Fair Value Accounting


 


 


Introduction


In accounting, fair value is usually used for assets that are meant to be accounted for at market prices, but a ‘market’ might not be available, and therefore an estimate of the ‘fair value’ is made. Usually this is not used where an asset or liability has a historical cost and is being depreciated or amortised. And is normally not used for assets where an established market price can be identified (Scott, 2009).


As indicated in the book of Scott (2009), most of the current accounting system is meant to control two distinct types of information asymmetry: adverse selection and moral hazard. Controlling adverse selection requires a decision usefulness approach that emphasises fair value accounting numbers that often fluctuate. Unfortunately, controlling moral hazard requires that income figures be highly correlated with management effort, which argues for the use of “hard numbers.”  With this, this paper discusses and analyses the factors in accounting procedures and issues in fair value with respect to Australian Accounting Standard Board (AASB). The main purpose of this paper is to discuss the factors involved in accounting procedures and issues in fair value accounting. Aside form this analysis, determination of fair values of assets in a business combination will be discussed since there are accusations in which Fair Value Accounting (FVA) deepening the current financial distress whilst proponents argue FVA is providing investors with information about the value of firm’s assets. In addition lobbyists from the banking industry have effectively had politicians use “pressure” on Accounting Standards Boards to redefine FVA.


 


Decision Usefulness


With respect to the current stance of global finance and usefulness of accounting in making decisions, the report of Russell Berman last April 2009 in AccountancyAge.com stated that US Treasury Secretary Tim Geithner’s recently announced proposals for US recovery have attracted extreme criticism in many quarters for failing to address the issue of Fair Value Accounting. As reported, Alex Pollock of the Washington-based American Enterprise Institute and a long-standing critic of mark-to-market accounting rules sees a missed opportunity for a more radical overhaul.[1]  Experts argued that the failure of US to pay attention on Fair Value Accounting created problems and deepening the global finance crisis.  According to the report of Berman, Alex Pollock stated that “a comprehensive plan would have to fix fair value accounting”. Similar to other accounting procedures, fair value accounting was used for making appropriate decisions (Scott, 2009).


Businesses in Australia are fast evolving. They are developing with respect to the changes of global market and issues in valuing. The focus on valuation has changed from nonfinancial items to financial assets and liabilities reflecting differing concerns over time. The use of market values for nonfinancial assets and, in some cases, inflation adjustment for monetary items was discussed intensively across the commercially developed world. A number of standard-setting bodies promulgated disclosure requirements or allowed the use of alternative accounting standards in this area under the title “current cost” accounting, which generally required the use of entry prices or their surrogates for nonfinancial assets but maintained historical cost for financial assets and liabilities with the possibility of some adjustment for general price changes.


In accordance to this development, extensive accounting and auditing procedures must be practiced for making effective decisions. This includes everything from external audits of accounting management policies and procedures to internal reviews of quantitative exposure measurement models. In essence, this process involves the evaluation whether or not its management process is working properly and efficiently. This must be done to assess if the company addresses the problems and risks being identified in the first process. Without this step, Australian businesses would not be able to come up with policies and regulations regarding Australian Accounting Standard Board (AASB), and would not be able to know if their measuring, monitoring and controlling processes are effective enough to suggest improvement of their operation and profit.


             


Positive Accounting and Agency


Basically, accounting processes like Fair Value Accounting generates summary measures of transactions and events that occurred during a period and of net assets at the balance sheet date. This process involves a great deal of aggregation, which is done via the recognition and measurement of assets and liabilities. Different valuation concepts are used. For example, some assets are measured at historical cost, others at fair value or market value, discounting is considered for measuring certain items and not for others.


