The Role of Fair Value Accounting - Literature review Example

THE ROLE OF FAIR VALUE ACCOUNTING ASSIGNMENT By Student’s Name Code + Course Name Professor’s Name University Cite, State Date Abstract The concept of fair value measurement resulted to a rather pervasive phenomenon to aspect of financial reporting for the past 20 years or so. Under the fair value accounting concept, business entities are expected to certain assets and liabilities at their immediate fair values as at the time of reporting. Thus, fair value is deemed to be the present market-based hypothetical values of the aforementioned items. Recently, numerous debates have arisen in regards to the usefulness of fair value accounting as it contributed to the financial crisis that happened between 2007 and 2009. This paper provides a discussion on the role of fair value accounting in provision of useful information for economic decision, its limitations as well as provides a subsequent evaluation of two Australian forms for the manner in which they have taken to apply FVA in preparation of financial statements. Keywords: fair value measurement, market-based hypothetical values, financial crisis Introduction The process of measuring accounting items is considered to be one of the most fundamental factors in the course of preparing for financial statements, which fairly depict the economic activity of an accounting business. It is important to ascertain that the elements attributed to financial statements can be fairly measured using numerous attributes that corresponds to both the nature and purpose for which the element has been incurred. Thus, reliability and relevance of these attributes are considered to be the fundamental attributes, which can be used in measuring such elements as assets, liabilities and equities of a given entity. The major goal of this paper rests with the examination of economic backgrounds of fair value accounting and also to depict its weaknesses in relation to accounting purposes. Part A The concept of accounting theory is defined in a given number of ways. It is perceived to be a substantive set of logical principles that avail a fair comprehension of existing practices to such users of general purposes financial statements as practitioners, potential investors as well as managers (Andre, Cazavan-Jeny, Dick, Richard & Walton, 2009). Consequently, it avails a distinctive conceptual framework needed for the evaluation of existing accounting practices as well as in guiding the development of newer practices and procedures. The conceptual framework for GPFRS defines the concepts, which are to be applied in the course of setting accounting standards as well as recommended practice guidelines. It is mainly focused on concepts that apply to general purpose financial reporting that is set under the accrual basis of accounting (Barlev & Haddad, 2003). It is crucial to mention that under the accrual basis of accounting, business transactions as well as other activities are recognised in financial statements of an entity whenever they are deemed to have occurred. This means that the business transactions and activities are recorded in the accounting records and thereafter recognised within the financial statements on the exact periods for which they occur (Barth & Landsman, 2010). Consequently, users of GPFRS are informed of relevant and useful past transactions that involve payment and receipt of cash in the course of the reporting period as well as the commitments to pay cash in the future periods through a set of fairly prepared financial statements under the accrual basis accounting (Beatty, Chamberlain & Magliolo, 1996). Following this line of reasoning, they avail information on historical transactions as well as other events that are deemed to be more useful to accounting information users for the sake of accountability as well as a fundamental input for decision making process on information that is availed by the form of a cash basis or other bases of financial reporting standards (Bloomfi eld, Nelson & Smith, 2006). The fundamental objectives of financial reporting, by business entities, rests with the provision of information that corresponds to it that is deemed useful to users of GPFRS for accountability as well as decision making purposes (Bloomfi eld, Nelson & Smith, 2006). Notwithstanding, the conceptual framework of accounting is not an end itself rather it avails important information to GPFRS users and their immediate levels of need. Users of general purpose financial statements fall under different categories that can be governments as well as other public sector and also, such service lenders and providers like banks, employers and also, customers (Hicks, 1946). Fair value is an accounting concept that is deemed to be useful market characteristics in measurement of financial reporting standards. It was selected to be a preferred solution to a never ending trade off that existed between reliability and aspects of relevance of accounting information. The conceptual framework expects fair value accounting to generate and establish information with a distinctive degree of decision usefulness as well as information hence, avail information that is deemed to be more useful to all potential investors (Hicks, 1946). As a result of this, all potential investors are able to access a more informative perception of a business entity’s well-being prowess. Consequently, fair value accounting removes possible levels of incentives related to purpose-built gain trading as well as asset securitisation and therefore, it is