Fair Value Accounting

Topics: Balance sheet, Fair value, Asset Pages: 6 (2109 words) Published: November 12, 2008
Moving towards Fair Value Accounting
In the past, historical cost measures were mainly used for reporting as they are reliable. However, historical cost is only relevant upon acquiring the asset and becomes irrelevant as time passes. On the other hand, fair value-based reporting, which accounts for changes in fair values, can produce balance sheet figures that provide a better reflection of the company’s value. This is also why accounting bodies are moving towards fair value accounting (FVA). One of the evident standards is the FASB Standard (SFAS) 157, ‘Fair Value Measurements’, to establish clear, consistent guidelines for fair values measurements and disclosures. SFAS No. 133, ‘Accounting for Derivative Instruments’ and IAS 39 also require entities to account for changes of fair value of derivatives depending on its use. SFAS No. 159, ‘Fair Value Option for Financial Assets/ Liabilities was adopted on February 07 to allow financial institutions to elect specific HTM and AFS securities to be treated similarly to trading securities, i.e. to adjust to fair value. Impaired assets are also required to be written down to fair value according to IAS 36, SFAS No. 142, ‘Goodwill and Other Intangible Assets” and SFAS No. 144, ‘Accounting for Impairment or Disposal of Long-lived Assets.’ Lastly, just recently on 29 May 08, FASB issued an exposure draft on the conceptual framework for financial reporting to support fair value measurement by placing emphasis on the balance sheet rather than income statement. All these initiatives clearly show the increasing importance of fair value as an accounting measurement attribute. There are also empirical evidences from research studies to show that FVA is relevant and useful to investors. Most studies aim to show a positive correlation between asset revaluations and share prices. Examples are these US-based research studies-Barth et al. (1996), Eccher et al. (1996) and Nelson (1996) which discovered that investment securities fair values do affect bank share prices. In addition, the findings indicate that investors are able to see through attempts of earnings manipulation and can discount loans’ fair value estimates made by financially weaker banks. Reliability is questionable

However, ever since standards were established, there have been many who were against FVA. Some say that FVA is only relevant for liquid assets such as held-for-trading securities and should not apply for long-term and intangible assets purchased with the intent of using the assets over their useful life. Some also argue that for FVA to be relevant, it has to be reliable as well. But the reliability here is questionable as explained below. The level of reliability depends on the inputs in the measurement process. FASB Standard 157, Fair Value Measurement, provides an input hierarchy to measure fair value. Level 1 inputs are readily observable in active markets, Level 2 inputs are related or similar observable inputs, while Level 3 are unobservable inputs. Securities are usually made up of Level 1 inputs which are highly reliable since fair values are recorded from actual transactions in the markets. Nevertheless, reliability is never certain as current values set by useful public information might be contaminated with speculative private information, resulting in increased uncertainty, cost, risk, volatility. The reliability of Level 2 and 3 inputs, which are mainly used for long-term and intangible assets, is even more questionable because these inputs are subject to a wide range of possible outcomes. The present value technique, a common method of valuation for Level 2 and 3 inputs, requires management projection of free cash flow and picking of discount rates which includes risk adjustment and volatility of market. The subjectivity of this valuation technique makes it unreliable. Ultimately, markets make their own estimates and usually forecast low for assets and high on liabilities, producing more volatile and...

Bibliography: Wallace, M. 2008. Stock valuation using fair value accounting data. Bank Accounting & Finance Apr/May: 11-16.
Ronen, J. 2008. To fair value or not to fair value: A broader perspective. Abacus 44(2):181-208.
Casabona, P. 2007. The impact of accounting profession’s movement toward fair value reporting in financial statements: An interview with Theresa Ahlstrom, Long Island Office managing Partner, KPMG LLP. Review of Business 27(4):6-9.
The Straits Times Tuesday October 14, 2008 Pg A24 Title: Mark to market : Dangers abound
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