Fair Value Accounting

Topics: Financial markets, Balance sheet, Generally Accepted Accounting Principles Pages: 5 (1658 words) Published: January 7, 2013
Topic: To what extent is “Fair Value Accounting” an effective method in measuring the values of financial instruments in financial statement?

In recent years, the breakout of global financial crisis has raised controversial debates about whether or not fair value accounting (FVA) is an effective method in measuring the values of financial instruments (Laux & Leuz, 2009). As two main accounting standards around the world, both International Financial Reporting Standards (IFRS) and US Financial Accounting Standards (FAS) have adopted FVA as an accounting method to judge the values of some financial instruments (Mala and Chand, 2011). This essay will argue that although FVA can provide timely and transparent price information to the users of accounting information in some cases, there are potential problems of FVA in measuring the values of financial instruments on account of unreliable evaluation models, biased prices in inefficient markets and a negative price contagion effect. There are three main parts in this essay. Firstly, it will give the definition of FVA and then it will analyze why the effectiveness of FVA may be limited from three aspects, namely unreliable evaluation models, biased prices in inefficient markets and a negative price contagion effect. At last, it will consider the pros of FVA regarding the timely and transparent information it provides in some cases and analyze the pros.

According to Financial Accounting Standards 157, fair value accounting can be defined as “an accounting method to measure the values of assets and liabilities based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. That is to say, FVA relies on the actual market prices of the financial instruments and records the exact market prices on the financial statements. In fact, FVA replaces historical cost accounting (HCA) with the development of accounting standards (Boyer, 2007). Compared with FVA, historical cost accounting can be described as an accounting measurement of values based on the original or historical cost when the company got the assets or liabilities. For example, a company bought a stock for 50 pounds last year. In this year, the price of the stock increases to 100 pounds. Under FVA, the company should record the value of the stock at 100 pounds this year while 50 pounds will be recognized under HCA. As the replaced FVA has been regarding as accelerating the global financial crisis, it draws a lot of attention in respect of its potential weaknesses in the accounting field.

Firstly, the model to estimate fair values of financial instruments in illiquid markets seems to have insufficient reliability (Laux & Leuz 2009 and Mala Chand 2011). If the markets for the identical or similar financial instruments whose values need to be evaluated are active, the available prices can be used to evaluate the fair values of them (Laux & Leuz 2009). However, if the markets do not exist, which means the the markets are inactive or illiquid, the fair evaluation model is needed to estimate the fair value of the financial instruments (Ball 2006). Specifically speaking, the model to evaluate fair values of financial instruments rely on the future cash flow of the financial instruments and borrowing rate of the company. The future cash flow can be described as the future cash inflow (income) and outflow (expense) brought by the financial instruments whilst the borrowing rate of a company can be considered as the cost of capital which can be invested in other investments rather than the financial instruments. The users of the evaluation model should firstly predict the future cash flow of the financial instruments and then use the borrowing rate of the company to calculate the present fair values. Ljiri (2005) states that using model to estimate the values of financial instruments provides significant discretionary...
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