sheet recognition 371
25.2 Different measurement and classification of financial assets 372
25.3 Buyer and seller hedges 382
25.4 Significant differences between IFRS and US GAAP 383
26.1 Summary of the advantages and disadvantages of each method 390

ix
Contributors

Kenichi Akiba is the Senior Technical Manager of the Accounting Standards Board of Japan
(ASBJ), which is the sole accounting standards setter in Japan. He is temporarily transferred from
KPMG AZSA & Co, one of Japan’s largest audit corporations newly formed in January 2004
with the merger of Asahi & Co and AZSA & Co. His role in the ASBJ since 2001 is being in
charge of some active projects to develop accounting standards and implementation guidance.
Prior to temporary transfer at ASBJ, he worked as an audit partner of Asahi & Co and provided
professional advice including accounting treatment of financial instruments and securitization.
From 1997 to 1999, he also served as a visiting scholar in the Institute for Monetary and
Economic Studies of the Bank of Japan. He graduated from Yokohama National University in
1986. He is a certified public accountant (CPA) in Japan and a member of the Japan Accounting
Association.

David Alexander is Professor of International Accounting at the University of Birmingham,

England. He is co-author of the Miller IAS/IFRS GAAP Guide, co-editor of The European
Accounting Guide and co-author of two IFRS-based textbooks. He has a particular interest in the
development of financial reporting theory and regulation, and of issues of concept transfer across
countries, languages and cultures.

George J. Benston is the John H. Harland Professor of Finance, Accounting and Economics in
the Goizueta Business School and Professor of Economics in the College of Arts and Sciences
of Emory University. He received his doctorate from the University of Chicago and is a CPA.
He has published over 160 books, monographs and articles in refereed academic journals in
accounting, finance and economics. His books include Worldwide Financial Reporting: The
Development and Future of Accounting Standards (Oxford University Press, 2006) and Following
the Money: The Enron Failures and the State of Corporate Disclosure (Brookings Institution,
2003), both with Robert Litan, Michael Bromwich and Alfred Wagenhofer, Regulating Financial
Markets: A Critique and Some Proposals (Hobart Paper 135, Institute of Economic Analysis,
London, UK, 1998 and American Enterprise Institute, 1999) and The Separation of Commercial
and Investment Banking: The Glass–Steagall Act Revisited and Reconsidered (Oxford University
Press, 1990).

x
 CONTRIBUTORS

Jannis Bischof was trained as an economist at the University of Passau, at the University of
Mannheim (both Germany) and at the Lund University (Sweden). Since 2004, he has been a
Ph.D. student at the Department of Accounting and Auditing at the University of Mannheim,
Germany. He is currently a Research Fellow of the National Research Centre on Concepts of
Rationality, Decision-making and Economic Modelling (SFB 504). His research projects concen-
trate on accounting for financial instruments according to International Financial Reporting
Standards (IFRS). Recent publications include articles in Zeitschrift für Betriebswirtschaft and
in several textbooks. He is also author of a book on accounting for portfolio hedges.

Michael Bromwich is the Chartered Institute of Management Accountants’ Professor of Account-

ing and Financial Management Emeritus at the London School of Economics and Political
Science. He was appointed to the CIMA Chair in October 1985. He was Convener of the
Department of Accounting and Finance for eight years. After qualifying as an accountant with
the Ford Motor Company he took a B.Sc.(Econ.) degree (specializing in Industry and Trade)
at the LSE in 1965. In 1970 he was appointed the first Professor of Accounting at the now
University of Cardiff and was then Professor of Finance and Accounting at Reading University
from 1977 to 1985. He has published some 100 articles. He teaches both management accounting
and financial corporate reporting.
His special areas of interest include the setting of accounting standards and their economic
meaning, fair value accounting, accounting for regulated industries and the OFR, strategic cost
analysis and accounting numbers for performance measurement. He was voted ACCA/AA
Distinguished Academic of the year in 1999. He is active in the profession, has served a term on
the Accounting Standards Committee and is a Past President of the Chartered Institute of
Management Accountants (1987/1988) and currently serves on CIMA’s Technical Committee. He
is the Accounting Adviser to the Office of Fair Trading. He has written a number of books,
including The Economics of Capital Budgeting (1976) and The Economics of Accounting Standards
Setting (ICAEW, 1985). His most recent books are Financial Reporting, Information and Capital
Markets (Pitman, 1992), Management Accounting: Pathways to Progress (CIMA, 1994) and with
others, Following the Money: The Enron Failure and the State of Corporate Disclosure (AEI–
Brookings Joint Center for Regulatory Studies, 2003) and Worldwide Financial Reporting: The
Development and Future of Accounting Standards (Oxford University Press, 2006).

David Cairns provides IFRS training and consulting services for preparers, auditors and users
of IFRS financial statements. He was Secretary-general of the International Accounting
Standards Committee from 1985 to 1994 and is a member of the IASB’s working group on
SME reporting. He has written extensively on IFRS. He is currently leading an evaluation of
IFRS financial statements of EU companies which the Institute of Chartered Accountants in
England and Wales is carrying out on behalf of the European Commission. He is a Visiting
Professor at the London School of Economics and a member of the UK’s Financial Reporting
Review Panel.

Anne Cazavan-Jeny is Associate Professor of Accounting at the ESSEC Business School. She
obtained her Ph.D. degree at HEC School of Management in 2003 and taught at the HEC, ESCP-
EAP and EDHEC business schools before joining ESSEC Business School in 2002. She teaches in
ESSEC in the MBA programme, as well as in executive education. Her fields of expertise are in
financial accounting, financial analysis, value creation and firms’ valuation. Her research interests
are financial information and capital markets, IPO, intangibles and CEO compensations. She has
published articles in the following journals: Review of Accounting and Finance (forthcoming in

xi
CONTRIBUTORS

2007), European Accounting Review (2006), Comptabilié-Contrôle-Audit (2004, 2005) and

Accounting, Auditing and Accountability Journal (2001).

Gabi Ebbers is a member of the Accounting Policy Department at Allianz SE in Munich, where
she works on the implementation of IFRS and US GAAP. Prior to joining Allianz, she was a
Project Manager at the German Accounting Standards Board. She has a Ph.D. from the Uni-
versity of Wales, Bangor, UK and publishes and lectures in the area of international financial
reporting. She is a member of the CFO Forum’s Working Groups and of the CEA Insurance
Accounting Committee.

Dean Galligan is Head of Structuring at Goldman Sachs in Europe. He has responsibility across
the financial product spectrum from financial derivatives through to project finance. Prior to
joining Goldman Sachs in 2001, he qualified at and worked for Arthur Andersen in London
within their Financial and Commodity Risk Consulting division. Dean is a qualified chartered
accountant and achieved an Order of Merit in his ICAEW Finals. He has a first class degree in
mathematics.

Ian P. N. Hague is a Principal with the Accounting Standards Board (AcSB) in Toronto, Canada.
For over ten years his primary responsibilities have been for international activities as well as
projects associated with accounting for financial instruments. He supports the AcSB’s liaison
activities with the International Accounting Standards Board (IASB) and is also a member of the
project team on the joint IASB/US Financial Accounting Standards Board (FASB) project to
develop a single, converged conceptual framework for global financial reporting. He has recently
finished introducing standards for recognition and measurement of financial instruments in
Canada, based on those of the IASB and FASB. Prior to joining the AcSB staff, Ian was with
Deloitte in Toronto and in London, England. He is qualified as a chartered accountant in both
Canada and England and Wales. He is a frequent speaker and writer on international accounting
standards and accounting for financial instruments, both in Canada and internationally.

Raphaël Jacquemard is a Partner in the French firm of KPMG. He works in transaction services
and has a strong practice on valuation topics such as purchase price allocation and impairment
tests. Prior to joining KPMG he specialized in business valuation, and has published on various
valuation topics such as banks valuation, merger accounting, purchase price allocation or fairness
opinions. He graduated at the Institut d’Etudes Politiques de Paris, chartered accountant and did
his postgraduate work in finance at the Paris I Panthéon-Sorbonne. He teaches at Institut
d’Etudes Politiques de Paris.

Robert E. Jensen is a retired Professor Emeritus from Trinity University, USA. He held endowed
chairs from three universities and was the American Accounting Association’s 2002 Outstanding
Accounting Educator Award recipient. In 2004, he received the AI/ET Section Outstanding
Educator Award for 2002–2003. The AI/ET Section is the Artificial Intelligence/Emerging Tech-
nologies Section of the American Accounting Association. In 1993 he conducted a multimedia
lecture tour in Finland, Sweden, the UK and Germany, and was the 1993/94 British Accounting
Association’s Distinguished International Visiting Scholar. He has made presentations in over
350 colleges and universities around the world. His specialties are technologies in accounting
education and accounting theory, particularly accounting for derivative financial instruments.
His website was noted as an outstanding helper site by the Chronicle of Higher Education. He still
updates this website daily at http://www.trinity.edu/rjensen/.

xii
 CONTRIBUTORS

Alfred M. King has been Vice-chairman and a Director of Marshall & Stevens since 2005. He
was previously Chairman of Valuation Research Corporation, another major international
professional firm. In his career to date he has personally appraised over $100 billion of assets.
A native of Boston, he graduated magna cum laude in economics from Harvard College in the
class of 1954. In 1959, he received an MBA in finance from Harvard Business School. He holds
the Certificate of Management Accounting, awarded for distinguished performance on the first
examination for accreditation. He has taught classes in cost management at Fordham University’s
Graduate School of Business Administration and is currently teaching accounting at University
of Mary Washington. He has written more than eighty articles for professional journals, eight of
which appeared in Strategic Finance and received certificates of merit as well as a silver and a
bronze medal. In addition, he is the author of Valuation: What Assets are Really Worth, published
in 2002 by Wiley. His most recent book, Fair Value for Financial Reporting, was recently published
(2006) by Wiley. Still active in the Institute of Management Accountants and a member of its
Financial Reporting Committee, he is also a member of the Financial Executives International
and is President of the Virginia Chapter. He is listed in the current edition of Who’s Who in
America and Who’s Who in Finance and Industry.

Andrew Lennard joined the staff of the Accounting Standards Board in 1990 from KPMG, where
he had spent several years supporting the firm’s professional activities in a technical role, special-
izing in lease accounting, off-balance sheet finance and hybrid capital instruments. In 1992 he
became ASB’s Assistant Technical Director, in which capacity he played a major part in the
development of Financial Reporting Standards, including FRS 4 ‘Capital Instruments’, and the
Board’s Statement of Principles for Financial Reporting. Now Director of Research, he plays a
central role in ASB management and currently chairs the ASB’s Pensions Advisory Panel.
Andrew is the author of ‘Liabilities and how to account for them’, published by the ASB, which
is available at www.asb.org.uk/public/downloads.cfm. Although of Scottish origin, Andrew is a
Fellow of the Institute of Chartered Accountants in England and Wales.

Warren McGregor was appointed to the International Accounting Standards Board in January
2001. Before joining the Board, he was a founding Director of Stevenson McGregor, a boutique
accounting practice specializing in financial reporting and accounting standards. Prior to that, he
was for ten years the Chief Executive Officer of the Australian Accounting Research Foundation
(AARF), the body that until 30 June 2000 was responsible for providing technical support to the
Australian Accounting Standards Board (AASB) in the development of Australian Accounting
Standards. From 1983 to 1999, he attended meetings of the IASC as Technical Adviser to the
Australian delegation. He was Chairman of the IASC’s Insurance Steering Committee, and a
founding member of the G4+1 group of national accounting standard setters. He was appointed
Professor, Department of Accounting and Finance, at Monash University in 2007.

Takashi Matabe is a Partner in the Division of Risk Management and Quality Control at
MISUZU Audit Corporation, Japan, a network firm of PriceWaterhouseCoopers. After being
involved in audit for manufacturing companies for twelve years, he was seconded to the Account-
ing Standards Board of Japan (ASBJ) from 2003 to 2006. He has a Master’s degree from Keio
graduate school and is a certified public accountant in Japan. He is a member of the review
committee for the Japanese translation for the IFRSs, which is published in association with the
IASC Foundation.

Franck Missonier-Piera is Associate Professor in the Department of Accounting and

Management Control at ESSEC Business School (France). He earned his Ph.D. in Business

xiii
CONTRIBUTORS

Administration from the University of Geneva (Switzerland) and is a certified management

accountant (Canada). As Assistant Professor, he served on the faculties of HEC-Montréal
(2000–2002) and the University of Lausanne (2002–2004), before joining ESSEC. His fields of
expertise are financial analysis and security valuation, IFRS and financial instruments. He has
published several articles in academic journals (e.g. Journal of International Financial Manage-
ment and Accounting, The Financial Review), and is co-author of one textbook on IFRS and
a research book on corporate governance. Its research focuses on the role of accounting data
(and the fair value issue) in corporate governance mechanisms such as Debt contracts and CEO
compensation plan.

Christopher J. Napier is Professor of Accounting at Royal Holloway, University of London. After

qualifying as a chartered accountant, he taught at the London School of Economics and the
University of Southampton (from where he received his Ph.D.) before taking up his present
position. He has served as a member of the Council of the Institute of Chartered Accountants in
England and Wales and was a member of the Institute’s Financial Reporting Committee from
1998 to 2004. His book Accounting for the Cost of Pensions (1983) provided the research basis for
the first UK accounting standard on pensions.

Paul Pacter holds two concurrent positions: Director of Standards for Small and Medium-sized
Entities (SMEs) at the International Accounting Standards Board in London; and Director,
Global IFRS Office of Deloitte Touche Tohmatsu in Hong Kong. The goal of his IASB work
is to develop accounting standards that reduce the financial reporting burden on SMEs. His
responsibilities at Deloitte include responding to client technical questions, writing an IAS news-
letter called IASPlus and managing the website (www.iasplus.com). He worked for the IASB’s
predecessor in London from 1996 to 2000, managing projects on financial instruments, interim
financial reporting, segment reporting, discontinuing operations, extractive industries, agri-
culture and electronic financial reporting. Previously, he worked for the US Financial Accounting
Standards Board for sixteen years, and, for seven years, was Commissioner of Finance of the City
of Stamford, Connecticut. Paul was Vice-Chairman of the Advisory Council to the US Govern-
mental Accounting Standards Board (1984–1989) and a member of GASB’s pensions task
force and FASB’s consolidation task force. He is co-author of two university textbooks and has
published over 100 professional monographs and articles. He received his Ph.D. from Michigan
State University and is a CPA. He has taught in several MBA programmes for working business
managers.

Andrew Spooner is a Partner of Deloitte and Touche LLP in the UK. He is a specialist in financial
instruments accounting and currently advises large corporate and banking clients on the applica-
tion of IFRS. Prior to joining Deloitte he was a Director of Accounting Policy at UBS Investment
Bank and was also an adviser to investment banks on the accounting implications of structured
transactions while at Arthur Andersen. Andrew is co-author of iGAAP 2007 Financial Instru-
ments: IAS 32, IAS 39 and IFRS 7 Explained (Third edition).

Kevin M. Stevenson is a Partner in the Global Capital Markets Group of PricewaterhouseCoopers

(PwC). He was the foundation Director of Technical Activities at the International Accounting
Standards Board (2002–2005), a founding partner of Stevenson McGregor (1999–2001), a former
Senior Technical Partner of PwC and National Technical Partner of Coopers & Lybrand in
Australia (1989–1999). Prior to that, he was Executive Director of the Australian Accounting
Research Foundation (1979–1989). He has been a member of the Australian Accounting

xiv
 CONTRIBUTORS

Standards Board and a foundation member of the Australian Urgent Issues Group, the Standing
Interpretations Committee of the International Accounting Standards Committee and the
International Financial Reporting Interpretations Committee (IFRIC). He was also inaugural
Chairman of IFRIC. He is the author of numerous articles and has contributed to many domestic
and international standards.

Petri Vehmanen is Professor of Accounting at the University of Tampere, Finland. He is also

Head of the Department of Economics and Accounting at the same university and Director of
the joint general executive MBA programme of the University of Tampere and the Tampere
University of Technology. He has a Ph.D. from the University of Tampere, Finland.

Peter Walton is Professor of Accounting at the ESSEC Business School, France, and co-director
of the ESSEC-KPMG Financial Reporting Chair. He worked as a controller for British and
French multinationals before becoming a journalist and researcher. He has a Ph.D. from the
London School of Economics and is a Chartered Certified Accountant. He is editor of World
Accounting Report and of the European Accounting Association’s journal Accounting in Europe.

Geoffrey Whittington is Emeritus Professor of Financial Accounting and a Life Fellow of

Fitzwilliam College, at the University of Cambridge. He is a Senior Associate of the Judge
Business School, attached to the Cambridge Endowment for Research in Finance. He is also
(since September 2006) a member of the UK Accounting Standards Board (ASB). From 2001
to 2006, he was a member of the International Accounting Standards Board (IASB). He is a
Fellow of the Institute of Chartered Accountants in England and Wales and has a doctorate in
economics from Cambridge. He has held chairs at Edinburgh, Bristol and Cambridge Universities
and has served on many professional, academic and regulatory committees. He has researched
and published on a wide range of topics in applied economics and accounting and has a special
interest in accounting for changing prices.

Allister Wilson is the Senior Technical Partner and Head of International Financial Reporting
in the UK firm of Ernst & Young LLP. Prior to joining Ernst & Young in the UK in 1987, he
held academic posts at the University of Cape Town and the University of Durban-Westville,
where he was the Associate Professor of Accounting and Head of Department of Accounting
and Auditing. He has published extensively in the area of international financial reporting and is a
co-author of Ernst & Young’s major work International GAAP® 2007 and of IFRS/US GAAP
Comparison, which is published in association with the IASC Foundation.

