Investments, tenth edition

19.5 

  Fair Value Accounting 

 Many major assets and liabilities are not traded in financial markets and do not have eas-

ily observable values. For example, we cannot simply look up the values of employee 

stock options, health care benefits for retired employees, or buildings and other real estate. 

While the true financial status of a firm may depend critically on these values, which can 

swing widely over time, common practice has been to simply value them at historic cost. 

Proponents of    fair  value  accounting,      also known as    mark-to-market  accounting,       argue 

that financial statements would give a truer picture of the firm if they better reflected the 

current market values of all assets and liabilities. 

 The Financial Accounting Standards Board’s Statement No. 157 on fair value account-

ing places assets in one of three “buckets.” Level 1 assets are traded in active markets and 

therefore should be valued at their market price. Level 2 assets are not actively traded, 

but their values still may be estimated using observable market data on similar assets. 

They can be “marked to a matrix” of comparable securities. Level 3 assets are hardest 

to value. Here it is difficult even to identify other assets that are similar enough to serve 

as benchmarks for their market values; one has to resort to pricing models to estimate 

their intrinsic values. Rather than mark to market, these values are often called “mark 

to model,” although they are also disparagingly known as mark-to-make believe, as the 

estimates are so prone to manipulation by creative use of model inputs. Since 2012, firms 

have been required to disclose more about the methods and assumptions used in their 

valuation models and to describe the sensitivity of their valuation estimates to changes in 

their methodology.  

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 D. Bergstresser, M. Desai, and J. Rauh, “Earnings Manipulation, Pension Assumptions, and Managerial Invest-

ment Decisions,”  Quarterly Journal of Economics  121 (2006), pp. 157–95.