Comparisons Between The Concepts Behind Fair Value Accounting And Historical Accounting Accounting Essay

Published:

Application 1 and 2 are modified historical cost accounting maintaining with standard revenue recognition. However, application 3 is a potential change in paradigm. >Fair Value to Whom? The article focuses on the shareholder. It rises up the question of what are the pluses and minuses of fair value accounting for reporting to shareholders.

Approach Used in the Fair Value Issue Discussion

The approach taken by the author is demand approach. In this approach, accounting is seen as a product and the product is subjected to design. Customer of the product is the shareholder. The product design features, which either fair value or historical cost will satisfy the customer's need. The author presumes that shareholders require accounting information for two reasons:

Valuation: shareholders use accounting information to know the (fair) value of the equity.

Stewardship: Shareholders use accounting information to evaluate management's stewardship.

Information for Better Markets

Lady using a tablet
Lady using a tablet

Professional

Essay Writers

Lady Using Tablet

Get your grade
or your money back

using our Essay Writing Service!

Essay Writing Service

If the historical cost information and fair values both are relevant, both of the info should be reported. The issue is which measurement basis of the accounting system we should focus on to determine the summary, bottom-line numbers, earnings and book value.

Comparisons between the Concepts behind Fair Value Accounting and Historical Accounting

Fair Value Accounting

Historical Cost Accounting

Primary information for valuation

Balance Sheet

Income statement

Price/Book Ratio

1

Not equal to 1

Earnings

Reports the stewardship of management

Reports company performance in arbitraging price in input and output markets.

Current income predict future income

Cannot

Can

Shock to value

Yes, report on the risk of equity investment

No, report shocks to trading in input and output market

P/E Ratio

Price/shock-to-value

(value at risk)

Current earnings (base) multiply with forecast of future earnings

The Demand for Fair Values

Ideal fair value accounting reports that the book value from the balance sheet can value a company. Earnings in the income statement have no influence or relation with the value of company.

Ideal historical value accounting reports that the earnings from income statement can value the company while the balance sheets do not report the value.

Under ideal fair value accounting, current book value can forecast the earnings and the book value is well enough for forecasting and valuation.

Meanwhile, under ideal historical value accounting, the earnings can be forecasted from its current earnings. In short, it can be said that the current earnings show the future earnings.

From the findings of the writer, to satisfy the valuation objective, it can be made by stating fair value in balance sheet or made from historical cost income statement.

Fair value accounting is considered better than historical cost accounting if one does not know the required equity returns. Valuation under historical cost accounting requires a required return. Fair value accounting can take the value in balance sheet without requiring of required return.

Fair Value Measurements

Fair value is defined as market exit price. According to FASB Standard 157, there are three levels of fair value measurement to define the market price. Level 1 measures the increasing of subjectivity levels; level 2 and 3 measure the hypothetical market price estimation. The author focuses on the measurement from level 1 in order to differentiate the pluses and minuses of fair value.

Pluses and Minuses of Level 1 Fair Value Measurement

Refer to FASB and IASB, in order to implement fair value accounting, we need to concern about two types of question. First, does exit value capture value to shareholders? Second, does fair value apply at the level of aggregate assets and liabilities that jointly produce value for shareholders?

All accounting information should possess reliable evidence and objectivity. If the shareholders' value is determined just by exposure to market price, then the fair values or market values are a plus. However when the firm arbitrages market price, then the fair values or market values are a minus. Fair value is inappropriate if the firm adds value for the sake of shareholders by buying the input and selling the output at different market prices.

Lady using a tablet
Lady using a tablet

Comprehensive

Writing Services

Lady Using Tablet

Plagiarism-free
Always on Time

Marked to Standard

Order Now

Next, the fair market prices are a minus when the fair market prices replace for historical cost information and prices which rely on historical cost information. The fair value would also be a minus if incompetent prices arise due to the loss of historical cost information which bring price bubbles into financial statements.

Fair Value Matching

Fair value accounting is likely to skip the extremely large number of rules which involved in implementing revenues and expenses matching in the income statement. However, fair value accounting is difficult to implement due to its own matching concept.