able to catapult the credibility level of financial reporting processess (Hicks, 1946). Given the recent developments in standard setting processess, the concept of fair value accounting measurement has translated to a rather pervasive nature in relation to financial reporting and also, it has led to unprecedented shifts in such aspects as the content, significance as well as the usefulness of information regarding the financial position and performances for that matter (Hitz, 2006). The role of fair value measurement is expounded fairly in different manners. For instance, in regards to the aspect of unrealised profits, it is stated that the revaluation of both assets and liabilities as at the balance sheet date to their respective up-to-date fair values can result to the immediate recognition of unrealised gains (Hitz, 2006). In the event that the aforementioned unrealised gains are distributed to owners, the business level of capital is subjected to erosion. Subsequently, in regards to the reliability of its measurement prowess, fair value is deemed as being a hypothetical value that depicts different conditions as well as positions of all market participants (Hitz, 2006). Part B; Limitations of Fair Value Accounting Opponents fair value accounting postulate that financial reporting standards that are focused on fair value measurement led to the financial crunch that hit the world between 2007 and 2009 and also, it substantially worsened the immediate position of the affected companies. Wallison (2008) is one of the major combatants of fair value accounting as he associates it with being the fundamental cause of the existing unprecedented decline in the values of asset base, increase in the instability levels of amongst the global financial institutions as well as the worst economic crisis within the United States of America (IFAC, 2008). It is also believed that fair value accounting is significantly pro-cycling and thus, it should be scrapped off or modified for purposes of ensuring that financial statements are able to present accounting information relating to the stability of a business entity rather than on its earnings power. In the banking sector, fair value accounting is perceived to be capable of spreading a “fire scale” prices that later causes of a vicious circle hence leading to a possible breakdown of the entire banking systems with immediate negative impacts to the underlying economy (Magnan, 2009). The integration of fair value measurement is able to prevent users from making judgments on whatever happened with their respective investments, which falls under the stewardship functions of accounting, as well as what the management will be able to use their investments for, which rests with function of accounting as a source of information for purposes of decision making (Magnan, 2009). In regards to recent financial crisis, numerous newer issues that relates to fair value accounting has occurred. For instance, the unrealised gains and losses from changes within the fair value postulates that dividend can as well be paid in advance of any immediate cash flow that has been obtained (Pozen, 2009). Consequently, the prejudice relating to the estimates of fair value accounting is able to open up space for the aspect of manipulation of earnings of a business entity. Fair values are deemed unreliable especially because of their immediate intrinsic errors associated with the measurement or the numerous inputs to measurement. It is crucial to mention that fair value measurements might be derived from specific models that consists of simplified assumptions that are able to introduce the aspect of measurement errors as well as it requires such inputs as income or cash flow forecasts, which are most likely subjected to the notion of measurement errors (Rappeport, 2008). This therefore stipulates that the different functions of accounting can be likely violated for that matter. Given that fair value accounting measurement is focused on a hypothetical value then it means its reliability is impeded in such situations as inactive and illiquid markets as well as under mass sale out of certain asset base. Fair value accounting is the immediate cause of suboptimal behaviours. It can translate to premature recognition of profits whenever it is compared with conventional historical cost models. This might result to the management being compelled to adopt adverse selection for purposes of meeting the expected or targeted values (Rummell, 2008). Some of the immediate business agencies are of the opinion that suboptimal behaviour that emanates from fair value accounting might influence the markets and might also result to systematic market risks as well as pro-cyclicality on an aggregate level. As a result, on an entity’s level the aspect of fair value accounting translates to increased information asymmetry as well as a reduction in transparency of financial reports (Ryan, 2008). In cases where business entities measure assets or liabilities at their immediate fair values or basically, in cases when entities re-measures an asset or liability of a firm, it tends to focus on the perceived benefits of limitations that are deemed relative to other marketplace participants (Financial Times ,2008). Such a notion can transpire to possible deviation from requirements of financial reporting standards however; this matter fairly matches up with the miss-inferences relating to the functioning of financial markets (Veron, 2008). The immediate low reliability aspect of fair value measurement is depicted as being the fundamental