An inquiry into the origins of fair value

Abstract

The article aims first to elucidate the role of the Enlightenment in the creation of the notion of fair value. The courts were already defending free market prices by 1750, before the main economic thinkers, Turgot, Cantillon, and Smith formulated their views as to why public welfare was best served by freely made private bargains. It is shown that the attachment of the word “fair” to market value is attributable to Smith’s own understanding of what constitutes distributive justice. A second puzzle addressed in the article is the delay, lasting longer than a century, between the commercial and judicial acceptance of fair value and the later acceptance of it by the standard setters of the accounting profession as the primary way to value business assets and liabilities.

Keywords

Adam Smith Cantillon Enlightenment fair value Salamanca Turgot

Introduction

This article concerns the historical origins of the concept of fair value in the modern accounting sense whereby fair value is measured by market value so long as the market itself is competitive and so long as the transaction recorded in the accounts is the result of the conditions of a valid contract (i.e. offer, acceptance, information symmetry, no duress or undue influence, no misrepresentation, and no failure of consideration). International Financial Reporting Standard (IFRS) 13 Fair Value Measurement (International Accounting Standards Board (IASB), 2012), which addresses fair value measurement in accounting, has been applicable for annual reporting periods from 1 January 2013. National accounting standards mentioning fair value prior to 2013 such as Statement of Financial Accounting Standards (SFAS) 115 Accounting for Certain Investments in Debt and Equity Securities issued by the United States Financial Accounting Standards Board (FASB, 1993) have defined fair value to be market value subject to the caveats mentioned above. This article examines the origins of the fair value doctrine in the Enlightenment and its precursors, in order to pinpoint how the idea that market value was appropriately deemed fair came into being.

When the FASB first used the term fair value, there was already a long established usage for the phrase in the American Internal Revenue Code and Regulations. For example, the “fair market rule” was applied under section 301(b)(1) of the Internal Revenue Code as amended in 1988, inter alia to transactions between members of an affiliated group (United States, 1990). Earlier still, the Revenue Act of 1918, Regulation 45 stated that fair market value was the amount which induces a willing seller to sell and a willing buyer to buy (Logan v Commissioner of Internal Revenue, 1930). That it should be defined as market value emerged during the Enlightenment period in Europe in the eighteenth century and the process of its formulation was based on various conceptual elements that developed at an earlier period as will be shown below. The most important element was Adam Smith’s Wealth of Nations not only because of the famous metaphor of the invisible hand but more because Smith’s notion of justice which directly explains the choice of the word “fair” in the phrase “fair value.” This idea will be discussed further in section “Why has the adoption of fair value by standards boards been such a recent phenomenon?” of this article. It is possible that there would have been a similar equivalence made between fair value and market value had Adam Smith not addressed the topic, because other authors, notably Turgot and Cantillon, previously had similar views on the matter, as will be discussed in section “Adam Smith,” but the speed and scope of the dissemination of Smith’s work far exceeded that of his precursors (Gottlieb, 2009; Smith, 2004). Adam Smith was one of the most important thinkers of the European, and in particular the Scottish, Enlightenment. The notion of applying Newtonian physics to economic activity, thereby implying an equilibrium seeking system, was not an idea that could be found in pre-Newtonian authors, whether it be the Physiocrats before Turgot, the School of Salamanca, the medieval Schoolmen or the classical writers of ancient Greece (Diemer and Guillemin, 2011; Donleavy, 2011). Fair value was therefore an idea born in the Enlightenment. Fair value as a term of moral approbation rather than a technical valuation was associated with the belief that competitive markets allocate resources optimally. This idea was bred in the Enlightenment and the fertilizer speeding its growth was the metaphor of the Invisible Hand.

The next two sections of the article explore the influences on Smith’s economic thought and the features of the Enlightenment age which helped to promote his ideas. The section “Adam Smith” discusses Smith’s writing on fairness and justice and his rationale for the view that free markets optimally allocate resources. The section concludes with a discussion of Smith’s antagonism to the ideas of Rousseau, and the role of Napoleon’s defeat at the Battle of Waterloo in facilitating the dominance of Smith’s views over Rousseau’s in the rapidly developing economies on both sides of the North Atlantic. The section “Why has the adoption of fair value by standards boards been such a recent phenomenon?” discusses why the replacement of historical cost by fair value in accounting standards occurred only at the end of the twentieth century, despite fair value having become an accepted notion both in law and in commerce almost two centuries earlier. The section “Conclusion and summary” offers a brief summary and conclusion.

