Background
The varying demand created by the users of financial report for information with respect to fair view of the performance, financial standings and alterations in the financial position have noticed the requirement for the accounting assessment system, resulting an organizations assessment from several viewpoints (Chen, Shroff and Zhang 2017). The topic relating to accounting assessment continuous to remain a controversial issue because of the mutations taking place in the use of traditional measurement that usually places focus on the transaction cost and market value assessment particularly for financial reporting.
Over the last decade, fair value accounting of determining the assets and liabilities at approximations of their present value is gradually on rise. This results in parting of century old traditional method of booking at historical cost. However, it also accompanies impediments throughout the world of business due to the accounting basis whether fair or historical cost affects the choice of investments and management decisions.
Commentators that lend their support to fair value accounting have put forward number of argument. An argument put forward by Xie (2016) states that fair value accounting of assets and liabilities is considered to be highly relevant than the historical cost method since the fair value method helps in better reflecting the original economic amount of the instrument. It is asserted that associated volatility and fair value simultaneously reveal the original fundamental especially the risk associated with instrument. Supporters have also pointed to numerous risk management and FAS 159 disclosure that necessitates an organization to state the reason behind selecting the use of fair value for a certain tool. Additionally, the disclosure makes it evidently clear that a large number of banks conduct their business on the fair value basis and defines the reason for using the fair value method.
Lachmann, Stefani and Wöhrmann (2015) favoured fair value accounting by stating that fair value method provides assistance to the investors, regulators and management with the necessary information that contributes in making informed decision. By disclosing the worth of assets, investors and regulators can communicate the performance of management. The argument is prolonged to suggest that investors and analyst take account of fair value while making decisions. In fact, analyst are positioned to assess the fair value when the inputs are not readily available visible. Proponents have placed their augment that rational and conversant investors are not only in the position of assessing the asset but also not transact without the fair value. To support the argument towards investors and analyst anticipations Fiechter et al. (2017) have pointed out that numerous extensive disclosure that is enclosed in the financial statements provide the investors with the necessary information to make decisions.
Pros of Fair Value Accounting
Another vital argument by Haswell and Evans (2017) states that fair value method of accounting offers transparency, which does, not existed while using the historical cost accounting. Insufficient transparency may prevent the investors in gaining a true understanding of financial position and in effect enable an organization to hide their losses. Haswell (2015) reiterates that only fair value method offers the transparency of information and honest reporting, it would take the markets to work out the unpredictability in moving forward. Supports of fair value have led their support by arguing that transparency effects the credibility of the fiscal marketplace and helps in contributing towards long run constancy.
Marra (2016) arguably supported fair value method of accounting as the more continuous process of valuation is necessary for an organization in order to enable the management in engaging with the behaviour that increases the market discipline and proactively circumvents unwanted risks. Jana and Schmidt (2017) stated that as with compensation for executives, the present market value of the instrument helps in motivating their behaviour and on not counting the changes, the executives might be prompted to excessive risk taking. An additional argument is particularly for assets having credit risk is that fair value accounting has been accepted as the method of accounting. A provision for making a credit loss does not technically represents fair value accounting, conversely it is the accepted practice of writing down the loans to the recoverable amount or to its fair value.
The probable reason for individuals across financial services to lend support on fair value accounting are numerous and complex. To outline a few, investment banks and assets managers have supported using fair value is because of their daily business to prepare the in-house balance sheets for the purpose of risk administration (Walton 2015). The familiarity with the method might have formed their preferences in fair value financial reporting standards.
Critics on the other hand argue that fair value method of accounting has created a false short run visibility in pension funding and have hastened their demise of defining the benefit scheme. Critics have arguably stated that the international financial crisis illustrates the pro-cyclicality of the fair value method when the accounting was firmly coupled towards prudential control system and unreliably marking the model in less liquid asset markets, particularly for those assets that are held for long-term purpose. An argument by Cannon, and Bedard (2016) stated that fair value accounting likely results in highly restrictive lending practice with more demanding covenants of loan. Furthermore, several critics have opinion that fair value accounting is fictitious and imaginary method of accounting. Walton (2015) lamented that fair value accounting is subjectivity with possibilities for manipulation and bias.
Cons of Fair Value Accounting
Several critics are comfortable with the historical cost or realisation accounting method based because it is accustomed and offer a stable mode for predicting the future accounting than the fair value accounting method. Filip et al. (2017) arguably states that earnings based on fair value cannot be predicted in the similar manner due to the prevalence of uncertain future events. The critics view this as the significant drawback in preparing budgets and forecasting financials to meet the analyst anticipations.