Caroline Woodward is a Director in PwC’s Global Accounting Consulting Services (IFRS) where
she advises on the value-related issues arising from the application of International Financial
Reporting Standards. She is a chartered accountant with twenty years of international valuation
experience. She has published many articles on financial reporting valuations, inward investment
and privatization and has contributed chapters on the accounting for and valuation of intangible
assets for the book, Brands: Visions and Values published by Wiley and Building and Enforcing
Intellectual Property Value sponsored by Morgan Stanley and NASDAQ, and published by Globe
White Page.

Jens Wüstemann was trained as an economist at the University of Frankfurt (Germany), at the
Université Paris IX-Dauphine (France), the Wharton School of the University of Pennsylvania
and the Stern School of the New York University (both USA). Since 2002, he has held the Chair

xv
CONTRIBUTORS

for Accounting and Auditing at the University of Mannheim, Germany. He is Board member of
the National Research Centre on Concepts of Rationality, Decision-making, and Economic
Modelling (SFB 504) and also leads a connected project. He holds the position of Academic
Director of the joint Executive MBA Programme of Mannheim Business School and ESSEC
Business School, Paris (France). His current research projects concentrate on institutional
economics, normative accounting research and behavioural law and economics. He is author of
numerous books on international accounting. Recent international publications have appeared
in the Journal of Institutional and Theoretical Economics, Journal of Corporation Law and
Accounting in Europe. He is a member of IFRS-related working groups of the European
Financial Reporting Advisory Group, Brussels (Belgium), and the German Accounting
Standards Committee, Berlin (Germany).

xvi
 Preface

The idea for this book came from a perception that, although fair value is keenly debated by
preparers of financial statements, auditors, users, standards-setters and academics, the literature is
relatively sparse, and, the views of practitioners and standards-setters are particularly difficult to
access. The intention was therefore to create an eclectic collection of papers that would approach
fair value from many different perspectives, and would, hopefully, inform the debate and provide
a starting point for anyone wanting to work on some aspect of fair value.
The contributors come from a wide variety of backgrounds, and the reader should expect that
the book therefore includes a wide variety of styles. A central issue in relation to the book is that,
although some cross-referencing is provided, each paper is intended to be capable of being read
on its own. When the subject is something as relatively narrow as fair value, and there are none-
theless twenty-six chapters, it is inevitable that there is a certain amount of duplication in the
background material. No attempt has been made to moderate that, because the view was taken
that removing background elements to a single place and referring the reader there would unwind
the logic of each chapter, and would be potentially an irritation and a distraction. This is intended
as a work of reference and not a textbook, and it seems people are unlikely to read it sequentially.
Readers are also asked to be aware that the views expressed in these chapters are those of the
individual authors, and should not be taken as representing the view of any organization with
which any of the contributors are connected.

Peter Walton

xvii
Acknowledgements

This is a collective work, and I should like to express my gratitude to the contributors, all very
busy people, for making a considerable effort to write the papers that form this book in a short
time frame. I am grateful to a number of people for helpful comments and suggestions, especially
David Cairns, Christopher Napier and Paul Pacter. The production process involved a large
number of people. My thanks are due to Jacqueline Curthoys and Francesca Heslop at Routledge
for commissioning the book and nursing it through to completion, as well as Emma Joyes,
Lyn Richards and Victoria Lincoln. I am grateful also to Jackie Fry at the Open University for
researching the literature on fair value, to Françoise Fitamant and Elisabeth Godzik at ESSEC
Business School who undertook much of the administration, and to Richard Casna for invaluable
help with sub-editing the material. The responsibility for errors is, of course, my own.
I acknowledge, with thanks, permission from Elsevier Science to reproduce George Benston’s
article ‘Fair Value Accounting: A Cautionary Tale from Enron’ which was first published in the
Journal of Accounting and Public Policy (July/August 2006, Vol. 25 pp. 465–484).

xviii
Section I
Introduction
 1
The nature of fair value

Peter Walton

As a number of contributors to this book (Chapter 6) discusses the different definitions

make clear, there are several possible mean- of fair value that have been used in the litera-
ings of fair value, making it, with the true and ture. Anne Cazavan-Jeny (Chapter 7) con-
fair view, an ‘accounting and legal will-o’-the- trasts a fair value balance sheet with other
wisp’ (Dean and Clarke 2005: i). Of course, measurement models used in business, while
the FASB is now, in SFAS 157, seeking to Warren McGregor speculates on possible
define it as an exit value. The rest of the world wider use of fair value (Chapter 8). Andrew
may or may not accept this, but even if they Lennard (Chapter 9) suggests that there is no
do, that does not rule out the possibility of one wholly satisfactory measurement basis.
using in accounting other variants of current Franck Missonier-Piera (Chapter 10) reviews
or market value: the labelling issue should not the research that has attempted to evaluate
be confused with the discussion of detailed the use of fair value or other revaluations. In
differences between alternative current values Chapter 11, Kevin Stevenson argues that the
as a measurement basis in accounting. This need for a coherent measurement objective
book sets out to explore the broadly defined has been ignored in the evolution of fair value.
notion of market value or current value from Petri Vehmanen explores the implications
as many different aspects as possible. (Chapter 12) of the way that accountants use
The book is divided into three sections. the term ‘measurement’, while Peter Walton
Section I aims to provide an introduction to (Chapter 13) compares IAS 39 with the short
the subject: David Cairns (Chapter 2) analyses life of the UK inflation accounting standard,
the use of fair value in IFRS, Alfred King SSAP 16. In Chapter 14, Geoffrey Whitting-
(Chapter 3) discusses the new FASB standard, ton compares fair value with other measure-
SFAS 157, from a valuer’s perspective, Ian ment bases and explains his modified deprival
Hague (Chapter 4) sets out the arguments in value approach. Allister Wilson (Chapter 15)
favour of using fair value in financial report- asks how reliable are fair value measurements,
ing, and finally Michael Bromwich (Chapter and Jens Wüstemann and Jannis Bischof
5) gives a critique of fair value from the per- (Chapter 16) analyse the effects of fair value
spectives of decision-making and economics. measurement on debt and equity.
Section II contains papers that put fair In Section III, the emphasis is on fair value
value into different contexts. David Alexander as currently experienced or as it may apply

3
P E T E R WA LT O N

in different business environments. George value of the property being used by it for the
Benston (Chapter 17) discusses how Enron convenience of the public.
used fair value, while Gabi Ebbers (Chapter
18) analyses the use of fair value in account- The court went on to specify:
ing in the insurance industry. In Chapter 19,
Dean Galligan gives a user’s perception of What the company is entitled to ask is a fair
how fair value impacts upon different sectors. return upon the value of that which it
employs for the public convenience. On the
Raphaël Jacquemard (Chapter 20) explains
other hand, what the public is entitled to
the problems posed to the auditor by fair
demand is that no more be exacted from
value measurement. Robert Jensen (Chapter it . . . than the services rendered . . . are rea-
21) reviews the different measurement bases sonably worth.
used in the FASB’s mixed attribute approach
and how fair value has been introduced in Rose (1996: 46) asserts: ‘the term “fair value”
the US. In Chapter 22 Kenichi Akiba and was a term invented and used by late nine-
Takashi Matabe discuss how fair value is seen teenth century populists to increase the appeal
in a Japanese context. Christopher Napier of the replacement value concept. This was
(Chapter 23) looks at pension accounting and part of their political stance for government
fair value, and in Chapter 24, Paul Pacter control of monopolies’.
reviews the problems of fair value in the Rutterford (2004: 136), reviewing equity
context of developing countries and small valuation techniques, says that fair value is
business. In the last two chapters Andrew used by analysts to mean the market value of
Spooner reviews IAS 39 and Caroline Wood- the net assets of a company, or its intrinsic
ward discusses IAS 36. value, contrasting with the market price. She
This first chapter will try, by way of an adds:
introduction to the current debate that is
evidenced in the following chapters, to put The concept of intrinsic or fair value, first
the use of fair value or market value into con- applied to equities in the South Sea Bubble
text. This context is partly one of historical of the 1720s, took off after the 1920s stock
evolution, and partly a discussion of how market boom and bust. In times of high
recent international standards are changing stock market valuations, analysts were
the traditional recognition boundaries. forced to consider whether share prices
really reflected intrinsic worth.

Moving to financial reporting, Chambers

Historical references
(1995) reproduces several early references to
fair value in accounting. He quotes (p. 521)
As Alfred King mentions in Chapter 3, the
Lisle (1903: I 208) writing that ‘all the assets
term ‘fair value’ has been in use for over a
that are included in a balance sheet should be
century in the US, meaning the value for
stated at their fair value’. Montgomery (1922:
which an asset could be exchanged between
I 74) is quoted (p. 508) as saying:
a willing buyer and willing seller, with know-
ledge of the market and without compulsion.
Even though market values have frequently
Rose (1996: 52–53) cites Smith v. Ames 169
been ignored in balance sheets, the time is
US 466 (1898), a decision on rate regulation. coming when more attention will be paid to
The court decision was: true values. Market value is the price at
which a seller willing to sell at a fair price
We hold . . . that the basis of all calculations and a buyer willing to buy at a fair price,
as to the reasonableness of rates to be both having reasonable knowledge of the
charged by a corporation . . . must be the fair facts, will trade.

4
 T H E N AT U R E O F FA I R VA L U E

Richard (2004: 99) points out that market is something altogether apart from trading
value has a long history in French accounting profit and loss, being merely an accidental
and was widely used in balance sheets in the variation (owing to external causes) in the
nineteenth century. He observes: value of certain property owned, but not
traded in: to carry the amount of such
variation to Profit and Loss Account would
The 1807 Commercial Code (itself drawing
be to disturb and obscure the results of
on the 1672 Savary Ordonnance) requires all
actual trading, and so render comparison
businesses to draw up an annual ‘inventory’
difficult, if not impossible.
of assets and liabilities. It does not provide
for any rule of valuation but gives in notes
It seems that the underlying notion of a
an example of the inventory (balance sheet)
in which it is said that the assets must be
market value was established in economic and
carried at their value (cours) on the day of legal contexts in the anglophone world by the
inventory. Value in this case is considered to end of the nineteenth century and possibly
be market value. before, while Savary’s current price approach
to the balance sheet spread to large parts
Although Richard was discussing the French of continental Europe from the seventeenth
case, the French statute was widely borrowed century onwards (even if abandoned in the
throughout Europe (Walton 1995: 5) and so twentieth century).
variants of market value would be found in Of course the appearance of fair value as a
much of the nineteenth-century company term in accounting standards is also a signifi-
legislation in continental Europe. cant part of the evolution of the term, albeit
Dicksee (1919) in his authoritative auditing more recent. However, I will not address that
manual does not mention fair value. However, here, as it is analysed in depth by David
he notes (pp. 187–188): Cairns (Chapter 2) and David Alexander
(Chapter 6) as well as being referred to in a
With regard to values, it will be observed number of other chapters.
that no basis of valuation is laid down (in
the Companies Act); but that the basis,
whatever it may be, has to be stated. The Uses of fair value
requirements in this respect are sufficiently
lax. The assets may be valued at cost price; at To read those newspapers that venture to
cost price less depreciation; at a valuation mention financial reporting standards and
made at any stated date; or presumably even fair value, one might think that fair value was
at book value; and yet the requirements of
some new invention. This part of the chapter
this section would be complied with. Upon
sets out the way fair values (or market values)
the whole it is by no means certain that a
are used to solve particular accounting
valuation ‘at cost price’ would not for this
purpose give more real information than any problems.
other.
Non-monetary transaction
Dicksee mentioned the effect of changes in
Some of the current literature on fair value in
the value of fixed assets (pp. 186–187):
accounting might lead one to believe that
its use as a measurement basis was new.
The points to be borne in mind here are that
Depreciation may reduce their value, and
However, that is not the case. As the law on
that Fluctuation may increase or reduce systematic promotion of limited liability
their value. Depreciation . . . is clearly an companies progressed from its nineteenth-
expense with which profit may be fairly century beginnings, the statutes have recog-
charged. . . . On the other hand, Fluctuation nized that there were instances in financial

5
P E T E R WA LT O N

reporting where no cost figure was available, of cost or market value. Here the fair value
and some form of current value had to be serves as an upper limit and therefore as a
used in its stead. ceiling for balance sheet amounts. Normally
Fair value is often required when a limited the stock valuation rule would be that market
liability company is formed. It is common- value in this context means selling price less
place, for example, for an unincorporated the costs of selling the product, which is of
small business at a particular stage of growth course different from SFAS 157, for example,
to decide to incorporate. At that point the which excludes selling costs. However, the
proprietor sells the assets of the business to principle is that current value should be used
the company, and typically receives shares in to check for excess book values.
exchange. The value at which the assets enter This principle extends, in theory, to all
the company’s books is at market, or fair, assets in countries that have variants of the
value at that time. Similarly, when an initial French Commercial Code with its require-
public offering is made, to take a privately ment to show assets at no more than their
owned business into a listed entity, the pro- market value (in practice, French companies
spectus must normally give a current in the twentieth century were still obliged to
valuation of the assets being acquired from use fair values, but actually used historical
the private business. To generalize, there are cost, with fair value being reflected only
situations that arise in accounting, and pre- for impairments and not typically for revalu-
sumably have done so for centuries, where no ations). In the UK, company law provides
money transaction takes place in an exchange, that fixed assets should not be carried at a
and a monetary value has to be found to value that could not reasonably be recovered,
measure the economic exchange. Usually this which meant that impairment write-offs were
value would be a form of market value. rare. However, IAS 36 Impairment of Assets
has introduced a much more systematic use of
current values for fixed assets.
Allocation tool
Without going into the subtleties of fair
A variant of this principle comes into play in value less costs to sell, and value in use
acquisition accounting. The use of fair value (Chapters 20 and 26 should be consulted),
in this area is much more recent, since prepar- IAS 36 builds on the traditional use of fair
ing consolidated statements only developed value as a benchmark that establishes a ceiling
during the twentieth century. The issue is, for balance sheet values.
however, similar. An acquirer has paid a
single sum to acquire a bundle of assets and
Reflecting executory contracts
liabilities, so there is no transaction price for
the acquisition of each asset and assumption In the 1990s, fair value has been used to
of each liability. The preparer has to carry out simulate the realization of a transaction. This
a purchase price allocation: in the absence is in the tradition of using a market value
of a monetary transaction, values have to be to provide a measurement basis when no
estimated, and fair value is the basis of that monetary transaction has taken place, but
estimation process. It is however, merely a with the difference that the transaction being
rational allocation tool. measured is incomplete.1 In both IAS 37 Pro-
visions, contingent liabilities and contingent
assets, with its requirement to recognize
Fair value as ceiling
‘onerous contracts’ and IAS 39 Financial
Market value has long been used as a bench- Instruments: Recognition and Measurement
mark for the valuation of stocks, where the with recognition of derivatives, the traditional
rule is that they should be valued at the lower recognition boundary of realization is set

6
 T H E N AT U R E O F FA I R VA L U E

aside in favour of recognizing the economic Basis for subsequent measurement

effect of an executory contract. For financial
instruments, this is done by simulating a The major innovation of the US and inter-
realization – the fair value representing the national standards on financial instruments
value that would have been realized if the was to introduce fair value as the mandatory
transaction were halted at balance sheet date. basis for subsequent measurement of some
(Some people consider that IAS 37 also instruments. Depending on one’s definition of
requires a provision at fair value, but David fair value, the entry price of an asset under
Cairns discusses this in Chapter 2.) historical cost is fair value – the current
The recognition of some executory con- purchase price. But traditionally, of course,
tracts is an aspect of the recent use of fair the entry cost is not subsequently modified,
value which does not appear to have been other than being written down, primarily
much discussed in the literature but has through depreciation or occasionally through
some importance in that (1) it changes the impairment.2 IAS 39 and SFAS 133 require
boundaries of the entity as recognized in certain financial instruments to be revalued at
accounting (which, given that accountants balance sheet date, with the change either
tend not to applaud change, is a probable flowing directly into equity or passing through
source of opposition); and (2) it has the the income statement. The IASC followed this
potential to be more extensively used in with IAS 40 Investment Property, which has
recognition and measurement. The joint an option to use fair value for subsequent
IASB/FASB revenue recognition project and measurement, and IAS 41 Agriculture, which
the IASB’s insurance contracts project both has mandatory revaluation of biological
have to address recognition and measurement assets at fair value. In 2003 the IASB modified
problems related to incomplete transactions. IAS 39 to include the fair value option, which
Under the traditional model, revenue is allows wider use of fair value for subsequent
recognized when the contract is complete, measurement.
although this approach is modified in relation It is this use of fair value that probably
to long-term contracts. The effect of this generates the most intense debate. Alfred
is on the whole for selling costs to be treated King points out (Chapter 3) that where fair
as a period expense (not in life assurance), value is estimated, changes in estimate could
whereas an economic analysis suggests that it impact upon the comprehensive income
would be useful to separate out the product statement significantly. In Chapter 15 Allister
manufacturing or service delivery costs and Wilson discusses the reliability of such
revenues from the selling costs and revenues. measurements. In general, preparers point out
One approach suggested by the project team that subsequent measurement creates vola-
is that when an executory contract exists, the tility in the financial statements. Standard-
entity could recognize both an asset (the right setters tend to argue that the volatility is in the
to obtain settlement from the client) and a economy, and revaluing reflects that volatility,
liability (the cost of providing the product or whereas only reporting initial entry costs and
service). This would cause the transaction to ultimate exit prices gives a false impression of
be recognized in stages. Such an approach stability. Put another way, a historical account
does not change the final profit or loss on has few uncertainties because the transactions
the completed transaction, but does spread are fully unwound, whereas a current account
recognition over the whole of the transaction reflects all the uncertainties of the incomplete
cycle. transaction.

