Fair Value and Fair Presentation of Financial Statements - Assignment Example

1. Fair Value The term 'Fair Value' refers to the unbiased estimated market value of an asset or a liability. Financial Accounting Standards Board (FASB) has defined fair value in standard number 157 as 'Fair value is 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' (FASB, 2006). Fair value is used to represent true value of an asset when the actual cost can not be measured with certainty in absence of actual exchange. 2. Fair Value and IFRS/IAS Fair Value concept has been used in a number of IFRS (International Financial Reporting Standards) and IAS (International Accounting Standards). Some examples are provided below: a. IFRS 5: Non - Current Assets Held for Sale and Discontinued Operations This IFRS specifies the accounting mechanism for non - current or fixed assets that are held for sale; and the accounting presentation and disclosure of discontinued operations. As per the requirements of IFRS 5, 'the assets that are held for sale are to measured at the lower of carrying amount and fair value less costs to sell' (IASB, n.d.). This means that the asset should be marketed for sale at a price which is arrived by considering the fair value of the asset. This ensures that financial statements provide a more realistic figure for fixed assets that are held for sale. b. IAS 16: Property, Plant and Equipment IAS 16 provides accounting treatment of property, plant and equipment and their revaluation for the purpose of financial reporting. As per the standard, 'after recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses' (IASB, n.d.). This shows that the standard requires assets to be represented in financial statements at their fair value as a true representation of their actual value at the time of balance sheet development. c. IAS 38: Intangible Assets This standard deals with recognition, measurement and revaluation of an intangible asset. An intangible asset is a non-monetary asset, and has no physical form. The standard requires revaluation of the intangible asset at the 'fair value at the date of revaluation less any subsequent accumulated amortization and any subsequent accumulated impairment losses' (IASB, n.d.). The fair value is determined with reference to active markets where the prices are available to the public, buyers and sellers are available, and items are traded in homogenous way. In addition to the above, IAS 32 and IAS 39 require the use of fair value for measuring and presenting the value of financial assets and financial liabilities. 3. Advantages and Disadvantages of Using Fair Value to Measure Value Fair value is an important estimation and provides valuable information about financial assets and liabilities as compared to their values which are based on historical cost concept (the original price paid to acquire that asset or incur the liability). Fair value is associated with current market conditions and environment, and hence provides a metric for comparing the value of financial instruments bought at different times. The fair value disclosure in financial statements provide valuable insight to investors and other stakeholders about realistic value of a company's assets and obligations, hence enhance the usefulness of financial statements. One critic on using fair value for measuring value is that it is less reliable as compared to the traditional historic cost concept. However, the advocates of fair value argue that it may be less reliable but certainly more relevant to decision makers (Shortridge Schroeder Wagoner, 2006). Another advantage of using fair value to measure value is that fair value 'improves comparability by making like things look alike and unlike things look different' (Willis, 1998). Fair value provides information about the expected benefits of assets or the expected obligations by liabilities under current environment and economic conditions. Fair value, however, is not completely reliable; as it provides only an estimate of the value of an asset or liability, and does not provide absolute assurance about the actual true value which may be higher or lower than the historic value. Willis, in his article quotes Colleen Cunningham, president and CEO of Financial Executives International (FEI) as 'Relevant information that is unreliable is useless to an investor. We must, therefore, be clear about the nature of the claim being made for an accounting number described as reliable'. One disadvantage of using fair value to measure value is that the financial statements can be manipulated since management's decision has been involved as per the fair value estimates. Since fair value is obtained from appraisals and valuation techniques, the values remain vulnerable to unfair practices and management bias. 4. Users' Needs and Fair Value Fair value produces financial statements that better represent the true value of a company, as opposed to historical cost. Since, value of the assets does not remain constant over time, hence historical cost can not be used to describe a company's financial position. As already stated above, the basic concept of fair value was developed as a consequence of the needs by market participants to have a relevant value to consider while entering into a financial transaction. If the participants use historical value of an asset or a liability as a basis to make transactions, one of the two parties will lose, as the price or value of the asset