The Nuances of fair value history: A rejoinder to Cardao-Pito

The contention

CP asserts I am mistaken in tracing FV to the trio who influenced Adam Smith:–Cantillon, Quesnay and Turgot. He asserts that since they were all people who believed value was sourced in land and labour, they should not be regarded as sourcing either the MTM or the NPV levels of FVA. CP asserts that because the ideas of Smith (1976 [1776]) and his influencers are inconsistent with Level 3 value, prefigured as he claims by Fisher (1907,1991 [1892]), that ‘therefore’ FV cannot directly result from the physiocrats, Cantillon (2010 [1755], 2015 [1755]) or Turgot (2011[1753-4,1769]). CP misunderstands that tracing an idea to its source is not by any means the same thing as claiming those sources directly created those ideas. As CP says more than once in his critique, history is more nuanced than that. The contention is that these writers who influenced Adam Smith played an identifiable role in shaping his thinking about markets in relation to the general good. His ideas about fairness were not derived from those three but were his own rather idiosyncratic thoughts. So, I never say, nor ever do I imply, that these three directly source FV. The transition from physiocrats through Smith (1976 [1776]) to the neoclassicals is indeed more nuanced than that.

FV in English law from the middle of the eighteenth century to the end of the twentieth

The law and the statute book in Anglo Saxon jurisdictions were using the term ‘fair value’ long before it entered the thoughts of the leaders of the accounting profession. The Revenue Act of 1918, Regulation 45, in the United States, for example, stated that fair market value was the amount, which induces a willing seller to sell and a willing buyer to buy (discussed in Logan v Commissioner of Internal Revenue, 1930).

FVA came later than the use of FV as a term of art. FV as a phrase was used in a ‘mark to market’, MTM, sense in the law courts and statutes of the Anglo-Saxon jurisdictions for centuries before that (see the cases listed later in this section). I have traced elsewhere the courts’ development of the phrase from 1750 onwards (Donleavy, 2011). My article was looking earlier than that, to the sources of the idea that the word ‘fair’ was appropriate to use to describe an MTM value. In the days when FV was first used, nobody dreamt of Irving Fisher, of the time value of money or even of the Trueblood ennoblement of ‘usefulness to decision makers’. Accounting by a clerk to his master was still a matter of good stewardship (Zeff, 2013).

The courts in England coined the term ‘fair value’ long before German train makers (as per Richard, 2004, cited by Cardao-Pito, 2017) or any accounting bodies.

In the medieval and exploration eras, what preceded (for Anglo Saxon jurisdictions) the law of contract was the significantly different legal doctrine of Assumpsit, which was the principle that the Courts of Equity would enforce a promise even without consideration if it would be unconscionable not to do so. That principle lingered till modern times in a jilted fiancée’s right to sue for breach of promise. The cross-over from Assumpsit to Contract was of course nuanced, but its central milestone was the 1750 case of the Earl of Chesterfield v Janssen (Ames, 1888). 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 FV. 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)

What we have here is the social contract as framed in modern legitimacy theory, not as framed in the eponymous creation of Smith’s critic, Jean Jacques Rousseau. The court is willing to leave freely negotiated contracts alone unless either party is in breach of a relevant duty to a third party or to the general good. That is, freely negotiated contracts are presumed fair and equitable unless evidence shows otherwise. Thus, the doctrine of laissez-faire was implicitly approved at law.

Immediately below, in chronological order, are the 13 leading English cases subsequent to Chesterfield that used the term ‘free market value’, ‘fair market value’ or ‘fair value’ in an MTM sense. The case titles are followed by their legal citation tags, rather than relegated to the list of references as the legal convention of case citation is different from ordinary citation and could be confusing to many readers. Therse cases are:

Arbitrator said fair market price of shares meant a pro rata share of the firm’s net assets, but Vinelott J in the Chancery Division said the word ‘fair’ was redundant and the market price was enough so long as there was a willing seller and willing buyer, and nobody was excluded from the bidding and there were no exceptional or freak circumstances to be considered.

