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Challenges of fair value accounting
This alert is issued by the staff of International Auditing and Assurance Standards Board (IAASB) in order to assist auditors by concerning areas within the International Standards on Auditing (ISAs) that are relevant in audit of the fair value accounting estimates in times when market is uncertainty. It has focus on financial instruments and related issues that concerning whether an entity has the ability to continue as a going concern. This alert is relevant to auditors of entities that have invested in financial instruments.
Recent market has experience the difficulties that arises in valuing the financial instruments when it is difficult to obtain sufficient information or market information is not available.
U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) similarly defined fair value as the amount for which an asset can be exchanged, a liability settled, between knowledgeable, willing parties, in an arm’s-length transaction. The appendix to ISA 454 discuss of fair value measurements and disclosures under different financial reporting frameworks, includes the fact that different definitions of “fair value” may or could exist under such frameworks.
The following matters described are particularly important for auditors and preparers when considering the fair value accounting estimates:
- The availability or lack of information or evidence and its reliability;
- The breadth of liabilities and assets to which fair value accounting is required to be applied;
- The choice and sophistication of acceptable valuation models and techniques;
- The need for disclosure in the financial statements about measurements methods and uncertainty especially when markets conditions are illiquid.
Of the above matters described, this can create the greatest challenges to preparers as well as auditors when obtaining the reliable information related to fair value in the current or present environment. The reliability of information available to management for support the making of fair value accounting estimate vary widely, and thus affect the degree of estimation uncertainty associated with the fair value. Market price information becomes unavailable and estimation needs to be made on the basis of other resources or information if markets become inactive in certain situation. The degrees of estimation uncertainty tend to increases and affects, in the results of the risks of material misstatement. There are limits of the information that management can obtain and maybe available to the auditor as audit evidence in such circumstances. Nevertheless, whether the inputs are observable or not, the auditors need to obtain sufficient audit evidence recognizing that the evidence maybe be different from information that has been previously available.
While estimation of fair value has proved to be difficult in light of market uncertainty, but it has not proved to be impossible to acquire sufficient information to record these fair value in financial statement.
Fair value accounting are commonly thought to related to financial assets and liability, thus the use of fair value is more widespread. The impact of fair value accounting maybe seen with regard to the value of goodwill and intangibles acquired in a business combination, endowment funds, non-monetary exchanges, share-based payments and the other classes of liabilities and assets.
Another challenge of fair value accounting is the widespread concern over the reliability of values in illiquid markets. When a company credit rating become deteriorates, many perceive a counterintuitive effect which they find difficult and hard to accept it. A failing rating would lead to a decline in the fair value of a company bonds such as liabilities, and if liabilities are included in the fair value this will create a profit at a time when the company performance may have get worse. As is well known, fair value accounting means the deterioration in the quality of the company own debts or liabilities, which will lowers its value in the present market. Correspondingly, with the improvement in the company’s credit quality, resulting in making its debts or liabilities more valuable, this can creates an accounting loss and reduction in capital of the company.
There are few problems occur when there are transactions are taking place on a regular basis and quoted prices in liquid markets, moving from there to the techniques or models for valuation of unquoted instruments is a real problems into uncertainty. And another issue of valuation exposed by the banking crisis has been the implications when markets become illiquid or even more close down, and this leaving the valuations becomes more uncertain.
In short, as fair value move away from that quoted price in liquid markets, the problems of reliability of these values become worse or even multiply.
Fair Value Accounting versus Historical Cost Accounting
In this context, probably most of the controversy of accounting research focuses on the comparison between two alternative accounting approaches such as fair value and historical costs accounting. The analysis of current accounting literature shows that the debate about fair value versus historical cost accounting mainly revolves around the divergence between relevance, namely the utility of accounting information for the various users, and reliability, namely the accuracy of information. The study of the differences between fair value and historical cost accounting can provide a foundation for alternative frameworks based on the assumption of incomplete and imperfect markets.
Firm valuation and fair value
Advocates of fair value accounting argued that the historical cost accounting is meaningless if there is no relationship between the market capitalization and the financial performance of the firm. The historical cost accounting can be consider as benchmark treatment and a growing gap is visible between the book value based on historical cost accounting and market capitalization of firms.
The historical cost accounting approach does not incorporate aspects of the future value. However, there will always be a divergence between the net values of assets and the market value of a firm, especially when current accounting approach does not recognize assets such as labor force and managements skills, and does not report internally generated goodwill. Subsequently, historical costs are adjusted for impairments and amortization, but not for increase in value of assets. But when value of assets decline and impairments is unrestricted, historical cost and fair value accounting are conceptually the same.
Relevance versus Reliability
The debate between historical cost and fair value accounting always revolves around the divergence between the relevance and reliability. As fair value accounting provide information concerning about current market condition and it’s contain a superior basic for expectations than outdated historical cost figure. The fair value practices are the most relevant measure for liabilities and assets. However some argued that historical cost accounting is the most accurate and appropriate ways to measure liabilities and assets that are held to maturity.
Advocates of historical cost accounting refer to reliability and accuracy of information available that is reasonable free from error. It also reduces the comparability of financial statement across entities. An estimation of fair value will inevitably be subject to managerial judgment and uncertain assumptions about future value, such as discount rates and future cash flows if markets are in the condition not liquid.
Performance Reporting and Volatility
Advocates of fair value argued that earnings management and income smoothing are possible under the historical cost accounting framework. If the results of corporate turn out badly, management can influence the reported income under historical cost accounting through the sale of its company assets, as a profit is reported if the net selling prices of an assets is larger than the net book value. But under the fair value accounting approach, the result is already reflected in the income statements and the asset is at fair value, thereby reducing the possibility of income smoothing.
Under the fair value paradigm, more and more liabilities and assets are measured on a continuing basis that reflects the market condition at the balance sheet. Then a firm that choose the fair value approach will report a loss or gain arising from a change in the fair value of that liability r asset after initial recognition. And if the assets are measured on a continuing basis that reflects the market conditions, the depreciation costs with a regular pattern will be less common.
Opponents of fair value accounting state that the fair value approach reduces the predictability of earnings and increase the volatility. Critics argued that fair value accounting contribute to stronger cyclicality of accounting measures and this tend to cause revaluation of assets, while the historical costs would create “hidden” reserves (Laux and Leuz, 2009). Capron (2005) warn against the disadvantages of the use of fair value measurement in financial reporting. Specifically, Capron argues that when the assts is accounted for at fair value, the values of financial statement of the organization are influenced by change of their market prices over time, and these measurements can lead to misinterpret the value of assets. Bignon, Biondi, and Ragot (2009) stated that the usage of fair value accounting is limited by specificities, complementarities and asymmetries of information. Fair value accounting reflects the changes in financial condition as the results of fluctuation in credit quality, interest rates and movements in foreign currency rates. Overall, the using of fair value accounting reduces the possibility of income smoothing. The use of fair value accounting will better reflects a company’s exposure towards risk when equity and income become more volatile because of changes in current market conditions (Donker, 2005).
But nowadays more and more organization or entities embrace the concepts of fair value accounting, the knowledge of sophisticated valuation models and judgments of accountants will take greater importance in the marketplace. Lastly, fair value accounting contains of a superior basis for financial reporting than the outdated historical cost accounting.
Many researchers altogether stated that fair value accounting approach provides more relevant information to creditors and investors than historical cost accounting (Rodriguez, Slof, Sola, Torrent, and Vilardell, 2011).