Advantages and Disadvantages of Fair Value Accounting (FVA)

The main purpose of this assessment is to analyze the concept of fair value accounting and how the same has affect the overall accounting process. The concept of fair value has an important significance in accounting and is used for measuring the assets and liabilities of the business. The fair value accounting principle requires businesses to value their assets and liabilities at current values rather than historical values (Christensen and Nikolaev 2013). However, there are certain debates and discussions which are associated with this concept which can affect the investment choices and management decisions. This assessment aims to reveal different aspects of fair value accounting and analyze academic journals for identifying the importance of fair value accounting.

FVA can be defined as an accounting process which allows the management of a company to report the assets and liabilities of the business at such prices which are similar to the fair values of the same. The advantages which can be identified for FVA are listed below in details:

• Accurate Valuation: The method of accounting is known to provide more accuracy in terms of financial reporting and valuation of assets and liabilities of the business. In case, the prices are anticipated to increase or decrease the valuation of assets and liabilities of the business would be showing such a fluctuation (Marra 2016). The company which applies FVA in reporting enables them to present accurate financial statement. In such a case, the management needs to prepare appropriate notes to account. Therefore, in other words, FVA allows businesses to present a realistic position of the assets and liabilities of the business.
• Measurement of True Income:The method also facilitates accurate and true measurement of the financial information in the annual reports of the business. In such an accounting practice, there is less opportunity for any manipulation of accounting data. The changes which takes place in the assets or liabilities of the business are also reflected in the income of the business and therefore the financial statements show appropriate view of the income and earnings of the business.
• Benefits to the Investors: The method of FVA allows the management of a business to appropriately reflect the assets and liabilities of the business at real values which in turn helps and guides the investors to assess the financial health of the business appropriately (Blankespooret al. 2013). The benefit to the investor in such a case is that they are able to take sound decisions on the basis of the financial statements which is prepared under FVA method.

There are also certain disadvantages which are associated with the concept of FVA and the same are discussed below in details:

• Regular Fluctuation in Values: The major disadvantage of this method of reporting is that the fluctuation in assets of the business happen on regular basis throughout the year and therefore the asset which is reported in the financial statement might not be showing appropriate value and are highly volatile (Magnan, Menini and Parbonetti 2015). These assets also affect the revenue of the business and in some cases also show misleading gains or losses considering the short-term position.
• Reduces Investors Satisfaction: In general cases, most of the business value their assets and liabilities on the basis of historical costs and therefore investors do not notice that a company has followed fair value accounting, any reduction in income of the business result in dissatisfaction of the investors of the business. This affects the business as potential investors refrain themselves from investing in such a company.
• Affects Historical Perspective: In case of Historical valuation, the changes in book value of the asset takes place when the business is purchasing or selling new or old assets. In similar case, the Valuation under Fair value changes on arbitrary issues and therefore, it can be said that the book value of the assets is affected on short term basis.

As per the journal of Marra (2016), the process of Fair value estimation follows a three-tier process and the same is shown below for every level:

The inputs which are covered in this level are cited prices of active markets for different assets or liabilities which are judged. As these prices are available in active market, the same are used by businesses for the purpose of measuring the fair value of assets or liabilities of a business. Therefore, the business needs to access the market when measuring the assets or liabilities of the business under fair value (Lachmann, Stefani and Wöhrmann 2015). The active market which is considered should have adequate volume and frequency for providing necessary pricing information. There can also arise a situation where in the active market is not showing accurate price and is not consistent with the fair value of measurement.

These are the inputs which are different from level 1 inputs and the same can be observed for assets and liabilities of a business. The inputs in this level can be described as quoted assets and liabilities of similar items in active market and the data which is available from the market is presentable in credit spreads, yield curves, interest rates. The fair value needs to categorized in level 3 form in case the inputs are of significant nature.

