Pros and Cons of Fair Value Accounting
The concept of Fair Value Accounting is not new as the companies all over the world have been using this method for the purpose of making effective business decisions. The managements of the companies can obtain the present market values of their assets under the fair value accounting that is also known as mark-to-market accounting. However, in the recent years, there have been some major arguments on the fact that this fair value accounting had significant contribution towards the world financial crisis. The main point of argument is that the fair value accounting leads to fulfill the needs for information for decision-making while increasing the complexity in the aspects of globalization and innovation-based economic system. The main aim of this report is the analysis of different aspects of fair value accounting.
It is needed for the managements of the business organizations to consider both the pross and cons of fair value accounting before adopting it for the business operations. The advantages and disadvantages are discussed below:
Timely Information: Fair value accounting helps the companies in providing most relevant information and estimates as it involves in the utilization of specific information for the time and preset market condition. This aspect makes the firms able in taking prompt corrective actions (Trajkovska, Temjanovski & Koleva, 2016).
Accurate Valuation: Fair value accounting assists the companies in providing more accurateness at the time of the assets and liabilities valuation. The valuation will be auto adjusted when there is an increase or decrease in the price. In this manner the companies become able in assessing their current financial standing (Sundgren, 2013).
More Information in the Financial Statements: Fair value accounting method helps in enhancing the power of information of the financial statements as compared to the historical cost method. Under the fair value accounting, the companies are needed to disclose information related to used methodology, assumptions and risk exposures.
Accurate Measurement of True Income: Under the process of fair value accounting, decrease in the opportunity to manipulate the accounting data can be seen. This process involves in tracking the changes in price based on the actual or estimated value. Due to this, the final net income reflects the changes to the income as a result of changes in the value of assets (Sundgren, 2013).
Most Popular Accounting Standard: Fair value accounting helps the companies in tracking the values of all types of assets starting from equipment to land and building while inaccuracy can be observed in historical cost accounting in tracking the actual cost of the assets after a long time. This aspect makes fair value accounting most popular among the companies (Trajkovska, Temjanovski & Koleva, 2016).
Three-Tier Process
Accurate Method to Survive in Economic Crisis: Under the historical cost accounting, the same value of the assets goes to the budget every year and it makes it difficult for the companies to survive in economic crisis. However, fair value accounting changes the value of assets that provides the companies with the opportunity to fight in the economic crisis (Christensen & Nikolaev, 2013).
Large Change in Values in the Same Year: Under the fair value accounting, some of the volatile assets of the companies can register large change in their values that can lead to the change in the income of the companies. This is not good for businesses (Chen, TAN & Wang, 2013).
Misery for the Companies: In case there is reduction in the values of the assets, the same trend can be seen in the other companies in the same industry. It creates a negative effect of downward valuation on the companies.
Reduction in Investors’ Satisfaction: Some investors do not notice the use of fair value accounting by the companies. For this reason, the decrease in the net income of the companies becomes a loss of income to the investors that lead to their dissatisfaction (Cannon & Bedard, 2016).
Misleading Information: Under the fair value accounting, there is a fair scope that the observed value of the asset indicates the fundamental value of the assets. This particular aspect creates deviation in the value of the assets that lead to confusing information.
Manipulation: In some specific situations, the management of the companies can get the chance to manipulate the fair value accounting process for their own benefits and it leads to the difference in trade and quoted price in the assets (Lachmann, Stefani & Wöhrmann, 2015).
Hence, it can be seen from the above discussion that fair value accounting has the above pros and cons that the companies need to consider.
In the article named “The Pros and Cons of Fair Value Accounting in a Globalized Economy: A Never Ending Debate”, the author, Antonio Marra, has mentioned the fact that the estimation in fair value measurement follows a three-tier process in the presence of a strict preference of the market-based measurement (Marra, 2016). In this context, it needs to be mentioned that the three tier process is a detailed process of fair value accounting. Fair value can be considered as a particular current value and it can be considered as the exit value under certain conditions. The governing principle of fair value accounting is majorly related to the market-based measurement and the assumption that the private information is reflected from the market price and data of the market participants. For this reason, fair value accounting can be considered as more reliable than other internal estimates. In case these market prices can fetch information effectively, they can represent the best estimate of the fair value (Marra, 2016).
