ACCT6007 Financial Accounting Theory and Practice
This essay critically analyzes the article written by Marra (2016) that emphasizes the implications of fair value (FV) accounting. In this essay, advantages and limitations of fair value accounting are explained.
In addition, it also explains the meaning of the statement related to use of three-tier process in fair accounting by using market-based measures. Moreover, it also provides a discussion on qualitative characteristics of financial information in using FV method.
Uses and limitations of Fair Value (FV) accounting
Fair value accounting is based on the current market value that highlights the most meaningful representation of the financial position of the organization. This method provides the updated information of the variables used in cost accounting.
According to Marra (2016), fair value accounting is effective to provide actual reflection on the financial conditions of the firms. However, the findings of Abbott & Tan‐Kantor (2018) argue that the fair value is not effective because it may cause volatility in the financial measurements like income and value of assets due to changes in the economic and market conditions over time.
It is because there is a significant impact of the market conditions on the value of the assets or the incomes and expenditures due to impact of volatility in the cost. Supporting to the findings of Marra (2016), Chung et al. (2016) also affirmed that fair method is better than the historic method in terms of value of the assets due to dependency on the latest and updated information.
On the other hand, historic accounting method is not effective than fair value accounting method because it depends on the outdated information that may lead to wrong decisions. But, fair value accounting method is appropriate to report the loss of real value of an asset due to inflation or the gain of real value in asset during deflation.
So, this method makes the better decisions for the management to assess the value of assets even on the impact of changing economic conditions. However, the study of Ellul et al., (2015) argues that the use of fair value accounting method can provide the opportunity to the management to earn private gains through misuse of the fair accounting.
In the study of Marra (2016), it is found that fair value method is closely related to the requirements of the globalized and information-based economy that enhances its significance and use in the future. Supporting to Marra (2016), Sharma (2018) highlights that fair value accounting is effective in terms of relevance, reliability, comparability and comprehensibility of financial information.
This finding can be supported by Magnan & Parbonetti (2018) that in this globalized and information driven economy, there is need to update the information available to make a fair decision. In relation to this, the changing business environment due to impact of globalization makes it mandatory for the firms to have updated information.
So, the use of fair value is the most suitable in perspective of the globalized and information-based economy. On contrary to this, Ellul et al. (2015) argued that fair value accounting is not a viable method of accounting. It is because this method fails to implement and causes the unreliable valuation when the ratio of output values to fair values for shareholders is not sustained supporting the views of Marra (2016).
At the same time, Nobes & Stadler (2015) depict that the use of fair values in accounting is disadvantageous when the markets are not liquid like during the financial crisis. It means this method will not be applicable in such adverse economic conditions because it can ruin the business of the company and does not provide any opportunities to recover from those adverse situations.
Three-tier process in fair value accounting
The measurement of fair value follows a three-tier process by considering the market based measures. According to ASC 820, the first tier in estimation of fair value shows the level 1 inputs that are quoted prices (unadjusted) in active markets for identical assets or liabilities.
These values can be identified by the reporting entity at the time of measurement or the date of the measurement. At the same time, the second tier is associated to the level 2 inputs that are quoted prices except the level 1 that are evident for the asset or liability in direct or indirect way.
The level 1 assets are valued as per the evident market prices as they can be marked to market. The key examples of the level 1 asset are gold bullion, foreign currencies, marketable securities, Treasury Bills, etc. (Linsmeier, 2013).
Level 2 inputs incorporate interest rates, default rates, credit spreads, yield curves, and inputs that are identified through market data by using the procedures like correlation. These level inputs are determined on the basis of quoted prices in inactive markets having observable inputs like yield curves, interest rates, and default rates. The key example of the level 2 asset is interest rate swap (Kornél, 2014).
On the other hand, the third tier is associated to the level 3 inputs that are related to the unobservable data and used when there is no availability of observable market inputs such as market prices. It is based on the own understanding of the company regarding assumptions like pricing of asset determined by the market participants (McDonough and Shakespeare, 2015).
These assets are generally not liquid and enable the firms to determine the fair value by using risk-adjusted value ranges. These assets are not actively traded but their estimation can be done through mix of prejudiced assumptions, multifaceted market prices, and arithmetical models (Henderson et al., 2015). The key examples of the level 3 assets are private equity shares, distressed debt, complex derivatives, foreign stocks, mortgage-backed securities (MBS), etc.
Qualitative characteristics of financial information include relevance, representational faithfulness, timeliness, understandability and comparability. Fair value method shows the relevance in terms because relevance is determined based on whether the fair value is used by the company or not to make the relevant financial reporting.
This method is helpful to present better predictive value and more relevant financial information. Even the accounting frameworks also consider the fair value as the most relevant accounting method. The fair value method is based on updated and latest information as the current market prices of the assets can ensure the trusty illustration of the financial data (Barth, 2013).
Similarly, undestandability is related to the classification, characterisation and presentation of the information in clear way. Fair value method is effective to present the information in well organized way and disclose the information in notes to the account.
Moreover, this method also considers the qualitative characteristic of comparability that shows the quality of information enabling the users to recognize the likeness and disparity between the two economic aspects (Cairns et al., 2011).
It is because fair value uses updated information that considers the differences and similarities in two sets of economic conditions. Moreover, timeliness is a valuable qualitative characteristic that is considered under fair value accounting method because it provides the information to decision markers before it loses its capacity to impact the decisions.
It means the firm can use this method to make timely decisions because update information enables the firms to make effective decisions within the timeline (Christensen & Nikolaev, 2013). FV measurement is generally used for the measurement of assets and liabilities in the financial statements.
It is helpful to estimate the price at which the assets are sold or liabilities are transferred between the market participants at the measurement date under specific market conditions. It is used for the specific asset or liability that is subject to measure, for non-financial asset that is appropriate to measure, principle market for the asset or liability and valuation technique (Ellul et al., 2015).
It can be stated that the fair value accounting method has own pros and cons, but it quite effective to provide the most valuable accounting aspects that makes it popular. At the same time, it can also be summarized that there is three-tier process including level 1, 2 and 3 that is useful to assess the value of the assets based on observable and non-observable ways.
Moreover, FV accounting measurement is the most applicable to assets and liabilities in the financial statements and follows the qualitative characteristics of relevance, representational faithfulness, timeliness, understandability and comparability.
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