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Use of Fair Value for Valuing Assets and Liabilities in Financial Statements

Accounting standards have been changing tremendously over the years. One of the areas that have been greatly changed in the recent past relates to the accounting reporting standards. In this regard, the use of fair value accounting has been on the rise as businesses need a more realistic reporting formula (Barlev & Haddad, 2003). This marks a major departure from the traditional accounting practices such as the historical costs. Therefore, the use of fair value has led to several implications across the businesses since the accounting decisions affect the investment choices and business management decisions. In the recent past, IASB has strongly recommended the use of fair value accounting. Therefore, this paper discusses the use of fair value for valuing assets and liabilities in financial statements.

The two bodies propelling the use of fair value accounting are the GAAP and the IFRS. These bodies have made the use of fair value accounting is currently being adopted by almost 100 countries. Therefore, these countries apply similar accounting strategies concerning the use of derivatives and hedges, financial assets, employee stock options, and the goodwill impairment testing (Ronen, 2008).   The explanation concerning the use of fair value is largely tied to the financial theory that financial markets are efficient and that their prevailing market prices are reliable measures of value.

Fair Value accounting is a kind of financial reporting whereby organizations are required by law to measure their assets and liabilities to determine their present value. The proponents of fair value accounting are of the view that it enhances the relevance of the accounting information (Bromwich, 2007; Bradbury, 2008). The measure will appear as a loss if the value of the liabilities is more or in case of deteriorating value of the assets. The incurred losses generally have a negative impact on the performance of an organization and this will influence the net gains of the company negatively (Penman, 2007). The actual goal of the measure is for organizations to find the most accurate estimate of the value of their business at current prices in case the business changes ownership.

There are various measures put in place to regulate the measurement and include the discount rate adjustment measures and information on the flow of cash which with regard to the current and future flow. It is however clear that the market prices prevailing is a good information source about the investment and will thus greatly influence the current and future rate of cash flow. Valuation therefore is either done using the market prices and often referred to as “mark-to-market” values and in case there no such price valuation is estimated using valuation models (Laux, 2012). The models are guided by market conditions like the change in the interest rates, and yield curves and in most instances, organizations give their financial reports to be used in such case based on their expected cash flows. Such estimation is referred to as mark-to-model as the main objective tool for measurement of the valuation was a model (Cairns, 2006). Measures of fair value of firms are reported in either organization’s balance sheet or their income statement which are periodical. Therefore, such measures indicate a firm’s gains or losses which are yet to be realized. The fair valuation is therefore based on the owner’s equity in the business and rather not the net income received in the business.

In case of trading in liquid markets, the measure of fair value is the best to be used as it will give the most accurate estimates. According to Bromwhich (2007), there are various models used for estimation and each model behave differently in terms of input data therefore can give a different estimation. Choosing the best model to use is challenging as it requires historical data of an organization which can be used as a reflection of the future change in cash flows based on past information on the same. It is therefore important for firms to determine the best model for their organization that will capture all relevant data about their organization in the best possible way possible (Benston, 2007). In case of market valuation, the aspect requires measures of market liquidity or any dissimilarity thus the accuracy of the information depends on the use of fair prices to get more accurate estimates.

The opportunity cost of using the fair value is the amortized cost accounting, which faces a lot of challenges unlike its alternative method (Veron, 2008). The method basically relies on historical data of the organization to speculate about the future flows of cash and expected change in the discounting rates to determine the position of a firm. The amortized cost apparently ignores the unrealized gains and losses over time and only accounts for the same during disposal in case an organization does no longer need a certain asset. However, companies therefore lose records of unrealized gains or gains that were realized during the period when the asset was still in position before disposal. The challenges experienced with the use of the method are directly linked to the use of the historical data as a source of information for valuation (Hague, 2007). The first issue is that income for firms is persistent as long as positions are held, but once they are mature, it will change to transitory as the market terms are expected to change and the owner of the business entity.

