[paper]Fair Value as a Relevant Metric A Theoretical Investigation

[paper]Fair Value as a Relevant Metric A Theoretical Investigation

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Unformatted text preview: 1 1/6/2006 Fair Value as a Relevant Metric: A Theoretical Investigation Amy K. Choy Amy.Choy@ualberta.ca University of Alberta Edmonton, Alberta T6G 2R6 ___________________________ This paper is based on my dissertation at Washington University. I am indebted to Ron King, chairman of my dissertation committee, for his suggestions, comments, and encouragement. I also appreciate the help from my committee members, including Randall Calvert, Angela Davis, Nick Dopuch, Nicole Jenkins, and Gary Miller. I would also like to thank Sudipta Basu, Mike Gibbins, Mahendra Gupta, Jennifer Kao, Thomas Matthews, Mikhail Pevzner, Grace Pownall, Alan Richardson, Tom Scott, Heather Wier and workshop participants at Emory University, University of Alberta, Washington University, and York University for their comments and suggestions. Any remaining errors are my own. 2 Abstract Supporters of fair value accounting claim that this metric has two central advantages, including that it is a relevant measure and that it accurately reflects the underlying economic condition of a firm. In this paper I investigate the robustness of these presumed advantages by undertaking three related analyses. First, I develop a theoretical framework to identify the necessary and sufficient conditions for market price (as a fair value metric) to be relevant. Second, I develop an economic model to examine the two claims. I show that, when markets are in disequilibrium, the market price of an asset alone does not reliably allow a user to infer a firms long-term value. If the user also has information regarding a firms economic profits, market price could be relevant. Third, I construct computer simulations of the economic model and find that reported accounting profits do not have the same predictive power as economic profits. I also find that there exists a non-trivial relationship between accounting profits and fair value that could help a user to identify a firms long-term value. Thus the usefulness of fair value depends on users understanding of this relationship. 3 1. Introduction There is a long-standing debate in the financial reporting field regarding the relative advantages of historical cost and current cost/fair value. 1 The debate centers on the reliability and relevance of each metric. Since historical cost is based on verifiable transactions, supporters of the metric often claim that it is reliable; however, this metric becomes less relevant with time. Currently, historical cost is the predominant measurement metric used in US GAAP. In recent years, fair value has gained support from government officials, business professionals, and standard setters. Supporters claim that fair value better reflects the underlying economic condition of a firm, can provide investors with insight into prevailing market values, 2 and also has a predictive advantage over historical cost....
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This note was uploaded on 04/28/2010 for the course ECON ACCT3011 taught by Professor Isabelgordon during the Summer '09 term at University of St Andrews.

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[paper]Fair Value as a Relevant Metric A Theoretical Investigation

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