It will be seen from the above that England’s courts were using fair value as a term of art in a strictly ’Mark To Market’ sense for 200 years before the Financial Accounting Standards Board (FASB) or International Accounting Standards Board (IASB) were established. In those courts, the use of the word fair meant no interference with the parties’ conducting negotiations on a roughly equal footing without duress or information asymmetry. That is, given validly enforceable contracts, FV was presumed. Contract law, like its creation, fair market value, is a child of the Enlightenment years.

Inaction at a distance in time: just price and FV

Just as Fereira and Cardao-Pito (2017) find in FVA echoes and resonances of Fisher (1907, 1991 [1892]), so for some two decades, Donleavy (2011) wondered if the modern notion of FV was, deliberately or accidentally, an echo and resonance of the medieval ‘just price’. After all, the lexical distance between just and fair or from price to value is not very long. After much research in museums, archives, especially in Europe, Donleavy (2011) came away unable to identify so much as a single strand of mimetic DNA to connect just price to FV. At the time when such a missing link could have been made evident, that is, the time from the end of the middle ages with the Fall of Constantinople to the Ottoman Turks in 1452 and the start of the Industrial Revolution in the Britain of Adam Smith in the 1770s, we had the great Age of Exploration led first by Portugal then overtaken by Spain. There was a major school that bridged medieval theology and modern classical economics in Iberia in that period, namely the School of Salamanca (Grice-Hutchison, 1952). Under Francisco de Vitoria, the University of Salamanca led a period of intense activity in theology, and it proposed a so-called positive theology. Schumpeter (1954) considered the Salamancans to be the founders of economics as a science.

The School of Salamanca tried to show that the explosive growth of international trade and exploration led by their compatriots was reconcilable with the fundamental principles of Christianity, including the principle that Aquinas had promulgated at the height of the middle ages, the just price. The most complete and methodical development of a Salamancan theory of value was by Martín de Azpilcueta and Luis de Molina who agreed on the importance of scarcity in explaining what we now call exchange value. Up until that time, the predominant theory of value had been the medieval theory based on the cost of production as the sole determinant of a just price. Luis de Molina developed a subjective theory of value and prices, which asserted that the usefulness of a good varied from person to person, so just prices would arise from mutual decisions in free commerce. Consequently, the just price of a good was nothing other than the natural, exchange-established price (Mele, 1999). There is no need to go beyond that. In a competitive market, they noted, buyers will not be able to pay less for a good than its usefulness to them and sellers will not be able to sell that good for more than what it is useful to them. In this manner, the Salamanca School was also able to resolve the ‘paradox of value’: diamonds, which are intrinsically useless, normally exchange at a much greater price than water, which has great usefulness. The Salamanca scholars concluded that as men are the best judges of what is ‘useful’ to them, diamonds must be useful in some mysterious way (Grice-Hutchinson, 1952). So near and yet so far. No extant Salamancan document or fragment makes any explicit step from just price to FV. I cannot use the ‘influence at a distance’ claim that CP has used to assert that Fisher’s schema resonates ‘with striking parallelism’ a century later with modern ideas of Level 3 FV. I cannot; because there is a classical logical fallacy at work there. It is the fallacy known as ‘post hoc ergo propter hoc’ (after that therefore because of that), which I reject and instead prefer the principle of Ockham’s Razor, as employed by Baker (2018) in the querying of the Fisher ‘resonance’ thesis that he suspects is just a coincidence. The same goes for just price and FV, neat and elegant as it would have been to trace one along an unbroken chain to the other. We must look for the origins of the idea of FV elsewhere in place and later in time, for unfortunately, under the Salamancans, just price never did mutate into FV, not even along a complex, meandering and nuanced road. Just price died before FV was born.

Naturally fair in the enlightenment?