Incorporation of the aspects of disclosures in the fair value and the current financial accounting methods helps institutions from avoiding the issues experienced with the use of the amortized cost (Hague, 2007). It therefore comes in hand as investors use the disclosed information to check for inconsistency and determine the amortized interest rates during the different periods reported in the financial report.

Fair value is often understood as the current, ideal value of an asset or liability based on existing market prices in case a firm wishes to exit from a business (Benston, 2007). The valuation is tagged to the measurement date which refers to the conditions prevailing during the dates indicated on the balance sheet. Firm’s perception or opinions from financial experts are not recommended in the determination of the liquidity of a firm but rather the ideal conditions existing in the market. Valuation should be based on the terms of orderly transactions which are transactions done willingly by the market participants without any incapacitation. This calls for the institutions conduct business as usual by looking for willing buyers to buy the assets and assumers of liabilities who are supposed to behave normally according to the prevailing market conditions. The aspects are the requirement of the FAS 157’s fair value and are incorporated in place to avoid issues arising during the preparation of the financial reports (Cairns, 2006).

 Assumptions involved in the process are that the market participants have a lot of information about the market conditions and are therefore not expected to behave justly. Another assumption is that they are willing and able to do the transaction. This may lead to two occurrences where the first one is in a case where the assumption occurs as expected and gives the ideal situation of fair value as was expected.

Fair value measures have different levels of input levels, which are dependent on some specifications as required by FAS 157. The first level accounts for the unadjusted market prices in the markets and include all similar products/items. The second level inputs, however, accounts for the directly/indirectly items that may provide the market data. In this class the active and inactive markets are both considered and often similar items are used. It therefore results to adjusted measures which are slightly less than the real market values and reliable information. The other class of inputs that fall in this class is the observable data, and in this case, the use of a model is required. The third level accommodates for inputs which are un-observable and often is a reflection of what the participants in the market will use (Benston, 2008).

However, in this study, there are lots criticisms towards the use of fair value as an accounting approach for valuation. The paper discusses the three major critiques developed and how the critiques can be overcome. The first issue criticized with the use of fair value is the unrealized gains and losses issue (Veron, 2008). According to critics, the losses and gain yet to be realized have a chance of reversing with more than 50% probability. In case of bubble prices, the value indicated as the market prices are expected to deviate from the significant expected values. The second phase, however, accounts for cases where the market prices fail to meet the expected future cash flows which may result if the flow is skewed. The bubble prices are influenced by the market conditions prevailing, which Benston, (2007), says may be a high level of optimism and liquidity thus leading to inflation. However, depression will also be experienced if the market condition signifies a high level of pessimism and illiquidity as far as essential values are considered. Market illiquidity refers to severe market conditions which are experienced during crisis periods and makes it difficult to prepare financial reports.

According to Bradson (2008) fair value accounting gives companies an opportunity to use, accurate reports with comprehensive financial information. The reports are prepared in time and have consistent results which can be used for comparisons irrespective of the market conditions. It is possible for companies to use updated records with the approach and limit the firm’s control over the net income. The measures of realized gains and losses are important to the management or the investors to determine the economic activities worth investing using the disclosed information.

One of the companies that used fair value accounting was Enron. When the company permitted to use fair values for their energy contracts, it extended revaluations, resulting into overstatement of revenue and net income. This gave the employees the strong incentives to develop and over value their projects leading to high operation expenses. With less successful projects, the losses incurred initiated additional accounting subterfuges that led to the collapse of the company. However, it is evident that the company’s internal control failed to monitor the mis-statements and the auditors failed to fair value estimates presented before them. Therefore, the fair value accounting cannot be blamed for the failure of the company, but the auditors and their internal control mechanisms. The other case study relates to the housing crisis. During the 2007 housing crisis, the fair value was used in the valuation of security backed by submarine mortgages. However, it was suggested that the use of fair value accounting was not responsible for the crisis, since a number of companies that used fair value reporting were not devastated by the crisis.