With this, we may say that financial accounting and reporting like Fair Asset Accounting should be governed by standards or rules that are developed by standard-setters or legal bodies on a national or international level. The objective is to provide decision-useful information to the stakeholders of the firm, often by focusing on information that investors in capital markets demand, but also on stewardship. Financial reports are audited by independent public accountants. They are subject to scrutiny by the board of directors and supervisory boards, respectively, or by audit committees. In many countries there is some form of public oversight by private boards or by government institutions, and enforcement is carried out by such institutions or the courts. All these institutions are supposed to assure the quality of financial reports.         


In finance, accounting and in accordance to the context of Australia, there are many variables that we have to consider such cash flow and profits, the Profits and Loss Account and Balance Sheet, and financial ratios. Aside from these factors, the “fair value” concept in businesses is also very vital to their development. Actually, it is all about the policy in which a certain business is obliged to submit financial reports in accordance to financial standards set by the country (Atril & Mclaney, 2004). So let say in Australia, financial reporting should comply with Australian Accounting Standard Board (AASB). Basically, financial reporting is very vital to the development of a certain organisation since it is the distinction whether the certain organisation are growing or not (Atril & Mclaney, 2004).  And with regards to the issues and criticisms of Fair Value Accounting:


  • Fair-value measurement aims to provide information about (potential) market prices of assets and liabilities. However, only in a world of perfect and complete markets can the fair value be precisely defined (van Deventer DR 2008). But in such a world there would be no need for financial reporting,  (Riahi-Belkaoui, A 1998) which contains market prices. The information on quantities would be sufficient, since all users could find the relevant prices. In the real world, markets are imperfect and incomplete, and the standard-setter has to decide which market is relevant (Pike, R & Neale, B 1999).  Even if he can make this decision, there are differences between a market price and a value in use. Assuming a rational investor, he or she will only invest in an asset if the value in use exceeds the market price. This investment creates a positive net present value. Therefore, the information on market prices can only be a conservative estimate of the value in use at the time of investment.

  • Selling prices are informative, but only if the enterprise really wants to sell the asset. Selling prices make sense for trading securities, but not for noncurrent assets like property, plant, and equipment, especially for special machinery, or for financial investments.

  • For many assets and liabilities, we cannot find market prices by looking closely at the markets. Instead, we must deduce the market prices by using valuation models (van Deventer DR 2008). For example, think about financial derivatives or some rental properties. The important questions are, what models are admissible and what are the realistic parameters?

  • Selling and buying prices of individual assets and liabilities are not good proxies for the contribution that such assets and liabilities make to the value of the firm. This value cannot be identified by individual valuation, item by item, and then adding the values. This addition would only be sufficient if the firm had no synergies and self-produced goodwill.

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    Given the threats and the management in fair value accounting procedures it must pass through, it is essential to discuss some possible strategies its implementation. From the policies given by Australian Accounting Standard Board (AASB), Australian businesses may manage them by using existing assets or existing resources as a counter troubles, and involves improvements to existing methods and systems, changes in responsibilities, improvements to accountability and internal controls.


               


    Regulatory


    Stringent approach to accounting policies and standards is a tool for the government to measure the legitimacy of an entity with regards to its relationship with the public and environment (Deegan & Rankin 1996 p. 60).  Financial reporting is one of the factors that need consideration not only by the Australian business organisations but also by the global community especially to those who are responsible in setting up the international financial reporting standard (IFRS) and AASB (Australian Accounting Standards Board 2009) to regulate accounting practices.  In line with this, the values reported by a certain company should conform to the standards given by AASB, IFRS or GAAP.  Fair values given to companies should also comply with their status in the market (van Deventer DR 2008).  Meaning, fair values should reflect to the factors in business like its earnings, growth and market.  Actually, the Financial Accounting Standards Board (FASB) in 2004 proposed guidance on how entities should decide fair value assessments for financial reporting purposes. The guideline would concern generally to financial and non-financial liabilities and assets considered at fair value beneath other authoritative accounting assertions. Lack of one single reliable outline for giving fair value measurements and developing a consistent estimate of a fair value in the deficiency of quoted prices may create incomparability and inconsistencies. The point of this guide is to eliminate the inconsistencies by constructing a solid support to be used in any fair value assessments (Australian Accounting Standards Board 2009).


