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Research Papers in Economics

152 FINANCIEEL FORUM / BANK- EN FINANCIEWEZEN 2009/2-3 LARCIER
DOSSIER: De financiële crisis: eerste balans/La crise financière: un premier bilan
Annelies RENDERS
Assistant Professor, Faculty 
of Business and Economics, 
KULeuven
Changing Fair Value Accounting
The recent credit crisis has led to a discussion about how to value financial assets and liabilities on
the balance sheet and in the income statement. The IASB, the accounting standards board that issues
the IFRS rules, decided recently to “ease” its accounting standards w.r.t. fair value accounting by
granting companies, under a limited number of circumstances, the option to value certain financial
assets and liabilities at historical cost.
This paper gives a short overview of the accounting standards before and after the recent amendments.
It also presents an overview of some academic research on the topic and concludes with the pros and
cons of fair value accounting.
1. Introduction
Since the introduction of the International
Financial Reporting Standards (IFRS) in
Europe, many companies, including finan-
cial institutions, need to recognise certain
balance sheet amounts at fair value, and to
record the changes in these values in the
income statement. For example, the Inter-
national Accounting Standard (IAS) 39
Financial Instruments: Recognition and
Measurement, developed by the Interna-
tional Accounting Standard Board (IASB),
requires certain investment securities and
derivatives to be measured at fair value.
However, the recent credit crunch trig-
gered a heated debate on how to measure
the fair value of financial instruments in
the third quarter of 2008. The financial
crisis and the associated decrease in fair
values of many financial  instruments
forced financial  institutions to make
considerable write-downs on financial
holdings, which resulted in heavy losses on
the  income statement. Furthermore, fair
value is defined under IAS 39 as the price,
at the measurement date, at which an
orderly transaction would take place
between market participants in an active
market. However, the financial crisis has
led to many forced liquidations and
distress sales, and turned many markets
inactive. Under these circumstances, how
should one measure fair value and does
one actually want to include fair values in
the balance sheet and income statement?
In the US, The Securities and Exchange
Commission (SEC) and the Financial
Accounting Standards Board (FASB) were
the first to respond to this problem by
issuing a clarification on how to imple-
ment the accounting standards with
respect to fair value accounting1. This clar-
ifying statement eases the requirement to
value financial holdings at fair value if no
active market exists.
In order to ensure that financial  institu-
tions using IFRS as an accounting standard
were not disadvantaged  in terms of
accounting rules and their interpretation,
the IASB has amended its accounting
standards with respect to fair value
accounting, too. More specifically, it has
published guidance on fair value measure-
ment in illiquid markets and has allowed
companies to reclassify certain financial
instruments. This reclassification makes it
possible for companies to value some of
their financial instruments using historical
cost instead of fair value.
This paper reviews the financial
accounting standards related with fair
value accounting before and after the
recent amendments by the IASB. It also
gives a short overview of academic studies
examining the effects of fair value
accounting on investors and financial insti-
tutions. Finally, the paper concludes by
discussing the pros and cons of fair value
versus historical cost accounting.
1. FASB Press Release 2008-234.LARCIER FORUM FINANCIER / REVUE BANCAIRE ET FINANCIÈRE 2009/2-3 153
ANNELIES RENDERS CHANGING FAIR VALUE ACCOUNTING
2. Measurement of Fair Value Before 
the Financial Crisis
The IASB has issued a number of accounting standards
related to fair value accounting. The two most important
standards are IAS 32: Financial Instruments: Disclosure
and Presentation and IAS 39: Financial Instruments:
Recognition and Measurement. IAS 32 is primarily a
disclosure standard, while IAS 39 describes how partic-
ular financial assets and liabilities are measured (i.e.
amortised cost or fair value), and how changes in the fair
values are recognised in the financial statements (i.e. in
equity or in income). In 2005, the IASB issued IFRS 7:
Financial Instruments: Disclosures. This standard
requires disclosure of detailed information for recognised
financial instruments, both those measured at fair value
and those that are not2.
Table 1 gives an overview of the different categories of
financial assets and liabilities and how they should be
measured according to IAS 39. Originally, IAS 39 distin-
guished four categories (categories (2) to (5)). In 2005, the
IASB amended IAS 39 by describing conditions under
which firms can elect to use fair value measurement for
financial  instruments. Under this so-called “fair value
option”, companies can designate, at the time of acquisi-
tion or issuance, a financial asset or liability to be meas-
ured at fair value, with value changes recognised  in
income (i.e. category (1) in Table 1). This option is avail-
able even if the financial asset or liability would normally
be measured at amortised cost, but only if the fair value
can be measured reliably.
Category (2), “Fair value through profit or loss – Held-
for-trading”,  includes all financial assets and liabilities
held for trading purposes. These should be measured at
fair value, with the changes recorded in the income state-
ment. Category (3), “Held-to-maturity”, and (5), “Loans
and receivables”, include for instance loans, receivables
and debt with a fixed maturity that the company will hold
until the maturity date. These items are recorded in the
balance sheet using amortised cost, i.e. h istorical cost
minus any subsequent amortization, depreciation, and
impairment.
