Exploring Fair Value (FV) Accounting: A Literature Review

With the economic condition and complex business condition, fair value accounting has been gaining momentum throughout the time. It helps accountants to record the assets and liabilities in the books of account of company. This report reveals the pros and cons of the fair value accounting and how it could be used by company to strengthen its reporting frameworks (Choudhary, et al. 2017).

Explain and explore Pros and Cons of Fair Value (FV) accounting after conducting literature review on the topic.

Fair value accounting has been used since ages and is not a modern or a just emerged concept. The method is widely used in financial reporting to make valuation measurements. The recent times have witnessed significant use of this method at several instances, however, the fight between whether it is useful or not still continues. This is so because there is no customised market where fair value is readily available and assumptions play a major role in the valuation part (Madhavan, et. al 2014). Resultant many pros as well as cons of the Fair Value accounting have been observed and the research material have also countersigned some of them.

Pros

• The fair value accounting has been supported by many people on the grounds that it provides the users with the information which is accurate as far as the valuation of assets and liabilities is considered. The valuation is made on the basis of current prices and that helps to analyse the current state of affairs (Marra, 2016).
• The information that is laid by this method is respectful to time, i.e. the information relates to the current time period (Choudhary, et al. 2017).
• The financial reporting done on the basis of fair value accounting is more detailed for the readers. There is a listing of the valuation method, risk exposures, assumptions, market sensitivity, and etc.
• Through true valuations comes the true income calculation of the financial corporation.
• It is debated in the current times that the historical accounting method is not providing the results that are expected out of any should financial reporting. The value that is prevailing now is of more use and is accurate. Hence, the fair value accounting offers an in built advantage (Cannon, & Bedard, 2016).

Cons

• For the business houses that have assets churned throughout the year and face a lot of volatility, this valuation method is not entertained (Choudhary, et al. 2017).
• Many a times the fair value accounting method is not disclosed and hence keeping the shareholders unaware of the use. This as a result makes the shareholders dissatisfied.
• A lot of assumptions are made while using this valuation method, and hence there are chances of incorporation of manipulation in the whole process.
• Using the fair value method of accounting, the importance that should be vested to the historical method is all lost (Israeli, 2015).

What does the author mean by the statement? ‘The estimation follows a three-tier process, with a strict preference for market-based measures’ p586. Explain the three – tier process in detail.

For any valuation method, there is an intense significance provided to the inputs that are used for valuation. The sources of the inputs can be varied. However, the relevancy that is forwarded by the different input methods is different. The three tier process that has been labelled by the author in the statement “the estimation follows a three-tier process, with a strict preference for market based measures” is the three level input hierarchies (Griffin, 2014). These are the different techniques of input valuation. In this the level 1 of the input hierarchy are the prices that are quoted in the active market on an unadjusted basis. These are those that are similar to the assets and liabilities that are to be valued. When level 2 inputs are considered, the inputs that are left other than the ones already comprising of the level 1 quoted prices. These represent the similar assets or liabilities on a quoted basis that are promoted in the market. These are observable inputs. Level 3 inputs however, are advised to be used at the minimal rate and are completely unobservable category of inputs. These are used in the situation when there is no availability of all the relevant inputs (Bens, Cheng, & Neamtiu, 2015).

However, there is a three tier of the input availability with any organisation while using the fair value accounting, but it should always rely upon the inputs that are completely observable and considered relevant. However, all these inputs have their own significance. This is so because the unobservable inputs are also used to make the fair value valuation when the observable inputs are out of availability (Glover. Taylor, & Wu, 2016).

What qualitative characteristics of financial information are considered in using FV method in financial reporting? FV measurement is most applicable to what element of financial statements (i.e. Asset, Liability, Owners Equity, Revenue and Expense), and to what aspect of that element?

The Three-Tier Process in FV Accounting

The qualitative characteristics to be considered while using the fair value method in financial reporting are:

• Usefulness of the information provided by the financial accounts and its relevance, i.e. the ability that the financial reporting entails in influencing user’s decisions (Choudhary, Merkley, & Schipper, 2017).
• The level at which the information in the financials is represented, i.e. whether it is faithful and reliable or not. There shouldn’t be any prejudice and the actual economic conditions are represented by them (Zheng, & Chen, 2017).

The element of financial reporting to which the fair value measurement is most applicable is the owners’ equity. The owners’ equity comprises of both the components of assets and liabilities. After the liabilities are deducted from the assets, the owner’s equity is computed. Resultant when the owner’s equity comes into picture, every element of the financials gets covered in that. However, this way it can be said that every element of financial reporting at some place makes use of the fair value accounting when this method is incorporated in business (Hodder, Hopkins, & Schipper, 2014).

In the owner’s equity, the aspect that is widely using the fair value method is its valuation. When the owner’s equity is valued at the fair value prevailing in the market, a clear picture of the current market value of the shareholders can be gathered. This way it becomes easier to analyse the value at which the corporation stands in the market. With the use of fair value accounting in owner’s equity, the comparison of the company’s performance can be done easily with the other companies in the same industry, and hence the market position can be easily known. By using the fair value accounting, company could easily evaluate the owner’s equity and the value creation in its books of account.

Conclusion

After assessing all the information and details of the fair value accounting and qualitative characteristics to be considered while using the fair value method, it could be inferred that company could easily strengthen the reporting and accounting frameworks of the business. It helps company to keep its books of accounts more transparent to its stakeholders. The fair value measurement method is used to identify the true and fair view of the assets and liabilities recorded in the books of account of company. Nonetheless, many big multinational companies are using the fair value accounting methods on quarterly basis to identify the fair value of its books of accounts.

References

Bens, D. A., Cheng, M., & Neamtiu, M. (2015). The impact of SEC disclosure monitoring on the uncertainty of fair value estimates. The Accounting Review, 91(2), 349-375.

Cannon, N. H., & Bedard, J. C. (2016). Auditing challenging fair value measurements: Evidence from the field. The Accounting Review, 92(4), 81-114.

Choudhary, P., Merkley, K. J., & Schipper, K. (2017). Qualitative characteristics of financial reporting errors deemed immaterial by managers.

Glover, S. M., Taylor, M. H., & Wu, Y. J. (2016). Current practices and challenges in auditing fair value measurements and complex estimates: Implications for auditing standards and the academy. Auditing: A Journal of Practice & Theory, 36(1), 63-84.

Griffin, J. B. (2014). The effects of uncertainty and disclosure on auditors’ fair value materiality decisions. Journal of Accounting Research, 52(5), 1165-1193.

Hodder, L., Hopkins, P., & Schipper, K. (2014). Fair value measurement in financial reporting. Foundations and Trends® in Accounting, 8(3-4), 143-270.

Israeli, D. (2015). Recognition versus disclosure: evidence from fair value of investment property. Review of Accounting Studies, 20(4), 1457-1503.

Madhavan, A., Yang, J., Zosin, L., Zalutsky, K., Asriev, A., & Butler, G. (2014). U.S. Patent Application No. 14/275,234.

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), 582-591.

Zheng, X., & Chen, J. (2017). FINANCIAL REPORTING QUALITY IN CHINA: A PERSPECTIVE OF QUALITATIVE CHARACTERISTICS. Transformation in Business & Economics, 16(3).