7
P E T E R WA LT O N

Conclusion Accounting for Investments (now withdrawn)

and IAS 26 Accounting and Reporting by
Retirement Benefit Plans also use fair value.
This chapter has aimed to establish that cur-
rent or market value has had some place in
statutory financial reporting in Europe since
References
the seventeenth century. It has also shown that
the concept of fair value as being a ‘normal’
Chambers, R.J. (1995) An Accounting Thesaurus:
market transaction existed in the anglophone 500 Years of Accounting. Oxford, Elsevier
world in the nineteenth century. The second Science.
objective was to provide an analysis of the use Dean, G. and Clarke, F. (2005) ‘ “True and fair” and
of fair value in historical cost accounting. The “fair value”: accounting and legal will-o’-the-
wisps’, Abacus Vol. 41, No. 2, pp. i–viii.
suggestion is that fair value has a long history
Dicksee, L.R. (1919) Auditing: A Practical Manual
of being used when no monetary amount for Auditors (11th edn). London, Gee & Co.
formed part of the exchange transaction. This Lisle, G. (1903) Encyclopedia of Accounting.
occurs often on the formation of a company. Edinburgh, Green.
Fair value has also been used in purchase Montgomery, R.H. (1922) Auditing (3rd edn). New
York, Ronald Publications.
price allocations following a business com-
Richard, J. (2004) ‘The secret past of fair value:
bination, and as a benchmark to provide an lessons from history applied to the French case’,
upper limit on balance sheet asset values. The Accounting in Europe Vol. 1, pp. 93–107.
chapter suggests that the innovations of the Rose, K.R. (1996) An Economic and Legal Perspec-
past decade are related primarily to the use of tive on Electric Utility Transition Costs. Colum-
bus, Ohio, The National Regulatory Research
fair value to bring executory contracts into
Institute.
the scope of the financial statements, and its Rutterford, J. (2004) ‘From dividend yield to dis-
use for subsequent measurement. counted cash flow: a history of UK and US
equity valuation techniques’, Accounting, Busi-
ness and Financial History Vol. 14, pp. 115–149.
Walton, P. (1995) ‘International accounting and
Notes history’ in Walton, P. (ed.) European Financial
Reporting – A History. London, Academic
1. This aspect is more extensively pursued in Press, pp. 1–10.
Walton (2006). Walton, P. (2006) ‘Fair value and executory con-
2. The IASC had used fair value prior to that. IAS tracts: moving the boundaries in international
16 Property Plant and Equipment has fair value accounting’, Accounting and Business Research
as an alternative measurement basis. IAS 25 Vol. 36, No. 4, pp. 337–343.

8
 2
The use of fair value in IFRS

David Cairns

The implementation of International As this chapter will show, IFRS are not
Financial Reporting Standards (IFRS), par- rapidly introducing fair value into asset and
ticularly in the European Union, has led to liability measurement; nor is the use of fair
frequent comments that IFRS are ‘fair value- values in any way extensive. In fact, there are
based standards’ and that the IASB is moving remarkably few fair value measurements in
inexorably towards full fair value accounting. the typical IFRS balance sheet. Therefore,
There appears to be a widespread belief that either the assertion that IFRS largely involves
IFRS require all assets and liabilities to be remeasurement at fair value is incorrect or
measured at fair value and all the resulting many IFRS financial statements are incorrect.
changes in fair value to be included as gains Furthermore, the use of fair values, with a
and losses in the income statement. As this small number of exceptions, mirrors long-
chapter1 will show, these views suggest a lack standing requirements of UK GAAP. UK
of understanding of, and confusion about, GAAP has long required the use of fair values
IFRS. They also bring into question the under- for the initial measurement of assets and
standing and application of existing national liabilities or the allocation of the cost of the
GAAP and historical cost accounting. acquisition in a business combination to the
Two examples may be used to illustrate the acquired assets and liabilities. The options to
confusion and misunderstanding. First, Ernst measure property, plant and equipment and
& Young in the United Kingdom argue: investment property at fair value at each
balance sheet date are long-standing UK
treatments that have been incorporated into
The valuation approach that the IASC has IFRS. More significantly, the extensive use of
embraced is rapidly introducing ‘fair value’
historical cost-based amounts, in particular
as the primary basis for asset/liability
for the measurement of many financial assets,
measurement. . . . This means that financial
reporting under IFRS largely involves a
and financial liabilities and as the dominating
process of asset/liability recognition, initial practice for tangible and intangible assets, is
measurement (at fair value), re-measure- common to both UK GAAP and IFRS.
ment (again, largely, at fair value) and The adoption of IFRS has introduced the
de-recognition. use of fair values for the measurement at each
(Ernst & Young 2005: 2) balance sheet date of derivatives and some

9
D AV I D C A I R N S

other financial assets and financial liabilities. portfolio, which includes Heathrow, Gat-
It has also introduced the requirement to wick and Stansted.
measure share-based payments to employees Mark Vaessen, a KPMG partner who
at fair value. In both cases, these are changes advises companies on IFRS, . . . agreed that
from existing UK practice but the lack of any property valuations were particularly
accounting standards for such items was a onerous.
significant deficiency in UK GAAP. (Financial Times, 18 May 2005: 1)
When referring to the measurement of
liabilities, Ernst & Young imply that the need While it is undoubtedly true that quarterly
to keep estimates of liabilities up to date is valuations of BAA’s property portfolio would
further evidence of the IASB’s use of fair be onerous and probably impracticable, BAA
value accounting. While current estimates of and KPMG’s IFRS partner (and, perhaps, the
liabilities may or may not be fair values (an Financial Times) are wrong if they believe that
issue that is dealt with below), the need to IFRS require the quarterly or even annual
keep estimates of liabilities up to date is surely revaluations of owner-occupied property.
a long-standing principle of UK GAAP (as IFRS allow such revaluations provided that
well as historical cost accounting in general they are kept up to date or they are used as
and the prudence principle in particular). deemed cost on the transition from previous
Ernst & Young also see the use of fair GAAP to IFRS (BAA used the second of
values in impairment testing as another these options). Unlike UK GAAP, IFRS do
extension of fair value accounting. Again, not even require the annual revaluation
this has been part of UK GAAP for almost of investment properties (but Heathrow,
fifteen years. Furthermore, impairment test- Gatwick and Stansted would not qualify as
ing reflects another long-standing principle of investment properties in BAA’s financial
accounting: any asset should not be carried at statements). BAA’s argument that it was
more than the entity expects to recover from dropping quarterly reporting to avoid the
its use or sale. mandatory use of fair values under IFRS was
The second example of the confusion and clearly wrong.
misunderstanding about the use of fair Like Ernst & Young, Benston et al. (2006)
values in IFRS is contained in a press report link the use of fair values with the asset/
covering the decision by the British Air- liability approach in the IASB’s Framework
ports Authority (BAA) to cease publishing for the Preparation and Presentation of
quarterly reports (which are, in any event, not Financial Statements and oppose some
required by UK regulators): aspects of the use of fair values. However,
unlike Ernst & Young, they acknowledge the
limited use of fair values in current IFRS and
BAA drops quarterly reporting to escape the
the limits on the likely extension of the use of
demands of IFRS
fair values:
BAA, the world’s biggest airports group, is
to stop publishing quarterly results to escape
The vigorous move of FASB and IASB to
the rigorous demands of IFRS.
the asset/liability approach goes hand in
. . . Under the standards, assets and lia- hand with increasing use of fair values. . . .
bilities – including property – must be shown At present, fair values are used in some
at fair value in all accounts and changes in accounting standards, including those con-
value must be recorded in profit and loss cerning financial instruments and, to a
statements. degree, other financial assets and liabilities,
Ms Ewing [BAA’s chief financial officer] for agricultural assets and revaluation of
said it was ‘in no way practical’ to do such fixed assets. . . . So far, beside contractual
frequent valuations of BAA’s giant property assets and liabilities . . . we know of no plan

10
 T H E U S E O F FA I R VA L U E I N I F R S

to extend the use of fair values to non- Disclosure of Government Assistance (IAS 20).
financial assets in other circumstances. In each case, fair value was used in the context
(Benston et al. 2006: 263) of the measurement of transactions on their
initial recognition in financial statements. For
While one may question Benston et al.’s example, IAS 17 [1982] used fair value in the
assumption that the asset/liability approach context of the initial measurement of an asset
necessarily implies the use of fair values, their acquired under a finance lease and IAS 20
understanding of both the current position of used fair value for the measurement of non-
the IASB and the FASB and the likelihood monetary grants.
of the extension of fair values is much closer The IASC continued with the same
to the truth. definition in IAS 22 Accounting for Business
Given this confusion and misunderstand- Combinations (IAS 22 [1983]) and IAS 25
ings about the use of fair values in IFRS, this Accounting for Investment. In both cases,
chapter examines the extent to which IFRS fair value was used for the measurement of
do, in fact, require the use of fair values for any non-cash consideration (including the
the measurement of assets and liabilities. It entity’s own equity securities). Fair value was
explains, first, the definition of fair value in also used in IAS 22 as the means of allocating
IFRS, the evolution of that definition and the the cost of acquisition to the acquired assets
use of fair values in each appropriate IFRS. It and liabilities; in other words, determining
then identifies the four main uses of fair value the cost of those assets and liabilities to the
in IFRS. The conclusions refer to possible acquirer.
areas in which the IASB might provide further The IASC retained the same definition
clarifications and guidance or extend the use in IAS 26 Accounting and Reporting by
of fair values. Retirement Benefit Plans (IAS 26). This was
the first standard to require the use of fair
value for the remeasurement of assets at each
The evolution of the definition balance sheet date. It required, and continues
and use of fair value in IFRS to require, the measurement of retirement
benefit plan investments at fair value at each
The IASC first used the term ‘fair value’ in balance sheet date (IAS 26: 32).
IAS 16 Accounting for Property, Plant and In 1988, the IASC began its financial
Equipment where it was defined as: ‘The instruments project,2 which extended the use
amount for which an asset could be of fair values for the remeasurement of
exchanged between knowledgeable, willing financial assets and financial liabilities at each
buyer and a knowledgeable seller in an arm’s balance sheet date. The IASC broadened the
length transaction’ (IAS 16 [1982]: 6). definition to cover liabilities as well as assets.
IAS 16 [1982] used fair value solely in the It also replaced the terms ‘seller’ and ‘buyer’
context of the measurement of any non- with the more generic term ‘parties’. As a
monetary consideration given in exchange for result, E40 Financial Instruments used the
an item of property, plant and equipment. following definition of fair value: ‘The
It did not use fair value in the context of amount for which an asset could be
the (optional) revaluation of property, plant exchanged, or a liability settled, between
and equipment at subsequent balance sheet knowledgeable, willing parties in an arm’s
dates. length transaction’ (E40: 4).
The IASC used the same definition in IAS In 1987, the IASC had begun its com-
17 Accounting for Leases (IAS 17 [1982]), IAS parability and improvements project,3 which,
18 Revenue Recognition (IAS 18 [1982]) and among other things, reconsidered the use of
IAS 20 Accounting for Government Grants and fair values in accounting for property, plant

11
D AV I D C A I R N S

and equipment, revenue and business com- instrument granted could be exchanged,
binations. The revised versions of IAS 18 and between knowledgeable, willing parties in an
IAS 22 used the E40 definition (IAS 18 [1993]: arm’s length transaction.
7 and IAS 22 [1993]: 9). Both standards con- (IFRS 2: A)
tinued to require the use of fair values for the
measurement of non-cash transactions. IAS IFRS 2 retained the long-standing principle
22 [1993] also continued to use fair value as that equity instruments issued in exchange for
the means of allocating the cost of acquisition assets should be measured at their fair values
to the acquired assets and liabilities. and not their nominal amounts. It extended
The revised version of IAS 16 used the this principle to equity instruments issued in
E40 definition of fair value but without exchange for services, in particular equity
the reference to liabilities (IAS 16 [1993]: 7). instruments issued in return for employee
As well as using fair value for measurement services.
of any non-monetary consideration, IAS 16 In IFRS 3 Business Combinations, IFRS 4
[1993] included a new requirement that Insurance Contracts, IFRS 5 Non-current
any (optional) revaluations of property, Assets Held for Sale and Discontinued
plant and equipment should be made to fair Operations and IFRS 7 Financial Instruments:
value. Disclosure (IFRS 7), the IASB reverted to the
The IASC and the IASB used the new previous definition without the reference to
definition (with or without the reference to equity instruments granted. IFRS 3 continues
liabilities) in IAS 32 Financial Instruments: to require the use of fair values for the
Presentation and Disclosure, IAS 36 Impair- measurement of any non-cash consideration
ment of Assets, IAS 38 Intangible Assets, IAS and the allocation of the cost of acquisition to
39 Financial Instruments: Recognition and the acquired assets and liabilities. IFRS 5
Measurement, IAS 40 Investment Property, extends the impairment principle in IAS 36
IAS 41 Agriculture and IFRS 1 First-time to non-current assets held for sale (arguably
Adoption of IFRS. IAS 39, IAS 40 and this is an unnecessary standard). IFRS 7
IAS 41 extended significantly the required or takes over and extends the fair value dis-
optional use of fair values for the subsequent closures in IAS 32. IFRS 4 and IFRS 6 are
measurement of assets and liabilities. A sub- both temporary standards and their use of
sequent change to IAS 39 introduced the fair values is largely limited to existing
notion that financial assets and financial practice.
liabilities should be measured on initial One obvious conclusion that may be drawn
recognition at their fair values (as opposed is that, apart from the replacement of ‘buyer’/
to their costs). IAS 32 introduced new ‘seller’ by ‘parties’ and the extension to cover
requirements on the disclosure of fair values. liabilities and equity instruments granted, the
IAS 36 formalized the consideration of fair definition of fair value in IFRS has remained
values in impairment testing. IAS 38 allowed unchanged for almost twenty-five years. It
optional revaluations of intangible assets to is therefore surprising that there is some
fair value but in very restricted circumstances. uncertainty about its meaning and some
In IFRS 2 Share-based Payment, the IASB confusion about what amounts are, and
broadened the definition of fair value to what are not, fair values. Another obvious
cover the grant of equity instruments as well conclusion is that, as explained in more detail
as assets and liabilities. Therefore, IFRS 2 below, the primary use of fair value has been
defines fair value as: for the measurement of transactions or
the components of transactions on initial
The amount for which an asset could be recognition.
exchanged, a liability settled or an equity

12
 T H E U S E O F FA I R VA L U E I N I F R S

The meaning of fair value in IFRS or, in settling such a liability, the estimate of
fair value takes into account market prices.
Before considering further the use of fair This principle is reflected in IFRS 2, IFRS 3,
values in IFRS, some clarification of its IFRS 7, IAS 16, IAS 39, IAS 40 and IAS 41.
meaning may be useful. The first point to The IASB is also unlikely to change this
recognize is that, as with some national principle but it is likely to issue further guid-
standards, IFRS use the term ‘fair value’ as a ance on its application.
generic term that may be applied to all assets, For assets, liabilities or equity instruments
liabilities and equity instruments irrespective that are not traded in active markets and for
of whether they are quoted or traded on which market information is not available, the
active markets. In other words, IFRS use estimation of fair value is likely to be difficult
market value as a subset of fair value – it is and, possibly, unreliable. Therefore IFRS
fair value as determined in an active market. prohibit the use of fair value in such circum-
This approach allows for the fact that fair stances for the subsequent measurement of
value must be determined in some circum- assets and liabilities (see, for example,
stances in which the asset, liability or equity intangible assets under IAS 38 and equity
instrument is not traded in an active market. instruments under IAS 39). IFRS allow
This is the case when, for example, tangible or greater flexibility for the use of less reliable
intangible assets are exchanged or unquoted fair values for the initial measurement of an
equity or debt securities are used as the asset or liability or when accounting for
purchase consideration in a business compound transaction (otherwise the asset,
combination. liability or transaction or its components
The IASB’s approach also means that the would be excluded from the financial state-
fair value of assets, liabilities and equity ments). They also still require the use of fair
instruments traded in an active market is their value in impairment testing (otherwise the
market values. This principle was reflected in carrying amount of the asset might be
IAS 25 and IAS 26 and is now included in overstated).
IFRS 2, IFRS 3, IFRS 7 and IAS 39. The link An examination of the definition of fair
with market values is also evident in IAS 16, value also helps clarify whether or not other
IAS 38, IAS 40 and IAS 41. The IASB is amounts used in IFRS financial statements
unlikely to change this principle but it is likely are fair values. For example, as most (but not
to issue further guidance on its application all) business transactions are arm’s length
(e.g. on which markets and on what prices).4 transactions between knowledgeable willing
In the absence of quoted prices in active parties, most historical costs approximate fair
markets, the IASB requires the use, when values at the transaction date. At subsequent
possible, of market information and favours dates, historical cost and historical cost-based
widely used and accepted valuation tech- amounts are not fair values (other than by
niques. Therefore, for assets, liabilities or coincidence). Therefore, cost less depreci-
equity instruments that are not traded in ation, cost less amortization and amortized
active markets or for which current quotes cost, as well as amounts determined using the
from such markets are unavailable, the entity equity method or proportionate consolidation
must estimate fair value using market infor- and the net book value of an entity, are not
mation (e.g. market rates of interest when fair values and are often significantly different
determining the fair value of a debt instru- from fair values.
ment). This reflects the fact that any rational, Under IFRS, the value in use of an asset
knowledgeable and willing party would take and the current value of the expected future
into account market information when payments required to settle a liability are
exchanging such an asset or equity instrument based on estimates of future cash flows

