Exploring The Pros And Cons Of Fair Value Accounting

Benefits and drawbacks of fair value accounting (FVA)

The theories of fair value accounting (FVA) have been followed in financial accounting for a long time, which mandates above the past two decades. The concept of “FVA” helps in measuring assets and liabilities with respect to their current worth. This has been a noteworthy modification of the reason that the books of accounts requires to be evaluated at actual price and not at their current worth. Moreover, these ideas lead to controversies, as few of the elements are needed to taken care of in terms of alternatives regarding financial propositions and management decisions. The current study would examine the different types of features regarding “FVA” by minutely assessing the given academic article.

According to Barth and Landsman (2017), FVA is a type of accounting where the companies measure and address the assets and liabilities at costs, which are similar to their equitable rates. The advantages of this process are discussed below:

(i) At the time of applying FVA, when the rate of the assets decline, the net profit of the company diminishes. Even with the raise in the rates of the liability, the computed net profit of the company declines as well. Net profit means the sum on which the company has to sustain the payment of tax. This is treated as an advantage for the organisation, as curtailed net profit means lesser payment of tax. Likewise, the outcome of rise in the assets and liabilities is decline in the equity of the company. When there is lower equity a company has to send lesser money on its daily activities. The outcome of this is lesser payment of bonus to their employees and more money is left in the account of the company (Amel-Zadeh, Barth & Landsman, 2017).   

(ii) The organisations who are utilising FVA have a more authentic income statement in contrast to those who are not utilising this process. During the period assets and liabilities are addressed for real worth, it leads to an authentic income statement. The companies utilising this process are required to disclose data related to the variations in the income statements via commercial notes. They have the opportunity for examining their income statements with the authentic equitable rates, this would allow them to undertake judicious alternatives regarding future business activities.

(iii) As FVA enlists assets and liabilities for their actual rates, the income statements present a better analysis of the financial strength of the company. This allows the shareholders in choosing better alternatives regarding investments with different types of companies (Campbell, D’Adduzio & Duchac, 2016). The required footnote declarations help the shareholders in assessing the effect of changes in the statements owing to the equitable rates of the assets and liabilities.

The three-tier process

However, FVA suffers from certain disadvantages they are discussed below:

(iv) The worth of a commodity could vary periodically in capricious markets. This leads to noteworthy changes to the worth and income of the company. The accountants’ cross out commodity losses compared to the income of the company. The companies who are public listed find it complicated, as the shareholders would find it hard to assess the worth of the companies with such changes taking place. Furthermore, the possibility of wrong assessment would lead to audit related problems.  

(v) The accountants observe the market during the time of discovering new worth for investitures or assets. When the rate of a commodity keeps on varying from place to place, it is required that the accountants resort to reasoning in order to assess the worth of the book items. If a company with similar investitures or assets try to assess the worth of a commodity in a different way in contrast to the other company, such a problem could arise based on the method followed by the accountant.  

(vi) From the classical point of view, there would be some variation in the “book value” of a company during the time it buys new assets or sells old ones (Chircop & Novotny-Farkas, 2016). However, FVA makes variations in the “book value” of a company due to random problems. For example, if an investitures experiences a major decline owing to its worth in “short-term”, it is mandatory for the company to carry out accounting changes. When the value rises, the changes done did not contribute to anything; rather, the “book value” of the company declines for a shorter interval. 

According to the given article of Marra (2016), equitable value evaluation follows a three-tier process having a strict inclination for “market-based” assessments. It is discussed below:

The “level one inputs” are unaccustomed mentioned costs in the active markets regarding those commodities which are identical to the assessed asset or liability. if the cost is recited in the active market, this cost is utilised by the company without modification during the period of assessing the equitable rate (Corona, Nan & Zhang, 2018). Therefore, it becomes crucial for the company to approach the market at the date of assessment. The active markets are those, in which business deals happen with sufficient quantity and randomness for giving cost data. If needed, a substitute procedure could be utilised and the standard authorises the principle, in which it would be implacable. Suppose, there could be a situation, in which the recited price in an market does not determine the equitable rate at the date of the assessment. This situation could occur when a crucial event such as- business sequence or restructuring happens after the market termination (Demerjian, Donovan & Larson, 2016). 