In medieval times, markets were regulated, often very tightly, and the term ‘free market’ would have sounded oxymoronic to stallholders in the Thaxted, Toulouse, Trier or Toledo of 1520 and earlier (Britnell, 1991). We owe to the Laissez-Faire movement of the seventeenth century, especially to Quesnay and the Physiocrats, that markets came to be seen as the manifestation of freedom.

That market value should be approved as FV emerged during the Enlightenment period in Europe in the eighteenth century, and the process of its formulation based on conceptual elements that developed in its earliest years, will be shown below. The most important element was Adam Smith’s (1976 [1776]) Wealth of Nations, not only because of the famous metaphor of the invisible hand, but also because Smith’s notion of justice explains the choice of the word ‘fair’ in the phrase ‘fair value’. It is possible that there would have been a similar equivalence made between FV and market value even if Adam Smith had not addressed the topic. Other authors, notably Turgot (2011 [1753-5], [1769]) and Cantillon (2010 [1755], 2015 [1755]), had similar views on the matter, as will be discussed below, 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 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).

As the Enlightenment gathered momentum, Newton and his contemporaries in the Royal Society elevated nature to a position of primacy through espousing Deism, the notion that God is the presumed creator of nature but is no longer actively involved in its processes. This elevation of nature was taken up in early political economy to place economic affairs within the realm of Newtonian physics, where it could be understood to respond to natural laws. Thus, Francois Quesnay who founded the Physiocratic school asserted that natural laws produced prosperity and should not be impeded (Diemer and Guillemin, 2011). The state’s responsibility was to enforce natural law. Their motto was ‘laisser faire, laisser passer’ (Gide and Rist, 1915: 45-47). Adam Smith met Quesnay and acknowledged his influence on his own subsequent work (Steiner, 2003). He too believed that natural laws operated independently of human action and returned to a natural state after any such action. But he also said in his Theory of Moral Sentiments (Smith, 1982 [1790] V ch 1: 560); ‘Civil government, so far as it is instituted for the security of property is in reality instituted for the defence of the rich against the poor, or those who have some property against those who have none at all’. Thus, he had a concept of fairness similar to modern notions of distributive fairness, equity and social justice. His notion of what the word justice itself denoted, however, was somewhat different from that.

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).

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 envisage an invisible hand, but his views were quite comparable with that metaphor. In the Baroque period of European history (ca 1618 to ca 1740) just before the Enlightenment’s high-water mark in the later eighteenth century, the physiocrats’ motto ‘laissez faire, laissez passer’ played the role of midwife to the metaphor of the invisible hand.

The law is one parent of accounting. The other parent, economics, was still in early adolescence in 1750. This was the very time when Cantillon and Turgot were coming to prominence and Quesnay had established a leading role among the physiocrats. Law did not influence economics. Economics preferred rather to be guided by the laws of the natural world as disclosed by Isaac Newton. In particular, the idea that forces tend to seek and settle in equilibrium was adopted and made into a rationale for laissez-faire economics (Diemer and Guillemin, 2011). Just as the cardinal sin in our time is to be deemed ‘inappropriate’, so in the Enlightenment era, the cardinal sin was to be unnatural.

Defalvard (1998) argues from his re-examination of Valeurs et monnaies, that Turgot’s (2011 [1769]) natural contract theory contains the prototype of Marshallian micro-economic 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’ (Menudo, 2010) balancing demand and supply, and it is accordingly plausible to trace the origins of Marshallian economics back past Smith to Turgot (Thornton, 2009).

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 labour (Rothbard, 1995). He, however, also held that market prices are not immediately decided by intrinsic value but are derived from supply and demand. (Finegold and Jona, 2010). 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 support of the idea that markets may be sourced in selfishness but they result in social benefit, including even markets for labour (Smith, 1976 [1776]: 68, cited in Thornton, 2009).

Smith’s (1976 [1776]) 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’ (Smith, 1982 [1790]: 270). Such use must be of a voluntary nature, not coerced or forced through government mechanisms. Moreover, as the following quotation shows, Smith (1982 [1790]: 327) found the notion of justice itself imprecise to the point of being almost chaotic, for he wrote:

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.

