Essay: Fair Value Accounting: Exploring Advantages And Disadvantages.

1. Identify the underlying social and corporate imperatives that underlie the accounting conceptual framework.
2. Identify the key players in Australian financial reporting regulation and articulate the relationship between International Financial Reporting Standards (IFRSs) and Australian Accounting Standards (AASs).

3. Explain the relationship between accounting theory, the accounting conceptual framework and accounting standards.
4. Work individually and in groups to identify and apply appropriate accounting standards to a range of authentic accounting scenarios

Advantages of Fair Value Accounting

For above the last two decades, the fair value accounting concept is followed. The idea behind it is measuring assets and liabilities at their existing values. This has been a significant deviation from the fact that the books of accounts need to be valued at historical cost and not at their existing values. However, this concept leads to a debate, as certain factors need to be taken into consideration for undertaking investment choices and management decisions. This paper would aim to explore the various aspects related to fair value accounting by critically analysing the provided academic article.

As commented by Chircop and Novotny-Farkas (2016), FVA is a kind of accounting where the organisations gauge and report their assets and liabilities at prices identical to their fair values. There are certain advantages of this method, which are enumerated as follows:

At the time of using FVA, when asset values fall, the net profit of the organisation declines. Even with the increase in liability values, the calculated net profit of the organisation falls as well. Net profit signifies the amount on which the company incurs tax. This is deemed to be an advantage for the business, as minimised net profit leads to lower tax payments. Similarly, increase in assets and liabilities results in fall in business equity. When there is lower equity, an organisation has lower amount of money to decide for its business operations. As a result, employee bonuses are reduced leaving more money in the pocket of the organisation (Demerjian, Donovan & Larson, 2016).

The companies using FVA have more accurate financial statements compared to those not using the method. At the time assets and liabilities are reported for actual values, it leads to realistic financial statements. The organisations using this method need to reveal information about changes in the financial statements through financial notes. They have the chance to investigate their financial statements with the real fair values, which enable them to undertake wise choices about future business operations.

As FVA lists liabilities and assets for their real values, the financial statements represent a better overview of the financial health of the organisation. This enables the investors in undertaking sound decisions about their investment alternatives with the organisation (Dong, Ryan & Zhang, 2014). The needed footnote disclosures assist the investors in investigating the impact of variations in statements because of fair values of assets and liabilities.

Disadvantages of Fair Value Accounting

However, FVA suffers from certain drawbacks and they are described briefly as follows:

The value of an item could change frequently in volatile markets. This results in significant variations in the value and earnings of the organisation. The accountants’ write-off item losses compared to the earnings of an organisation. The public listed organisations find it complex, as the investors might face difficulties in valuing the organisations with such variations in place. Moreover, the potential for wrong valuations could result in audit issues.

The accountants view the market at the time of finding new value for investments or assets. When the value of an item differs from region to region, the accountants need to make judgement call on valuing book items. If an organisation with identical investments or assets values items differently compared to another, the issues might arise due to the valuation method of the accountant.

From the historical perspective, there would be change in the book value of an organisation at the time it purchases new assets or sells old assets (Durocher & Gendron, 2014). On the other hand, FVA changes the book value of an organisation for arbitrary issues. For instance, if an investment encounters a major fall in value for short-term, it is necessary for the organisation to undertake accounting modifications. When the value increases, the modifications did not conduct anything; instead, the book value of the organisation falls for a shorter timeframe.

According to the provided article of Marra (2016), fair value estimation follows a three-tier process having a stringent preference for market-based measures. The hierarchy is described briefly as follows:

These inputs are unadjusted cited prices in the active markets in relation to items similar to the asset or liability gauged. If the price is quoted in an active market, the price is used by the organisation without adjustment at the time of gauging fair value (Georgiou, 2018). Thus, it becomes necessary for the organisation to access the market at the date of measurement. The active markets are those, in which transactions occur with adequate volume and frequency for providing pricing information. If necessary, an alternative technique could be used and the standard establishes criteria, in which it might be applicable. For instance, there might be a situation, in which the price quoted in an active market does not depict fair value at the date of measurement. This situation might happen when an important event like business combination or reorganisation occurs after the market closure (Goh et al., 2015).

Three-Tier Process of Fair Value Estimation

These are the inputs except the quoted prices in level 1, which could be observed for that asset or liability. They are described as quoted liabilities or assets for identical items in active markets or supported with the help of market data like credit spreads, rates of interest and yield curves. Adjustments might be required to these inputs and if they are important. it is necessary to categorise the fair value in the form of level 3.

