Pros And Cons Of Fair Value Accounting

Exploring the Three-Tier Process Involved in FV Estimation

Concept of the FVA (fair value accounting) is quite old in financial reporting or business decisions.  However, owing to big changes that generally takes place in duration of 20 to 30 years in global economy. It led to financial crisis in the year 2007 and re-emerged as the hottest topic under the agenda of the accounting standards setters for IFRS as well as US GAAP. Research carried out by Marra (2016), maintained balance among cons and pros of FVA and lending ammunition of the same. However, it is closely related with the requirements of information based and globalized economy.

Pros of fair value accounting –

Superiority of the fair value accounting over the transaction based accounting is powerfully linked with the concept of applied predictive ability and changes may take place accordingly.  Various pros or advantages of fair value accounting are as follows –

• Accurate valuation – fair value (FV) accounting method assists in providing the data more accurately in terms of valuations of the liabilities and assets. If the prices are likely to diminish or enhance the valuation will also change accordingly. Current market price allows the businesses or individuals to know where they stand exactly (Marra, 2016).
• Timely information – as fair value accounting uses the specific information as per the time and present market scenario it attempts to deliver most relevant projection possible. Further, it has great value for the firm and encourages the corrective actions promptly (Magnan, Menini & Parbonetti, 2015).
• It provides survival method for difficult economy – as per the historical method, same value is used for an asset each year in the budget. However, the economy can get difficult and the price may get reduced which in turn may become the financial burden. FV accounting permits reduction of asset within the market that gives a chance to the business for fighting.
• It helps in measuring the true income – les opportunity will be there for manipulating the accounting data if FV accounting method is used. Instead of utilising the asset’s sale for affecting the losses or gains price change are tracked simply on the basis of estimated or actual value. Changes in the income takes place with changes in the asset value that is reflected in final net income figure (Demerjian, Donovan & Larson, 2016).

Cons or disadvantages of fair value accounting –

Irrespective of the fact that FV accounting is considered as plus on conceptual aspects, implementation of FV accounting fails and if the relationship among fair value and exit price does not hold good to the stakeholders the process of entire valuation will become unreliable. For instance, while an organization holds the net asset values of which comes from executing the business plan rather from the fluctuation in the market price FV accounting becomes meaningless. Various other cons associated with the FV accounting are as follows –

• Investors are less satisfied – some of the investors do not notice that the entity is using the FV accounting approach for accounting. It generates dissatisfaction among the investors as loss of the value under net income becomes the loss of income for the investors. As many of the investors are involved in trading of the commodities instead of utilising them for the purpose of investment, it may create tough situation for the portfolio that may lead the investors to be away from business altogether (Marra, 2016).
• Manipulation – price manipulation by the organizations also involves the risk with regard to obtain of the the FV estimates as in the liquid markets and trading through the firms may have an impact on quoted as well as traded price.
• Downward valuations – if the business is experiencing reduction in net income owing to losses of assets, it may create the domino effect on overall region or industry. This downward valuation may trigger to unnecessary selling owing to the volatility in market. However, if the fair value accounting is not used it will reduce the event of downward valuations and eventually will lead to more stability in terms of investors (Trajkovska, Temjanovski & Koleva, 2016).

Three – tier process involved in estimation –

Implementation of fair value concept utilises 3 tier hierarchies. Governing principle is the primacy for the basis on market and assumption that the market data and prices will replicate private information of different market participants and hence it is far more reliable as compared to the internal estimates. Therefore, the market prices represent best estimates for the fair value in case where the prices aggregate the information efficiently. The relevant information quality reflected in the market price is analysed based on the active market condition. It is the continuous trading of item on the market that is sufficiently liquid is needed for the market price to be qualified as the estimates of the fair value. However, if the market price does not display sufficient quality or if is it is not available, 2^nd level of estimations considers the market price of the comparable items where the comparability directly means to profile of cash flow naturally. When such prices is usable, mark – to – market method fails and the fair value is mandatory to be anticipated through internal calculations and estimates. Sufficient guidance exists on the valuation model for the financial instruments and the accepted methods can be found in market place. For the non-financial items the estimation of FV rests on the approach of PV. Statements of financial accounting concept, statements of the financial accounting standards along with the modifications, IAS (international accounting standards) develops the methods and principles for the measurements. Main driver of the valuation considered as economic view for the measurement that is grounded in the modern and neo classical theory of finance. Further, it distinguishes the traditional approach from the residual earnings and expected amount of cash flow. In aggregate, the fair value is recognised as particular current value that is the exit value is considered as per idealized conditions. Hence, the estimation is 3-tier process with the strict preference for the market based measure.