Enlightenment and economics

There is general agreement that “Michel Foucault’s claim that the Enlightenment ‘has determined, at least in part, what we are, what we think and what we do today’ (is) beyond serious dispute” (Garrard, 2006: 1). The Enlightenment involved a belief on the part of many intellectuals in a primary force which had set in motion a perfect system of self-governing and self-sustaining Natural Law in which Newtonian mechanics were paralleled throughout the biosphere, the body politic and in a newly conceptualized social system called the economy. All systems had natural laws and the effect of them was to bring order to everything by way of the concept of equilibrium (Diemer and Guillemin, 2011).

In Britain, the Enlightenment was facilitated first by the break from Rome under Henry VIII but much more by the stability that came with the restoration of the monarchy in 1660, following which were major scientific advances, such as Robert Boyle’s (1660) discovery of the gas pressure constant and Sir Isaac Newton’s (1680) publication of Philosophiae Naturalis Principia Mathematica, which described Newton’s laws of motion and his universal law of gravitation (Rudolph, 2013). A third burst to British innovation, and arguably the birth of the Enlightenment in Britain, came in 1689, when the Bill of Rights enshrined parliamentary sovereignty and brought to the throne William of Orange, which led directly to the foundation of the Bank of England and the world’s first active and liquid capital market in the City of London (Rudolph, 2013). Within two decades, the London stock market nearly collapsed with the 1721 South Sea Bubble, in which it was shown that financial gravity operated like Newtonian gravity, at least in so far as what goes up must come down.

As the Enlightenment gathered momentum, Newton and his contemporaries in the Royal Society elevated nature to a position of primacy by explaining the world with God as being merely the creator of nature but not present in human affairs. This elevation of nature was taken up in early political economy so as to place economic affairs within the realm of Newtonian physics where it could be understood to respond to natural laws. The idea began with Francois Quesnay who founded the Physiocratic school which asserted that natural laws produced prosperity and should not be impeded (Sabine, 1948). The state’s responsibility was to enforce natural law.

The Physiocrats thought there was a natural order that allowed human beings to live together. Men did not come together via an arbitrary “social contract” as held by Rousseau. Rather, humans discover the laws of the natural order that allow them to live in society without losing significant freedoms (Lucas, 2011).

Many of the ideas of the Physiocrats spread throughout Europe and were at least partially adopted in Sweden, Tuscany, Spain, and in the newly created United States. Adam Smith met Quesnay and acknowledged his influence on Smith’s subsequent work (Steiner, 2003).

Richard Cantillon (1680–1734) imported Newton’s forces of inertia and gravity in the natural world into human affairs and market competition in economics. In his Essay on the Nature of Commerce in General, Cantillon (2010[1755]) argued that rational self-interest operating in a system of freely adjusting markets would lead to order and stable prices. He did not go so far as to articulate an invisible hand, but his views were quite comparable with that metaphor. In the baroque period of European history and culture, just before the Enlightenment’s high water mark in the later eighteenth century, there arose a political attitude that played the role of midwife to the metaphor of the invisible hand. That attitude is the subject of the next section.

Laissez faire and the common law

The term laissez faire appears to have originated in a meeting that took place around 1681 between France’s Comptroller-General of Finances, Jean-Baptiste Colbert, a mercantilist, and a group of French businessmen headed by M. Le Gendre. When Colbert asked how the French state could be of service to the merchants and help promote their commerce, Le Gendre replied simply “laissez-nous faire” (“leave it to us” or “let us do it”). The report of the Colbert–Le Gendre meeting appeared in a 1751 article in the Journal Economique, written by the French minister and champion of free trade, the Marquis D’Argenson (2007[1751])–this being the first known appearance of the term in print (p. 111).

Quesnay adopted the phrases laissez-faire and laissez-passer, laissez-faire being resonant with the Chinese term “wu wei” of which Quesnay had learned (Gerlach, 2005). The Chinese had believed that there can be good government only when a perfect harmony exists between the “Way of Man” (governmental institutions) and the “Way of Nature” (Quesnay’s natural order). Laissez-faire was popularized by one of Quesnay’s readers, the Physiocrat Vincent de Gournay (Gerlach, 2005). De Gournay held that the government should allow the laws of nature to govern economic activity, with the state only intervening to protect life, liberty, and property. His ideas were taken up by Quesnay and Turgot. Quesnay persuaded the King of France, Louis XV, to adopt laissez-faire. On 17 September 1754, the King abolished all tolls and restraints on the sale and transport of grain and for more than a decade the experiment was a success, but then in 1768, there was a poor harvest, and the cost of bread rose so high that there was widespread starvation while merchants exported grain in order to obtain the best profit. In 1770, the edict allowing free trade was revoked, but laissez-faire nevertheless remained a rallying cry for entrepreneurs (Durant and Durant, 1967).

