Fair Value Accounting: Advantages, Disadvantages, And Implementation
What is Fair Value Accounting?
Fair value accounting makes the use of present market values as the basis for identifying certain assets and liabilities. Fair value represents the estimated price based on which the assets are sold or the liabilities are settled in a transaction to the third party under the present market conditions (Livne & Markarian, 2018). The latest financial crisis has shifted its focus on the fair value accounting and resulted in major political debate.
As per the critic’s, fair value accounting has backed considerably to the financial crisis and has aggravated severalty the financial organisations globally. Advances in the finance and accounting research have gained both the supporters and critics of using the fair value measurement in accounting. Perhaps, the fair value standards define how the fair value must be ascertained for the financial purposes.
Similar to any accounting method, there are numerous advantages and disadvantages which should be taken into the account prior to implementing the fair value accounting.
Timely Information: As fair value accounting makes the use of specific information for the present market conditions, it makes an attempt to offer the most relevant estimation (Amel-Zadeh et al., 2017). Fair value accounting has higher informative value for a business and encourages quick corrective actions.
Accurate valuation: Fair value accounting assist in providing correct information while determining the correct values of assets and liabilities. If the prices are anticipated to fall or increase, then the fair value can help in providing correct information. (McInnis et al., 2018).
Information on Financial Statement than Historical Cost: Fair value method of accounting helps in improving the information power of financial statement in contrast to other method of accounting (Xie, 2016). The fair value method of accounting mandates a firm to disclose the necessary information regarding the method used, assumption made, associated sensitiveness and issues which leads to thorough financial statement.
Measurement of True Income: Under the fair value method there is less chance of manipulating the accounting information. Rather than using the sale of assets to impact the gains and losses, the change in price is merely tracked based on the real or projected value.
Providing a process of existence in difficult economy: Under the historical method, the similar value of the asset goes in the line of budget each year. When difficulty prevails in an economy and values are reduced, then it can be fiscal burden (Demerjian et al., 2016). The fair value accounting enables reduction of assets in the difficult market which allows the business to keep a fighting chance.
Advantages of Fair Value Accounting
Can result in large fluctuations of value: There are certain business that has not gained any benefit from the fair value accounting method. These business usually own assets that varies largely in value frequently all through the year (Macve, 2015). Assets that are volatile can reflect changes in income which is not accurate for long term financial picture, resulting in deceptive losses or gains during the short run picture.
Misery for company: If a business is witnessing reduction in the net income due to loss of assets then this trend typically results in domino effect all through the industry or region. Downward valuation is considered as transmissible and result in unnecessary volatility in the market (Cannon & Bedard, 2016). When the fair value method of accounting is not used then there is no occurrence of downward valuation with better investor stability which can maintain the overall industry balance.
Reduction in investor satisfaction: There are some investors that does not usually sees that a business uses fair value method in accounting. This results in dissatisfaction among the investors due to the loss of value in the net earnings which simultaneously results in loss of income for the shareholders as well. As several shareholders are involved in trading commodities, rather than using them for investment it can hit their portfolio significantly and causing the investors to stay away from the business.
The application of the three tier concept makes the use of three-tier hierarchy. The governing principle is regarded as the supremacy of market based measure and maintains supposition that market values and statistics provides private data of numerous market participants which is highly reliable than the internal estimations. The quality of information that is portrayed in the market prices is evaluated based on the effective market principle that are regularly traded on the sufficient liquid market in order to qualify the market price for determining the fair value (Ettredge et al., 2014). If the market price does not provide adequate level of satisfactory quality, the second level of estimation takes into the account the market price of similar items where the comparability naturally reveals the profile of cash flow. There is sufficient amount of guidance available on the valuation model for financial tools and recognised approaches are found in the market place.
Overall, fair value can be recognized as the exact current value which represents the exit price under the perfect circumstances. The valuation follows the three-tier procedure with severe inclination for the measures based on market. The fair value method infers a dynamic valuation of the financial as well as non-financial assets. The initial identification of the assets is associated to the acquirement of lone assets or to the acquirement of set of assets due to the company’s merger and acquisition (Durocher & Gendron, 2014). The Purchase Price Allocation necessitates the acquirer to recognize the specific assets and liabilities associated to acquisition and record them in the purchase price. Any kind of added difference amid the purchase price and asset fair value that is acquired is treated as the goodwill.