Finally, in category (4), “Available-for-sale”, a company
should classify all financial assets and liabilities that are
available for sale. These are recorded at fair value, but the
changes in fair value are recognised in equity and will only
affect the income statement when the item is sold.
3. Recent Amendments to Fair Value 
Accounting
In the light of the recent financial crisis and its effect on
banks’ f inancial statements, the IASB has undertaken
three amendments to its accounting standards. First, the
IASB has amended IAS 39 to permit reclassifications of
financial  instruments under certain circumstances (see
Table 1). Second, it has extended the disclosure require-
ments related to financial instruments. Finally, the IASB
has published a guidance for the application of fair value
in illiquid markets.
On 13 October 2008, the IASB issued amendments to IAS
39 and IFRS 7 that permit the reclassification of some
financial instruments. The main reason for the amend-
ments is to ensure that “European financial institutions
are not disadvantaged vis-à-vis their  international
competitors  in terms of accounting rules and of their
interpretation.” The amendments address the desire to
reduce the differences between IFRS and US GAAP.
The changes to IAS 39 permit an entity to reclassify non-
derivative financial assets and liabilities out of the  “Fair
value through profit or loss – held-for-trading” (FVTPL –
HFT) and “Available-for-sale” (AFS) categories under
limited circumstances. The criteria vary, depending on
whether the asset would have met the definition of
“Loans and receivables” at initial recognition.
A debt instrument that would have met the definition of
“Loans and receivables” may be classified out of the
FVTPL – HFT or AFS category to the “Loans and receiv-
ables” category if the company has the intention and
ability to hold the debt instrument for the foreseeable
future or until maturity.
Any other debt or equity instrument may be reclassified
from FVTPL – HFT to AFS, or to HTM (in case of debt
instruments only) if (1) the financial asset is no longer held
for the purpose of selling in the near future and (2) in
“rare” circumstances. In its press release of 13 October
2008, the IASB stated that “the deterioration of the
world’s financial markets’ in the third quarter of 2008 is
an example of a “rare” circumstance.
2. In the US, the Financial Accounting Standards Board (FASB) has likewise issued several standards that mandate disclosure or recognition of accounting amounts
using fair values. Two important disclosure standards are SFAS No. 107, Disclosure about Fair Value of Financial Instruments and SFAS No. 119, Disclosure about
Derivative Financial Instruments and Fair Value of Financial Instruments. The most significant fair value recognition standards in the US are SFAS No. 115,
Accounting for Certain Investments in Debt and Equity Securities, SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities and SFAS
No. 157, Fair Value Measurements. The accounting treatments under US GAAP and IFRS are fairly similar.154 FINANCIEEL FORUM / BANK- EN FINANCIEWEZEN 2009/2-3 LARCIER
CHANGING FAIR VALUE ACCOUNTING ANNELIES RENDERS
Companies may reclassify a financial asset with effect
from 1 July 2008. However, reclassifications made after
1 November 2008 are only effective from the date of
reclassification.
In order to increase the transparency to investors, the
IASB also amended IFRS 7 in order to include more
disclosures with regard to the reclassifications. For
example, companies have to disclose the amount reclassi-
fied in and out of each category and details of the “rare”
circumstances.
On 31 October 2008, the IASB published educational
guidance on the application of fair value measurement
when markets become inactive. It presents a fair value
hierarchy which consists of three levels of information a
company can use to arrive at the fair value of an asset.
First of all, a company should use the quoted price of an
identical asset in an active market (Level 1 inputs). When
there is no such active market, the company should use a
valuation technique in order to measure the fair value. As
inputs to the valuation model, the company should give
preference to observable inputs, such as quoted prices for
similar assets in active markets, or for identical or similar
assets in inactive markets (Level 2 inputs). These inputs
may also include inputs that are derived from or corrobo-
rated by observable market data by correlation or other
means. In other words, the company should make use of
observable market data of related assets or related
markets. When no such inputs are available, the company
should use unobservable inputs for the asset, e.g. the
company’s own expectations (Level 3 inputs).
Of course, Level 1 inputs provide the most reliable
evidence of fair value and as such should be used to
measure fair value whenever available.
Table 1: Classification of Financial Assets and Liabilities according to IAS 39, Before and After the Amendment
1 Debt represents all interest bearing securities other than loans and receivables.
Source: KPMG.
4. Results From Studies Related to Fair 
Value Accounting
Related, this part of the paper gives a short overview of
the academic literature on fair value accounting. A
number of studies have examined the usefulness of fair
value accounting for investors. These studies find overall
that fair value accounting provides useful financial infor-
mation to investors over and above the other accounting
information (e.g. Bernard et al., 1995; Barth et al., 1996;
Nelson 1996). In these studies, the usefulness of the infor-
mation is assessed by the association between share prices
and accounting  information. However, the degree of
usefulness appears to be lower for fair value measures that
are estimated by management (e.g. valuation methods
using Level 3 inputs).
