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Strategic Consequences of Historical Cost and Fair Value Measurements
Ricardo F. Reis and Phillip C. Stocken
Executive Summary
This paper examines the measurement of nonfinancial assets in imperfectly competitive markets. We analyze a duopoly model where two competing firms are required to value their inventory. Both firms learn the exogenous parameters of the demand function for the single product that both produce. Each firm obtains private information about the cost of manufacturing its inventory, and then both firms simultaneously and privately manufacture their inventory. They publicly report the value of their inventory using the asset valuation rule — either historical cost or fair value — that an authoritative accounting body prescribes. After releasing their accounting reports, the firms participate in a pricing game where each firm simultaneously names a selling price and thereafter sells the commodity, at most up to its inventory holding. Consumers purchase the commodity from the firm that offers the lower price, and then, to the extent that this firm cannot meet the market demand, consumers purchase the commodity from the firm that offers the higher price. Last, the firms' payoffs are determined. We view our model as applying to industries characterized by a few competitors that manufacture and sell homogeneous products for which the product specifications change frequently, such as in the manufacture of annual flu vaccines.
First, we consider the case where all firms are mandatorily required to value their inventory using historical cost. We find that when firms privately observe their costs of manufacturing inventory and then prepare a financial report using this valuation measure, the report does not always reveal a firm's inventory level, and, moreover, the informativeness of the report varies with the firm's inventory level. In settings where firms study their competitor's financial reports to learn about them, the firms are less capable of anticipating each other's behavior. Consequently, they manufacture less inventory and in turn are less profitable than they would be in a setting where they could perfectly anticipate each other's behavior.
Second, we consider the case where firms are required to value their inventory at fair value. The firms participate in an imperfectly competitive market where they do not behave as price-takers. Accordingly, given the absence of quoted prices in an active market, we assume, consistent with the Financial Accounting Standards Board's hierarchy of information inputs, that the firms value their inventory at the future cash flow they expect it to generate. We find that when firms use fair value, their financial statements completely reveal their inventory level. The accounting reports thus allow the firms to anticipate each other's behavior. Therefore, firms manufacture more inventory, earn higher expected profits, and generate greater social welfare when they use fair value than when they use historical cost. In addition, reports prepared using fair value are more useful for valuing the firm than those prepared using historical cost.
Accountants have long been critical of fair value measurements because such estimates of future cash flows are subjective. We address this criticism by suppressing uncertainty attributable to market demand. We construct a model with the feature that when firms value their inventory, there is no exogenous source of uncertainty that might confound estimates of the cash flows that the firms generate. Despite eliminating this source of uncertainty, we find that the strategic interaction between firms in an imperfectly competitive market generates an endogenous source of uncertainty. We also find that measuring the fair value of assets in the presence of this type of uncertainty requires preparers of financial statements to have an intimate understanding of the multiperiod game between the firms so that they can determine market clearing — or equilibrium — prices. This assumption, however, is typically difficult to satisfy in a complex institutional setting.
We highlight this implementation issue while assuming that the rival firms can unambiguously compute and credibly disclose their asset values in equilibrium. We deliberately suppress the auditability concern commonly associated with fair value measurements. Nevertheless, it is readily apparent from observing the vital role of the common knowledge assumption in our equilibrium analysis that there are additional complexities associated with auditing fair value measurements. For example, how might the multistage game between rivals become common knowledge among the independent auditors so that they can determine the equilibrium, thereby allowing them to appropriately opine on their clients' asset measurements?