Relevance and Reliability of Fair Values: Discussion of Issues Raised in “Fair Value Accounting for Financial Instruments: Some Implications for Bank Regulation”

In his paper, Professor Landsman reviews research on both the relevance and reliability of reporting fair values for loans and other financial instruments (Landsman (2005)). Accounting standard setters define fair value as the amount that would be paid or received for the item being valued in an arm’s length transaction between knowledgeable parties. This is a market value definition and the standard setters have indicated that, if available, a current market price for the item is said to be the best estimate of its fair value. Relevance means that the fair value is capable of making a difference to financial statement users’ decisions. Reliability means that the reported fair value represents what it is purported to represent (Barth et al (2001), p. 80). Professor Landsman concludes that the evidence on fair value reporting supports its relevance. On reliability, he suggests there is some uncertainty, using evidence from Barth, Landsman, and Rendleman (1998) based on testing a pricing model for corporate bonds. He further discusses banks’ use of their private information in determining loan fair values and consequences of model valuation errors on earnings volatility. In my discussion, I first comment on issues concerning fair value relevance tests and the standard setters’ relevance criterion. I then consider the potential importance and reliability of models for loan fair values. Here my comments expand on Professor Landsman’s discussion of model reliability.