Laissez-faire comprises four beliefs, according to Gaspard (2004), as follows.

The individual is the basic unit in society.

The individual has a natural right to freedom.

The physical order of nature is a harmonious and self-regulating system.

Corporations are creatures of the State and therefore must be watched closely by the citizenry due to their propensity to disrupt the competitive markets’ natural order. It is assumed that markets should be competitive, a rule that the early advocates of laissez-faire emphasized.

At the same time that the Physiocrats, Smith, and Ricardo were developing the economics of competitive markets, pursuant to the ideas of laissez-faire and the invisible hand, common law was moving from the medieval practice of the writ based on the action of assumpsit to the body of law now known as contract and sale of goods. Assumpsit was a writ to enforce a promise that had been allegedly breached. It was an action for a detriment incurred on the faith of the promise, which had been suffered by the person to whom the promise had been made (Ames, 1888). Contract law developed against a background of the common law notion of Equity whereby the Court of Chancery would prevent gross injustice from occurring in civil cases by imposing ideas of fairness, free bargaining, information symmetry, and the avoidance of unjust enrichment upon business sales and purchases, whether done privately or in public markets. There slowly evolved the idea of the fair transaction and the fair market. A crucial milestone in this development was the case of the Earl of Chesterfield v Janssen (1750). The Lord Chancellor of England and Wales, Lord Hardwick, added in his ratio decidendi some words that set the scene for the transition to a notion of legally enforceable fair value. He said,

Particular persons in contracts shall not only transact bona fide between themselves, but shall not transact mala fide in respect of other persons, who stand in such a relation to either as to be affected by the contract or consequences of it; and as the rest of mankind beside the parties contracting are concerned, it is properly said to be governed on public utility. (Earl of Chesterfield v Janssen, 1750: 100–101)

The anonymous author of the 1750 court journal adds in footnote 18 on the last page of the record of the judgment,

But notwithstanding the favourable regard of some of the cases, the Courts of Equity, with a most salutary regard for the protection of the pubic, have always refused to lay down any general rule marking the bounds of such bargains for expectancies as might be considered fair or otherwise. (Earl of Chesterfield v Janssen, 1750: 531)

Thus, by as early as 1750, English law anticipated economics in holding that freely negotiated contracts should be left alone by the law courts. Laissez-faire was already approved at law.

Adam Smith

Precursors

There are two authors who directly influenced Smith and whom he cites in his work, Turgot and Cantillon. These two, more than Quesnay, articulated ideas that anticipated the key economic ideas of Smith.

Turgot created a theory of just exchange on the basis of a contractualist approach (Menudo, 2010). A contractualist is one who believes that there is virtue and fairness in freely negotiated contracts without any need to have regard to any abstract notions of general welfare. Turgot, Cantillon, and Smith all were contractualists in that sense, but all had caveats about the consequences of this view.

Although Turgot was a Physiocrat, he gave demand a supporting role in his theory of value. Although Turgot contributed aspects of what would later be termed marginal utility, he could not totally abandon Physiocratic concepts, so for him land was an anchor of all value (Yamamoto, 2016). Defalvard (1998) nonetheless argues from his reexamination of Valeurs et monnaies, that Turgot’s (2011[1753–1754]) natural contract theory contains the prototype of Marshallian microeconomic theory; for in one of Turgot’s first economic essays, Plan d’un ouvrage sur le commerce, la circulation et l’interet de l’argent, la richesse des Etats, he formulated a theory of “just exchange” on the basis of a contractualist approach (Menudo, 2010). Turgot was one of the first economists to attribute price levels and changes to demand and supply, and it is accordingly plausible to trace the origins of Marshallian economics back past Smith to Turgot. Key quotations now follow from Turgot (2011[1769]: 88–92).

Turgot (2011[1769]) views the bilateral formation of contracts as follows:

If one gives four measures of maize for five bundles of firewood, one also gives five bundles of firewood for four measures of maize and, consequently, four measures of maize are equivalent, in this particular exchange, to five bundles of firewood. These two things have, therefore, an equal exchangeable value” [Indeed …], “the equality of exchangeable value is the necessary condition of free exchange. (p. 88, cited in Theocarakis, 2008)

In an economic exchange, it is necessary that each party is convinced of the quality and quantity of every thing exchanged. In this type of agreement it is natural that everyone should desire to receive as much as he can, and to give as little; and both being equally masters of what they have to barter, it is in a man’s own breast to balance the attachment he has to the thing he gives, with the desire he feels to possess that which he is willing to receive, and consequently to fix the quantity of each of the exchanged things. (Turgot, 2011[1769]: 90, cited in Miller, 2000)