at the time of making the transaction can certainly be different than the time it was initially acquired. This limitation of historical cost has been overcome by fair value accounting concept. In addition to the benefits of fair value to individuals and investors, it has many uses for organisations as well. Fair value is also a required measure for many financial instruments as a regulatory requirement. Hence, companies have to employ fair value calculations to meet regulatory bodies' requirements. In addition to using fair value measures to comply with public reporting requirements, companies use fair value to 'measure their financial instruments at fair value for a number of internal processes including making investing and trading decisions, managing and measuring risks, determining how much capital to devote to various lines of business, and calculating compensation. The use of fair value measurements is deemed to be relevant in these areas' (Bond Market Association, 2002). Similarly, auditors who have the responsibility to comment on the adequacy of internal controls and transparency, completeness and accuracy of financial statements can benefit from the use of fair value to analyse financial statements thorough with various perspectives. The use of fair value is mandated by standards like IFRS and IAS, which are used by auditors as guidance for evaluating an organisation's financial statements. As seen from above, using fair value provides benefits to all stakeholders in evaluating the state and performance of a company. 5. Fair Value and Fair Presentation of Financial Statements The use of fair value has been conceptualized and supported by all accounting standards and regulatory bodies. As stated by IAS 1, 'Presentation of Financial Statements', 'Financial statements shall present fairly the financial position, financial performance and cash flows of an entity. In virtually all circumstances, a fair presentation is achieved by compliance with applicable IFRSs' (IASB, n.d.). The IFRS requires companies to adopt fair value accounting for financial reporting; hence International Accounting Standards Board (IASB) has mandated the use of fair value as a required criterion to present financial statements. In addition, IAS 39 'Financial Instruments: Recognition and Measurement' requires the company to periodically appraise the financial assets and financial liabilities of the organisation to arrive at the fair value of these assets and liabilities in order to provide the information to stakeholders with reasonable estimation of the actual current value of the instrument (IASB, n.d.). By considering the two IAS described above and other like IAS 32 and IFRS 7, it can be ascertained that international standards and best practices promote the use of fair value for presentation of financial statements. However, fair value does not provide an absolutely accurate result; instead, it is an estimation of the present market value of an asset and/ or a liability, and hence is prone to estimation errors. In spite of this inherent limitation, fair value is considered to be the closest estimation of the real value of an asset or a liability and thus, its use is mandated by international standards as above. A fair presentation of financial statements provides information regarding the affairs of the company, its assets and liabilities and gives an indication to the stakeholders about the overall financial health of the company. Though, the results may not be accurate to the dollar, yet they give value added estimates and hence, the use of fair value is recommended to obtain true, up to date and fair representation of a company's position and financial health being. References Bond Market Association (2002). Explanation and Benefits of Fair Value Accounting. Retrieved April 28, 2007 from the World ide Web: http://www.isda.org/speeches/pdf/FV101_2.pdf Financial Accounting Standards Board. (2006). Statement of Financial Accounting Standard No. 157: Fair Value Measurement. Retrieved April 28, 2007 from the World Wide Web: http://www.fasb.org/pdf/fas157.pdf International Accounting Standards Board. (n.d.). IFRS 5: Non-Current Assets Held for Sale and Discontinued Operations. Retrieved April 27, 2007 from the World Wide Web: http://www.iasb.org/NR/rdonlyres/FB2F41EE-F425-4C9F-B317-2D8D7003BBB7/0/IFRS5.pdf International Accounting Standards Board. (n.d.). IAS 16: Property, Plant and Equipment. Retrieved April 27, 2007 from the World Wide Web: http://www.iasb.org/NR/rdonlyres/C10C2381-6B52-4C4A-92D4-7874C40040D0/0/IAS16.pdf International Accounting Standards Board. (n.d.). IAS 1: Presentation of Financial Statements.. Retrieved April 27, 2007 from the World Wide Web: http://www.iasb.org/NR/rdonlyres/80B373BF-BB16-45AB-B3F7-8385CD4979EA/0/IAS1.pdf International Accounting Standards Board. (n.d.). IAS 39: Financial Instruments Recognition and Measurement.. http://www.iasb.org/NR/rdonlyres/1D9CBD62-F0A8-4401-A90D-483C63800CAA/0/IAS39.pdf Shortridge, T. R., Schroeder, A., Wagoner, E. (2006) Fair Value Accounting: Analysing the Changing Environment. The CPA Journal. Retrieved April 29, 2007 from the World Wide Web: http://www.nysscpa.org/cpajournal/2006/406/essentials/p37.htm Willis, W. D. (198) Relevance of Fair Value Information for Financial Instruments. FASB Viewpoints. Retrieved April 29, 2007 from the World Wide Web: http://www.wiwi.uni-frankfurt.de/schwerpunkte/accounting/spbib/dload/PV_FaVap.pdf Read More