It will be a minus if fair value accounting without asset and liability matching. It should be noted that both asset and liability must be fair valued, or else it will cause mismatching in income statement. Furthermore, matching issue becomes more complex when the value is tied to customer relationships.

Pluses and Minuses of Level 2 and Level 3 Fair Value Measurements

In Level 2 and Level 3, fair value is estimated based on market price rather than value-in-use. Problem occurred where there is no guideline in making estimation. Bias might involved as the estimation is based on one's assessment. That kind of estimation contradicts the objectivity of market price. There are few issues arise in the use of estimated fair values:

Fair value accounting estimated under section 3.1 is applies when shareholder value is determined by exposure of market price. However, there is limitation when it involved illiquid market which the value is not determined by the market prices.

Enforcement of discipline in estimating market prices at Level 3 is doubted as it is based on one's assumption and bias is taken into consideration.

Errors of fair value estimation will cause errors in balance sheet and income statement.

There is difference when historical cost involves estimates and estimated fair values. Fair value is estimated based on historical transaction record. On the other hand, level 2 is estimated based on "observable inputs" which is different from referring present value of cash flows when marking to model.

Historical cost is estimated based on the actual transaction record. However, estimated fair values settle up against estimated fair values when it is without historical transaction accounting.

FASB Statement 157 required valuation methodology for estimation errors to be disclosed.

Tolerance by shareholders regarding to fair value is limited.

Conclusion: Pluses and Minuses

Fair value accounting with investment funds is working for valuation and stewardship as the one-to-one relationship between exit prices and fair value to shareholders is holds. However, historical cost accounting is applied if one-to-one condition is failed. Although both fair value accounting and historical cost accounting have its own problems and criticism, but fair value accounting is preferable as it provides more transparency compared to historical cost accounting.

Philip Broadley's View

In examining Penman's finding, Philip Broadly declares that he agrees with almost all of the findings, particularly the notion that fair value accounting of assets and liabilities represent paramount information for investors. However, he disputes the notion that those involved in preparation of financial reporting are infrequent users of financial reporting.

Philip Broadly is a chairman of Hundred Group of Financial Directors, his perspective on fair value is on preparer's perspective. Company, boards and management are the preparer of financial statements. Preparer perspective is actually akin with the objective of the company. Preparer wants to prepare a report that will reflect the way businesses are managed and to provide relevant, reliable, comparable and comprehensible information to a wide range of users either external or internal, to assist them in making rational and wise economic decisions and also to provide a basis for assessment of the results of management's stewardship of the resources entrusted to it.

Philip stated that fair value is predicted on the availability of observable price. Accountants are not typically trained to evaluate the accuracy and validity of fair value amounts and they have relied on fair values amounts calculated from internal models used by other departments within the organization. Thus, fair value for internal models may be illusory because it may not provide a consistency across reporting company. Governance policies should be adopted to ensure accurate and reliable measurements.

Lady using a tablet
Lady using a tablet

This Essay is

a Student's Work

Lady Using Tablet

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Examples of our work

Hundred Groups try to simplify the accounting standards by reducing the cost and complexity for preparers, increase usefulness and understandability for both internal and external users, and to avoid problem that can arise due to lack of clarity, comparability and transparency.

Broadley give an example that financial reporting overlap with pensions. Companies are unquestionably changing their pensions and funding policies because of the volatility impact of the reporting requirements. He highlights the particular problem of trying to measure hundred of billions pounds of pension liabilities off of a very long dated gilt benchmark that is made up of 2bn of index-linked stock. Rather than focusing on a single number, there should be more communication based around a range of possible outcomes.

Lastly, Philip stated that fair value can provide better information for the market when there is an observable market price exist and the tests of depth and liquidity can be passed. Fair value benefits the investors as fair values are more accurate, timely and comparable across different firms. Financial disclosures that use fair value can provide investors with insight into prevailing market value. Management must also provide sufficient information rather than just voicing out opinion.