Next, Turgot (2011[1769]) proposes that the actual price of an item is the mean price of all the prices agreed between buyers and sellers bilaterally:

The value of the wine and corn is not fixed by the two proprietors with respect to their own wants and reciprocal abilities, but by a general balance of the wants of all the sellers of corn, with those of all the sellers of wine … The medium price [prix mitoyen] between the different offers and the different demands will become the current price to which all the buyers and sellers will conform in their exchanges. (p. 91, cited in Miller, 2000)

Sabbagh (2012) shows that an extract, at least, of Smith’s (1976 [1776]) Wealth of Nations reached Turgot well before publication, but no response from Turgot back to Smith is recorded. Turgot’s own work, however, reached the English speaking public at around the same time as Smith’s. The first translation in English of Turgot’s Reflexions sur la formation et la distribution des richesses was serialized in 1791–1792 in an obscure English periodical and was made by Benjamin Vaughan (1751–1835), who played a role in the negotiations that led to American independence, and who was responsible for the publication of Benjamin Franklin’s works in 1779. Vaughan settled in America and promulgated Turgot’s work there (De Vivo and Sabbagh, 2015).

Cantillon (2010 [1755]), early in his main work, Essay regarding the origins of wealth and price formation on the market, advocated an “intrinsic” theory of value, based on the input of land and labor (Rothbard, 1995), but he touched also on a subjective theory of value. Cantillon (2010 [1755]) held that market prices are not immediately decided by intrinsic value, but are derived from supply and demand. He considered market prices to be derived by comparing supply (by which he meant the quantity of a particular good in a particular market) with demand (which he said was represented by the quantity of money offered by the buyer; Finegold and Jona, 2010).

Cantillon (2010 [1755]) argued that everyone is really an entrepreneur because their incomes and profits are at risk. He described how the transition from the feudal economy to one based on the price system – where the motivation of profit and loss drive the economy – will, ceteris paribus, move the economy into harmony or equilibrium. His “isolated estate” model anticipates Smith thus: “The owner breaks up his estate into farms that are leased to farmers. Farmers, in turn, direct and sustain their workers. The owner uses rent payments from the farmers to buy goods from artisans and entrepreneurs” (Cantillon, 2010 [1755]: 79–80).

If the farmers produced more of a good than previously, there would be a surplus, prices would fall, and, according to Cantillon (1959 [1755]: 81) “farmers always take care to use their land for the production of those things which they think will fetch the best price at market.”

Cantillon’s calculations of the relationship between labor and land led Smith (1976 [1776]) to refer to Cantillon in the Wealth of Nations. Thornton (2009) argues that the fact that both of Smith’s economic applications of the invisible hand appear together in Cantillon’s model of the isolated estate and are explicitly driven by self-interest makes Cantillon the most plausible source of Smith’s concept of the invisible hand. Cantillon is mentioned by Smith in the first edition of the Wealth of Nations in the context of Cantillon’s calculation that “the lowest species of common labourers must everywhere earn at least double their own maintenance” (Smith, 1976 [1776]: 68, cited in Thornton, 2009). Rothbard (1995: 40) credits Cantillon with being one of the first theorists to isolate economic phenomena with simple models, where otherwise uncontrollable variables can be fixed. Cantillon made frequent use of the concept of ceteris paribus throughout his Essay in an attempt to neutralize independent variables, and the use of this phrase is his most conspicuous legacy to the development of economics, for better or worse.

Adam Smith in focus

The origins of “fair” value in Smith’s ideas

Smith’s invisible hand is well-known and its role in advocating for markets as the optimal allocating mechanism of resources is clear. What is less well-known is the direct contribution made by Smith to the way “fair” is used in fair value. Smith did not see fairness as social justice. He saw justice as having both commutative and distributive aspects neither of which had to do with egalitarian notions.

Smith called for a society of commutative justice, with each “abstaining from what is another’s” (Smith, 1982 [1790]: 269), and a society in which the individual’s distributive justice is to display “the becoming use of what is our own” (p. 270).

Smith’s (1982 [1790]) notion of distributive justice differs from modern distributive, or social, justice. For Smith, distributive justice was making what he termed “a becoming use” of one’s own resources. Such use must be of a voluntary nature, not coerced or forced through government mechanisms. Moreover, as the following quotation shows, Smith (1982 [1790]) found the notion of justice itself imprecise to the point of being almost chaotic:

As mentioned above, distributive justice is not a grammar; it is loose, vague, and indeterminate; like the rules which critics lay down for the attainment of what is sublime and elegant in composition. (p. 327)

Thus, for Smith what was just and fair was not interfering with other people’s property (commutative justice) and the good husbanding of one’s own property (distributive). Perhaps the latter was influenced by Cantillon (2010 [1775]) who argued that initial disparities of wealth were rendered almost insignificant by the common needs of every individual for food and necessities which naturally were met from the expenditure of funds by the landowners and wealthier farmers.