These inputs could not be observed and they need to be used as a minimum. Under situations where it is not possible to observe the relevant inputs, they are needed to be developed for reflecting the assumptions that the market participants would utilise at the time of ascertaining an effective price for asset or liability (Lachmann, Stefani & Wöhrmann, 2015). The organisation is required to increase its utilisation of pertinent observable inputs along with reducing the utilisation of unobservable inputs. For instance, cash flow estimations might be used for valuing an unlisted organisation. All the measurements of fair value are categorised based on the lowest level input, which carries greater significance.

All business organisations require considering certain qualitative characteristics of financial information when fair value accounting is used. The initial characteristic is relevance, which needs financial information to be pertinent so that the users of the financial statements could undertake appropriate decisions (Livne & Markarian, 2018). The second characteristic is identified as materiality, which needs the accountants and auditors to concentrate on financial information expected to influence the decision-making process of the users. The third characteristic is faithful representation that ensures true and fair depiction of the financial information, especially; it should be free from misstatements. The fourth characteristic is comparability that needs the financial information to be distinguished across organisations and periods (Magnan, Menini & Parbonetti, 2015). The fifth characteristic is verifiability, which includes communicating the underlying economic information of the business operations of an organisation. The sixth characteristic is timeliness, which requires disclosure of financial information within stipulated time by avoiding any delay. The final characteristic is understandability, which needs to ensure that the users understand financial information effectively having sound knowledge of economic and business activities.

All these characteristics deem to possess relationships with the fair value accounting method. In this method, the prices of all items need to be relevant and fair for representing their fair values. Moreover, it is necessary to provide such disclosures in a timely manner to the various users of the financial statements (Palea, 2014). Moreover, in fair value accounting, it is necessary that the financial statements do not contain materiality issues so that right information could be delivered to the users of the financial statements. Along with this, it is noteworthy to mention that the application of fair value accounting is made especially for assets and liabilities, as these items possess particular characteristics. As per the assumption of fair value accounting method, the market participants follow a particular order in relation to transactions of assets and liabilities with the intention of transferring or selling the assets (Xie, 2016). Moreover, the fair values of assets and liabilities could be transferred to the upcoming years.

Qualitative Characteristics of Financial Information

Conclusion:

It is apparent from the above discussion that fair value accounting method has certain benefits like investor benefit, realistic assumptions and minimised net income. However, it suffers from certain drawbacks like frequent modifications, lower reliability and minimised book values of assets and liabilities. Moreover, it has been evaluated that the method follows a three-tier process in order to have strict preference for market-based measures. Thus, three levels of inputs are discussed in this paper, which include both observable and unobservable inputs. Finally, it has been analysed that the fair value accounting method follows all the essential qualitative characteristics of financial information so that accurate and timely information could be provided to the various users of the financial statements of the business organisations.

References:

Chircop, J., & Novotny-Farkas, Z. (2016). The economic consequences of extending the use of fair value accounting in regulatory capital calculations. Journal of Accounting and Economics, 62(2-3), 183-203.

Demerjian, P. R., Donovan, J., & Larson, C. R. (2016). Fair value accounting and debt contracting: Evidence from adoption of SFAS 159. Journal of Accounting Research, 54(4), 1041-1076.

Dong, M., Ryan, S., & Zhang, X. J. (2014). Preserving amortized costs within a fair-value-accounting framework: Reclassification of gains and losses on available-for-sale securities upon realization. Review of Accounting Studies, 19(1), 242-280.

Durocher, S., & Gendron, Y. (2014). Epistemic commitment and cognitive disunity toward fair-value accounting. Accounting and Business Research, 44(6), 630-655.

Georgiou, O. (2018). The worth of fair value accounting: dissonance between users and standard setters. Contemporary Accounting Research, 35(3), 1297-1331.

Goh, B. W., Li, D., Ng, J., & Yong, K. O. (2015). Market pricing of banks’ fair value assets reported under SFAS 157 since the 2008 financial crisis. Journal of Accounting and Public Policy, 34(2), 129-145.

Lachmann, M., Stefani, U., & Wöhrmann, A. (2015). Fair value accounting for liabilities: Presentation format of credit risk changes and individual information processing. Accounting, Organizations and Society, 41, 21-38.

Livne, G., & Markarian, G. (Eds.). (2018). The Routledge Companion to Fair Value in Accounting. Routledge.

Magnan, M., Menini, A., & Parbonetti, A. (2015). Fair value accounting: information or confusion for financial markets?. Review of Accounting Studies, 20(1), 559-591.

Marra, A. (2016). The Pros and Cons of Fair Value Accounting in a Globalized Economy: A Never Ending Debate. Journal of Accounting, Auditing & Finance, 31(4), 582-591.

Palea, V. (2014). Fair value accounting and its usefulness to financial statement users. Journal of Financial Reporting and Accounting, 12(2), 102-116.

Xie, B. (2016). Does fair value accounting exacerbate the procyclicality of bank lending?. Journal of Accounting Research, 54(1), 235-274.