The purpose of this memo is to provide a discussion on the issues of the reliability and relevancy trade off evident between the three levels of the Fair Value Hierarchy. Summary
Through research of theories, studies and examples, several issues about the relevance and reliability of the Fair Value Hierarchy arose. The Fair Value Hierarchy has been perceived to present levels of inputs with increasing reliability going up the hierarchy, while simultaneously reducing information relevance. In response to these issues many have suggested alternative approaches and measures. Historical cost measurement has been regarded as relevant and appropriate as it removes all subjectivity. Additionally advocates of an informational approach recommend that accounting data should be treated only as an aid to users’ decision making not complete basis. This approach also supports application of different measures for different purposes in financial accounting. Thus, I recommend that while fulfilling the requirements of AASB 7, adopting an informational approach through use of additional historical costing alongside fair value measurements would be ideal for the nature of this home decor company. Discussion
The method by which I have reached my conclusion has been structured with supporting studies, theories and examples. Having first accessed the KPMG Flash Report, I gained firm understanding of the underlying causation and intentions for the amendments to IFRS 7. I then researched on issues surrounding the relevance and reliability of the Fair Value Hierarchy in order to obtain broader knowledge of its effectiveness. Further research on alternative and differing perspectives allowed for broader knowledge for my conclusion. Subsequently, I supported the theories with studies and related them to actual annual reports of appropriate companies. The Fair Value Hierarchy can be interpreted to present a structure of levels with increasing reliability going up the hierarchy (i.e. from Level 3 to Level 1) (Fornaro and Barbera, 2007), while simultaneously reducing relevance (Whittington, 2010). Fornaro and Barbera (2007) suggest that the reliability of the can be measured on the basis of observable and unobservable inputs. Observable inputs reflect assumptions that market participants would deduce, based on market data obtained from independent sources. Hence, Level 1, containing the most direct observable inputs, and Level 2, consisting of other observable inputs, are claimed to be the most reliable information. In contrast, Level 3 financial information is sourced from unobservable inputs; the use of reporting entity’s own assumptions of market inputs. Consequently, Level 3 is regarded as least reliable as the nature of its inputs create subjectivity, is vulnerable to measurement error and difficult to verify independently. Whittington (2010) proposes that market-specific fair value measurements such as those in Level 1and 2 do not always prove to be relevant. Level 1 inputs follow the assumption that markets are complete and perfect, allowing for a unique market value based on all information for all assets and liabilities. However, the reality that markets are neither perfect nor complete due to sources such as information asymmetry therefore show that this ideal ‘quoted prices... for identical instruments’ input is not available or appropriate for all financial instrument. It is in these situations that Level 1 loses its relevancy and entity-specific inputs of Level 3 gains relevancy. Nonetheless, Whittington’s (2010) view of relevancy could be regarded as pertinent only to preparers of financial information. Users of financial information, on the other hand, can be perceived to adversely examine relevancy between the levels (Landsman, 2007). Landsman (2007) conducted worldwide studies finding that the more reliable the inputs the...