The invisible hand

Smith (1982 [1790]) first used the metaphor of an “invisible hand” in his book The Theory of Moral Sentiments to describe the unintentional effects of economic self-organization from economic self-interest. The idea lying behind the “invisible hand,” though not the metaphor itself, has been attributed by Rasmussen (2008) to Bernard De Mandeville’s (2014 [1705]) Fable of the Bees.

At the dawn of the Industrial Revolution, the ideal of the gentleman as someone who would be fair and cooperative in business dealings, and did so not merely through self-interest, exercised a powerful hold on behavior. This ideal, which was supported by men’s clubs through which gossip about miscreants could quickly spread, created an environment in which opportunism became taboo (Hoff, 2011). This means that self-interest was not seen then as naked, cruel, or brutal, but quite acceptable so long as it was well sheathed by a gentlemanly manner and appearance.

Smith (1976[1776]: 454) asserted the scalability of private agreements to general social prosperity in the passage below:

Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society, which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to the society.

The invisible hand quotation itself now follows. Although Smith (1976 [1776]) is discussing the gains from international trade when the passage begins, by the end his invisible hand has taken the reader to economic transactions in general:

As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it. (p. 456)

Natural price and market price

Following Cantillon, Smith (1976 [1776]: 256) differentiated between an underlying natural price in a market and the ever changing market price, and thought the latter could not long deviate from the former. Thus, natural law guided prices back to an underlying natural level when they deviated from it. Prior to concluding this article, some caveats on this pattern making are offered.

Smith versus Rousseau

Both Adam Smith and Jean Jacques Rousseau were stars of the Enlightenment (Rasmussen, 2013). Rousseau inspired the leaders of the French revolution including the embodiment of that revolution, Napoleon, and he later influenced socialist and Marxist thinkers. Smith’s ideas were supported by those opposed to the French revolution and to Napoleon. In some ways, the defeat of Napoleon at the Battle of Waterloo in 1815 was also a decisive defeat for the Rousseau version of the Enlightenment at the hands of the Smith version. There is a direct line from Smith to Marshall’s formulation of modern microeconomics and thence to the champions of free marketeers on the right of all democratic political parties. Gerber and Godet (2008) plausibly claim that the United States is probably the most faithful political expression of the eighteenth century Enlightenment, by which they mean the ideas of Smith. The antipathy and opposition of Smith to Rousseau had such important and lasting consequences that it is worth examining its character in a little more detail.

According to Rasmussen (2008), Smith was contending with Rousseau over the moral character of commercial society and related ethical and political issues. In passages from Rousseau’s Discours sur l’origine de l’inégalité that Smith had translated in his article in The Edinburgh Review in 1756, Rousseau mentioned disparagingly the notion of an invisible hand. Smith in turn registers his disdain of “Mr. Rousseau of Geneva” by satirically esteeming Rousseau’s effusive dedication to Geneva, which Smith argued to be entirely incongruous with his other passages about society’s endemic deceit (Lomonaco, 2002). The contrast is shown in the following Rousseau extract translated and provided by Smith himself in a 1756 letter (Lucas, 2011: 144):

To conclude, an insatiable ambition, an ardor to raise his relative fortune, not so much from any real necessity, as to set himself above others, inspires all men with a direful propensity to hurt one another; with a secret jealousy, so much the more dangerous, as to strike its blow more surely, it often assumes the mask of good will; in short, with concurrence and rivalship on one side; on the other, with opposition of interest; and always with the concealed desire of making profit at the expense of some other person: All these evils are the first effects of property, and the inseparable attendants of beginning inequality. (Italics added)

Smith (1976[1776]: 456) responded by asserting the coincidence of social welfare with private self-interest by the agency of the invisible hand.

Where Rousseau sees dependence and subordination, Smith sees interdependence and reciprocity among = where Rousseau sees endemic deceit, Smith sees a candid self-interest within just rules; where Rousseau sees exploitation and immiseration, Smith sees a concatenation of voluntary agreements yielding widespread benefits and the development of virtues (Lucas, 2011).

Why has the adoption of fair value by standards boards been such a recent phenomenon?

