Fair Value Accounting and Cash Flow Predictions

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Fair Value’s Affect on Accounting’s Ability to Predict Future Cash Flows: A Glance Back and a Look at the Potential Impact of Reaching the Goal *

Keji Chen University of Alabama Gregory A. Sommers Southern Methodist University and Gary K. Taylor University of Alabama

Current Draft: September 14, 2006 First Draft: August 28, 2006

The comments of Robert Ingram, Mary Stone, and workshop participants at the University of Alabama are greatly appreciated.

ABSTRACT The FASB appears to be moving toward fair value accounting with increasing momentum. Most of the current discussions related to the fair value accounting movement center around relevance and reliability of the reported values. Instead of evaluating the relative merits of these views, the current study frames the issue based on the objectives of financial reporting as stated in SFAC No. 1. Specifically, we focus on the potential detriment of fair value on accounting’s predictive ability for future cash flows. We show that, even with fair value requirements in recent standards, the correlation between current accounting numbers and current market data has not improved through time, nor has the correlation between current accounting numbers and future cash flows improved. Our most important finding is that the correlation between market data (in essence, fair value accounting) and future cash flows is significantly lower than the correlation between current accounting and future cash flows. That is, achieving fair value accounting would reduce the predictive ability of financial reporting for future cash flows. Thus the current focus on potentially increased relevance weighed against issues of reliability has failed to consider the potential impact on the predictive objective of accounting.

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1. Introduction The FASB appears to be moving toward fair value accounting with increasing momentum. “Since the early 1980s, financial reporting standard setters have tended to base new standards on fair value measurement.” (CFA 2005a, p. 4) Proponents of fair value accounting argue that the relevance of financial information would increase under fair value accounting.1 On the other hand, opponents contend that uncertainty in the measurement of fair value decreases the reliability of the information. Rather than addressing the relative merits of these views, we raise the issue of whether fair value accounting is compatible with the pre-established objectives of financial reporting. Specifically, we show that, if fair value accounting is achieved, the ability of financial accounting to predict future cash flows will be reduced.2 We directly test whether fair value accounting, the goal, would be detrimental to the predictive ability of accounting by examining the association of prices and returns (the fair values that represents book value and income under fair value accounting) with subsequent cash flows. We show that current accounting (book value and earnings) has more explanatory power for future cash flows than the “fair value” numbers. This is consistent with the intuition that the unexpected (transitory) portion of returns is higher than the unexpected portion of earnings. This transitory portion of returns may not be a reasonable indicator of expected future cash flows; while earnings, since it is expected to be more persistent than returns, may be more highly correlated with expected future cash flows. The evaluation of the movement toward fair value accounting should be considered on whether it helps achieving the objectives of financial reporting. Statement of Financial For example, CFA (2005a, p. 4) argues that “Decisions about whether to purchase, sell, or hold investments are based upon the fair values of the investments and expectations about future changes in their fair values. Financial statements based on outdated historical costs are less useful for making such assessments.” 2 We do not attempt to build a model that predicts future cash flows....
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