Qualitative characteristics of financial information

The “level two inputs” are excluded from the recited costs in level one, which could be noticed for that asset or liability. These are explained as recited assets or liabilities for similar commodities in active market or backed with the help of market information such as- “credit spreads, “interest rates” and “yield curves”. Modifications could be needed to these inputs and if they are crucial. It is important to classify the equitable rates in the form of level three.

The “level three inputs” are not noticeable and they are required to be utilised as a minimum. During those situations where it is not feasible to notice the applicable inputs, they are required to be created for highlighting the hypothesis that the market participants would use during the period of determining an impactful cost for asset or liability (Livne & Markarian, 2018). The company is needed to raise its usage of appropriate noticeable inputs along with diminishing the usage of non-noticeable inputs. Suppose, cash flow evaluations could be utilised for evaluating a non-reported company. All the assessments of equitable rates are classified depending upon the lowest level input, that carries greater importance. 

All business corporations need to take care of some precise qualitative features of financial data when FVA is utilised. The preliminary feature is applicability, that requires financial data to be appropriate so that the users of the income statements could take the right decisions (Magnan, Menini & Parbonetti, 2015). The second feature is recognised as relativity, which requires the accountants and auditors to focus on financial data anticipated to impact the decision making capability of the users. The third feature is trustworthy presentation that assures correct and just representation of the financial data, specifically, ist needs to be free from biasness. The fourth feature is affinity, which requires the financial data to be esteemed over companies and periods (McInnis, Yu & Yust, 2018). The fifth feature is audit-ability, which involves communicating the elemental economic data of the business functionalities of a company. The sixth feature is “timeliness”, that needs the revealing of financial data within the scheduled period by avoiding any delay. The last feature is clarity, that requires assuring that the users understand the financial data impact-fully having decent knowledge of economic and business operations.

All these features believe to occupy connection with the FVA process. In this process, the costs of all commodities require to be proper and correct for presenting their equitable rates. Furthermore, it is important to give such declarations in a timely way to different users of income statements (Sami, 2015). Moreover, in FVA, it is vital that the income statement do not possess relativity problems so that the correct data could be provided to the users of the income statements. Alongside this, it notable to disclose that the implication of FVA is made specifically for assets and liabilities, as these commodities occupy specific features. As per the hypothesis of FVA process, the market participants follow a specific sequence in regarding transaction of assets and liabilities with the aim of carrying or selling the assets (Yoo, Choi, & Pae, 2018). Furthermore, the equitable rates of the assets and liabilities could be carried to the upcoming years. 

Conclusion:

It is visible from the above argument that FVA process has some advantages such as- advantage for shareholders, authentic hypothesis and curtailed net earnings. On the other hand, it also experiences some disadvantages such as- random changes, lower accuracy and reduced “book values” of assets and liabilities. However, it has been assessed that this process follows “three-tier” system in order to have severe inclination for “market-based” assessments. Therefore, three levels of inputs has been cited in this study, that involves noticeable and non-noticeable inputs. Lastly, it has been examined that FVA process follows all the necessary qualitative features of financial data so that appropriate and on time data could be given to all the users of income statements of the business corporations. 

References:

Amel-Zadeh, A., Barth, M. E., & Landsman, W. R. (2017). Erratum to: The contribution of bank regulation and fair value accounting to procyclical leverage. Review of Accounting Studies, 22(3), 1455-1457.

Barth, M. E., & Landsman, W. R. (2017). The contribution of bank regulation and fair value accounting to procyclical leverage.

Campbell, J., D’Adduzio, J., & Duchac, J. (2016). The use of fair value accounting in risk management in non-financial firms. Book chapter in.

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.

Corona, C., Nan, L., & Zhang, G. (2018). Banks’ Asset Reporting Frequency and Capital Regulation: An Analysis of Discretionary Use of Fair Value Accounting. The Accounting Review.

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.

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.

McInnis, J. M., Yu, Y., & Yust, C. G. (2018). Does Fair Value Accounting Provide More Useful Financial Statements Than Current GAAP For Banks?. The Accounting Review.

Sami, H. (2015). Discussion of “Value-relevance of Earnings and Book Value Over the Institutional Transition in China: The Suitability of Fair Value Accounting in this Merging Market”. International Journal of Accounting, 2(50), 224-228.

Yoo, C. Y., Choi, T. H., & Pae, J. (2018). Demand for fair value accounting: The case of the asset revaluation boom in Korea during the global financial crisis. Journal of Business Finance & Accounting, 45(1-2), 92-114.