13
D AV I D C A I R N S

discounted at current market rates of interest. estimates for the fair value of any asset or
Therefore, the amounts are indicative of the liability often significantly outweighs the dif-
amounts that rational, willing and know- ference between entry price and exit price. For
ledgeable parties would take into account example, any debate about entry or exit prices
when considering the exchange of the asset is probably irrelevant in the determination of
or equity instrument or settlement of the the fair value of an unquoted equity invest-
liability. These amounts may therefore ment, a property or an intangible asset.
approximate fair values but they should not
be presumed to be fair values. They are not
described in IFRS as fair values. When do IFRS require or allow the
Fair value less costs to sell (IAS 36 and use of fair value?
IFRS 5) and fair value less point-of-sale costs
(IAS 41) are, by definition, based on fair value From the earlier review of the use of fair value
but are lower than fair value. Net realizable in IFRS, it is clear that IFRS require or allow
value (IAS 2) probably approximates the fair the use of fair value in financial statements in
value of inventories held for resale but exceeds four main ways:
the fair value of work in progress and raw
materials as it does not allow for any profits 1 for the measurement of transactions
on the completion of inventories. (and the resulting assets, liabilities and
Even with an understanding of the defin- equity items) at initial recognition in
ition and what is and what is not fair value, the financial statements;
IFRS are unclear whether fair value should 2 for the allocation of the initial amount
be based on an entry price or an exit price of at which a transaction is recognized
an asset, liability or equity instrument. The among its constituent parts;
definition may imply an exit (selling) price as 3 for the subsequent measurement of
it defines the fair value of an asset as the price assets and liabilities;
at which that asset could be exchanged, i.e. 4 in the determination of the recoverable
sold or transferred.5 However, the use of fair amount of assets.
value in IFRS implies that fair value should
be an entry (purchase) price when it is used to It is important to distinguish between these
determine the cost of an asset, liability or four uses. The use of fair values in the first,
equity instrument issued. It should be an exit second and fourth cases is essential even in
(selling) price when it is used for impairment historical cost financial statements, and does
purposes. not require (or imply) the use of fair values at
When fair values are used for the sub- each subsequent balance sheet date.
sequent measurement of assets and liabilities,
it is less clear whether they should be entry
The use of fair value for
prices or exit prices. The IASB appears to be
measurement at initial recognition
moving towards the use of exit prices (see, for
example, the requirement in IAS 39 to use bid The IASC’s first use of fair value was for the
prices for financial assets and the proposals in measurement of transactions, i.e. to deter-
IASB (2007)), which could result in the recog- mine the cost of assets or liabilities. As
nition of a loss for the difference between explained earlier, the term ‘fair value’ first
entry price and exit price on the initial recog- appeared in the IAS 16 [1982] where it was
nition of an asset. used to measure the cost of property, plant
Irrespective of whether fair value is an and equipment acquired in exchange for
entry price or an exit price, it is worth another asset. Fair value was used in a similar
remembering that the range of possible way to measure:

14
 T H E U S E O F FA I R VA L U E I N I F R S

leased property and the related finance measured had the consideration taken the
lease obligation under IAS 17 [1982]; form of cash or cash equivalents rather than
exchanges of goods and services under another asset or a liability or an equity
IAS 18 [1982]; instrument. In such circumstance, it is logical
non-monetary government grants that fair values should be based on entry
under IAS 20; prices.
the purchase consideration of a busi- IFRS 1 First-time Adoption of IFRS uses a
ness combination that is an acquisition similar approach in the limited circumstances
under IAS 22 [1983]; of transition to IFRS from some other set
investments acquired by the issue of of standards, laws and so on. It allows, but
shares or other securities or in exchange does not require, an entity to use fair value at
for other assets under IAS 25. transition date as the deemed IFRS cost of
property, plant and equipment. This conces-
Both the IASC and the IASB have con- sion was introduced primarily to help those
tinued to require the use of fair values in such entities that may not have previously collected
circumstances (see Table 2.1). In all these cir- the necessary information to determine cost in
cumstances, fair value is used so that non-cash accordance with IFRS (IFRS 1.BC41). The
transactions may be included in the financial concession is, however, available to all entities
statements. Some amount needs to be and has been used by several who could have
assigned to these transactions (otherwise they determined IFRS costs. In such circumstance,
would be omitted from the financial state- it is again logical that fair values should be
ments). Both the IASC believed, and the based on entry prices.
IASB believe, that the amount should be The use of fair values to determine cost,
the fair value of the consideration given or whether on the initial recognition of assets or
received. In other words, IFRS require that liabilities or the transition to IFRS, does not
these transactions should be measured at the require the use of fair value for the subsequent
same amount at which they would have been measurement of those assets or liabilities at

Table 2.1. The use of fair value in the initial measurement of transactions

IAS 16 Cost of an item of property, plant and equipment acquired in exchange for a non-monetary asset
or assets, or a combination of monetary and non-monetary assets (provided the transaction has
commercial substance) (IAS 16.24)
IAS 17 Measurement of asset and liability arising on a finance lease in the financial statements of the
lessee (unless fair value is higher than present value and minimum lease payments) (IAS 17.20)
IAS 18 Measurement of consideration received or receivable for revenue (unless goods or services are
swapped for goods or services which are of a similar nature and value) (IAS 18.9)
IAS 20 Measurement of transfer of non-monetary asset from government to entity (option) (IAS 20.23)
IAS 38 Measurement of an intangible asset acquired in exchange for a non-monetary asset or assets, or a
combination of monetary and non-monetary assets (provided the transaction has commercial
substance) (IAS 38.45)
IAS 39 Measurement of financial asset or financial liability (IAS 38.43)
IAS 41 Measurement of biological asset and agricultural produce harvested from entity’s biological
assets (IAS 41.12 and 13)
IFRS 1 Measurement of property, plant and equipment at the date of transition to IFRS (IFRS 1.16)
IFRS 2 Measurement of goods and services received and the equity instruments granted in equity-settled
share-based payment transactions (IFRS 2.10)
Measurement of the liability incurred for the goods and services received in cash-settled share-
based payment transaction (IFRS 2.30)
IFRS 3 Measurement of the assets given, liabilities incurred or assumed and equity instrument issued by
the acquirer (IFRS 3.24)

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D AV I D C A I R N S

later balance sheet dates. The entity uses the claim may be true and may lead to subsequent
fair values as cost or deemed cost. It may sub- measurement at fair value, it does not justify
sequently use the historical cost model (unless recording, say, the acquisition of an asset on
otherwise required by IAS 39 or IAS 41). acquisition date at an amount different from
In practice, many entities choose to use the what was paid for it.
historical cost model. As explained earlier, the new approach
The use of fair values to record transactions gives rise to day 1 gains and losses when the
is particularly important in more complex fair value of an asset or liability differs from
transactions; for example, the exchange of the fair value of the consideration given or
financial instruments on the refinancing or assumed. It also places an immense burden on
restructuring of debt or a sale and leaseback the preparers of financial statements who will
transaction. The resulting amounts are again have to determine the fair value of every
used as cost. Therefore, for example, an transaction in order to consider whether it
exchange of debt instruments is measured should be recorded at fair value instead of
using the fair values of the respective instru- cost. The approach is absurd in those cases in
ments and fair value of the debt assumed is which an entity is required or allowed to
then used as its cost for the purpose of apply- measure the assets or liabilities at subsequent
ing amortized cost accounting under IAS 39. balance sheet dates at historical cost or
Again, the use of fair values to measure the historical cost-based amounts.
transactions does not, in itself, require the
use of fair values at subsequent balance sheet
dates. The use of fair value to allocate the
While IFRS have long required the use of cost of compound transactions
fair value to measure the cost of assets or An entity is sometimes faced with the need to
liabilities (in other words, the consideration allocate the total cost (or fair value) of a com-
paid or assumed), the IASB has begun to pound transaction over its constituent parts.
require that assets and liabilities should be This usually means treating one part as the
measured at initial recognition at fair value residual; that is, as the difference between
even when this amount differs from cost (i.e. the total amount of the transaction and the
the fair value of the consideration given or amounts allocated to the other parts. This
received). For example, while the original leads to the IASC’s second use of fair values.
version of IAS 39 adopted the traditional The most obvious example of a compound
approach, the 2004 version of IAS 39 adopts transaction is a business combination. The
the new approach by requiring that financial acquirer measures the cost of acquisition at
assets and financial liabilities should be meas- the fair value of the consideration given but
ured on initial recognition at their fair values. then needs to allocate that cost of acquisition
The basis of conclusions in IAS 39 [2004] is to the acquired assets and liabilities. The
silent on the reasons for the change. IASC recognized the need to use some form
The IASB has subsequently issued a discus- of values as early as 1975 in IAS 3 Consoli-
sion paper Measurement Bases for Financial dated Financial Statements:
Accounting – Measurement on Initial Recogni-
tion which proposes that all assets and
At the date of acquisition the cost of a
liabilities should be measured on initial
parent company’s investment in a subsidiary
recognition at their fair values even when is allocated, if possible, to the subsidiary’s
these amounts differ from cost. Remarkably, individual identifiable assets and liabilities
the discussion paper does not justify this on the basis of their values, and the allocated
change other than by arguing that fair value is amounts serve as the basis on which the sub-
more relevant than historical cost. While that sidiary’s assets and liabilities are reported in

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 T H E U S E O F FA I R VA L U E I N I F R S

the parent company’s consolidated financial Table 2.2. The use of fair value in the
statements subject to the acquisition. allocation of the initial amount of compound
(IAS 3: 13; emphasis added) transactions to their constituent parts

IAS 3 did not include any further guidance IAS 32 Measurement of liability component
on what it meant by ‘values’; that had to wait of a compound financial instrument
(equity component is the residual)
for IAS 22 [1983], which required: ‘In pre-
(IAS 32.31)
paring consolidated financial statements, IFRS 3 Measurement of aquiree’s identifiable
the identifiable assets and liabilities of the assets, liabilities and contingent
acquired enterprise should be restated to their liabilities at acquisition date in a
fair values at the date of acquisition’ (IAS 22 business combination (goodwill is the
residual) (IFRS 3.36)
[1983]: 39).
This principle means that assets and lia-
bilities acquired in a business combination under IAS 39 Financial Instruments;
are measured at the date of acquisition at Recognition and Measurement.
the same amount at which they would have
been measured if they had been acquired The IASB is also considering whether to
separately. It treats goodwill as the residual. use fair values to allocate compound revenue
Again, the use of fair values in this way does transactions between their component parts.
not require the use of fair value for the sub- Table 2.2 summarizes the use of fair values
sequent measurement of the acquired assets for the allocation of the total amount of
and liabilities at later balance sheet dates. The compound transactions among their con-
fair values at the date of acquisition are used stituent parts. The use of fair values in such
subsequently as the historical costs of the circumstances means that the constituent
acquired assets or liabilities. parts of compound transactions (with the
The IASC and the IASB retained this exception of the residual item) are measured
principle in IAS 22 [1993] and IFRS 3. Some- at approximately the same amounts at which
what surprisingly, however, IAS 22 [1993] they would have been measured had they been
allowed the use of a different principle when acquired separately. In such circumstance, it
there were minority interests involved (see is logical that fair values should be based on
IAS 22 [1993]: 31), but this aberration was entry prices.
removed in IFRS 3. The 1993 and 1998 The use of fair values in this way does
versions of IAS 22 and IFRS 3 provided not require the use of fair values for the
further guidance on the determination of subsequent measurement of the assets or
the fair values of the acquired assets and liabilities at later balance sheet dates. The
liabilities. entity uses the fair values as cost. Again, the
Fair values are used in a similar way when use of fair values to measure the transactions
dealing with complex financial instruments. does not, in itself, require the use of fair
For example, they are used to: values at subsequent balance sheet dates.

allocate the total amount of a com-

The use of fair values in the
pound financial instrument among its
subsequent measurement of assets
constituent parts under IAS 32 Finan-
and liabilities
cial Instruments: Presentation and
Disclosure; While the IASC frequently used fair values to
allocate the total amount of a com- measure transactions at initial recognition
pound instrument between an embed- and to allocate the initial cost of compound
ded derivative and the host contract instruments, it was much slower to require or

17
D AV I D C A I R N S

allow the use of fair values for the subsequent measured at fair value (E40.89). There was no
measurement of assets and liabilities. There option to use historical cost-based amounts
was no reference to fair values in either IAS 6 for those assets and liabilities. E40 also
Accounting Responses to Changing Prices or included a fair value option under which all
IAS 15 Information Reflecting the Effects of financial assets and financial liabilities could
Changing Prices. Furthermore, while IAS 16 be measured at fair value (E40.137 and 138).
[1982] allowed the use of revalued amounts E48 Financial Instruments replaced E40 but
for property, plant and equipment, it did not retained the same broad approach to sub-
require that revalued amounts should be, or sequent measurement (but with some modi-
be based on, fair values. Instead, it allowed fications). A similar approach, albeit with
revalued amounts to be any amounts that did further amendments, was included in IAS 39
not exceed recoverable amount (IAS 16 Financial Instruments: Recognition and
[1982]: 44 and 45). Measurement. The most significant difference
The IASC introduced subsequent meas- between E40/E48 and IAS 39 was that deriva-
urement at fair value for the first time in 1986 tives used as hedging instruments have to be
in IAS 25 Accounting for Investments. IAS 25 measured at fair value under IAS 39, but
allowed (but did not require) the use of either would usually have been measured at his-
market values or revalued amounts for torical cost under the proposals in E40 and
investments (including investment property). E48. Other differences included the borderline
Market value was defined as the amount between those financial assets and financial
obtainable from the sale of an investment in liabilities that must be measured at fair value
an active market (IAS 25.3) – in other words, and those that may be measured at historical
fair value as determined by an active market. cost or amortized cost. The fair value option
Revalued amount was not defined but the that appeared in IAS 39 in 2004 and was
explanation suggested that fair value should modified in 2005 is both narrower and more
be used (IAS 25.22 and 25). flexible from the fair value option proposed in
IAS 26 Accounting and Reporting by E40 and E48.
Retirement Benefit Plans, approved a year The 1993 revision of IAS 16 continued to
after IAS 25, requires the use of fair value for allow an entity to use the revaluation model
the measurement of the investments of a for property, plant and equipment but, for the
retirement benefit plan (IAS 26.35). It first time, required that revaluations be made
explains that, in the case of marketable to fair value and be kept up to date so that
securities, fair value is usually market value carrying amount did not differ from fair
(IAS 26.27). Interestingly, IAS 26 allows, as value (IAS 16 [1993]: 30). The same approach
an exception to the general principle, the use was later included in IAS 38 Intangible Assets,
of amortized cost for securities that have a although the opportunity to use the
fixed redemption value and that have been revaluation model for intangible assets is
acquired to match the obligations of the severely restricted and is, therefore, rarely
plan (IAS 26.27). This possibility had not used.
been included in IAS 25 but it is the same The IASC extended the use of fair value for
accounting as held-to-maturity accounting subsequent measurement in both IAS 40
that appeared ten years later in IAS 39. Investment Property and IAS 41 Agriculture.
The IASC proposed that fair value should The exposure draft that preceded IAS 40 was
be required for subsequent measurement for the first ever proposal from the IASC to
the first time in E40 Financial Instruments, require the use of fair value for the subsequent
which was issued in 1992. E40 proposed measurement of any non-financial assets.
that financial assets and financial liabilities However, the comment letters on the exposure
resulting from operating activities should be draft persuaded the IASC that its proposal

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 T H E U S E O F FA I R VA L U E I N I F R S

was impracticable (IAS 40: B43–B48). There- amounts. For all other assets, an entity may
fore, IAS 40 allows a choice between the use use historical cost-based amounts, and the
of fair values and historical costs. vast majority of entities reporting under
In IAS 41, its final Standard, the IASC IFRS choose to do this. IFRS do allow the use
required the use of fair values for subsequent of fair values for some other assets and a
measurement of certain non-financial assets. few liabilities. IFRS prohibit the use of fair
Biological assets should be measured at fair values for most intangible assets, goodwill,
value (less estimated point-of-sale costs) at inventories and virtually all liabilities.
each balance sheet date except when the entity
concludes, on initial recognition of the assets,
The use of fair value in impairment
that fair values cannot be measured reliably
testing
(IAS 41.12). Agricultural produce harvested
from an entity’s biological assets must be The fourth use of fair value in IFRS forms
measured at fair value (less estimated point- part of the process of impairment testing.
of-sale costs) at the point of harvest (IAS One of the oldest accounting principles in
41.13) – in this case there are no exceptions. most jurisdictions is that assets must not be
As Tables 2.3, 2.4 and 2.5 show, the con- carried at more than the amount that the
sequence of all these developments is that the entity expects to recover from their use or sale
mandatory use of fair values for the sub- (for convenience referred to as ‘recoverable
sequent measurement of assets and liabilities amount’, although this term is used in only
is limited to derivatives, other held-for-trading some IFRS).
financial assets and financial liabilities, avail- This impairment principle is included in
able-for-sale financial assets and agricultural every IFRS that deals with assets. It is the
produce at the point of harvest. The use of basis for any write down of inventories to net
fair values for investment property and bio- realizable value (IAS 2) and the recognition
logical assets was clearly the preferred of expected losses on construction and other
approach of the IASC but in both cases an service contracts (IAS 11 and IAS 18). It also
entity may opt to use historical cost-based restricts the amount of deferred tax assets

