A study on Full Fair Value Accounting

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Over the last decades, standard setters and regulators have directed their efforts to find the best solution for the accounting treatments based on the recent crisis to fulfil the requirements of the IASB Conceptual Framework as a result the current debate is on Fair Value Accounting (FVA). Trying to make this work for the entities and their users they are also trying to introduce the Full Fair Value Accounting (FFVA). The importance of FFVA seems to increase further on the international scene due to recent global crisis. The financial crisis has turned the spotlight on fair value (FV); as a result the standard setters revised and changed some standards to help entities. It is important to mention that FV is referred to in a number of boards trying to shape this system which are IASB, IFRS and FASB. Some of the standards are IAS 39 Financial Instruments, IAS 40 Investment Properties, IFRS 7Financial Instruments: Disclosures, SFAS 157 Fair Value Measurement, to set up clear, consistent guidelines for FV measurements and disclosures. FVA is a modern way of accounting treatment and being adopted by many countries across the world. Standard setters argue that FV measurements appear to meet the conceptual framework criteria so the focus will be based on how FV is treat financial instruments. In the underneath discussion using theoretical and practical issues, we will illustrate the FFVA and the benefits to investors using an example based on fair value disclosures (Example 12: Assets measured at FV) from the exposure draft (ED/2009/5).

Main Body

Conceptual Framework

Under IASC (1989) conceptual framework is a "coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting". Using conceptual framework entities must apply standards and principles providing financial information about the financial position, performance and financial flexibility of companies that is useful to a wide range of users in reaching economic decisions. Under International Accounting Harmonization (IAH) standards are harmonized with regulations and these standards give useful and comparable financial statements for the benefits of the users.

Investors and Full Fair Value Accounting

Investors consist of two categories which are existing investors and potential investors. Both categories try to analyze their investment through financial statements, external information (information about future profits) and through mathematical models to balance their risks and rewards. Under standard setters view theoretically when the company meets the interest of investors then all other areas will meet their objectives. In order to be useful as a basis for rational economic decision-making, financial information must be relevant, reliable and comparable. This will be achieved through the application of FV.

The rule of FV became famous just after the global economic crisis and the financial scandals such as Enron and Lehman Brothers. FV is defined by IASB as "the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm's length transaction, the market price in a theoretically perfect market". In other words, FV is the expected gross exchange value, without any reduction for transaction costs. For each asset and liability exists one and only one FV which can be determined by valuation techniques. What is meant by FFVA is that all financial instruments, assets and liabilities need to be measured at FV and registering any variations in their value immediately on the income statement. Measuring all financial instruments, assets and liabilities by their FV will give users a 'True and Fair View' of the company's real financial condition because only FV reflects the existing financial situations and changes in them.

The adoption of FFVA has some advantages and disadvantages as well. "Modigliani and Miller have shown that the value of an entity is determined solely by summing up the capital values of the individual investments given the absence of taxes and of information asymmetries. However, outside this ideal world not only the investment structure significantly influences the value of an entity but also the capital structure". Measuring assets and liabilities at FV, the information provided will allow investors to have a better view to assess future performance and returns. FV is being a more information-rich concept, given that it is a market-based value representing the outcome of the views of all the market participants, not just of one such participant, namely the reporting company, historical cost being specific to a single entity.

Advantages and Disadvantages of FFVA in Investors' view

Financial Reports serve the needs of investors who take the detailed financial information they need to reach a decision. Under the FFVA changes in assets, liabilities and equities should be recognized in the primary financial statements including as much information as possible that is currently disclosed outside of the financial statements. Companies must understand what characteristics make the information useful for investor's financial decision-making. The quality of the information to investors arises from financial statements, its relevance, reliability, accuracy, comparability and understandability. Also, the timeliness of the information affects the cost of capital investors and the risk of investment in the entity's securities.

Three of the most important characteristics of information are relevance, reliability and comparability. Relevant information can influence an economic decision as result investors can use that information to make their decisions. Information about the current level and structure of a company are relevant to investors when they try to predict the risks and the ability of the company to be going concern. On the other hand, if the use of FV is new for some transactions the previous financial statements lacked relevant information.

In addition, reliability of information according to investors' perspective is that which faithfully represents what it reasonably be expected to present. The reliability of information must be free from material error and bias and in order to be depended upon by investors. Information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading. Sometimes, information is highly relevant to investors' decision making process, has been moved out of the company's financial statements because it is uncertain. It is critical that investors be provided with full disclosure of such information in the financial statements. Investors through FFVA are able to compare the financial statements of entities through time and also are able to compare different entities of the similar industry in order to evaluate their virtual financial position and performance. The measurement of the financial effect must be carried out at a consistent basis.

On the other side of the coin, one disadvantage of FV is that, it does not require a transaction to have occurred to recognise the change in value; it can recognize profits and losses earlier than would the historical cost approach. Here, there is a risk because FV overstates values and profits leading to stronger balance sheets when markets are rising but equally has a tendency to overstate the declines in value, resulting in weaker balance sheets. This has led to criticism that FV adds to so-called 'pro-cyclicality' by amplifying the effects of the business cycle. Financial institutions have complained that FVA has effectively been driving business behaviour rather than reflecting it. This is done by encouraging banks to over-lend in good times while exaggerating their financial problems when the business cycle turns down. Although this tendency to follow the market has the advantage of transparency to investors, it may not produce the financial information most suitable for prudential supervision purposes.

