As most FASRI followers are aware, the IASB and FASB are revising their Conceptual Frameworks.  The new and old frameworks posit that relevance of information for making decisions is a key attribute for determining if a particular number should be included in financial reports. I recently attended a presentation of a research paper by Lisa Koonce titled “How Do Financial Statement Users Assess and Use Relevance and Reliability?” (with Kadous and Thayer).

While the paper contains a number of issues that would lead to interesting debate within the FASRI community, this post focuses on how the authors manipulate the relevance of fair value information regarding a building.  This task is harder than it might sound.  I was not impressed by their first attempt – one group of subjects was told the building was to be sold in the short term, while the other group was told the building was a long term investment.  The problem is, as a passive investment, fair value is relevant in both cases for assessing current period stock price.

The authors’ second approach to manipulating relevance seems much more appropriate.  One group is told the building is being held as a passive investment, while the other is told the building will be used for production purposes.  During my year as FASB Research Fellow, I and others at the FASB observed that constituents tend to accept fair value accounting in the first case but tend to view it as not very relevant in the second.  Why?  My intuition is that as a passive investment, the cash flows generated for the company by the building will be determined by market forces, so a market price of the building is very relevant to assessing the value of the company.  But when used in production, the cash flows produced by an asset will depend on all of the potential firm-specific synergies that the asset brings to the company.  For example, while the market may value two buildings on different sides of a town (or a state) the same, the cash flows generated from using the building in production will be higher if the company acquires the building on its side of town (lower transportation costs).  My impression is that rather than trying to add up the fair value of each productive asset, most investors try to project the economic rents (income, cash flows, or other measures) generated by using the productive assets collectively, and apply some present value technique to the rents.

In this sense, the fair value of a single productive asset is not very relevant to assessing current stock price of the company because the market price for the single asset probably does not reflect all of the possible firm-specific synergies associated with that asset.  Kudos to Koonce and her co-authors for developing this second manipulation.  If any other experimental researchers are struggling to find a good manipulation for relevance, I urge you to contact Lisa.