The persistence of historical cost in accounting standards

Fair value only entered accounting standards with the publication of SFAS 115 (FASB, 1993), despite the increasing commitment of the standard setters to decision usefulness to investors over all rival objectives of accounting reports since the 1973 Trueblood Report (Baker and Burlaud, 2015). Before Trueblood, accounting principles remained anchored to the primacy of reliability and verifiability, or, as the British saw it, a true and fair view. Liang (2001) reports the American Accounting Association (AAA) saw accounting not as a process of valuation but rather as a process of applying the matching principle to disclose realized profit. The adoption of the matching principle was strongly reinforced by income tax legislation and court decisions.

Mumford (2000) attributes the reign of historical costs for virtually the whole of the nineteenth and twentieth centuries, first to the need for assets to be severable in order that they could be easily sold to meet debts, and second to the view that historical cost rules were more conservative than mark to market as prices were falling for most of the period to the Second World War. In the nineteenth century, the protection of loan creditors took precedence over the rewarding of equity stockholders, so it was seen as essential to maintain a sharp and effective division between capital and revenue, so as to preclude payment of dividends out of capital. Sprouse and Moonitz (1962) loosened the anchorage to historical cost in their handbook, but the Securities Exchange Commission (SEC) held fast to that anchorage on the grounds it was less misleading than alternative valuation bases (Markarian, 2014).

The bankruptcy in the early 1930s of Krueger and Toll, the Swedish Match Company, had involved derivatives being marked to market, and it was a factor in the then new SEC forbidding the practice in 1934 (Flesher and Flesher, 1986). The Wall Street Crash stopped the balance sheet being the focus of accounting reports, as, in the view of Close (2007), there was a “growing realization” that stock price was a function of earnings potential rather than of the value of its assets. The anchoring of historical cost was supported by the SEC which opposed arbitrary asset mark-ups, and was also supported by the executive committee of the AAA, and by Paton and Littleton’s (1940) provision of a conceptual rationale for its wide usage (Markarian, 2014). Even as early as 1934, however, property revaluations were allowed in the balance sheet so long as their realization was an evidenced fact (Watts and Mackintosh, 2006). Nevertheless, 10 years after the great depression, the practice of upward revaluation of assets had fully disappeared from public American financial reports (Swieringa, 2011).

Paton and Littleton’s (1940) conceptual framework held that accounting is not to measure cost price, replacement cost, or liquidation value but to measure earnings power. That view made the income statement the most important financial statement. Paton and Littleton (1940) was reprinted 16 times and became a classic which shaped accounting in the United States and internationally. It was a leading cause of historical cost being accepted as the basis of accounting values (Markarian, 2014). Its primacy continued until the inflation of the period following the 1973 Organization of Petroleum Exporting Countries (OPEC) Oil Crisis led business and the professions to echo the already long-standing academic criticism of historical cost as a valuation base for financial accounting (Emerson, 2010).

The Current Cost Accounting (CCA) interval

The subversion of the purchasing power of money in the late seventies led to brief flirtations on both sides of the Atlantic with CCA to maintain physical capital intact and the partial use of Constant Purchasing Power Accounting (CPP) to assess the purchasing power gains or losses from holding monetary items (Clarke, 1982; Macve, 2016 [1997]). Duncan and Moores’ (1988) survey of business students as proxies for investors found that CCA was held to be more useful for investment decisions than traditional accounting.

CCA fell into disuse with the easing of inflation in the late 1980s and the associated withdrawal of the applicable standards, although CPP continues allowable to this day under International Accounting Standard (IAS) 29 Financial Reporting in Hyperinflationary Economies (IASB, 1989) in conditions of hyperinflation such as in Venezuela at the time of writing. It may be that CCA was preferred to mark to market valuations of assets because the abhorrence of risking payment of dividends out of capital was still very strong (Pong and Whittington, 1996).

SFAS 115 and its politics

The Trueblood Report (American Institute of Certified Public Accountants (AICPA), 1973) supported the views of an earlier 1966 report issued by the AAA (1966), A Statement of Basic Accounting Theory, which argued that the primary objective of financial reporting should be usefulness for decision-making. It took two decades before the implications of adopting the decision usefulness perspective of accounting reports changed the opinions of the accounting standard setters to the extent that they prescribed mandating fair value in a standard. The first standard to sanction and recommend fair value accounting was SFAS 115 Accounting for Certain Investments in Debt and Equity Securities (FASB, 1993). “Certain investments” meant derivatives and for them historical cost was irrelevant as value to the business and their deprival value was a function of exit value rather than entry value. It therefore became the first breach in the wall of historical cost balance sheets. SFAS 115 was opposed by the banking community but by now the fair valuing of investments was favored by the SEC (Zeff, 2005).