The above scenario leads to the shortcomings of fair value accounting. First, fair value accounting may be limited in that the fair values may not be based on the actual market prices. Whenever the fair values are not restricted, the fair values are often based on the actual market prices that are often costly to determine and verify. The other challenge associated with fair value accounting is that the fair values for inventories and fixed assets included in the business combinations presents problems that are not recognized. Finally, the fair values can easily be manipulated by the accountants and the managers and this can be very difficult to verify.

The above mentioned challenges have therefore called for mitigation measures to be put in place to control the accuracy of the estimation obtained from the valuation. The first control measure is the FAS 157 and other accounting standards which are used specifically in observation of specific positions. As a security measure, firms should safeguard information about the input measures used in the valuation of their assets and liabilities both the qualitative and qualitative information on the same. Such acts is important for investors use as they will make decisions whether the information withheld is reliable to be used or should not be used. The second adjustment of the valuation process is that the fair value, estimation is done quarterly. In case of errors in past estimation, the errors can therefore be corrected in the preceding estimation in the next quarters. As a tool of valuation, the fair value accounting is therefore considered as the best tool. It advocates for disclosures in the valuation process and helps investors to find loopholes in the management of the organizations and thus make the management liable for such issues. The measures, therefore, credits for the explanations given by the management during the release of the financial reports as it is possible to have identified issues causing alter ration in meeting targets. Investors can therefore measure the productivity of their management during the release of such reports, especially using the disclosed information.

In conclusion, there is a strong support towards the use of fair value. Despite the drawbacks realized in the Enron case study, fair value is still  reliability accounting method. Most researchers and financial analysts believe that the use of fair value for valuation is essential to any investor as compared to the other approaches. The paper therefore gives a wide range of benefits experienced from the use of the above approach. The use of fair value as an accounting measure is helpful as it correct mistakes done in the past in the future preparation of the financial reports. The amortized approach does not have the attribute to self-correct itself, thus it is incapacitated. The use of fair value gives consistent results which make comparisons of different positions possible, unlike the amortized approach that gives inconsistent figures.

 

Bibliography

Benston, G.J. (2008). ‘The shortcomings of fair-value accounting described in SFAS 157’, Journal of Accounting and Public Policy, 27(2): 101–14. 

Hague, I.P.N. (2007), ‘The case for fair value’ in P. Walton (ed) The Routledge Companion to Fair Value and Financial Reporting, London: Routledge, pp. 32-45.

Veron, N. (2008). Fair value accounting is the wrong scapegoat for this crisis. Accounting in Europe, 5(2): 63–9. 

Barlev, B. and Haddad, J.R. (2003), ‘Fair Value Accounting and the Management of the Firm’, Critical Perspectives on Accounting, 14(4): 383-415.

Benston, G.J. (2007), ‘Fair Value Accounting: A cautionary tale from Enron’, in P. Walton (ed) The Routledge Companion to Fair Value and Financial Reporting, London: Routledge, pp. 233-46. 

Bradbury, M (2008), ‘Discussion of Whittington’, Abacus, 44(2): 169-80.  (Note: this is a discussion of the Whittington paper listed below).

Bromwich, M. (2007), ‘Fair values: imaginary prices and mystical markets – a clarificatory review’ in P. Walton (ed) The Routledge Companion to Fair Value and Financial Reporting, London: Routledge, pp. 46-67. 

Cairns, D. (2006), ‘The Use of Fair Value in IFRS’, Accounting in Europe, 3: 5-22. 

Georgiou, O. and Jack, L. (2011). In pursuit of legitimacy: A history behind fair value accounting, British Accounting Review, 43(4): 311–323. 

Laux, V. (2012). Financial instruments, financial reporting, and financial stability, Accounting and Business Research, 42(3): 239-260. 

Penman, SH (2007), ‘Financial reporting quality: Is fair value a plus or a minus?’, Accounting and Business Research, Special Issue: International Accounting Policy Forum, pp. 33-44. 

Ronen, J (2008), ‘To Fair Value or not to Fair Value: A broader perspective’, Abacus, 44(2) 181-208. 

 

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