Fair Value Accounting - Essay Example

Fair value accounting Introduction Fair value system of accounting involves the practice of estimating prices of assets and liabilities on the basis of current market value, instead of their book value. As per the US GAAP (United States Generally Accepted Principles), fair value is the amount at which an asset is purchased or sold in the market. Fair value is basically the current price existing for an asset or liability in the market (Ahmed, Kilic and Lobo, 2006). This type of valuation is only used for those assets or liabilities, which are valued in the balance sheet based on mark to market valuation. Assets that are valued on basis of historical costs, fair value accounting is not used. This system of accounting had begun in the late 19th century when economists started believing that the fairest way of measuring assets is on grounds of their existing market value. However, with advancement of time, economists came up with more dominant means of accounting such as, historical cost accounting. Although assets and liabilities in the fair value system of accounting are valued as per the existing market price, it is not always necessary for the both to be same. Fair value is basically the price that a party is ready to pay for a given asset in the current period. This price may vary marginally from existing prices in the market. The fair value in such a transaction is determined on the basis of respective advantages and disadvantages that both parties obtain from a given transaction of selling an asset (Barth, Beaver and Landsman, 2001). Fair value and historical cost for users of financial statements The fair value system of accounting has been an emerging practice of accounting for assets and liabilities in past decade. The concept is a major distinction from the existing century old practice of historical costing. Most economists are of the opinion that fair value accounting helps in rendering accounting information more reliable. Historical cost accounting is considered to be more conservative and dependable as compared with fair value system (Plantin, Sapra and Shin, 2008). The system of accounting that requires to be used depends upon nature of the asset or liability being valued. A plot of land that is bought at $1 million continues to be recorded in books for the same value, even after five years in the historical system of accounting. Nevertheless, if the same plot of land is bought by another company at present, it would be recorded in the books at a higher value, considering that value of land is constantly appreciating. As a result, historical cost accounting leads to undervaluation of assets (Cotter and Zimmer, 2003). Although Fair value system of accounting is regarded as a more updated means of recording information in the financial statements, experts have criticized the system to be dubious in many ways. Fair value system of accounting was believed to be one of the reasons behind the economic crisis of 2008. Due to the fair value system, assets prices were seen to rise. The fair value gains on scrutinized assets held by many financial institutions were reckoned as net income. Such net income was used for calculating executive bonuses. As asset prices began to fall, net income slumped and many financial institutions began blaming the fair value system for accelerating the markdown (Power, 2010). Even though fair value system has raised concerns for regulating authorities, it is widely used in many countries for valuing different derivative and hedging instruments as well as for valuation of employee stock options. Therefore, it is generally observed that assets, which are subject to depreciation over a stipulated time period of use, are recorded in the books on basis of historical cost accounting. Instruments such as, derivatives, follow the fair value system as they require to be recorded in books based on their current market value (Danbolt and Rees, 2008). Experts are of the opinion that since financial market are well-regulated with a proper pricing system, it is easier to follow fair value system of accounting for those assets, which are traded in such markets (Watts, 2003). Users of financial statements, such as, investors, generally prefer assets to be valued on the basis of fair value system as this helps in reporting assets on their existing market values. This is considered to be a more up-to-date method of recording information in the books of accounts. Audit firms also stress upon the usage of fair value system of accounting. They believe that fair value system is an adequate trade-off between relevance and reliability of financial information (Allen and Carletti, 2008). US GAAP and IFRS in historical cost accounting US GAAP and the IFRS are the two major accounting systems, based upon which the financial records are maintained and presented to the users. Under both GAAP and IFRS, historical cost is identified as one at which assets and liabilities were originally procured. It is considered as a highly stable system of accounting. The historical system is, hence, criticized by many and is held to be inaccurate as true value of the assets is neglected (Benston, 2008). As per the IFRS principles, in order to arrive at correct values while maintaining books on the historical cost basis, the management is required to use many tools for reaching accuracy. These include depreciation and appreciation of the book values. This makes the historical cost accounting system highly complex. It becomes extremely difficult for the management to verify accuracy and relevance of the financial statements (Magnan and Cormier, 2005). As per the IFRS rules, historical cost accounting in respect of monetary items, which are denoted in terms of foreign currency, are required to be reported in financial statements on basis of the closing rates. Under the GAAP principles, revaluation of assets that are recorded in the books based on historical cost accounting is essential. However, under the IFRS rules, it is not a necessity. Revaluation of assets is done on the basis of their fair value. As per the GAAP rules, it is essential to revalue freehold property at an interval of three years. Under historical cost system, an entity is required to record gains or losses as per the net monetary position. Non-monetary assets are recorded on the basis of indexation. Economic rent is also important in the context of historical cost accounting. It is reckoned irrelevant to depreciate a property of land, which is held for over twenty years. As a result, use of economic rent becomes necessary (Laux and Leuz, 2009). Capital maintenance in units of constant purchasing power is suggested as an alternative system to historical costing by the IASB. The system suggests that financial capital can be measured in monetary terms or by using the constant purchasing power model. It is important to note that the historical cost accounting system does not record gains until they have been realized. It is also to be noted that the historical accounting system does not recognize opportunity costs. It also neglects any loss upon the values of assets due to inflation (Holthausen and Watts, 2001). US GAAP and IFRS in Fair value accounting There exists a conflict in the concept of fair value accounting between IFRS and GAAP. According to GAAP, fair value is equal to the exit value of an asset. It is considered as price that is received when an asset is sold or transferred. This concept is deemed applicable for financial instruments, but not for tangible and intangible assets. It is also feasible only in a situation where there is market along with market participants (Martin, Rich and Wilks, 2006). There are many sub-prime securities, which have no markets or participants. On the other hand, IFRS recognizes fair value as market price that has been decided upon by existing participants of a financial transaction. This theory of fair value accounting has been widely accepted by most organizations. As per the IFRS principles, when there are no markets existing for an asset, the prices are determined on three levels. In the first level, assets are priced based upon their quoted price. In the second level, prices are quoted on the basis of similar assets. Level three includes all other measurement types, which allow both income and cost approaches (Milburn, 2008). US GAAP and the IFRS have different guidelines in respect of fair value accounting, which makes the process of reporting highly complicated. Moreover, GAAP regulations in terms of fair value accounting are more complex. The IASB and FASB have been consistently trying to reduce differences existing between IFRS and GAAP rules in context of fair value accounting (Ryan, 2008). Conclusion The weaknesses of fair value system of accounting were neglected by many accounting experts and regulatory authorities (Aboody, Barth and Kasznik, 2004). Both IFRS and GAAP principles have failed to identify a proper pricing system for sub-prime assets. The convergence of IFRS and GAAP for removing differences in fair value accounting has been slow. Although fair value system of accounting is considered to be better by most organizations, many experts have reached the conclusion that this system undermines significant proportion of traditional concepts of accounting. 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