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 [1755]) 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. 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 behaviour. 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 (Sabbagh, 2012). This is the sociological and cultural parallel of the Court’s dictum in the Earl of Chesterfield’s case that approved free contracts so long as salient public interests were not harmed.

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.

This section has shown that CP’s claim that I sought to argue FV to be the direct result of the arguments of Quesnay, Cantillon and Turgot is wrong. While refuting theclaim, I have outlined a nuanced picture of the origins of the use of the word fair in the term fair value, with special reference to the idiosyncratic notions of justice held by Adam Smith. I do not say that Smith (1976 [1776], 1982 [1790]) himself used the words fair value in the way they are used now. My account is rather more nuanced. What I do say is that the strange use of the word ‘fair’ in FV coincides mightily with Smith’s jaundiced view of justice and, therefore, of fairness. I have shown that the phrase was employed in the law courts of England from the late eighteenth century onward but have not claimed that the law influenced economics in its use of that notion. In the next section, I explore how economics fed the notion into accounting.

The contention

CP claims ‘Another shortcoming in Donleavy’s (2019) study is to assume that accounting based on market values always has the same motivation as fair value accounting’ (Cardao-Pito, 2020). In fact, I assumed nothing about the motivation of people doing accounting. However, I take on board much of CP’s account of the development of FVA and its adoption by standard setters, as he has taken an explicitly European perspective instead of my narrower Anglo Saxon one. I doubt if the characterization of accounting historical phases by Ding et al. (2008) as either static or dynamic illuminates the phenomena it surveys. It ties ‘static’ too closely to balance sheets and ‘dynamic’ too closely to income statements to be much more than a tautology, even after being elegantly filtered by Richard (2004). CP keenly adopts the distinction in his work. However, CP’s drawing attention to the French and German advocacy of market value accounting (preferred by creditors) in the very period I assert that historic cost held sway, is a correction I am obliged to accept for the continent of Europe at least.

However, CP claims something more, as follows.

It can, thus, be observed that it is possible to have accounting systems based on historical costs which are compatible with the registering of certain accounting rubrics by their market values when these are lower than the net value of costs (prudent accounting).

Here, he generalizes the lower of cost or market principle (regularly applied to inventory) unaccountably to all assets, which is surely a mistake.

FVA and standard setters

Dean and Clarke (2010) trace the origin of FV only as far back as 1898 when the US case of Smyth v. Ames on utility pricing was decided. US utility prices were set periodically to ensure a predetermined fair rate of return on the FV of the assets employed. The FV rate base could include whatever monetary amount was ‘fair and reasonable’ to both operators and consumers according to the circumstances of time. This use of ‘fair’ is, however, the usual every day one, and that is not the same as MTM, so it is perhaps only a coincidence that the FV phrase is used in the case cited (Dean and Clarke, 2010).

Cardao-Pito (2020) claims that earlier advocates of market value accounting have been motivated by quite distinctly different arguments from its current advocates but cites no evidence for this claim. In the Anglo-Saxon world, ‘usefulness to decision makers’ has been standard setters’ conventional wisdom since the 1973 Trueblood Report. FV itself only entered accounting standards with the publication of SFAS 12 in 1975 but it entered centre stage with SFAS 115 (FASB, 1993), despite the increasing commitment of the standard setters to decision usefulness over all rival objectives of accounting reports since Trueblood (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 that 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 (Anglo Saxon) reign of historical costs for virtually the whole of the nineteenth and twentieth centuries, first to the need for assets to be severable so that they could be easily sold to meet debts, and second to the view that historical cost rules were more conservative than MTM as prices were falling for most of the period up to the Second World War. In the nineteenth century, the protection of loan creditors took precedence over the rewarding of equity stock-holders, so it was seen as essential to maintain a sharp and effective division between capital and revenue, to preclude payment of dividends out of capital. Sprouse and Moonitz (1962) loosened the anchorage to historical cost in their handbook, but the Securities and Exchange Commission (SEC) held fast to that anchorage on the grounds that it was less misleading than alternative valuation bases (Markarian, 2014).