Table 2.3. The use of fair value in subsequent measurement

IAS 16 Measurement of item of property, plant and equipment (option) (IAS 16.31)
IAS 19 Measurement of plan assets of post-employment benefit plan (IAS 19.54[d])
IAS 26 Measurement of retirement benefit plan investments in the financial statements of the retirement
benefit plan (IAS 26.32)
IAS 27 Measurement of investments in subsidiaries, jointly controlled entities and associates in separate
financial statements (option) (IAS 27.37, IAS 28.35 and IAS 31.46)
IAS 28 Investments in associates held by venture capital organizations or mutual funds, unit trusts and
similar entities (option) (IAS 28.1)
IAS 31 Investments in jointly controlled entities held by venture capital organizations or mutual funds,
unit trusts and similar entities (option) (IAS 31.1)
IAS 38 Measurement of intangible assets (provided initially recognized at cost and fair value determined
by reference to active market) (option) (IAS 38.75)
IAS 39 Measurement of held-for-trading financial assets and financial liabilities, including all derivatives
(IAS 39.9 and 46)
Measurement of other financial assets and financial liabilities (subject to conditions) (option)
(IAS 39.9 and 46)
IAS 40 Measurement of investment property (option but preferred) (IAS 40.33)
IAS 41 Measurement of biological assets (option) (IAS 41.12)
Measurement of agricultural produce harvested for entity’s biological assets (IAS 41.13)

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Table 2.4. Subsequent measurement of assets in IFRS consolidated financial statements

Usual measurement basis allowed by Fair value option

IFRS and adopted in practice

Non-current assets
Property, plant and Cost Yes
equipment
Investment property Fair value (preferred by IFRS) or Yes
cost
Biological assets Fair value (unless cannot be –
determined on initial recognition)
Goodwill Cost (residual) No
Other intangible assets Cost Yes (in very restricted circumstances)
Associates Equity method Only for associates of venture capital
entities, mutual funds, etc.
Jointly controlled entities Proportionate consolidation Only for associates of venture capital
(preferred) or equity method entities, mutual funds, etc.
Available-for-sale financial Fair value –
assets
Loans and receivables Amortized cost Yes (but rare)

Current assets
Inventories Cost No
Construction contract assets Cost No
Harvested agricultural Fair value –
produce
Trade receivables Amortized cost Yes (but rare)
Finance lease receivables Amortized cost No
Other loans and receivables Amortized cost Yes (but rare)
Held for trading investments Fair value –
Derivatives Fair value –
Held-to-maturity investments Amortized cost Exclude from held-to-maturity
category
Cash equivalents Fair value –
Cash Fair value (same as cost) –

(IAS 12) and defined benefit plan assets (IAS goodwill. The IASC therefore developed IAS
19). IAS 16 [1982 and 1993] included the 36 Impairment of Assets, which deals with the
impairment principle for property, plant and impairment of property, plant and equip-
equipment. IAS 22 [1983 and 1993] included ment, intangible assets and goodwill (see also
the impairment principle for goodwill. Chapter 26). At the same time, the IASC dealt
By the early 1990s, it had become apparent with the impairment of financial assets in IAS
that the then IAS included insufficient guid- 39 (see also Chapter 25).
ance on the determination of the recoverable Fair value plays an important part in apply-
amount of property, plant and equipment or ing the impairment principle to property,
goodwill. Furthermore, the IASC had begun plant and equipment and intangible assets
work on intangible assets and had, as a result, because an entity can recover such assets by
decided to reconsider the accounting for selling them, in particular by exchanging them

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Table 2.5. Subsequent measurement of liabilities in IFRS consolidated financial statements

Usual measurement basis allowed by IFRS and adopted Fair value option*
in practice

Non-current liabilities
Long-term borrowings Amortized cost No
Finance lease obligations Amortized cost No
Defined benefit post- Present value of expected payments less fair value of No
employment obligations plan assets
Deferred tax Expected payments No
Long-term provisions Present value of expected payments No

Current liabilities
Trade payables Amortized cost No
Derivatives Fair value –
Short-term borrowings Amortized cost No
Current portion of long-term Amortized cost No
borrowings
Other financial liabilities Amortized cost Yes
Current tax payable Expected payments No
Short-term provisions Expected payments No

Note
* The fair value option may be used for financial liabilities only when it contains an embedded derivative there
is an ‘accounting mismatch’ or when the liabilities are managed and evaluated on a fair value basis in
accordance with a documented risk strategy (IAS 39: 11A)

with another knowledgeable, willing party measured at amortized cost using the original
in an arm’s length transaction. Therefore, fair effect interest rate (IAS 39: 9 and 46), which
value (less costs to sell) is one of the possible ignores the effects of changes in interest rates
solutions for recoverable amount for property, on their fair values. Recoverable amount is
plant and equipment and intangible assets also determined using the original effective
(IAS 36: 6). It is logical that fair value in such interest rate (IAS 39: 63) so ignoring the
circumstances must be an exit price. changes in fair value resulting from changes in
For the same reason, fair value is also used interest rates.
when considering the impairment of financial IFRS 5 Non-current Assets Held for Sale
assets. However, the further consideration of and Discontinued Operations seeks to deter-
impairment is redundant for financial assets mine the recoverable amount of non-current
that are measured at each balance sheet date assets (including disposal groups) that are
at fair value with all the resulting gains and classified as held for sale. While IFRS 5 and
losses included in profit or loss. It is relevant, IAS 36 imply otherwise, this is in fact an
however, in the case of available-for-sale application of the impairment principle in
financial assets because unrealized gains and IAS 36 to non-current assets that the entity
losses are included in equity until disposal or expects to sell rather than use. The recoverable
impairment (IAS 39: 67). amount of these assets is, therefore, fair
In principle, fair value is also relevant to the value (less costs to sell). It must be an exit
determination of the recoverables amount of price.
loans and receivables and held-to-maturity Table 2.6 summarizes the use of fair value
investments. However, these assets are in impairment testing.

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D AV I D C A I R N S

Table 2.6. The use of fair value in the determination of the impairment of assets

Recoverable amount IFRS dealing with impairment

Non-current assets
Property, plant and equipment Higher of value in use and fair value IAS 36
less costs to sell
Investment property (fair value Fair value IAS 40
model)
Investment property (cost model) Higher of value in use and fair value IAS 36
less costs to sell
Biological assets (fair value Fair value less point-of-sale costs IAS 41
model)
Biological assets (cost model) Higher of value in use and fair value IAS 36
less costs to sell
Goodwill Higher of value in use and fair value IAS 36
less costs to sell
Other intangible assets Higher of value in use and fair value IAS 36
less costs to sell
Associates Higher of value in use and fair value IAS 36
less costs to sell
Jointly controlled entities (equity Higher of value in use and fair value IAS 36
method) less costs to sell
Available-for-sale financial assets Fair value IAS 39
Loans and receivables Present value of future cash flows IAS 39
discounted using original effective
interest rate

Current assets
Inventories Net realizable value IAS 2
Construction contract assets Excess of contract revenue over IAS 11
contract costs
Harvested agricultural produce Fair value less point-of-sale costs IAS 41
Trade receivables Present value of future cash flows IAS 39
discounted using original effective
interest rate
Finance lease receivables Present value of future cash flows IAS 17
discounted using interest rate implicit in
lease
Other loans and receivables Present value of future cash flows IAS 39
discounted using original effective
interest rate
Held for trading investments Fair value IAS 39
Derivatives Fair value IAS 39
Held-to-maturity investments Present value of future cash flows IAS 39
discounted using original effective
interest rate
Cash equivalents Fair value IAS 39

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 T H E U S E O F FA I R VA L U E I N I F R S

Conclusions ciples in financial reporting in general and his-

torical cost accounting in particular. It should
This chapter shows that the use of fair values also have been part of what people understand
in IFRS financial statements is nowhere near by prudence. The fact that the transition to
as extensive as many imply. In particular, it is IFRS has revealed many impairment losses
not true to say that IFRS require that all assets suggests that previous financial statements
and liabilities should be measured at fair were unreliable and lacked prudence.
value. It is also far from true to say that IFRS It is likely that the IASB will continue to use
require all financial assets and financial liabil- fair values as the means of ensuring that
ities to be measured at fair value. The reality is transactions are represented faithfully in the
that the use of fair values in IFRS for the sub- financial statements and in impairment test-
sequent measurement of assets and liabilities ing. Any significant extension of the use of
is very limited – both in theory and in practice. fair values for the subsequent measurement of
It is true to say that IFRS are placing much assets and liabilities is likely to meet strong
more emphasis on the use of fair values to resistance both in the IASB itself as well as its
record transactions and to allocate the initial constituency. Those who resist, however,
amount of transactions among its constituent should bear in mind that the current reliance
parts. This process began almost twenty-five on historical cost-based amounts provides less
years ago and reflects the practice in many relevant information and omits some assets
national standards. The growth in such and, possibly, liabilities from the financial
requirements also reflects the increasing com- statements. And those who criticize the
plexity of many business transactions as well as limited use of fair values in IFRS should
the IASB’s desire (and that of business entities question their application of national GAAP
and their auditors) to ensure that IFRS deal and whether previous financial statements
with a large proportion of these transactions. really had the qualities they claimed.
Fair values, or some other estimates of value,
must be used; otherwise non-cash transac-
Notes
tions will be omitted from the financial state-
ments and compound transactions will not be 1. This chapter is based on Cairns (2006).
disaggregated. If the use of fair values in such 2. For further information on this project, see
circumstances is new, the previous financial Cairns (2002, pp. 34–37).
3. Ibid., pp. 364–383.
statements lacked relevant information.
4. See IASB (2007).
IFRS are also placing more emphasis on 5. Ibid., pp. 8–9.
the need for up-to-date estimates of the
amounts required to settle non-financial liabil-
ities (e.g. provisions and pensions). This is not References
fair value accounting. Furthermore, if it is seen Benston, G. J., Bromwich, M., Litan, R. E. and
as something new, it brings into question the Wagenhofer, A. (2006) Worldwide Financial
way entities and their auditors were applying Reporting: The Development and Future of
national standards and the apparent emphasis Accounting Standards (New York: Oxford Uni-
versity Press).
that some have placed in the past (and con-
Cairns, D. (2002) Applying International Accounting
tinue to place) on such notions as prudence. Standards (London: Tolley LexisNexis).
If the use of up-to-date estimates increases Cairns, D. (2006) ‘The Use and Evolution of Fair
the amount of such liabilities, the previous Value in IFRS’, Accounting in Europe Vol. 3,
financial statements lacked prudence. pp. 5–22.
Ernst & Young (2005) How Fair is Fair Value?
The use of fair values in testing for impair-
(London: Ernst & Young).
ment is also not new and not fair value ISAB (2007) Fair Value Measurement (London:
accounting. It is part of one of the oldest prin- IASB).

23
3
What SFAS 157 does, and does not, accomplish

Alfred M. King

There are very few finance professionals who ing will be disappointed that the Statement
are without a strongly held viewpoint on the merely tells one how to determine fair
topic of fair value accounting. Some (mostly value, not when FV can or should be used in
financial statement preparers and financial financial statements. Those opposed to FV
analysts) dread the day that IASB and accounting will be equally disappointed
FASB formally adopt a fair value basis of because the Statement appears to be one in a
accounting. Others (primarily academicians series of steps that will inevitably result in full
and theoreticians) are counting the days until FV accounting.
we get rid of historical cost accounting and This chapter summarizes the Standard and
move to a total fair value (‘FV’) basis. Just its multiple changes in determining FV. It then
from the way this paragraph is written, it comments on the proposed changes from the
is not hard to deduce that the author is pre- author’s perspective as a valuation specialist
dicting that accounting regulators, sooner with 38 years of experience who has valued
or later, are going to shift to a FV accounting over $100 billion of assets during that time.
and reporting paradigm. Finally, it goes out on a limb and makes a
‘Beware the unintended consequences’ is prediction about how imminent fair value
this author’s advice to all participants in accounting really is.
this ongoing debate. Full adoption of FV
accounting, as and when it is adopted, will
fundamentally change both accounting and What does SFAS 157 actually
auditing as we know it today. Security analysis say?
will be significantly affected, as will be indi-
vidual and institutional investors, albeit SFAS 157 is explicit that it does not require
perhaps to a lesser extent. fair values in any new area of financial report-
Neither side of this debate – and it is a real ing where FV is not now required. All it
debate within the accounting profession – is does is provide a common definition, with
going to be happy with the FASB’s latest pro- accompanying rules for how to determine FV.
nouncement, SFAS 157, Fair Value Measure- So people wanting FV accounting as quickly
ments, issued in September 2006. Those as possible will be disappointed that the
looking for quicker adoption of FV account- Board did not move more quickly. On the

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 W H AT S FA S 1 5 7 D O E S A N D D O E S N O T A C C O M P L I S H

other hand, those who fear FV accounting determine the values based on the best avail-
were not assuaged because it is clear that with able information. The ‘market-based
an approved methodology the FASB will now measurement’ rather than the ‘entity-specific
be able to move forward and implement FV measurement’ is to be used whenever possible.
more quickly. It is this requirement that represents the big
Now let us look at some of the specifics change for financial statement preparers and
of the Standard. Discussed below is the fact appraisers and is discussed in the next section.
that the Standard introduces a brand new The Statement requires valuation of lia-
definition of fair value, one that has far- bilities, including recognition of the risk or
reaching consequences. credit-worthiness of the firm with the liability.
The Statement ‘emphasizes that fair value is In practice, this means that if a firm has a
a market-based measurement, not an entity- liability, say, for future environmental costs,
specific measurement’. This too is discussed and its credit deteriorates, then the value of
below in looking at the Board’s new definition the liability will be reduced. Many observers
of fair value. believe this is counter-intuitive but it is a
The Statement establishes a ‘hierarchy of mechanical result of looking to the market-
values’ with three levels. One should always place rather than to the entity itself.
use values determined from the highest The Statement explicitly precludes so-called
possible level. Level 1 represents prices of ‘blockage discounts’, whereby a large block of
items that trade in an active market (e.g. stock is valued at a discount because trying to
stocks quoted in the Wall Street Journal or sell it all at once would itself depress the price.
Financial Times). Of course very few indi- This requirement appears hard to reconcile
viduals or firms look to an appraisal specialist with the emphasis on marketplace partici-
to determine the value of 100 shares of pants who in practice would suffer a price
Microsoft or AT&T. For practical purposes, decline from trying to sell a large block of
this ‘Level 1’ is a non-issue. stock. The fact that this requirement
Level 2 represents the value of assets for is illogical with respect to the rest of the
which there are no directly quoted prices, Standard is just one of the quirks of having
but where adjustments can readily be made accountants (FASB) tell appraisers how to do
from quoted prices or other information. An their job.
example would be the restricted stock of a Finally, the Statement greatly expands the
publicly traded company. The price without requirements for supplemental disclosures in
the restriction is clearly known and the the footnotes regarding the values of assets
required adjustment for the lack of market- and liabilities at fair value. Again, it is outside
ability (the restriction) can be determined the scope of this chapter to discuss the specific
from comparable market transactions. Level 2 disclosure requirements and readers are
requires some professional judgement, but referred to the FASB document itself. Suffice
essentially is limited to the valuation of it to say that the length of total footnote
financial instruments, a subject outside the disclosures will certainly increase as a result of
scope of this chapter. SFAS 157.
That leaves Level 3, which represents the
lowest level in the hierarchy, but one where
the vast majority of valuations take place. The new definition of fair value
For example, in a purchase price allocation
the total purchase price is known, but the For over 110 years, appraisers, lawyers, judges
specific values of the software, trade name and businessmen thought they knew the
or customer relationships are not available definition of fair market value (FMV). While
from quoted sources. So an appraiser has to disputes could rage over the actual value

25
ALFRED M. KING

determination, virtually all parties agreed on a tained and worth more, or poorly designed
single definition. While taking many different and maintained and worth less. Or, in the case
wordings, all the definitions essentially read as of intangible assets, the appraiser has to
follows: determine the values of trade names and
customer relationships for the buyer. We
Fair market value is defined as the price for take into consideration the buyer’s plans for
which property would exchange between a those assets (e.g. whether or not acquired
willing buyer and a willing seller, each having software will continue to be used or discarded
reasonable knowledge of all relevant facts, because the buyer’s software is better). We
neither under compulsion to buy or sell, and determine how much value is assigned to the
with equity to both. software based on our understanding of
The essential elements of this definition the transaction.
are:
Now let us look at the FASB definition of
FV in SFAS 157:
willing buyer and willing seller agree
on a transaction price;
both buyers and sellers are know- Fair value is the price that would be received
ledgeable about the item being for an asset, or paid to transfer a liability, in
valued; a current transaction between marketplace
the transaction is voluntary for both participants in the reference market for the
parties – not a forced sale or asset or liability.
liquidation;
the transaction regarding the asset is On the surface this definition is similar to
perceived as fair to both parties. the standard definition of FMV quoted
above, but there is one major difference that at
In most cases appraisers are determining first may be quite subtle. Instead of dealing
‘value’ in the absence of a transaction for the with the proverbial ‘willing buyer and willing
specific asset/assets. Therefore, in a buy-and- seller’, the FASB now uses the term ‘market-
sell agreement the parties look to an appraiser place participants’. Is there a difference
to determine what the shares of stock would between willing buyers and willing sellers and
sell for if they were put on the market. The marketplace participants?
appraiser determines who the most likely The answer turns out to be ‘Yes’, there is a
buyer might be and then evaluates the asset difference because of one more change
in terms of its utility to that ‘buyer’. In effect, inserted by the FASB. Now their definition of
a specific transaction is contemplated or FV is supposed to be applied to the price that
assumed and the appraiser provides his pro- the seller would receive, not the price that the
fessional judgement as to the price at which buyer would have to pay. Take a very simple
both parties would be willing to buy or sell the example and this difference becomes appar-
asset. ent. A used milling machine has two separate
In an allocation of purchase price we know values, one to the buyer and one to the seller.
the total payment made for the bundle of If you want to buy a milling machine you
assets but then have to determine the specific have to pay a used equipment dealer the price
values of all the individual assets which made asked. On the other hand, if you have a sur-
up the business that had been bought. Again, plus machine that you want to sell, the used
there is a specific transaction willingly entered equipment dealer will offer you much less.
into between the parties, and the only dif- The reason is simple. The dealer has to make a
ferences of opinion under current rules prior profit and cover the costs of transportation,
to SFAS 157 will be whether the property, storage and cost of money. In the used
plant and equipment (PP&E) is well main- equipment market there will often be a 100