                Those who hold on to the fair value measurement system uphold that it has many advantages, pointing out two major arguments. The first is significance. Fair value measurement of an entity’s assets and liabilities results in escalating significance of financial statement information (Thomas, W 2002), so that readers of the financial statement will now adjust tremendously in interpreting entity reports. Financial strength, liquidity and cash flow become effortlessly assessed.


                The second major issue is consistency. A situation case where some financial statement items are accessible at fair value, while others are offered at cost may confuse financial statement readers (Thomas, W 2002). In addition, fair value measurement may cause early detection of unrealised profits as a result of an augment in market value. Moreover, a measurement of fair value for unquoted items imposes the use of authorities, placing an important cost burden on companies in order to acquire a consistent valuation.


     


    Conclusion


    The intention of standard-setters with regard to financial items is to illustrate the economic value of each class of assets and liabilities as if they were independent from each other and other entity resources; these values were linearly additive and as far as potential purged of super profits and managerial purpose. This outlook relies on neither a strong theory nor on empirical evidence. It is really based on an economy with all relevant markets being well organised and in perfect equilibrium, which results in markets consistent with the standard-setters’ scenario and in market prices that reflect economic values.  As shown, this paper has examined the issues pertaining to Fair Value Accounting.  Ideally, fair values embody the market’s expectations concerning assets and liabilities. Thus, AASB, IFRS or GAAP wishes to substitute the views of the market for those of the management. They see present value measures as providing an estimate of fair value only where market prices are unavailable. Only when a market price for an asset or liability or for similar assets and liabilities is absent is a present value valuation necessary, as otherwise the marketplace’s view of present values of such items is embodied in market prices that are held to capture all elements relevant to asset value.


    The standard setter’s such as AASB, IFRS and GAAP major argument for fair value is that the accounting valuations should, ideally, recognise the amount of asset cash flows and their timing and expectations of changes therein, the time value of money, the price of the risk inherent in assets, and other factors. It is argued that it is only fair values that capture just these factors. Using managerial estimates includes additional items to those listed above that reflect differing managerial information and different preferences to the market. Allowing for these in accounting would mean that identical items would be valued differently. The underlying wish is for accounting like Fair Value accounting to state things “as they are”, free of any managerial manipulation.


     


    References:


    Australian Accounting Standards Board 2009, viewed 3 June 2009, <http://www.aasb.com.au>


     


    Atrill, P & McLaney, E 2004, Financial Accounting for Decision Makers, 4th edn., Prentice-Hall, New Jersey.


     


    Deegan, C & Rankin, M 1996, “Do Australian companies report environmental news objectively? An analysis of environmental disclosures by firms prosecuted successfully by the Environmental Protection Authority”, Accounting, Auditing and Accountability Journal, vol. 9. no. 2. pp. 50-67


     


    Pike, R & Neale, B 1999, Corporate Finance and Investment Decision and Strategies, 3rd edn., Pearson Education Limited, England.


     


    Riahi-Belkaoui, A 1998, Financial Analysis and the Predictability of Important Economic Events, Quorum Books, Westport, Connecticut.


     


    Scott, W 2009, Financial Accounting Theory. Prentice Hall. ISBN:9780132072861


     


    Thomas, W 2002, ‘The rise and fall of Enron; when a company looks too good to be true, it usually is’, Journal of Accountancy, 1 April.


     


    van Deventer DR 2008, Fair-Value Accounting, CDOs and the Credit Crisis of 2007–2008, viewed 3 June 2009,  Bank Accounting & Finance. <http://www.kamakuraco.com/Portals/0/doclibrary/BAF_21-06_08_Deventer.pdf>


     


    [1] From http://www.accountancyage.com/accountancyage/analysis/2239867/reforms-slammed-ducking-fair



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