attribute especially in cases where markets process are falling tremendously or in cases where markets suffer from the lack of liquidity (Wallison, 2008). Part C For this section, the paper examines the financial statements of both Global Petroleum Limited and Global Masters Fund Limited for purposes of establishing the extent to which the two entities have been able to adopt the aspect of fair value accounting. The financial statements attributed to Global Masters fund Limited have been prepared on the conceptual framework of accrual basis accounting and based on historical costs except for its “Available-For-Sale Financial Assets” which are measured at their immediate fair values (Global Masters Fund Limited, 2014). The firm’s policy does not allow it to hold any form of securities meant for short term trading purposes hence its investment portfolio is categorised as “Available-For-Sale-financial Assets”. These investments are first recognised and thereafter measured at their respective fair values with gains or losses being depicted as separate elements of equity until the period when the investment is derecognised or impaired (Global Masters Fund Limited, 2014). The immediate fair values of investments that are in active trade within the different financial securities markets are determined by way of referencing to the quoted market bid prices at the close of business on the balance sheet date. On the other hand, the entity’s policy requires that the fair value of investments, which are unlisted unit trusts, should be established by way of referencing the redemption values (Global Masters Fund Limited, 2014). The financial statements of Global Petroleum Limited have been prepared and measured on the basis of historical cost basis. The firm adopts a fair value accounting approach when reporting on “Assets held for sale” items, which are measured at the lowest of their immediate carrying amounts and fair values less the impending costs to sell. Subsequently, the trade and other receivables items are recognised at their immediate fair values and thereafter measured at an armotised costs that is less than allowances for all doubtful debts. Thus, it can be noted that Global Petroleum Limited fair value estimation is determined on carrying amounts of items at the year ends. The firm’s financial instruments, which include of trade and other payables, receivables and cash and cash term deposits, are the main items that are subjected to fair value accounting by the firm (Global Petroleum Limited, 2014). As mentioned earlier, it is important to ascertain that the elements attributed to financial statements can be fairly measured using numerous attributes that corresponds to both the nature and purpose for which the element has been incurred (Barlev & Haddad, 2003). Thus, reliability and relevance of these attributes are considered to be the fundamental attributes, which can be used in measuring such elements as assets, liabilities and equities of a given entity. From the discussion above, it can be seen that the two firms have gone a step further to ascertain distinctive areas where the aspect of fair value accounting has been deployed effectively and efficiently. It can be established that the two firms have employed fair value accounting to distinguish the reporting of both assets and liabilities like the assets available for sales and such liabilities as employee benefits (Barlev & Haddad, 2003). Notably, the fair value accounting has not been applied in matters related to income revenues for the firm because it tends to diminish the real aspect of dividends pay outs. Therefore, it can be said that most firms use fair value accounting however; the degree of their applicability depends with the benefits it can present to reporting financial statements (Barlev & Haddad, 2003). Conclusion As it can be seen, fair value accounting for Australia based firms’ helps to provide accurate valuation of both assets and liabilities on an ongoing basis to all users of a company’s financial accounting information. For instance, for the two companies above, whenever the price of an asset or liability has been deemed to increase, the entity at hand engage in marking up the value of the asset or liability to its immediate current market price in order to depict the consideration it would likely receive in the event that it sold the asset. Subsequently, the benefits of adopting fair value accounting have helped in reporting the true and accurate levels of income. It is important to ascertain that fair value accounting inhibits entities capacity to potentially manipulate their respective reported net income. The adoption of fair value accounting facilitates the gains and losses from any given prices changes for either assets or liabilities being reported for the exact period on which they occur. References List Andre, P., Cazavan-Jeny, A., Dick, W., Richard, C & Walton, P. 2009, “Fair Value Accounting and the Banking Crisis in 2008: Shooting the Messenger.” Accounting in Europe, vol. 6, no. 1, p. 3–24 Barlev, B & Haddad, J. R. 2003, “Fair Value Accounting and the Management of the Firm.” Critical Perspectives on Accounting, vol. 14, no. 4, p. 383–415. Barth, M. E & Landsman, W. R. 2010, “How did Financial Reporting Contribute to the Financial Crisis?” European Accounting Review, vol. 19, no. 3, pp. 399–423. 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J. 2009, “Fixing Fair Value Accounting.” Paris, OECD Accrual Accounting Symposium, Retrieved on January 20, 2015 from www.oecd.org/dataoecd/1/22/42416969.pdf Read More