Qualitative Characteristics
In this process, the assessment of the quality of information is done based on the criterion of active market and as per this criterion, there is a need for regular trading of the item in the sufficient liquid market in order to qualify as a fair value estimate (Marra, 2016). In case, the market prices are not available, there is a need to consider the second level of estimation where the market prices of the comparable items refer to the profile of cash flow. When there is not any scope to use these prices, fair of the fair value accounting can seen that requires the mandatory estimation of fair value with the use of internal estimations and calculations (Marra, 2016). In case of the non-financial assets, the dependency of fair value estimations can be seen on the present value approach. It needs to be mentioned that the main driver of the fair value accounting is an economic measurement view related to the modern neo-classical theory. At the same time, this aspect distinguishes the traditional valuation approaches from residual earnings and expected cash flows (Marra, 2016).
It needs to be mentioned that the companies are needed to consider some specific qualitative characteristics of financial information at the time to use fair value accounting. Relevance is one of those characteristic. Information is considered as relevant when it is provided to the users before it loses the stability to influence the decision-making process of the users (Nobes & Stadler, 2015). After that, faithful representation is the second qualitative characteristics that need to be considered in fair value accounting and it implies that all the information needs to be faithfully presented in order to make them complete, accurate, neutral and free from errors or bias. Understandability is the next qualitative characteristic that needs to be considered in fair value accounting as it helps in classifying, characterizing and categorizing the information before presenting them (Choudhary, Merkley & Schipper, 2017). The last qualitative characteristic is timelines and it means that the financial information must be available to the users at the time of decision-making process and before it loses its stability. The connection of all these qualitative characteristics can be seen with the process of fair value accounting. Under fair value accounting, the prices of the assets and liabilities must be relevant and faithfully represented in order to provide the present fair value of them. In addition, they need to be presented to the companies in the timely manner (Hasan, Abdullah & Hossain, 2014).
At the same time, it needs to be mentioned that the fair value measurement is most applicable for the assets and liabilities and the main reason for this is the specific characteristics of assets and liabilities (Schwarzbichler, Steiner & Turnheim, 2018). The fair value accounting assumes that the transaction of the assets and liabilities is done in an orderly basis between the market participants with the aim to sell or transfer the assets. At the same time, the fair values of the assets and liabilities are transferable to the next years (AASB, 2013).
Conclusion
It can be seen from the above discussion that it is important for the firms to take into consideration the advantages as well as disadvantages of fair value accounting at the time of its adoption. After that, as per the above discussion, the fair value accounting process follows a three-tier process at the time of the valuation of the assets and liabilities of the business. The main qualitative characteristics that need to be followed in fair value accounting are relevance, faithful representation, timeliness and others. According to the above discussion, the process of fair value accounting is mostly relevant to the assets and liabilities of the companies.
References
AASB, C. A. S. (2013). Fair Value Measurement. May2009.
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., TAN, H. T., & Wang, E. Y. (2013). Fair value accounting and managers’ hedging decisions. Journal of Accounting Research, 51(1), 67-103.
Choudhary, P., Merkley, K. J., & Schipper, K. (2017). Qualitative characteristics of financial reporting errors deemed immaterial by managers.
Christensen, H. B., & Nikolaev, V. V. (2013). Does fair value accounting for non-financial assets pass the market test?. Review of Accounting Studies, 18(3), 734-775.
Hasan, M., Abdullah, S. N., & Hossain, S. Z. H. (2014). Qualitative characteristics of financial reporting. The Pakistan Accountant, 50(1), 23-31.
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.
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.
Nobes, C. W., & Stadler, C. (2015). The qualitative characteristics of financial information, and managers’ accounting decisions: evidence from IFRS policy changes. Accounting and Business Research, 45(5), 572-601.
Schwarzbichler, M., Steiner, C., & Turnheim, D. (2018). Fair Value Measurement. In Financial Steering (pp. 431-440). Springer, Cham.
Sundgren, S. (2013). Is fair value accounting really fair? A discussion of pros and cons with fair value measurement. The Finnish Journal of Business Economics, 62(3-4), 242-250.
Trajkovska, O. G., Temjanovski, R., & Koleva, B. (2016). FAIR VALUE ACCOUNTING-PROS AND CONS. Journal of Economics, 1(2).
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