The effect of SFAS 115 was to expand the use of fair value as the relevant measurement basis for financial instruments. While the Standard retained the held-to-maturity concept for investments and exempted them from having to use fair value, the Board did make clear its intent to move toward a greater use of fair value for assets generally (Close, 2007). Shim and Larkin (1988) reported that the SEC had surveyed top executives over the proposed rules in SFAS 115 and found widespread opposition to it, on the grounds that it would be expensive and burdensome to implement, would apply to assets much more than to liabilities and could increase the prevalence of earnings manipulation. However, by a 5–2 vote, the FASB did issue SFAS 115. Although the SEC argued strongly for fair value accounting, with all gains and losses recognized in earnings, the banking industry vociferously opposed it because of the resulting earnings volatility. A political compromise was reached whereby SFAS 115 (FASB, 1993) would separately recognize “trading securities” and “available for sale securities.” Both would be on the balance sheet at fair value, but the unrealized gains and losses on “available for sale securities” would be parked in shareholders’ equity, and not be taken to earnings (Zeff, 2005).

Suspension and after

Internationally, IAS 39 (IASB, 1999) had provisions similar to SFAS 115, and it prompted a reaction by European banks, which pressured government authorities to overrule the standard, and the governments in turn pressured the IASB which, in June 2005, amended IAS 39 to reduce volatility in the financial statements of banks and other financial institutions (Markarian, 2014). Further exacerbating the political problems associated with IAS 39, in 2008, banks around the world faced substantial write-offs of their trading and available for sale securities portfolios. The accounting treatment of these losses differed substantially between the United States and the IFRS subscribing countries. In the United States, SFAS 115 provided an option to transfer securities from the trading or available for sale category into the held to maturity category (i.e. to suspend fair value measurement of the respective assets). American banks made use of this opportunity (Laux and Leuz, 2009), but European banks could not avoid reporting the losses because IAS 39 required that “an entity shall not reclassify a financial instrument into or out of the fair value through profit or loss category while it is held or issued” (IASB, 1999: 21). As a result, at the peak of the financial crisis in October 2008, the IASB decided to suspend its normal due process in order to issue an amendment to IAS 39 (André et al., 2009) which allowed companies to retroactively reclassify financial assets previously recognized at fair value into categories that permitted recognition at amortized cost, and so avoid significant write-downs in the carrying value of financial assets. Meanwhile the US Congress voted to suppress fair value accounting rules through the Emergency Economic Stabilization Act of 2008, claiming issues of social welfare and investor protection (Bougen and Young, 2012). The suspension of fair value accounting at the peak of the Global Financial Crisis did not presage the abandonment of fair value. On the contrary, fair value became consolidated as the orthodox mode of valuing both assets and liabilities. This is a remarkable contrast to the effects of the 1929 Crash on accounting and the next section discusses why this was so.

The role of financial economic theory in the adoption of fair value

Power (2010) gives several reasons for the victory of fair value at the turn of the century. First, the problem of accounting for derivatives provided a platform and catalyst for demands to expand the use of fair values to all financial instruments. Second, the transformation of the balance sheet by conceptual framework projects from a legal to an economic institution created a demand for asset and liability numbers to be economically meaningful, a demand which fair value could claim to satisfy. Third, fair value became important to the development of a professional, regulatory identity for standard-setters. Finally, fair value enthusiasts drew on the cultural authority of financial economics. Power’s (2010) four factors go a considerable way in explaining why a transactions-based, realization-focused conception of accounting gave way to one aligned with markets and valuation models. Nobody on the FASB or IASB regarded as a fatal objection Lee’s (2006) argument that the Hicksian income justification for fair value accounting on balance sheets is voided by the exclusion of intangible assets from such valuation.

Whitley (1986) analyses the transformation of business finance into financial economics in the United States as part of the post-war expansion and “scientization” of economics. According to Whitley, analytical work in finance was low in uncertainty because of its ideal-typical nature, but it faced the problem of correspondence rules which might link its insights with testable empirical enquiry. The priority of theory as high status work meant that econometric difficulty was subservient to analytical models operating with relatively simple axioms of behavior. As an example, in postulating the idea that asset prices depend on the sensitivity of expected returns to market variance, the Capital Asset Pricing Model is in effect an elaboration and definition of what is meant by rationality (Whitley, 1986). According to Whitley (1986), employers and financial elites embraced the institutionalization of the neoclassical conceptions of economic theory because of the demand for knowledge created by the rise of capital markets. Despite the unreality of its core elements, such as the assumption of perfect markets, financial economics gained legitimacy for practitioners to a far greater extent than other fields of management studies had achieved. Whitley suggests that the close links with practice had more to do with financial economics as a reputational system than with the direct applicability of its analytical core. Abbott (1988) has argued, purely “academic” knowledge has always played a significant role for professions, providing the rational theories needed by practice. Power (2010) holds that financial economics is almost the perfect example of this. Fair value as a principle has become a kind of myth in that it depends for its efficacy and reality on the fact that it is widely believed (Scott, 1992). The critics of fair values have had no clearly definable alternative abstract myth to offer in its place, claims Power (2010). However, the Whitley criticism is part of a wider unease that elegant financial theory has been insufficiently sourced in, or validated by, empirical data from the real world, as is focused in the conclusion of this article.