26
 W H AT S FA S 1 5 7 D O E S A N D D O E S N O T A C C O M P L I S H

per cent difference (or 50 per cent, depending Company B could, or might have, been sold to
on which you use as the base for calculation) a buyout firm then the customer relationship
between the price at which dealers will buy an asset is quite valuable.
asset and the price for which they will sell the Now the FASB thinks it has resolved this
identical asset. issue by requiring appraisers to determine
Further, the emphasis on marketplace par- who the ‘market participant’ is. If the appraisal
ticipants has a dramatic effect on certain asset firm makes a judgement that the only realistic
valuations in a purchase price allocation. Take buyer for Company B is another OEM, how
a manufacturer of original equipment (OEM) do we respond to an auditor or a regulator
auto parts. There are only a dozen or so who says, ‘Well, in my judgement, Company B
major auto companies in the entire world and could have been bought by a buyout firm’?
most large OEMs sell to all of these buyers. The fact that Company B actually had sold
Now if Company A buys another OEM, to another OEM is interesting, but not
Company B, the issue is simple: Do the cus- dispositive.
tomer relationships of Company B have any The impact on Company A’s financial
value to Company A? statements is going to be material depending
Most corporate officials, and almost all on where one comes out on this issue; the
appraisers, would argue that since Company more that is allocated to the customer relation-
A is both larger and already selling to the 12 ship intangible, the higher will be the
potential customers, Company B’s relation- amortization expense over the next few years.
ships with the purchasing staffs of those auto If less is allocated to customer relationships,
companies have little value. Company B is then goodwill, the residual, will be higher.
bought because of its production facilities Since goodwill is not amortized (although
and its product line, not because the Sales VP tested annually for impairment) Company A’s
is a close friend of Honda’s Purchasing VP. reported profit-and-loss statement will dir-
After all, Company A already knows everyone ectly reflect the judgement on who is actually
it needs to do business with at Honda. the appropriate marketplace participant for
Thus, from the perspective of the buyer, the valuing that customer relationship.
entity to use the FASB’s term, Company B’s The problem is that in one case we have
customer relationships have little value and a real buyer and in the other we have only a
certainly were not the reason to enter into ‘hypothetical’ buyer. Determining values ‘as
the transaction. But look at this customer if’ something happened which in practice
relationship asset from the perspective of the did not happen seems to this author as if
‘marketplace participant’. If Company B were we are entering an ‘Alice-in-Wonderland’
acquired by an equity buyout firm, one with never-never world. This writer learned in
no expertise in auto parts manufacturing, Accounting 101 that one looks to transactions
the customer relationships established by as the most solid evidence of value. Well,
Company B would be crucial. A firm such as now we stop looking at actual transaction
Texas Pacific, Bain Capital or KKR would and start determining the value of what might
buy Company B as a financial investment and happen, even though it did not happen.
would rely on the existing management to
continue selling to Honda, and so forth.
Consequently, the value of Company B’s Implications for valuation
customer relationships is strictly a function of specialists
who you assume the ‘marketplace participant’
is. If Company B would only be sold to In performing valuations that will be used
another OEM firm, then we can assign a in financial reporting, valuation specialists
low value to customer relationships. But if will now have to look beyond the actual

27
ALFRED M. KING

transaction and ask a number of questions Meanwhile, until the FASB resolves this
about hypothetical transactions in order to issue we as appraisers will have to become
determine what the mythical marketplace highly creative and use a lot of imagination in
participants might do. Just a single example reading the minds of marketplace participants
here will suffice to point out the problem. who in fact have not acquired the asset. How
Suppose a Picasso painting sold at do we explain this to our clients?
Sotheby’s for $30 million. The winning bidder Even more important, how do companies
thought the painting, at least to him, was explain to investors and creditors that they are
worth $30 million. The next highest bidder, taking a big impairment charge because the
the loser, had dropped out at $29 million. asset they acquired last year is not being used
Now the winner comes to an appraiser and and has lost all of its ‘value’? Look at just
asks what his new Picasso should be insured one real life example. When Oracle bought
for. Until recently most appraisers would have PeopleSoft they stated very publicly that
said $30 million, or perhaps even more they were buying the customer relationships
because in case of loss he might have to pay because they were going to migrate users to
even more for a comparable painting. But Oracle’s own software. Oracle had no use for
under the marketplace participant approach and was going to disregard both PeopleSoft’s
the value has to be considered $29 million. name and software.
This is because there is nobody else in the Now in valuing the acquisition of People-
world who is willing to pay $30 million, but we Soft for Oracle, should significant value be
do know of a real live buyer at $29 million. ascribed to the acquired software and trade
Obviously, the underbidder is a ‘marketplace name? If PeopleSoft had been bought by
participant’. So far so good. But what about KKR or Bain Capital, then those buyers
the buyer’s financial statements? Does he have would have kept, and used, the name and
a $30 million asset (cost) or a $29 million asset software. So if KKR and Bain Capital are the
(based on marketplace participants)? If it is marketplace participants, we as appraisers
the latter, how do you explain the immediate would have to place large values on the trade
one-day loss in value of $1million? The fact name and software.
is that the buyer is not going to turn around But in the hands of Oracle those same
and sell the painting; he paid $30 million and highly valued name and software have no
a comparable work of art would probably value and they are not going to spend a nickel
cost him the same $30 million. maintaining the value of either asset. In fact
Valuation specialists no longer look to the they bought PeopleSoft in order to get rid
economics of the specific transaction, i.e. of the name and software! Under SFAS 157,
expected synergies to the buyer. Now we have however, we would place large dollar amounts
to look at what other prospective (but not on the Oracle balance sheet for the trade name
real) buyers might do if they had bought the and software; then a year later when the time
target company, which they did not. comes to do the annual impairment test, guess
Some members of the FASB appear to what? The assets have gone down in value and
understand this conundrum and are suggest- within two or three years will be worthless.
ing that allocations of purchase price under Under SFAS 144 Oracle would test the
SFAS 141 should perhaps be based on the assets for impairment, they would have zero
buyer’s actual transaction and assumptions. value and they would now be written off.
But then the values so determined would not How does Oracle tells its shareholders and
meet the new SFAS 157 definition of fair creditors, ‘Well we took a loss of $x billion
value. Result? Perhaps SFAS 141 should be this year, but don’t worry, we never planned to
changed to indicate that allocations are not use those assets in the first place’?
made at fair value! One of the objectives of financial reporting

28
 W H AT S FA S 1 5 7 D O E S A N D D O E S N O T A C C O M P L I S H

is to provide useful information to investors missed, under the new accounting it will now
and creditors about management perform- have a $1 million gain, which flows directly to
ance, and future cash flows. How does the P&L.
development of hypothetical values on It does not take an experienced CFO to
the one hand, and the almost immediate realize that in this case companies are going
impairment charge of those same values a to ask their attorneys and appraisers to be
year later, help investors and creditors in ultra-conservative. Who knows, in the
any way whatsoever? It is submitted that example above, maybe the plaintiff’s chances
it not only does not help, it positively are 10 per cent, not 1 per cent. In that case one
hinders informed analysis of management would set up a $10 million reserve that would
performance. flow back into income at some future date.
Worst of all, it is not the FASB but the Once again we will be using ‘Alice-in-
valuation specialist who will bear the burden Wonderland’ accounting. In fact, we might
of explaining the new paradigm of financial require all entering accounting students to
reporting: ‘never-never land accounting’. read that book prior to commencing account-
ancy studies!
My recommendation for CFOs and cor-
Implications for accountants porate controllers is simple, albeit self-serving:
in industry Talk to a competent valuation specialist
before you get too far along on the due
Because we will be entering a new world diligence effort for a prospective M&A
of financial reporting as soon as SFAS 157 transaction. Actually try and work out what
becomes effective (late 2007) it behoves the future accounting is going to be and the
financial officers to study prospective acquisi- impact on both the balance sheet and the
tions closely. The accounting implications of P&L. Perhaps this advance look will prevent
a purchase transaction are no longer going to some unpleasant (or perhaps pleasant!)
be straightforward and susceptible to com- surprises.
mon sense. As just one example, take legal
liabilities.
Under current accounting in the United Implications for auditors
States (SFAS 5) liabilities are not shown on a
balance sheet unless they can be determined Auditors are definitely going to be affected by
and have better than a 50 per cent probability SFAS 157. How does an auditor review the
of being incurred. Now under SFAS 157, all judgements made by management, and the
liabilities acquired are going to have to be valuation specialist, as to what hypothetical
valued and placed on the balance sheet. marketplace participants might do? Once one
This means that if a company has been gets away from a real transaction between an
served with a lawsuit asking for $100 million actual buyer and an actual seller and go to
in damages, but the company’s attorney says ‘what might be’, there are going to be a lot of
the plaintiff has only a 1 per cent chance of problems (for a detailed review, see Chapter
prevailing, the buyer still has to reflect a $1 20). True, auditors currently have to review
million liability (1 per cent of $100 million). management judgements on bad debt reserves
Maybe that is good accounting and maybe it or inventory valuations. But in those situ-
is not. The one thing we can be sure of is that ations at least the auditor can look at past
the buyer will never pay out $1 million in performance and judge the reasonableness of
damages. The real answer is binary: either current assumptions.
zero or $100 million will be paid out. So, When we get to one-off unique M&A
assuming the buyer wins when the case is dis- transactions – and have to speculate about

29
ALFRED M. KING

who the hypothetical marketplace par- review the valuation specialist’s reasoning and
ticipants are and how they might behave – assumptions, and the auditor can either dis-
auditors are going to be in a weak position to agree or agree with what has been presented.
assert that they disagree with the valuation As more and more companies’ financial
specialist’s assumptions. statements are based on fair value, the work
The former Chief Auditor of the Public of the auditor as we have known it is going to
Company Accounting Oversight Board change and change dramatically. Perhaps
(PCAOB) in charge of all US auditing auditors are going to have to study valuation
standards said in a speech that in his opinion and in effect train themselves to become valu-
it was impossible to audit value information. ation specialists. Just as there are auditors
Because the valuation specialist, at the end who specialize in information technology, so
of the day, is using personal judgement, it is some auditors are likely to specialize in fair
hard to audit that judgement. value.
Can you ‘audit’ a physician who diagnoses
you with a stomach ulcer instead of stomach
cancer, or vice versa? No, but subsequent Unintended consequences of fair
events will either bear out the diagnosis value accounting
or invalidate it. Similarly, a valuation will
ultimately be borne out by a transaction or I have not addressed all the implications of
other evidence. going to a full-bore fair value financial report-
But it is impossible for me, as an appraiser, ing model because SFAS 157 does not yet go
to ‘prove’ that I am right. I may have an that far. The FASB and IASB have publicly
excellent track record, be respected by my stated, however, that fair value accounting
peers and contemporaries, and make a per- is their goal. Issuance of SFAS 157 then
suasive case as to why I came up with my becomes a necessary, but not sufficient, step
value indication, but I still cannot ‘prove’ the on the way to full fair value accounting. The
answer the way an accountant can prove Boards can now say, as they move inexorably
the original cost of a milling machine by to FV accounting, ‘Well, you know how to do
going to the paid invoice. it, now we are simply extending the use of FV
The FASB has set up a hierarchy of values, to one more asset category’. Some people are
so it will be possible to demonstrate that a anticipating this ‘salami slicing’ as being how
Level 1 value is better than anything else – the two Boards will gradually introduce full
except that there are very few Level 1 values in fair value accounting.
corporate financial statements. Similarly, The subject of full fair value accounting is
Level 2 will be better than Level 3, but as outside the scope of this chapter, which deals
required in the Standard, it will still require with SFAS 157. But if this writer were forced
professional judgement. In my experience to make a prediction it would be that fair
there are relatively few Level 2 values in value accounting will be with us within 15 to
financial statements. So that leaves virtually 18 years, i.e. before 2025. Historical cost
all valuations for financial statements in Level accounting has served us well for the past 75
3, which effectively gets us back to square years, but its days are numbered.
one in supporting the work of the valuation The problems with fair value accounting
specialist. are very straightforward. Changes in values
The only way to resolve this issue is to of assets are going to be orders of magnitude
accept the fact that valuation is an art, not a larger than the impact of a business’s regular
science. Accept that a valuation specialist operations. A small change in external interest
must use his or her professional judgements. rates (determined of course by market par-
Accept the fact that an auditor can only ticipants) will have a magnified impact on the

30
 W H AT S FA S 1 5 7 D O E S A N D D O E S N O T A C C O M P L I S H

valuation of most intangibles. Assume the current sales and operating profit will tell
trade name Coca-Cola® is worth $50 billion, shareholders and analysts what is happening.
as many observers have stated. A 5 per cent Of what additional benefit is it to share-
change in the value of that intangible – some holders and analysts to have Microsoft’s own
$2.5 billion in a year – would then totally evaluation of the value of its major asset?
swamp Coca-Cola’s reported earnings from In fact, many security analysts have been
operations. It should be noted that a 5 per against fair value disclosures for that very
cent change, either plus or minus, is very reason. They want to analyse and tell their
common in valuing intangibles. clients what they, the analysts, think the com-
A second problem with fair value account- pany is worth. If companies go to full fair
ing is that developing and displaying the ‘fair value accounting, the role of a security
value’ of assets that the business has no plans analyst will be to second-guess management’s
to sell or turn into cash provides a misleading determinations of value. As discussed above
picture. The proponents of fair value argue with respect to auditors, trying to second-
that if shareholders ‘know’ the real fair value guess someone else’s determination of value is
of the assets owned by the company in which for practical purposes an exercise in futility.
they hold shares, they can then determine how To end this chapter, I predict that FASB
well management is performing. But take the and IASB will in fact march inexorably
case of Microsoft. What is the value of its towards fair value accounting. It is also pre-
Windows® software? At least $50 billion dicted that there will be serious unintended
based on current and projected cash flow. But consequences and that both company
can Microsoft actually sell the software in managements and shareholders, as well as
total to a single financial or strategic buyer? analysts, will then demand that companies
No, but Microsoft will continue to generate provide, as supplementary information,
cash flows every year from individual buyers. financial information without fair value!
If sales go up, the value of the intangible asset
will increase. If the sales and cash flows (NB. The author would appreciate hearing
decrease in a year, the value of the intangible from readers as to their views on this topic.
that year will drop. But in either case the Contact him at [email protected].)