Pros or Advantages of Fair Value Accounting

Various qualitative characteristics of the financial information those are considered in the FV methods are as follows –

• Relevance – it is the capability of making the difference with regard to the decisions taken by the users as the capital provider in their capacity. However, the analysts focus more on the earning quality instead of financial reporting quality. As current value of the asset is considered more appropriate against the purchase price, it is considered that the FVA is more appropriate as compared to the historical cost approach. However, along with predictive value the confirmatory value also contributes to relevance of the information included in the financial reporting.
• Faithful representation – it is the 2^ndqualitative characteristics. To represent the economic phenomena faithfully the annual reports shall be neutral, complete and must be free from any material error. It is measures through various items referred as completeness, neutrality, verifiability, freedom from the material error (Henderson et al., 2015).
• Understandability – it is enhanced when the information is segregated, presented and characterized concisely and clearly. It is referred to while the information quality allows the users in comprehending the meaning. It is measured through 5 items that highlights the clearness and transparency of information presented under the annual reports (Birt, Muthusamy & Bir, 2017).
• Comparability – it is the 2^ndenhancing qualitative characteristics. It is the information quality that allows the users to recognise the similarities and differences among 2 sets of the economic phenomena. To be more specific, similar situation shall be presented in the same way and conversely the different situation shall be differently presented. It is measured through 6 items those focus on the consistency. 4 items of which refer to consistency using the same accounting procedures and policies from particular period to period within the company (Mbobo & Ekpo, 2016).
• Timeliness – final enhancing qualitative characteristics is timeliness. It means the information shall be available to the decision makers before its capacity for influencing the decisions lost. The term timeliness refers to time taken for revealing information and is associated in general with the decision usefulness. While examining the information quality given in the annual reports, it is measured through natural logarithm for the number of days between the year end and signature of auditors on the report after the year end is computed (Magnan & Parbonetti, 2018).

Fair value measurement is considered as most applicable to asset element of the financial statements as initial recognition of the asset at the fair values is the only major issue associated with fair value measurement. Initial recognition is associated with the single asset acquisition or acquisition of group of asset owing to the result of merger and acquisition (Carcello et al., 2017). However, the latter case is exceptionally sensitive with regard to the PPA (purchase price allocation), where wide level of managerial discretion is involved. The PPA requires that the acquirer shall identify the individual liabilities and assets associated with the acquisition and accounting them at the purchase price. Additional differences, if any among the fair value and purchase price of asset is accounted as the goodwill. However, even after the initial recognition fair value measurement for the assets on continuous basis requires judgements and potential for usage of opportunistic estimates for beating personal target for management at firm level thresholds (Sellhorn & Stier, 2018).

Reference 

Birt, J. L., Muthusamy, K., & Bir, P. (2017). XBRL and the qualitative characteristics of useful financial information. Accounting Research Journal, 30(01), 107-126.

Carcello, J. V., Neal, T. L., Reid, L. C., & Shipman, J. E. (2017). Auditor Independence and Fair Value Accounting: An Examination of Non-Audit Fees and Goodwill Impairments.

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.

Henderson, S., Peirson, G., Herbohn, K., & Howieson, B. (2015). Issues in financial accounting. Pearson Higher Education AU.

Iasplus.com. (2018). IFRS 13 — Fair Value Measurement. Retrieved 8 November 2018, from https://www.iasplus.com/en/standards/ifrs/ifrs13

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.

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.

Mbobo, M. E., & Ekpo, N. B. (2016). Operationalising the qualitative characteristics of financial reporting. International Journal of Finance and Accounting, 5(4), 184-192.

Sellhorn, T., & Stier, C. (2018). Fair value measurement for long-lived operating assets: Research evidence. European Accounting Review, 1-31.

Trajkovska, O. G., Temjanovski, R., & Koleva, B. (2016). Fair Value Accounting-Pros And Cons. Journal of Economics, 1(2).