Institutional factors

Fair value and the primacy of decision usefulness for investors was strongly upheld by the IASB Chair, Sir David Tweedie, throughout his tenure, not least because he believed it was harder to smooth income under fair value than was possible under the other valuation bases (Palea, 2014). Botzem and Quack (2009) see the rise of the IASB itself as closely bound up with the fair value doctrine which has facilitated the development of an independent professional regulatory identity for standard setters. This supports Perry and Nölke (2006) who had asserted that fair value is central to the transnational authority of IASB.

The globalization of the accounting profession in the final two decades of the last century made it hard for accounting to be anchored in national law and in legal concepts rather than in the universal postulates of economics. The neoliberal turn of politics under Reagan and Thatcher in the 1980s raised the salience and prestige of neoclassical economics in general and financial economics in particular (Markarian, 2014; Zhang, 2012). It was the source of the case put forward in favor of adopting fair value by such leading accounting academics as Barth who asserted (in Barth and Landsman, 1995: 42) that a

fair value balance sheet reflects all value relevant information in settings economically equivalent to perfect and complete markets … [Moreover] the income statement is redundant, income realization is not relevant to valuation, and any intangible asset relating to management skill, asset synergies, or options is reflected fully in the balance sheet.

The primacy of theory over observation

Gordon and Boland (1998) argue that market prices fail to reflect the information required to provide measurements that are used in real-life decision-making. This failure is due to the employment of an “ideal” economic world’s assumptions that do not, and cannot, fit the real world of business. This is at odds with the views of many of the leaders of the accountancy profession around the world (Williams and Ravenscroft, 2015). We are still in the process of discovering, however, what decision-making processes real-life decision makers really use in making their decisions as opposed to what they “optimally” should be using according to the postulates of financial economics (at the historical root of which is Smith’s invisible hand). Well evidenced criticism of the standard setters’ habit of assuming what users need rather than of ascertaining it (such as that of Young, 2006) has yet to have much effect on the standard setting process.

Many Enlightenment authors sought to unite empiricism with the notion of law-like universe by arguing that economic laws are no more than general facts, apparent from everyday life. This position, by denying that theory had any connection with the hypothetical, the instrumental, or the abstract, blurred the distinction between theory and fact, taught classical economists to see their theorizing as fact, and gave the classical economists license to pursue their theoretical speculations (Coleman, 1996).

Conclusion and summary

The article aimed first to elucidate the role of the Enlightenment in the creation of the notion of fair value. The courts were already defending free market prices by 1750, before the main economic thinkers, Turgot, Cantillon, and Smith formulated their views as to why public welfare was best served by freely made private bargains. It has been argued in this article that the attachment of the word “fair” to market value is attributable to Smith’s own understanding of what constitutes distributive justice.

A second puzzle addressed in the article is the delay, lasting longer than a century, between the commercial and judicial acceptance of fair value and the later acceptance by the standard setters of the accounting profession. It has been argued the globalization of the profession required a framework of theory not anchored in any one national legal framework and that financial economics has been used to provide such a framework.

Cantillon rather than Smith could perhaps be blamed for the use of the “ceteris paribus” escape clause throughout economics, used as it is to boost confidence in economic theory regardless of empirical observation. This has affected how accountancy views fair value, for it treats Level 1 fair value as not just the preferred valuation method but also the natural, normal, and fairest one. What this ignores especially are the market imperfections attributable to oligopoly, background state subsidy, information asymmetry, and a lack of rational decision-making in the real world. This in turn is deeply rooted in the Enlightenment’s need to believe that the Newtonian universe, with its laws and equilibria, is reflected in the mundane world of the economy. It is ironic that the apostles of rational, critical thinking should in this regard be indistinguishable from the mystical magical followers of Hermes Trismegistus (Fortune, 1974: 44) whose doctrine, “As above, so below,” is the epistemological foundation of astrology, witchcraft, and magic spells. Perhaps the doctrine of the invisible hand really belongs with these practices rather than with the economic arm of social science.

Footnotes

Funding

The author(s) received no financial support for the research, authorship, and/or publication of this article.

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