31
4
The case for fair value

Ian P. N. Hague

Introduction recaps briefly what fair value is and its essen-

tial properties. It discusses the relationship
Previous chapters in this book have explained between fair value and market prices – a
the nature of fair value, as well as how that relationship that is essential to understand the
term is used in existing International Finan- relevance of fair value – and also considers
cial Reporting Standards (IFRS) and is value relevance – the relationship between fair
used in Statement of Financial Accounting values and observed stock market values. The
Standards No. 157 (FAS 157),1 issued by the chapter then explores the attributes of fair
United States Financial Accounting Stand- value information that make it relevant to
ards Board (FASB) in September 2006. The users of financial statements and briefly con-
International Accounting Standards Board siders issues associated with fair value for
(IASB) proposes to make its definition of fair liabilities. Finally, the chapter comments on
value convergent with that of the FASB. Thus, some of the practicalities of determining fair
the IASB and FASB should soon have a values, considering reliability as well as
common definition and use of the term ‘fair costs and benefits. (Chapter 5 explores the
value’ to be applied whenever that term is disadvantages of fair value.)
referred to in accounting standards. Chapters
2 and 21 have also documented the increasing
use of fair value by accounting standards The objective of financial
setters. reporting
The increasing use of fair value in financial
reporting has been controversial. This chapter Any examination of the use of a particular
examines why accounting standards setters measurement characteristic must start with an
are more and more often requiring the use examination of the purposes for which that
of fair value in financial reporting. characteristic is to be used. Just as an indi-
First, to provide a framework for the vidual planning to purchase an automobile
analysis, this chapter briefly reviews the considers whether they want to use it for one-
objective of financial reporting and the person driving in warm, sunny climates (in
characteristics of decision-useful financial which case they might select a small convert-
reporting information. The chapter then ible) or for a five-person family that regularly

32
 T H E C A S E F O R FA I R VA L U E

takes back-country camping trips (in which IASB/FASB Discussion Paper, that equates, at
case they might select a four-wheel-drive mini- least for profit-oriented entities in the private
van), the purpose, or objective, of financial sector, to provision of information to help
reporting must be taken into account in assess the amounts, timing and uncertainty of
determining whether a measurement charac- future cash flows. Thus we need to evaluate
teristic satisfies that objective. the case for fair value in financial reporting
The IASB Framework for the Preparation against this objective.
and Presentation of Financial Statements Some believe that an additional objective
(IASB Framework)2 states the objective of should be specified – that of stewardship. The
financial statements as follows: IASB Framework notes:

The objective of financial statements is to Financial statements also show the results
provide information about the financial of the stewardship of management, or the
position, performance and changes in accountability of management for the
financial position of an entity that is useful resources entrusted to it. Those users who
to a wide range of users in making economic wish to assess the stewardship or account-
decisions. ability of management do so in order that
(IASB Framework, paragraph 12) they may make economic decisions; these
decisions may include, for example, whether
to hold or sell their investment in the entity
A joint project between the IASB and the
or whether to reappoint or replace the
FASB currently proposes to update this to
management.
state a common objective as follows:3 (IASB Framework, paragraph 14)

The objective of general purpose external While the IASB/FASB Discussion Paper does
financial reporting is to provide information not separately identify such an objective, it
that is useful to present and potential inves-
does acknowledge that information useful for
tors and creditors and others in making
making economic decisions will also be useful
investment, credit, and similar resource
for stewardship purposes. We will see later in
allocation decisions.
(IASB/FASB Discussion Paper, this chapter (under ‘Gains and losses reported
paragraph OB2) in periods in which price changes occur’,
p. 38) that fair value information can also be
To help achieve its objective, financial useful in assessing management’s stewardship
reporting should provide information to of assets and liabilities.
help present and potential investors and
creditors and others to assess the amounts,
timing, and uncertainty of the entity’s future
cash inflows and outflows (the entity’s future
Characteristics of decision-
cash flows). That information is essential in useful financial reporting
assessing an entity’s ability to generate net information
cash inflows and thus to provide returns to
investors and creditors. To assess whether a particular measurement
(IASB/FASB Discussion Paper, characteristic provides decision-useful infor-
paragraph OB3) mation we also need to consider what the
characteristics of decision-useful financial
Each of these objectives focuses on providing reporting information are. The IASB Frame-
information that is useful to make economic work identifies four principal qualitative
decisions – that is, investment, credit and simi- characteristics – attributes that make the
lar resource allocation decisions. As explained information provided in financial state-
in the quote from paragraph OB3 of the ments useful to users. These four principal

33
Another random document with
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Fig. 255.—The Great Beguin Convent at Ghent, called the Convent of St. Elizabeth,
founded in the Twelfth Century, and which now occupies the same site as in
1234, when the Countess Jane gave a code of rules to the community.—
General View taken from the “Ghent Churches,” by Baron Kervyn de
Volkaersbeke, reproducing the Engraving of P. J. Goetghebuer.
Contemporaneously with the foundation in Palestine of the order
of the Templars—a hospitaller and military order, which had no
connection with the monastic orders, and which for a long time
devoted all its energies to defending the holy places by prayer and
force of arms—St. Norbert, the reformer of the regular canons of the
St. Augustine order, founded the Premonstrants in Picardy; Stephen
of Muret, a contemplative cenobite of Limoges, founded the order of
Grandmont in his province; another Frenchman, Aimeric Malefaye,
Patriarch of Antioch, being alarmed at the relaxation of discipline in
the monasteries of Asia Minor, introduced some useful reforms into
the establishment upon Mount Carmel; while Stephen Harding, third
abbot of the Cistercians, an active propagator of the rules which
Robert de Molême drew up under the title of “Charte de Charité,”
entrusted to his pupil, St. Bernard, the destinies of the new
communities which sprang from this glorious cradle. It was in the
middle of the twelfth century that there appeared upon the scene
one of the brightest lights of the Church, namely, St. Bernard, Abbot
of Clairvaux (Fig. 254), which he founded, and which was called the
third daughter of the Cistercians. He was an admirable orator, a
savant of the first rank, a brilliant writer, and an eminent statesman;
he had under his control all the interests and secrets of Christendom
and of the sovereign papacy, and he never used them for purposes
of worldly ambition. He sent forth vast armies of Crusaders to the
East, but he adhered to his character of monk and apostle, by
devoting his energies to combating the Oriental heretics by verbal
arguments; to preventing schisms; to appeasing the scholastic
quarrels, in which the famous Abelard was one of the disputants; to
aiding with his counsels the popes and the monarchs; and to
pouring forth, from diocese to diocese, from council to council, and
from synod to synod, that fervid and powerful eloquence which won
him all hearts. The death of the illustrious abbot of Clairvaux, in
1153, was a terrible blow to the Church, and an irreparable loss for
monastic institutions; for there was no one to take his place or to
continue his work of reformation in the monasteries of the
Benedictine order.
 Fig. 256.—A Beguin.—From an
Engraving in the “Histoire de
l’Origine des Béguines Belges,” by
Hallman.
Amongst the contemporary monks, who were founders or
reformers of abbeys, we need only mention the Danish Archbishop
Eckel, Felix of Valois, John of Matha, the Englishman Gilbert of
Sempringham, the Liége priest Lambert Begh or Lebègue, who
created the Beguin convents (Figs. 255 and 256), of which there are
so many in the Netherlands, and which were pious retreats where
the Beguins lived in common without taking the vows. But the
eminent reputation of these austere personages sinks into
comparative insignificance before the touching legend of Heloisa, the
unfortunate wife of Abelard, who quitted the convent of Argenteuil,
near Paris, to immure herself in “the Paraclete,” a house which she
had founded in Champagne, to await and receive there the mortal
remains of her beloved lord.

Fig. 257.—Carved Ivory Chaplet of Beads and Girdle of an Abbess

(Sixteenth Century). Collection of M. Achille Jubinal.
Following her example, many women of equal endowments
sought in mental labour and in devotional exercises an aliment for
their moral activity; and, when the great St. Dominic commenced his
apostleship (1170–1221), he found them ready to receive his
teaching. He accordingly created, under the St. Augustine rule, in
unison with the preaching brothers, afterwards called Dominicans
(Fig. 258), a congregation of preaching sisters known by the same
title, namely, Dominicaines.

Fig. 258.—The most famous Members of the Dominican Order.—1. Hugh de St.
Cher, Cardinal of St. Sabine, the most learned theologian of his time, who died
March 19, 1263. 2. St. Antoninus, Archbishop of Florence, 1389–1459. 3. John
Dominicus (the blessed), Cardinal of Ragusa, 1360–1419. 4. Pope Innocent V.,
born in Savoy, died June 22, 1276. 5. St. Dominic, founder of the Order of
Preachers (1170–1221). 6. Pope St. Benedict XI., born at Treviso (1240–
1304).—From a Fresco of the Crucifixion, by Fra Angelico, in the Convent of
St. Mark at Florence (Fifteenth Century).—From a copy belonging to M. H.
Delaborde.
The vulgar tongue was absolutely prohibited in the Dominican
houses, Latin alone being used for conversation. The principal
European languages were, however, taught for preaching purposes:
including the southern idioms, familiar to St. Dominic and St.
Raymond, whose eloquence had so deep an effect in Languedoc and
Provence, as well as in a part of Spain (1175–1275); and the
northern idioms of the Sclaves and the Tartars, which a preaching
brother of Breslau, St. Hyacinthus (1183–1257), used to some
purpose in a successful mission that ended in the establishment of
two monasteries, at Cracow and at Kiew. In these still barbarous
regions, St. Hedwige, the wife of a duke of Poland, who died in
1243, founded at Trebnitz a convent of the Cistercian order, and at
about the same period a queen of Castille created one at Valladolid
(Fig. 259). At this epoch, also, the Sisterhood of St. Clare, founded
in 1218 by St. Clare, at the suggestion of St. Francis of Assisi, failed
in its attempts to extend the order beyond Italy.

Fig. 259.—Maria de Molina, Queen of Castille (1284–1321), handing to the

Cistercian Nuns the Charter of Foundation for their convent.—Bas-relief from
her Tomb at Valladolid.—From an Engraving in the “Iconografia Española” of
M. Carderera.
Fig. 260.—St. Thomas in a Council of Prelates and Doctors held at Anagni in 1256,
and presided over by Pope Alexander IV., defending the attack made upon the
monastic orders by the University of Paris, and successfully refuting the
assertions of William of St. Amour. The saint, of whom the back only is seen,
is in the foreground, with St. Bonaventura at his right. Near the Pope are
seated the Cardinals Hugh de Saint-Cher and Jean des Ursins, and next to
them the Bishop of Messina, the famous Albert the Great, the heads of
orders, the deputies of King Louis IX., &c.—From a Painting in the Louvre, by
Benozzo Gozzoli (Fourteenth Century), termed the “Triumph of St. Thomas of
Aquinas.”

The poor and docile religious militia organized by St. Francis of

Assisi under the name of Minors or Franciscans (1208), at that time
set the world an edifying example of Christian humility and self-
denial. The chief characteristic of the Franciscans was their complete
renunciation of all worldly goods. This mendicant order increased so
rapidly that their saintly founder was able to gather round him, in his
monastery of Assisi, five thousand delegates from religious houses
which had been built in nine years from the founding of the order.
There were occasionally some unfortunate quarrels between the
secular clergy and the monastic orders. One of the most notorious
was that which broke out between the University of Paris and the
mendicant orders. The university was in the habit of suspending its
lectures when it had any dispute with the government. The
Dominicans and the Franciscans having refused to submit to this
practice, their priests were deprived of their professorial chairs, and
all their monks excluded from the university. A doctor, William of St.
Amour, published a violent diatribe against the mendicant orders.
The quarrel lasted a long time, and Popes Innocent IV. and
Alexander IV. supported the cause of the monks in several bulls
issued upon this subject (Fig. 260). The university, in the end,
consented to reopen its doors to them, but only on the condition
that they should always occupy the lowest rank, and in the public
disputations not urge their views until the other doctors had had
their say. It may be imagined how this petty restriction was put up
with by these humble monks, when we remember that among those
whom the doctors treated with so much contumely were such men
as Roger Bauer, Duns Scotus, and St. Bonaventura among the
Franciscans; and Albert the Great, Vincent of Beauvais, and St.
Thomas of Aquinas among the Dominicans. It was the last-
mentioned of these who defended the mendicant orders from the
attacks of William of St. Amour.
Towards the close of the thirteenth century, and during two-thirds
of the fourteenth, many reforms took place in the monastic orders,
especially in that of the minor brothers (Fig. 261), who changed
their name with each change of rules. The new orders, however,
obtained but a slight celebrity, and lasted only a short time, with the
exception of that of Mercy, for the ransom of the captives—an
eminently charitable work, instituted by St. Nolasque, a Languedoc
crusader, who died in 1256. We must not, however, forget to
mention St. Bridget, the inspired Scandinavian (1302–1372), who,
during a journey to Jerusalem, conceived the idea of founding the
order of St. Saviour, which she established in Sweden; nor Gerhard
Groot, surnamed the Great (1340–1384), founder, in Holland, of the
Brethren of the Common Life, who devoted their time to the
teaching of the poor, and whose chief occupation was to copy the
books of the Fathers and of other ecclesiastical writers.
Fig. 261.—St. Anthony of Padua, a Franciscan
Friar, anxious to demonstrate to a heretic,
who asked him to perform a miracle, the
truth of the Holy Sacrament of the Altar,
commands a mule to adore the Eucharist.
The mule, though ravenously hungry,
refuses the oats that his master is sifting,
and kneels down at the bidding of the
saint.—Miniature from the “Heures” of Anne
of Brittany (Manuscript of the Fifteenth
Century), National Library, Paris.
 The disorder prevalent in that century extended unfortunately to
the Church; the priests—notably the monks and the regular canons
—gradually laid on one side the spirit of holy meditation, the habits
of prayer, seclusion, and pious works. Young men were admitted into
the abbeys without having gone through the period of novitiate; the
monks were not compelled to be resident, and many members of a
chapter or of a congregation were never or rarely present at the
services. An increase of the penalties for breach of discipline failed to
suppress these abuses, and in some churches and communities,
those monks who attended the services were provided with
counters, each of which, when given up in the chapel, entitled the
holder to a small sum of money. Leave of absence was also granted
quarterly and half-yearly, on condition that the rest of the year
should be passed in residence. Different abbeys formed mutual
communities for prayer and good works, which bound them closely
together; while, at the end of the thirteenth century, several
diocesan chapters had drawn up new constitutional codes, which
were to be read each year, and adopted for guidance; but the
external troubles were always reacting upon the internal quiet of the
religious houses. The abuses which had crept into many of them, in
reference to the distribution of the property belonging to the monks
in each monastery, also added fresh elements of discord; for the
laymen often retained possession of these portions and diminished
by so much the resources of the community, which none the less
continued to shelter the needy, to feed the hungry, and to bestow
alms.
Whilst Battista Spagnuolo, of Mantua, General of the Carmelite
Order, and one of the most celebrated Latin poets of the fifteenth
century, vainly endeavoured to reform his ill-disciplined monks, St.
Bernardine of Sienna (1380–1446), more fortunate if not more
gifted, set a practical example by joining the order of St. Francis,
with the intention of introducing the needed reforms. He founded
three hundred houses of the Brethren of the Stricter Observance,
which were urgently needed at a period when Europe was being
devastated by three scourges—the plague, famine, and the sword.
At about the same epoch, St. Colette of Corbie succeeded, by the
exercise of an angelic sweetness, in correcting the abuses which had
found their way into the convent of the St. Clare and many other
female congregations, more recently formed under the Franciscan
rules; St. Francis, of Romagna, instituted the Collatine order (1425),
and St. Jeanne de Valois, daughter of Louis XI. (1464–1505),
founded the community of the Sisterhood of the Annunciation, at
Bourges, where her husband, the Duke of Orleans, had banished
her, previous to repudiating the marriage. This virtuous princess was
guided by the counsels of the Calabrian, St. Francis of Paula, the
celebrated founder of the order of the Minimi (1416–1507), who,
when summoned to France by Louis XI., and resident in Touraine
under the eye of that most suspicious and mistrustful of monarchs,
had so far won his confidence as to induce the king to prepare for
death like a Christian.
The Barnabites, and other religious institutions of more or less
importance, which had principally in view the conversion of heretics
by preaching, date from the close of the fifteenth century, and the
origin of many of them was due to the spirit of morality and
philanthropy then in vogue. Thus the first house of the Penitents,
founded at Paris in 1496 by a Gray Friar under the name of Tisseran,
afterwards became celebrated for its wholesome example amid the
dissolute morals of the sixteenth century.
Fig. 262.—St. Theresa, the Reformer of the Carmelites,
who died in 1582.—From a Portrait of the period
engraved in the “Iconografia Española” of M.
Carderera.
Fig. 263.—The Great Martyrdom of Nangasaki (Sept. 10, 1622), in which twenty-
two missionaries and native Christians were burnt to death, and thirty others,
including several women and children, beheaded, in presence of a vast crowd.
—From a Japanese water-colour Drawing of the period, preserved in the Gésu
Convent at Rome.—Pope Pius IX. commemorated this event by the
beatification of two hundred and five martyrs, which was decreed at Rome on
the 7th of July, 1867.