Disadvantages of Fair Value Accounting
Following the original recognition, the measurement at fair value of assets and liabilities on the continuous basis requires judgement. The probable use of opportunistic estimation is to beat the personal administrative targets or company level threshold. IAS 36, developed the principles and procedures for measurements of fair value. Particularly, they undertake the economic view that are clearly grounded on contemporary neo-classical theory of finance and distinguishing the traditional from the anticipated cash flow and outstanding earning methods (Magnan & Parbonetti, 2018). To review, the fair value constitutes the specific present value, which represent the exit value under the idealized state of affairs. Therefore, it can be rightly said that approximation follows the three-tier procedure with the firm inclination for the market based measures.
The qualitative characteristics of Financial Information is given below;
- Relevance:Information turn out to be significant when it is offered to the users before the stability is lost to influence the process of decision making. Numerous past literatures have stressed on the vitality of information associated to financial reporting concerning the role involved in creating differences among the users of decision (Chen et al., 2017). Relevancy helps in improving the capability and innovations in the decision making.
- Faithful representation:Faithful representation is considered as the second qualitative characteristics which implies that all the information in the financial report should be presented faithfully (Cannon & Bedard, 2016). The main reason for faithful representation is that it is associated to the facts where all the phenomenon and transactions are changeable with time so that the annual report documents every events and transactions carefully and faithfully.
- Understandability:Understandability refers to procedure of characterizing, classifying, categorization and presentation of financial information that are clear and concise. Understandability enables the users in making sure that financial information is clear and transparent.
- Comparability:Comparability is the fourth qualitative characteristics of financial information. Comparability refers to the ability where the information is used in explaining and recognizing the similarities and differences among two common transactions of economic phenomena.
- Timeliness:Timeliness is associated to the decision that are useful for financial reports. It takes into the time that is taken to provide the information in the annual reports. Timeliness measures the terms of number of days taken by the auditor to sign the accounting books at the end of the year.
The measurement of fair value is applicable to the realisable worth of the assets and liabilities (Livne & Markarian, 2018). Under the fair value measurement, the assets are carried based on the sum of cash that can be presently acquired by selling the asset based on the systematic disposal. While the liabilities are carried based on their settlement values particularly the undiscounted amount of cash that is anticipated to be paid or content the liabilities during the normal business course.
As per the advantages and disadvantages of fair value in accounting it is understandable that the conception is far from being treated as picture-perfect. It is hard to ascertain whether the contribution to development of bookkeeping is helpful. Even though fair value conversation appears to be far from being over the present crisis offered an interesting setting to additionally discover the issue and comprehend them better to fix the limitation.
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.
Cannon, N. H., & Bedard, J. C. (2016). Auditing challenging fair value measurements: Evidence from the field. The Accounting Review, 92(4), 81-114.
Chen, W., Shroff, P. K., & Zhang, I. (2017). Fair value accounting: Consequences of booking market-driven goodwill impairment.
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.
Durocher, S., & Gendron, Y. (2014). Epistemic commitment and cognitive disunity toward fair-value accounting. Accounting and Business Research, 44(6), 630-655.
Ettredge, M. L., Xu, Y., & Yi, H. S. (2014). Fair value measurements and audit fees: Evidence from the banking industry. Auditing: A Journal of Practice & Theory, 33(3), 33-58.
Livne, G., & Markarian, G. (Eds.). (2018). The Routledge Companion to Fair Value in Accounting. Routledge.
Macve, R. H. (2015). Fair value vs conservatism? Aspects of the history of accounting, auditing, business and finance from ancient Mesopotamia to modern China. The British Accounting Review, 47(2), 124-141.
Magnan, M., & Parbonetti, A. (2018). Fair value accounting: a standard-setting perspective. In The Routledge Companion to Fair Value in Accounting (pp. 59-73). 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.
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.
Xie, B. (2016). Does fair value accounting exacerbate the procyclicality of bank lending?. Journal of Accounting Research, 54(1), 235-274.