While most of the proponents agree that fair value method of accounting is the relevant mode for measuring the financial assets and liabilities with which an organization actively trades, some critics have argued that historical cost method is more suitable if the management wants to hold the asset or be indebted in a liability until its maturity. The rationale behind critics’ argument against fair value accounting is that historical cost method better helps in reflecting the economic substance of the transaction and the actual amount of cash flow over the time. Sapkauskiene and Orlovskij (2017) in its argument stated that fair value method only reveals the effects of events and transaction in which an organization may not participant and are generally immaterial.
An argument by Marra (2016) criticised fair value accounting by stating that the results from fair value accounting on an organization financial liabilities is counterintuitive given its credits risk deviates. On such circumstances, the fair value of the fiscal accountability would fall when the issued firm credit risk worsens. This is because the interest rate on the initial issue date would be lower than it would have been if the liabilities were issued on the current date. Contrariwise, if an organizations credit rating enhances there would be an increase in the fair value of its financial liability.
Another argument by Jana and Schmidt (2017) against fair value accounting states that fair value accounting results in volatility in earnings on the circumstances that if the variations in the fair values are reported in earnings. Critics believe that this volatility in earnings might not be associated with the management performance and would make more difficult for the users to forecast the future performance.
The “International Financial Reporting Standard” states that a wide range of techniques for valuation can be employed in measuring the fair value of unquoted equity instruments. Judgements are required in applying the techniques for valuation but also requires judgement in selection of valuation techniques (Filip et al. 2017). This comprises of the information that are available to investor. For example, an investor is most likely to place more amount of emphasis on the comparable entity valuation tools where adequate comparable entity peers are or the details relating to observed transactions are known.
Valuation Techniques for Fair Value Accounting
Likewise, investors is most expected to place focus on the discounted cash flow method where for example an investee cash flow represents a unique character such as uneven growth rates (Sapkauskiene and Orlovskij 2017). Alternatively, at the time of measuring the fair value of unquoted equity instruments the investors might decide on the particular evidences and circumstances where it is appropriate to implement the net adjusted net asset method.
Conclusion:
Conclusively the findings reveal that the decisions that are relevant for fair value measurement can be acceptable from the both perspective, nevertheless the conceptual case cannot be considered wrong. The evidence, belligerence and opinion that inspires the standard setters validation of fair value turns out to be tentatively limited in its validity and applicability.
Many critics have tried to make the fair value accounting the culprit during the recent global financial meltdown. The financial illiteracy tied fair value accounting with lack of understanding and knowledge. A concentrated effort is required to re-educate all the practicing accountants, auditors’ financial analyst etc. from old-style bookkeeping model to fair value method of accounting.
Reference List:
Cannon, N.H. and Bedard, J.C., 2016. Auditing challenging fair value measurements: Evidence from the field. The Accounting Review, 92(4), pp.81-114.
Chen, W., Shroff, P.K. and Zhang, I., 2017. Fair value accounting: Consequences of booking market-driven goodwill impairment.
Fiechter, P., Landsman, W.R., Peasnell, K. and Renders, A., 2017. The IFRS option to reclassify financial assets out of fair value in 2008: the roles played by regulatory capital and too-important-to-fail status. Review of Accounting Studies, 22(4), pp.1698-1731.
Filip, A., Hammami, A., Huang, Z., Jeny, A., Magnan, M. and Moldovan, R., 2017. Literature Review on the Effect of Implementation of IFRS 13 Fair Value Measurement.
Haswell, S. and Evans, E., 2017. Enron, fair value accounting, and financial crises: A concise history. Accounting, Auditing & Accountability Journal, (just-accepted), pp.00-00.
Haswell, S., 2015. Fair value accounting and financial crises: an actor-network study.
Jana, S. and Schmidt, M., 2017. Model-based fair values for financial instruments: relevance or reliability? Conjoint measurement-based evidence.
Lachmann, M., Stefani, U. and Wöhrmann, A., 2015. Fair value accounting for liabilities: Presentation format of credit risk changes and individual information processing. Accounting, organizations and society, 41, pp.21-38.
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), pp.582-591.
Sapkauskiene, A. and Orlovskij, S., 2017. The usefulness of fair value estimates for financial decision making–a literature review. Zeszyty Teoretyczne Rachunkowo?ci, (93 (149)), pp.163-173.
Walton, P., 2015. IFRS in Europe–an observer’s perspective of the next 10 years. Accounting in Europe, 12(2), pp.135-151.
Xie, B., 2016. Does fair value accounting exacerbate the procyclicality of bank lending?. Journal of Accounting Research, 54(1), pp.235-274.
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