Before the 1929 crisis, most US organizations were characterized by heterogeneous self-reporting and self-ruling views about financial information, which brought about a large disparity of financial reporting models, so CP claims with good citational evidence. The historical cost standards were imposed in the 1930s, not only in response to the crisis, but also to mitigate various questionable accounting practices, abuses and scandals. 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. In 1938, FDR abolished MTM accounting, which was widely believed to have made the depression more severe. Hanselman (2009), however, reported that it was not until 1938 that the Federal Reserve forced other regulators to use historical cost accounting for banks’ assets; and 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 upwards 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 oil crisis led business and professions to echo the already long-standing academic criticism of historical cost as a valuation base for financial accounting (Emerson, 2010). The subversion of the purchasing power of money in the late 1970s led to brief flirtations on both sides of the Atlantic with current cost accounting (CCA) to maintain physical capital intact and the partial use of Constant Purchasing Power (CPP) accounting to assess the purchasing power gains or losses from holding monetary items (Clarke, 1982; Macve, 2016 [1997]). CCA fell into disuse with the easing of inflation in the late 1980s and the associated withdrawal of the applicable standards. It may be that CCA was preferred to MTM valuations of assets because the abhorrence of risking payment of dividends out of capital was still very strong (Pong and Whittington, 1996). Cardao-Pito (2020) claims that FVA is not yet accepted by standard setters as the primary way to value business assets and liabilities but applies only to a small number of items ‘when no other sensible alternatives are available’. This is untrue. FVA was accepted by all the main (United States and United Kingdom) standard setters including the IASB, the Center for Audit Quality, Council of Institutional Investors, Institute of Chartered Accountants and the Chartered Financial Analysts Association.

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 (often abbreviated to ASOBAT in the literature), 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 FV in a standard. The first standard to sanction and recommend FVA 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 favoured by the SEC (Zeff, 2005).

The effect of SFAS 115 was to expand the use of FV 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 FV, the Board did make clear its intent to move towards a greater use of FV 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 FVA, 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 FV, 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). The SEC finally declared in favour of FVA at its 1991 Washington D.C. conference (Rieger, 2005).

Power (2010) gives several reasons for the victory of FV at the turn of this century. First, the problem of accounting for derivatives provided a platform and catalyst for demands to expand the use of FVs 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 FV could claim to satisfy. Third, FV became important to the development of a professional, regulatory identity for standard setters. Finally, FV 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 FVA on balance sheets is voided by the exclusion of intangible assets from such valuation. Cardao-Pito (2020) does not address the arguments by Power (2010) at all.

FV 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 FV 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 FV 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 FV is central to the transnational authority of the 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, even in China (Markarian, 2014; Zhang, 2012). It was the source of the case put forward in favour of adopting FV by the leading accounting academics, Barth and Landsman (1995: 42) note 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’.

This quotation exemplifies the kind of elegant theoretical edifice only loosely coupled to the real world towards which CP and I share strong scepticism. The next section goes further into this issue on the footing that CP’s differences with me on particular assertions may overlay a deeper agreement on the harm done by elegant a priori theory in accounting and economics.

MTM inferior to mark to (an NPV) model

Cardao-Pito (2020) asserts that I think FV is the same as MTM and asks whether the standards and regulations I cite also think so. No, of course we do not, but the standard setters do assert the primacy of MTM over mark to model.

Cardao-Pito (2020) declares that Cardao-Pito and Ferreira (2018a, 2018b) show that the FV standards mentioned by Donleavy (2019) seem to be aligned with Irving Fisher’s theoretical writings regarding economic and accounting value, and market prices. Claiming the imprimatur of Fisher for FV is quite ambitious on CP’s part. Cassuto (2017), in reviewing W.A. Friedman’s book Fortune Tellers: the story of America’s first economic forecasters, said Fisher was first in a distinguished line of mathematical economists. He was the first to distinguish stocks from flows, the first to identify the role of velocity of money in price levels and the first to formulate a coherent and mathematically robust theory of interest rates, but he did not foresee the 1929 Wall Street crash. Indeed, he said stocks were correctly valued in the immediate lead-in to the crash.