Another problem lies in the FV is the treatment of liabilities. When a company's credit rating deteriorates, many perceive a counter-intuitive effect which they find it difficult to accept. A falling rating would lead to a decline in the FV of a company's liabilities for instance, and if they were reported at FV this would create a profit at a time when the company's performance or prospects may have got worse. As a result investors of financial statements may not interpret FV properly when analysing the company's results.

Example 12 Disclosure: Assets measured at FV

Based on the example illustrated in Appendices about Disclosure, Assets measured at FV the IFRS requires quantitative disclosures about the FV of each class of asset and liabilities. In our example we can see that the assets are all financial instruments except Land and Buildings. Under IFRS 7: Financial Instruments: Disclosure, entities need to provide to users certain and sufficient information about the measurement and the classification of each measurement to provide reconciliation with the balance sheet figures. The objective of the disclosure of those assets is to provide information to users which can enable them to assess the methods and inputs used to develop those figures and the effect of the measurement on profitability. Recognition of gains and losses in the period occur will provide a better reflection of managements' stewardship. Investors under these circumstances will evaluate the financial statements and their disclosures to have a broader view for their economic decision. The FV hierarchy used to measure FV is divided into three levels: Level 1 (referred as mark-to-market) comprises the highest level of market inputs. What is meant is that, "quoted prices for identical instruments traded in active markets where trading is of sufficient frequency and volume that prices are readily and publicly available". This category of Fair Value Hierarchy is the most reliable for investors because it gives evidence of FV of each instrument.

Moreover, Level 2 and 3 are more complex to measure because entities need to use hypothetical market prices. These levels referred as 'mark-to-model'. Level 2 estimates based on observable market inputs. The bases for these estimates include quoted prices for similar items in active markets, quoted prices for identical or similar assets in non-active markets, prices which are not current are substantially variable, either over time or between market participants, are not publicly available and other observable market inputs. In Level 3 estimates use of non-observable market inputs, which of course cover a wide range of possibilities. In using such inputs the aim is to stimulate how the market would arrive at market price based on the assumptions that the market is believed to entertain. In this case, Level 3 prices are used when the Level 1&2 is not available. Entities must disclose the methods and the inputs used in the FV measurement and the information used to develop those inputs, and what is 'observable' and 'unobservable' market inputs.

Assuming that the company is a going concern, in this example equity investment totaled (£75) is divided in three categories which are Level 1, 2, 3 and the amount for each category is £30, £40, £5 respectively. For investors £30 (Level 1 prices) is the most objective and reliable evidence. Also, investors feel more confident to measure and understand those prices because are based on quoted prices and the information provided by entities financial statements is useful. In contrast, may be detrimental to investors to base their decisions on this level because if the market prices are not efficient (price bubble) will show bubble prices on Balance Sheet and also there will be bubble gains on the income statement. On the other hand, Level 2&3 (£40, £5 respectively) is based on hypothetical prices as a result measurement for investors is not so reliable and is complex. Based on those amounts (£40, £5) it will be more helpful for investors to have a range for this instrument and not a constant number. For example, it is difficult to measure the level 2&3 that the price of the instrument at FV is £40 or £5. This complexity will be influence the investors' decision-making. Companies in order to reduce the complexity and awareness of investors for Level 2&3 use more disclosures on estimation of financial instruments include risk (liquidity and credit) and the effects of that estimates on earnings and financial position. Under these circumstances financial statements will be more reliable, relevant and understandable to the investors having more useful information for their economic decisions. Investors must know that past performance does not assure similar future returns as a result they need to make adjustments for their expectations about future performance.

Valuing financial instruments at their FV will allow investors to obtain a "truer and fairer view" of the company's real financial situation. A sensitivity analysis disclosure for all Level 3 FV measurements is required by the revised standard. The purpose of the sensitivity analysis disclosure is to provide investors and users with information about measurement uncertainty for Level 3 FV measurements.


Bearing in mind the aforementioned arguments, Full Fair Value Accounting (FFVA) is undoubtly the most controversial issue in the financial world nowadays, full of arguments that do not need further scrutiny but need more economic analysis. It is a complex issue to tackle though it is a powerful tool towards transparency. Some companies find it too strict and too costly to have third parties to evaluate their assets and liabilities every year. On the other hand, from an investor's point of view, FV is more realistic and transparent which enables them to reach a wiser decision and enables them to see the value of an asset or liability at a certain amount of time and finally this represents a more true and fair view of the accounts. Disclosures of the fair value hierarchy in the notes of Financial Statements will be helpful for investors to evaluate their decisions as a result to have a broader view and risk evaluation. Concluding, the challenge is to overcome these difficulties in order to enhance the use of FV and the overall usefulness of financial reporting information.