The preliminary results of a study on how the market
reacts to financial  institutions that reclassify financial
instruments from fair value to historical cost using the
amendments to IAS 39 show that investors react nega-
tively to this reclassification (Paananen and Renders
Category Measurement Type of security Subsequent reclassification
IAS 39 (prior to amend-
ments)
IAS 39 (with most recent 
amendments)
1) Fair value through profit or 
loss – designated
Fair value through profit or loss Debt1 Not permitted Still not permitted
Equity
Loans and receivables
2) Fair value through profit or 
loss – held-for-trading
Fair value through profit or loss Debt1 Not permitted Reclassify in “rare” circumstan-
ces to:
– Held-to-maturity
– Available-for-sale
Equity Reclassify in “rare” circumstan-
ces to Available-for-sale
Loans and receivables Reclassify to Loans and recei-
vables
3) Held-to-maturity Amortised cost Debt (with fixed maturity) Reclassify to Available-for-sale Still allowed
4) Available-for-sale Fair value through equity Debt1 Reclassify to Held-to-maturity Still allowed
Equity Not permitted Still not permitted
Loans and receivables Not permitted Reclassify to Loans and recei-
vables
5) Loans and receivables Amortised cost Loans and receivables Not permitted Still not permittedLARCIER FORUM FINANCIER / REVUE BANCAIRE ET FINANCIÈRE 2009/2-3 155
ANNELIES RENDERS CHANGING FAIR VALUE ACCOUNTING
2009). This suggests that investors apparently see through
the accounting practices and that changing the accounting
standards will not result in more credible financial
reports.
On the other hand, a number of studies have examined
the impact of fair value accounting on financial institu-
tions. Allen and Carletti (2006) show that, in times of
financial crises, fair value accounting may lead to banks
becoming  insolvent, whereas the use of historical cost
accounting would not compromise the solvency of banks.
Plantin  et al. (2004) find that, while a historical cost
regime is also not perfect and may lead to some inefficien-
cies, fair value accounting can lead to increased price vola-
tility.
In sum, the literature seems to indicate that in “normal”
circumstances, fair value accounting presents users of
financial statements with better information, but in times
of crises it may worsen the illiquidity problems of finan-
cial institutions.
5. Conclusion: Pros and Cons of Fair 
Value Accounting
As an answer to the recent financial crisis, both the IASB
and the FASB decided to allow companies under certain
circumstances to measure financial assets and liabilities
using historical costs instead of fair value and gave some
guidance on how to measure fair value in illiquid markets.
However, it seems that the credit crisis has reopened the
debate on which measurement method, fair value or
historical cost, is the “best” measure and hence should be
used in the future.
Historically,  in Continental Europe, the national
accounting standards used mainly historical cost
accounting, but allowed companies to revalue or write
down  items based on their market value (i.e. m ixed-
attribute accounting). With the introduction of IFRS in
Europe, fair value accounting became commonplace.
There are a number of reasons why accounting regulators,
including the IASB, have issued standards requiring fair
value recognition. First, it mitigates the use of accounting-
motivated transaction structures designed to exploit
opportunities for earnings management created by the
“mixed-attribute” accounting model. Second, fair value
accounting for all financial  instruments reduces the
complexity of financial reporting (e.g. hedge accounting).
Third, historical cost is a very objective measure, but the
value reported on the balance sheet may be far from the
real (market) value of the item, and as a consequence, it
has no information value for investors. Finally, derivates
often have a historical value of zero and only gain or lose
value dependent on the developments in the market of the
underlying item.
However, there are also drawbacks associated with the
use of fair values. A key issue, one which has recently
come under great scrutiny, is whether fair values of finan-
cial statement items can be measured reliably, especially
for those financial instruments for which no active market
exists. In these cases, management must estimate the fair
value of the instruments and this may result in a lower
reliability of the accounting numbers. Second, for many
assets, the fair value only becomes relevant when the asset
is sold.
In conclusion, fair value accounting seems to mitigate
some of the concerns related with historical cost
accounting. However, if fair value accounting is used, we
should make sure that investors are provided with exten-
sive disclosures about the assumptions that are made,
especially for items for which no active market exists.
More importantly, we should carefully select the items for
which we will use fair value accounting. Hence, the recent
amendments by the IASB seem to be a quick response to
tackle the criticisms against fair value accounting in the
light of the financial crisis. Yet, a more profound theoret-
ical underpinning of when to apply fair value accounting
seems needed.
References
ALLEN, F. and E. CARLETTI, 2006, Mark-to-market accounting and
liquidity pricing, Working paper, University of Pennsylvania.
BARTH, M.E., W.H. BEAVER and W.R. LANDSMAN, 1996, “Value-rele-
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Changing fair value accounting.

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Changing fair value accounting.

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