No. 119: Trade-offs in the Design of Fair Value Standards

Abstract

This paper analyzes the information quality of the current fair value standard in US-GAAP and IFRS in terms of value relevance and faithful representation. The current standard favors reliable market-based inputs over sometimes more relevant entity-specific inputs as it requires preparers to use the measurement approach, which maximizes observable inputs and minimizes unobservable inputs. We apply a model of rational expectations in line with Fischer and Verrecchia (2000) and introduce an information structure including public market-wide signals and managerial private signals. In contrast to common intuition, we find that maximizing observable inputs does not necessarily lead to a better faithful representation in the sense of a lower managerial bias. In fact, an alternative standard, which requires the maximization of unobservable inputs, can simultaneously provide a lower managerial bias and a higher value relevance than the current standard, depending on the information environment. This is the case, for example, when the corporate governance system is moderate and the uncertainty about the underlying asset is sufficiently high. The results are important for regulators and scholars since they show that the trade-offs for standard setters are not as clear-cut as commonly suggested.