Cardao-Pito (2020) claims that ‘true’ FV is the Fisher sanctified Level 3 since it is ‘a theoretical explanation how market prices appear at levels 1 and 2’ because ‘fair value regulators assume . . . markets are efficient processors of information regarding discounted forecasts’. However, there is not one single standard that explicitly espouses either the Efficient Market Hypothesis (EMH) or the Capital Asset Pricing Model (CAPM), but also none that contradicts them. Levels 1 and 2 values source Level 3, not vice versa. IFRS 13 (IASB, 2012) is very specific on this point. In section 61, it states as follows:

An entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs.

Not one accounting standard can be found that suggests NPV as FVA Level 3 is empirically, conceptually or in any other way, superior to Level 1 MTM valuation. That this implies standard setters are not very taken with the usefulness of the idea of value in use is a safe assumption. The next paragraph suggests an explanation for that.

Differences between value in use and entry or exit values are arguably measures affected considerably by management skill. Value in use is the only measure that captures total firm value associated with an asset and is consistent with the going concern tenet of generally accepted accounting principles (GAAP). It is, however, possible that measurement error could be so severe that entry or exit values could be more value relevant. Private information can be reflected, nonetheless, only in value in use. (Beaver, 1987; Beaver and Landsman, 1983). Investors are concerned about reliability of management estimates of Level 3 valuations (Chang et al., 2010). Companies with higher exposure to Level 3 assets have higher costs of equity capital (Riedl and Serafeim, 2009).

The ‘Seminality’ of Modigliani and Miller

Cardao-Pito (2020) asserts that Modigliani and Miller (1958) (MM) is ‘the seminal text’ and supports Fisher’s assertions as refracted by CP and addressed in the subsection ‘MTM inferior to mark to (an NPV) model’ above.’ The MM thesis has been widely criticized, modified and arguably twice superseded by pecking order theory (Myers and Majluf, 1984; Myers, 1984) and by trade-off theory (Shyam-Sunder and Myers, 1999). Ezra Solomon quipped ‘a perfect capital market is one in which the MM theory holds (De Egaña et al, 2016). Yet, MM retains an aura of such high intellectual charisma that even an empiricist, as CP seems at heart to be, cannot hide his reverence for the MM fairy tale. He is not alone. In the rest of this section, some plausible explanations for this arguably irrational obeisance to theories, such as the original MM capital structure theory, are explored.

Theory and falsification

Boland (1981: 1034) says metaphysical statements may be false, but we may never know it because of the assumptions of a research programme, which are deliberately put beyond question. This applies to the EMH, to MM, to the Barth and Landsman postulation of FVA and any other economic theory, which manipulate the weasel words, ‘ceteris paribus’. Merton (2006) reports Samuelson’s caution that from a non-empirical base of axioms you cannot get empirical results. Deductive analysis cannot determine whether the empirical properties of the stochastic model come close to resembling the empirical determinants of today’s real-world markets (Samuelson, 1965: 783).

Many Enlightenment authors sought to unite empiricism with the notion of a 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 licence to pursue their theoretical speculations (Coleman, 1996). Cantillon, (2010 [1755], 2015 [1755]) 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. It has been the source of intellectual moral hazard plaguing the field of establishment financial economics, enabling metaphysical constructions such as the EMH in the strong form, the CAPM and the original and unmodified MM proposition to gain a following attributable at least as much to mathematical elegance as to explanatory power.

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 (1986), 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 behaviour. As an example, in postulating the idea that asset prices depend on the sensitivity of expected returns to market variance, the CAPM 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 CAPM with 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. FV 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 FVs have had no clearly definable alternative abstract myth to offer in its place (Power, 2010). However, the Whitley (1986) 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.