ACCT6007-Discussion On Fair Value Accounting Essay

Questions:

1.Explain and explore Pros and Cons of Fair Value (FV) accounting after conducting literature review on the topic.
2.What does the author mean by the statement? ‘the estimation follows a three-tier process, with a strict preference for market-based measures’ p586. Explain the three – tier process in detail.
3.What qualitative characteristic/s of financial information is considered in using FV method in financial reporting? FV measurement is most applicable to what element of financial statements (i.e. Asset, Liability, Owners Equity, Revenue and Expense), and to what aspect of that element?

Answer:

In the given assignment, the fair value accounting has been discussed extensively, the pros and cons of the same has been discussed with relevant literature on the same and the three tier process mentioned in the statement “the estimation follows a three-tier process, with a strict preference for market-based measures” has also been analysed. Fair valuation is one of the integral parts of financial reporting and hence the qualitative characteristic of the same has also been highlighted (Alexander, 2016). Finally, the elements of the financial statements to which the fair valuation can be applied has also been discussed.

Fair valuation is one of the valuation techniques or the sale price which is being agreed in between buyer and the seller assuming that both the parties to the transaction are having the knowledge of the transaction (Chaudron, 2018). It is basically the unbiased estimate of the market value of the asset, goods and services. It takes into account many factors like that of acquisition and distribution cost, replacement cost, supply and demand conditions prevailing in the market and utility of the product at a given point of time. Off late, it has gained a substantial importance in the field of valuation and is being used extensively for reporting purposes. There are various pros and cons of using this technique of valuing things. Some of the pros of the same has been mentioned below:

  1. It provides accurate valuation of the assets and the liabilities as it takes into account all the market factors and thus helps businesses and individuals to know where they stand(Werner, 2017).
  2. It provides the measurement of true income of an entity as it considers all the relevant market factors and the inflation factor and trued up assets or liability is being reflected.
  3. It has been the most widely used and accepted valuation in accounting standards as well as the historical cost method is not useful and valid if the asset life has been long(Oberoi, 2018).
  4. It forms one of the survival strategy in the changing and dynamic economy. Where economy is is difficult and there are a number of fluctuations, fair value gives allows for asset reduction and gives the businesses the fighting edge.

Some of the cons of the fair value accounting has been shown below:

  1. It is usually ineffective and non worthy when there are large fluctuations in the value during several times of the year. There are some businesses in which the assets values undergo a large fluctuations and such volatility is actually not good to record in the books from long term perspective as there is huge fluctuations in the short term and thus gives misleading picture.
  2. In case one of the businesses is seeing the downward revaluations due to the decrease in the value of the assets, it tends to create the domino effect in the industry. It tends to creates downward valuations and is even contagious. Thus, many industries and companies try to avoid this method of accounting as it triggers inventor instability(Dichev, 2017).
  3. When the companies are using the fair value approach of accounting and reporting, the investors who do not notice the same may end up on the losing side and the downward revaluations in the asset values may lead to investor dissatisfaction who use it as commodities instead of investments(Vieira, O’Dwyer, & Schneider, 2017).
  4. The historical track of the asset or the liability of the company is being lost when the fair valuation is being used. During some of the years there may be a situation when the company has performed well but due to lowering down of assets, the net profit may also seem to be less thus artificially lowering the success of the businesses(Linden & Freeman, 2017).

However, no matter what if the investors are being informed on the use of fair value accounting, its benefits always outweighs the risk associated with it.


The statement by the author “the estimation follows a three-tier process, with a strict preference for market-based measures” is completely true as there are 3 various levels of input that is required for the fair valuation and the inputs are being categorised in the different levels of hierarchy. Level 1 data includes quoted prices for the similar assets which are comparable in the active market that is accessible to the respective entity as on the measurement date. It is one of the most reliable evidence of the fair value available in the market and is used directly, if available without any major adjustments (Goldmann, 2016). Level 2 are the inputs other than the quoted market value that are available for the asset or the liability, either directly or indirectly. Some of the level 2 inputs include the value of the similar assets in the active market or quoted price of the identical assets in the market that is not so active. It also includes inputs other than the quoted prices like that of interest rates, implied volatilities and the credit spreads. Finally, the level 3 inputs includes the unobservable inputs for the assets and the liabilities. Unobservable inputs are being used to measure the fair value to the extent the observable inputs are not being available. This is like using of the information which is most relatable as far as possible considering the circumstances of the case (Kewell & Linsley, 2017).

Fair value accounting and reporting method helps in meeting many of the qualitative characteristics of the financial statements some of which are correctness and completeness in recording the value of the transaction as it considers the most viable and acceptable value prevailing in the market at that point of time. Furthermore, it renders the financial data relevant and faithful and makes it available and reliable for decision making purposes (Heminway, 2017). As per IASB, emphasis has been placed on the conceptual framework of accounting as per which useful financial statements must satisfy 2 basis qualitative characteristics like those of relevance and representational faithfulness. Both these aspects are being met by the fair valuation accounting and thus makes decision making easy. Off late many companies have adopted the fair valuation accounting and reporting approach and thus the comparability aspect of the financials is also being met and the users comes to know how far the asset values have fluctuated in the market (Jefferson, 2017).

There are various elements to which the fair valuation measurement technique can be applied like that of assets and the liabilities. Some of them are assets like that of buildings and other fixed assets. It is generally being applied on the investments where the value keeps on changing every now and the derivative financial instruments and other financial instruments. It is also being applied in valuation of the creditors and the debtors as well in few of the cases. The most common avenues where the fair valuation technique is being used is retirement benefits, the leasing transactions, the share based payments and the financial assets (Choy, 2018).

Thus, we can say that fair valuation technique has become one of the most widely used and accepted means of valuation and reporting off late as it gives the best measure in the ever dynamic world.

References

Alexander, F. (2016). The Changing Face of Accountability. The Journal of Higher Education, 71(4), 411-431.

Chaudron, R. (2018). Bank's interest rate risk and profitability in a prolonged environment of low interest rates. Journal of Banking and Finance, 89, 94-104.

Choy, Y. K. (2018). Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis. Ecological Economics, 145. doi:

Dichev, I. (2017). On the conceptual foundations of financial reporting. Accounting and Business Research, 47(6), 617-632. Retrieved from

Goldmann, K. (2016). Financial Liquidity and Profitability Management in Practice of Polish Business. Financial Environment and Business Development, 4, 103-112. Retrieved from

Heminway, J. (2017). Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and Organic Documents. SSRN, 1-35.

Jefferson, M. (2017). Energy, Complexity and Wealth Maximization, R. Ayres. Springer, Switzerland . Technological Forecasting and Social Change, 353-354.

Kewell, B., & Linsley, P. (2017). Risk tools and risk technologies. The Routledge Companion to Accounting and Risk, 15.

Linden, B., & Freeman, R. (2017). Profit and Other Values: Thick Evaluation in Decision Making. Business Ethics Quarterly, 27(3), 353-379. doi:

Oberoi, J. (2018). Interest rate risk management and the mix of fixed and floating rate debt. Journal of Banking and Finance, 86, 70-86.

Vieira, R., O’Dwyer, B., & Schneider, R. (2017). Aligning Strategy and Performance Management Systems. SAGE Journals, 30(1).

Werner, M. (2017). Financial process mining - Accounting data structure dependent control flow inference. International Journal of Accounting Information Systems, 25, 57-80.

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