The inputs under this level are observed to a minimum level and in this situation the evaluation of the new inputs is not feasible and therefore the same are taken on assumption basis estimating the market prices for the assets or liabilities of the business. The business is required to enhance its utilization of pertinent observable inputs along with diminish the overall utilization of unobservable inputs. An instance can be provided where cash flow estimation is used by a business for appropriate valuation of an unlisted organization (Demerjian, Donovan and Larson 2016). In such a case, all valuation in terms of fair value is done on the basis of lowest level inputs which carries more significance.

Three Tier Process

A business which is following fair value accounting process in the reporting framework of the business must consider the qualitative characteristics of the financial statements of the business. The qualitative characteristics are classified into two major heads which are fundamental qualitative characteristics and enhancing qualitative characteristics (Barth 2013). One of the characteristics is relevance of the information which is presented in the financial statement which requires that information which are of significance and can affect the business in one or the other should be included in the financial statements of the business. Another element is materiality of the information which demands such information should be contained in the annual reports which can influence the decision-making process of the investors. Another characteristic states that the information should be represented faithfully and should be free from any material misstatements. One of the enhancing characteristic is that the information which is presented in the financial statements should be comparable in nature so that distinction between the performance of the business in industry and across periods can be made (Kim, Kraft and Ryan 2013). Verifiability is another characteristic which allows verification in the performance of the business on the basis of the annual reports of the business. Another characteristic is timeliness which requires businesses to report crucial financial information within the stipulated time period (Wang 2014). The last characteristic is understandability which requires the business to present the financial information of the business in such a manner that the information is easily interpreted and understood by the users of the annual reports.

The qualitative characteristics which are discussed above are all related to fair value accounting techniques. The prices which are considered under this method needs to be relevant with the market rates and the method also reveal material information in the annual reports. Moreover, the information needs to be disclosed with in a specified period therefore the element of timeliness is followed. Therefore, it can be said that fair value accounting is consistent with all the qualitative characteristics of a financial statement and can be used by businesses for measuring assets, liabilities and equity of the business.

Conclusion

The above discussion shows that fair value accounting process can be used by companies for the purpose of reporting considering the benefits and limitation which are associated with the process. The above discussion points out both benefits and limitations which needs to be considered. The above discussion also identifies three- tier levels of fair value accounting which includes both observable and unobservable inputs. The assessment also shows the relation of qualitative characteristics of a financial statement with the method of fair value accounting and how the same can impact the users of the financial statement of a business.   

Reference

Barth, M.E., 2013. Measurement in financial reporting: The need for concepts. Accounting Horizons, 28(2), pp.331-352.

Blankespoor, E., Linsmeier, T.J., Petroni, K.R. and Shakespeare, C., 2013. Fair value accounting for financial instruments: Does it improve the association between bank leverage and credit risk?. The Accounting Review, 88(4), pp.1143-1177.

Christensen, H.B. and Nikolaev, V.V., 2013. Does fair value accounting for non-financial assets pass the market test?. Review of Accounting Studies, 18(3), pp.734-775.

Demerjian, P.R., Donovan, J. and Larson, C.R., 2016. Fair value accounting and debt contracting: Evidence from adoption of SFAS 159. Journal of Accounting Research, 54(4), pp.1041-107

Kim, S., Kraft, P. and Ryan, S.G., 2013. Financial statement comparability and credit risk. Review of Accounting Studies, 18(3), pp.783-823.

Lachmann, M., Stefani, U. and Wöhrmann, A., 2015. Fair value accounting for liabilities: Presentation format of credit risk changes and individual information processing. Accounting, Organizations and Society, 41, pp.21-38.

Magnan, M., Menini, A. and Parbonetti, A., 2015. Fair value accounting: information or confusion for financial markets?. Review of Accounting Studies, 20(1), pp.559-591.

Marra, A., 2016. The Pros and Cons of Fair Value Accounting in a Globalized Economy: A Never Ending Debate. Journal of Accounting, Auditing & Finance, 31(4), pp.582-591.

Wang, C., 2014. Accounting standards harmonization and financial statement comparability: Evidence from transnational information transfer. Journal of Accounting Research, 52(4), pp.955-992.