A great literary event, though only indirectly connected with the

history of the monastic orders, nevertheless enables us to form an
accurate judgment as to the intellectual character of the religious
houses during the last thirty-five years of the fifteenth century, and
the first years of the sixteenth: we refer to the invention of printing.
Whatever may have been the causes that induced these houses to
encourage the extension of printing, the action of each community is
made manifest by its achievements in that vast laboratory which
typographical art had founded, in the stead of a few cells and
studies where the human hand had been wearily transcribing
manuscript after manuscript.
 In an obscure monastery at Subiaco, near Rome, two printers
from Mayence, Sweynheym and Pannartz, guests of the monks,
published the first edition of Lactantius, followed by several other
valuable works of ecclesiastical authors (1465–1467); in the
monastery of St. Eusebius, within the walls of Rome, George Laver,
of Würzburg, printed many publications, about 1470. Several clerks
brought up in the episcopal schools of Metz, Liége, Mayence, and
Tuscany—Adam Rot, Paul Leenen, Ulric Zell, and Jacob Caroli—
superintended in person printing-offices at Rome, Cologne, and
Florence, which were worthy rivals of those which were being
established in every direction by ordinary traders. Colard Mansion, a
clerk belonging to a community at Bruges, who was specially
entrusted with the copying of manuscripts (1414–1473) conceived
the idea of substituting for the tedious process of the pen and the
engraving pencil the rapidity of movable types and screw printing-
presses. The Brethren of the Common Life, his colleagues, who were
settled at Rhingau, near Mayence, at Val St. Marie, Nuremberg, at
Cologne, and at Rostock, imitated the example of Colard Mansion,
and from mere calligraphists became master-printers (1474–1479).
Two theological doctors of the Sorbonne, William Fichet and Jehan
de la Pierre, also induced three skilful German workmen, Ulric
Gering, Martin Crantz, and Michael Friburger, to come to Paris,
where they provided them with a place to set up their presses and
to establish a workshop (1470). This was the origin of printing in
Paris. Two years later, William Caxton obtained leave to print in
England, beneath the roof of Westminster Abbey; while in
Switzerland, a canon of Munster (in Argovia), Hélias Hélye (1472,
1473), had some small presses at work. Soon after this, the
Dominicans, the Carthusians, and the Carmelites established large
printing workshops at Pisa, Parma, Genoa, and Metz (1476–1482);
the Franciscans, surnamed Frères Conférenciers, who had a
settlement near Gaude, in Holland, also opened a printing-office;
and lastly, such celebrated orders as those of Cluny and Cîteaux,
branches of the Benedictines, sent for workmen to their houses in
Burgundy, at Clervaux, in Champagne, and Montserrat in Catalonia,
to print the principal liturgical books, which were termed the books
of common prayer.
The members of the Order of Jesus, founded in Paris by the
Spanish nobleman St. Ignatius Loyola, on his return from a
pilgrimage to the Holy Land (1534), from this period devoted
themselves closely to the work of social regeneration—an
undertaking which, looked at in all its different phases, seemed as if
it could only be brought about by means of religious reform. While
St. Francis Xavier, the friend and companion of St. Ignatius, made
use of the influence of the Order of Jesus to convert the idolatrous
peoples in the Indian Ocean (Fig. 263), the Jesuit clerks, a learned
and highly intellectual body, in a short time obtained a hold over the
whole world, forming one vast army which answered as one man to
the commands of the Holy See, and whose representatives were
everywhere to be met with, in the professorial chairs, in the schools,
in the affairs of State, and more especially in the various domains of
literature, science, and art. Thus the sixteenth century, during which
Luther and Calvin made such an onslaught upon the Catholic Church
and the monastic orders, gave birth to a new religious order, which,
though the most recent, was the most powerful and invincible of
them all. Luther, who had worn the cowl in the monastery of the
Augustines at Erfurt, and Calvin, who had been canon in the chapter
of Noyon, urged the Huguenots to make away with the monasteries;
but their number only seemed to increase whenever one of them
was destroyed by the sacrilegious hands of the heretics.
Fig. 264.—Seal of the Monastery of St. Louis of
Poissy, belonging to the Order of Preaching
Brothers of the St. Dominic rule.—St. Louis,
with a halo round his head, is covering with
the folds of his cloak the people who are
imploring him for protection.
 CHARITABLE INSTITUTIONS.
Christian Charity in the First Centuries of the Church.—The Eastern
Empresses.—The Holy Roman Ladies.—Olympiade, Melanie,
Marcella, and Paula.—Charity at the Court of the Franks.—St.
Margaret of Scotland and Matilda of England.—Hedwige of
Poland.—Origin of the Lazar-houses.—The Lazarists in France and
in England.—Progress and Vicissitudes of the Order of St.
Lazarus.—The Foundations of St. Louis.—The Order of Mercy
founded by St. Nolasque.—St. Catherine of Sienna and St.
Francis.—Bernardin Obrégon.—Jean de Dieu.—Philippe de Néri.—
Antoine Yvan.
t Christ’s coming, the Greco-Roman civilisation
had reached the last stages of corruption, and
the slavery of the vast majority of men failed
to satisfy the thirst for supremacy which
devoured the small section of privileged
leaders in ancient society. The barbarian
peoples, on their part, recognised no other
power than that of brute force, nor any other pleasures than those
of sanguinary orgies. To transform this condition of society, which
toiled only for money and sensual enjoyment, Christ gave forth
these touching and sublime words, “Blessed are the poor in spirit:
blessed are the pure in heart” (Beati pauperes spiritu: beati mundo
corde). To the savage spirit of the barbarian who deified brute force
Christ opposed the reverence for all that is weak and feeble by
clothing himself with all manner of infirmities: “Come, ye blessed of
my Father; I was poor, I was sick, I was in prison, and ye comforted
me; inasmuch as ye have done it unto one of the least of these my
brethren, ye have done it unto me.”
In these powerful words was contained the germ of modern
civilisation; wherever the Gospel reaches a feeling of tenderness and
respect for the poor and the weak must go hand in hand with the
spirit of chastity, self-denial, and devotion. Two words unknown to
the old world sum up this transformation—humility and charity. The
rich, the high-born, and even the offspring of royalty, from the
moment they believe in the divine word, are found tending the sick
in hospitals, and the proof of true belief in the Messiah is ever the
same as that which He gave to attest his divine mission to John’s
disciples: “Unto the poor the Gospel is preached.”

Fig. 265.—Hospitality.—Jesus Christ, represented as a Pilgrim, being

received by two Preaching Brothers of the Order of St. Dominic.—
Fresco-painting by Fra Angelico in St. Mark’s Convent at Florence
(Fifteenth Century).
From the first days of Christianity we find the great apostle of the
Gentiles recommending the giving of alms, and stimulating the
generosity of the faithful. “If the amount collected,” he says, “makes
it worth while, I will come myself and take it to our brethren.” The
apostles appointed deacons to distribute the alms. One of those who
reflected the greatest honour on this appointment was St.
Laurentius, the noble martyr. He had seen his bishop, his spiritual
father, led out to execution, and he became entrusted with the care
of the property of his church (Fig. 266). The prefect of the
prætorium said to him, “I know that you have gold and silver vessels
for your sacrifices; let me have these treasures, which the prince
requires for maintaining his troops.” The holy deacon replied, “I
know that our church is rich; I will let you have all its most valuable
contents, but you must give me three days to put everything in
order.” He made use of this delay to bring together the poor whom
he maintained, and divided the silver and gold amongst them. The
prefect came upon the appointed day, and St. Laurentius, pointing to
the crowd of halt and poor, said with a saintly pride, which he
afterwards expiated by his martyrdom, “Here are the treasures
which I promised you; the real gold is the divine light which
illuminates these poor men, the disciples and brethren of Jesus
Christ.”
 Fig. 266.—Pope Sixtus II. handing to St. Laurentius, in 258, the
Treasures of the Church, to be distributed amongst the Poor.—
Fresco, painted by Fra Angelico, in the Chapel of Nicholas V. in
the Vatican (Fifteenth Century).
Thus Christian charity began in the days of the apostles, and went
on increasing even amidst persecution; but it did not reach its full
expansion until the conversion of the Emperor Constantine at length
obtained for the Church peace and liberty.
 Helen, the wife of Constantius Chlorus, and mother of Constantine
(247–328), may be regarded as having most brilliantly inaugurated
the era of Christian charity in the Middle Ages. Simple and modest,
kind to the suffering and to the needy, she tended and consoled the
poor with maternal solicitude; her fortune was exclusively devoted to
their relief. When, in her extreme old age, this pious lady went to
visit the Holy Places in Palestine, she made most munificent gifts to
the sick soldiers, whom the imperial government left without relief;
also to the places where the inhabitants were poor; and to the
religious houses and churches, whose mission it was “to succour the
suffering members of Jesus Christ” (Fig. 265), according to the
figurative expression which the new faith used to characterize
human misery. She recalled the exiles, ransomed the captives,
released from the mines the unfortunate men who had been
condemned to labour underground, and obtained for them the
means of living in open daylight, thus causing them to bless her
name and that of her God. Her daughter Constance also devoted
herself to works of charity; she was accompanied by a band of
maidens whom she animated with her example—and this was, in
fact, the first school of Sisters of Charity.
Despite the religious disputes of this century, Christian charity did
not stop here; it received a further impulse during the reign of
Theodosius, thanks to Placilla his wife, and to Pulcheria his daughter,
both of whom were canonised after death. Placilla and Pulcheria
were the guardian angels of the imperial palace, Placilla especially
being full of compassion for all those who were in distress. She
would go, without attendant, to visit the poor in their hovels; she
passed whole days with the sick in the infirmaries attached to the
canonical churches and convents, never shrinking from any
charitable service, however repugnant it might be. Pulcheria, a
worthy rival of her mother, was associated with her in all these good
works by their eloquent panegyrist, St. Gregory of Nyssa. She was,
nevertheless, outdone by another Pulcheria, grand-daughter of the
great Theodosius, who was called augusta, and who already, at the
death of her father the Emperor Arcadius, though at that time only
sixteen, was a model of piety and wisdom; she established so severe
a rule of life and such complete asceticism around her, that her
palace was commonly “the convent” (asceterium vulgo diceretur).
For forty years she reigned like a saint and a great empress, and this
period was for the Church a golden age.

Fig. 267.—The Holy Brothers, Cosmas and Damianus (end of the Third Century),
visiting a sick man and relieving him.—Picture on wood, by Francesco Peselli,
in the Louvre (Fifteenth Century).
Many other heroines of Christian charity descended from an
illustrious family at that time exiled in the forests of Pontus, were
also distinguished by the same virtues; to wit, Emmelia, mother of
St. Basilius, Macrina his aunt, and Macrina his sister, who were true
servants of the poor, undertaking as they did long journeys to
discover unknown suffering, with a view to its relief. Anthusa,
mother of St. John Chrysostom, suffered great privations in order to
give away as much as possible, whilst Olympiade, widow of a prefect
of Constantinople, and heiress of an immense fortune, distributed
her money with ungrudging freedom. The emperor, who was anxious
to marry Olympiade to a member of his own family, deprived her of
the management of her property, but afterwards restored it to her,
knowing what a noble use she would make of it. Olympiade visited
the sick, the orphans, the widows, and the aged, gave alms to the
prisoners and the exiles, and ransomed the captives, for her
liberality knew no bounds; she was, moreover, seconded in her
works of charity by ecclesiastical virgins (vierges ecclésiastiques),
devoted to the service of God. Never was woman’s apostolic mission
more effective, nor had charity more zealous servants.
The wonderful influence which Olympiade and her companions
exercised in the Christian world, towards the close of the fourth
century, was derived from their ardent charity, which radiated from
Constantinople throughout the whole empire, and awoke a
sympathetic response at Rome, Milan, Lyons, Trèves, Rheims, &c.
Thus Melanie, the elder daughter of the Consul Marcellinus, Proba,
Falconia, St. Juliana, St. Demetriada, St. Paula, mother of St.
Ambrose, and her daughter St. Marcellina, Roman ladies of the
highest rank, were endowed with the heroism of the Roman
character purified by the Christian religion. St. Ambrose, who has
given us so touching an account of their good works, calls them “the
august brides of Jesus Christ.” They dwelt with their own families,
but passed nearly all their time in workshops, where they laboured
together for the benefit of the poor, leaving off their occupations
only to sing hymns, recite psalms, attend church for the hearing of
God’s word, sharing with each other the task of instructing the
people, distributing alms to the poor, and giving succour to the
weak. Thus was prepared the way for the first charitable institutions
which were called into existence at the bidding of Melanie the
Younger, Fabiola, St. Paulina, and St. Pammachius, thanks to the
help given by a great number of Roman ladies whose lives set an
example of all the Christian virtues.
Whilst St. Melanie the Younger was exciting the enthusiasm of the
Catholic world by her ardent charity, St. Marcella, the most illustrious
of the gifted daughters of St. Jerome, was the pride and admiration
of the Roman aristocracy. Gifted in the very highest degree both in
respect to birth, wealth, grace, and beauty, at a time, too, when
these rare endowments were rendered such a source of peril, owing
to the capture of the Eternal City by Alaric (410), she had withdrawn
to a modest dwelling on the Aventine Hill, with Principia, a young
maiden recommended to her by St. Jerome. Here she had to submit
to every kind of outrage, without permitting her zeal to be lessened
by this cruel trial. She afterwards opened a fresh centre of charity,
having founded not far from Rome the Convent of the Relieving
Virgins (Vierges Secourables), which was taken as a model for many
similar institutions throughout Italy.

Fig. 268.—Robert I., Duke of Burgundy, having slain his father-in-law, builds the
Church of Sémur to expiate the crime, and has the parricide represented on
the building.—Tympan in the portico of the Church of Sémur (Eleventh
Century).
Her friend St. Paula, who was Roman by birth, and a descendant
of the Scipios, whose daughters were saints, whose theatre of action
was in the East, whose tomb was at Bethlehem, and whose
panegyrist was St. Jerome, followed in her footsteps. A widow at
thirty, she effected a sweeping change in her own household and
property, set all her slaves at liberty, and devoted herself to doing
good; then shrouding herself in an incomparable modesty, and
breaking off all her social ties, she emigrated to Palestine, where she
worked miracles of charity. Long before her death, in 404, she had
distributed all her worldly wealth to the poor. She had herself
become so needy that it was necessary to borrow money to pay for
her funeral, and her beloved daughter, who closed her eyes,
inherited nothing but her faith and charity.
The marvels of charity wrought by the Christian ladies for two
centuries were imitated in the fifth by many bishops, who had in
turn become missionaries and dispensers of alms. St. Paulinus, the
illustrious Bishop of Nolo, who died in 431 at the age of eighty, after
having for forty years fed, clothed, and comforted the poor of his
diocese, after having released the insolvent debtors from prison,
ransomed the captives, and allowed himself to be sold as a slave to
the barbarians in order to rescue from their hands the son of an
unfortunate widow, is the most perfect type of the prelates of this
remarkable epoch. Amongst his many other remarkable
contributions to literature, must be cited his “Discourse on
Almsgiving,” which is an eloquent exposition of his doctrine. St.
Paulinus, by his teaching and his example, had formed an eminent
school of disciples, amongst them Sulpicius Severus (363–420), who,
in concert with some pious ladies of the Roman aristocracy, seems to
have been desirous of inaugurating a new era of things in the reign
of Gregory the Great.
The ransom of the captives was the most urgent of the works of
charity in the sixth century, for the wars and invasions of the
barbarians had reduced whole populations to slavery; and so the
Church devoted all its resources and efforts to this work of
redemption, Pope Gregory deeming no sacrifice too great for
furthering it. He was, moreover, powerfully seconded by the earnest
efforts of women who constituted themselves the humble handmaids
of Jesus Christ. The Empress Constantina, her sister-in-law
Theodissa, St. Sopatra, and St. Damienna, all of whom were imperial
princesses, sent him enormous sums from Constantinople; the
Empress Leontia, Theodelinda, Queen of the Lombards, and her son
Theodoaldus acted in a similar manner. As Christianity extended
westward, the bright light of charity radiated in the same direction.
St. Adelberga, wife of the first Christian King of England, and her
daughter Bertha, wife of Ethelbert, King of Kent, were zealous in the
cause of benevolence upon their conversion to the faith.
This impulse given to the Christian spirit did not slacken: St.
Clotilda, Queen of the Franks, who was guided by the counsels of
the Archbishop of Rheims, the eminent doctor St. Remigius; St.
Albofleda, sister of Clovis; St. Radegonda of Thuringia, wife of King
Clotaire, who founded a hospital at Athies, and a monastery at
Poitiers; and St. Bathilda, of noble birth, who, after degrading herself
to the humble condition of slavery, shared the throne of Neustria as
the wife of Clovis II., were so many heroines of charity. Bathilda, in
the course of a long and wise administration of affairs (645–680),
was the good angel of the unfortunate. The abbot St. Gènes was her
almoner, and her privy councillors were St. Eloi, St. Owen, St. Leger
—venerable prelates whose active and pious co-operation was in
perfect harmony with the prompting of her own heart. She founded
abbeys, and, what was even more useful, increased the number of
hospitals which were built in every direction. The royal abbey of
Chelles, near Paris, founded by Queen Clotilda and rebuilt by
Bathilda, and another monastery which she constructed after the
same plan, were establishments of religious education, literary
instruction, and benevolence.
Fig. 269.—Works of Charity.—Reduced Fac-simile of a Drawing of the Fifteenth
Century, attributed to Savonarola, in the National Collection of Drawings. The
artist shows the practice of works of mercy being carried on in each of the
detached cottages, the mottoes recalling the texts in which Christ intimates
that at the Last Judgment the exercise of Charity will weigh heaviest in the
scale. In No. 1, the sick are being tended in their beds or picked up in the
streets; in No. 2, the people are being clothed; No. 3 represents travellers
who are being given to drink; No. 4, the hungry receiving bread; No. 5,
pilgrims being sheltered; No. 6, a dead body being prepared for burial; No. 7,
the visiting of prisoners. The last scene is a sanctuary in which the divine
sacrifice—the true source of Christian charity—is being celebrated, whilst a
penitent is obtaining the remission of his sins because he has practised
charity. In the foreground rich men are throwing their money into a heap, and
the poor are receiving their share of it. The monk whose bust is seen to the
left is perhaps Bernardin de Feltri, preaching in encouragement of this good
work.
During the eighth and ninth centuries, a great number of
hospitable houses were built upon the high-roads leading from
France to Italy, from France to Spain, and also from Spain to the
confines of civilised Germany. The Carlovingian kings, beginning with
Charlemagne and ending with Charles the Bald, with the view of
facilitating international commerce throughout the vast extent of
their empire, ordered the establishment of a number of free houses
of which travellers might make halting-places, and in which they
could count upon finding not only security, but any assistance which
they might require. The establishment of lazar-houses or lazarettos,
the origin of which dates from the fifth century, seems to have been
less a work of charity than a sanitary measure of precaution against
leprosy, a terrible and incurable malady which was generally looked
upon as a punishment from heaven. These lazar-houses increased in
the West, as the relations of Europe with the East became more
general. It is from this period also that may be dated the foundation
of many Hôtels-Dieu, religious asylums, most of which were
constructed in close proximity to the porch of the cathedral
churches, taking the place of the ancient canonical infirmaries. Such
was the Hôtel-Dieu in Paris, the origin of which is lost in the
obscurities of the Middle Ages.
After an interval of dejection and selfishness which must be
attributed to the misfortunes that overwhelmed the peoples and
ruined the Church, Christian charity, though permanent and
persistent in each diocese, though too often ineffectual, was the
distinguishing characteristic of several contemporary sovereigns.
Edward the Elder, son of Alfred the Great (900–925), surnamed in
the Roman breviary “the father of the poor and of the orphan,” must
be mentioned as the first of them, for the various benevolent
institutions which he created were never a burden upon his subjects,
the whole cost coming out of his private revenues.
Canute I., leader of the Danes, converted to Christianity by a
French princess to whom he was married, did as much good at the
close of his reign as he had done evil in the early part of it by his
persecution of the Christians (1016–1036). Olaus or Olaf of Sweden,
and Olaus of Norway, King of the Scandinavians, founders of two
Christian monarchies in the North, intermixed works of charity with
dogmatic principles, and rendered the religion of Christ popular by