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Fair value can be defined under FAS 157 as the specific hypothetical (exit) market price that results under close to ideal market conditions. This value must be considered in which the transaction takes place between knowledgeable, independent and economically rational parties (Lam & Lau, 2012). Both parties involved are assumed to interact on a basis that they are exposed to identical information set (econbiz). Decision usefulness theory implies that the accounting is a process that provides relevant and reliable information to the decision makers such as the existing or potential investors, stakeholders, lenders and other creditors (arc.hhs).
Fair value accounting (FVA) that takes market value as a consideration is most relevant to decision-useful information especially under a complete and perfect market condition known as the active market (Hitz, 2012). Nevertheless, it is debated that the measures of exit value actually provides partial relevant information which fit into the decision usefulness theory. For instance, exit values reflect the advantages gained by not selling the assets. This help firm to quantify the opportunity cost of continuing business as a going concern (Ronen, textbook).
However, Ronen (yr) provides another view that fair value does not always provide the most relevant measures. As an illustration, because fair value accounting based on exit values, they failed to reflect the used value of the assets' employed within the firm specific operations. This will lead investors to be unaware of the future cash flow that will be generated by the asset within the firm. Meanwhile, FVA still lack in meeting the informative objective of financial statements.
Nevertheless, FVA is still argued to be more relevant as compared to historical cost accounting. For instance, FVA that measure the current value of assets and liabilities does not allow for manipulation and thus increases the reliability and transparency of information available. Besides that, with FVA, shareholders can direct their focus to value of equity and its changes. This not only increase the stewardship function and decrease the agency cost, it is also a way of effective management (Hadded, 2003).
When there is active market value, FVA is considered to be able to provide reliable information. On the other hand, when there is no active market value, the reliability of fair value is questionable. When information is not reliable, it could not assist in decision making and therefore have violated the assumption of decision usefulness of FVA. This is because when there is no market value, the fair value will based hypothetical and subjective measures from internally generated assumption and estimated about the future.
Nonetheless, when relevance and reliable is traded-off against one another, investors viewed relevance information as more important consideration and therefore, FVA become more important (Power, 2010). this problem can be mitigate by including estimates of future in the financial statements which in turn will result in more useful information for decision making It is also suggested that disclosing notes in the financial statements will help in overcoming this problem.
Controversies surrounding the use of fair value accounting
With FVA, some argue that the measurement of assets and liabilities at fair value reflect market conditions and hence provide timely information thereby increased transparency and allowed prompt corrective actions. Nonetheless, controversy arises on whether FVA is indeed helpful in providing transparency and whether it leads to undesirable actions on the part of banks and firms (Lauz, 2010).
The central issue for FVA is the change in Level 1 to Level 3 measurement. Level 1 input are observable and measurable in an active markets based upon quoted market prices for identical assets and liabilities. Level 2 will be used as quoted prices from the sources other than Level 1 which is either observable directly or indirectly. Both the level is known as mark-market models (FASB, 2006; Grant Thornton, 2008). In contrast, Level 3 input are unobservable inputs which applies when there is no active market value. This is known as the mark-to-model accounting. This had led firm to provide subjective fair value prices that are entirely dependent upon management's assumptions such as internal valuation model thus are argued to be less neutral compared to Level 1 and 2 measurements (Grant Thornton, 2008). Hague (2009) argue that when there is a biased price exists, it will lead to the problem of transparency and integrity which are important to the investors.
Meanwhile, the way FVA is recognized and measured are the crux to controversies (Fahnestock and Bostwick, n.d.). Critique also arises as a result of today's innovative and complex financial instruments which is very subjective to illiquid and volatile market. This problem have take place in the banking and broker-dealer industries. Even companies that provide credit default swaps on the underlying asset will be impacted by the FVA. For example, when there is triggered protection for default assets, companies still required to record unrealized losses on the contract because in FVA as a decrease in underlying assets. Companies involved in auction rate securities will also be affected with FVA when they suffer loss in this investment. Thus FVA has been criticized to provide inaccurate results during unusual market condition. This is claimed to be harmful to company in the long run (Nally, 2008).
Besides that, FVA are claimed to be the cause of volatility and contagion in market. As an illustration, when underlying assets that are used to derive the fair value endure from volatility which is then reflected in the value of fair valued assets shown in the statement of financial position (SoFP). Volatility that affects values in SoFP will also lead to volatility in the income statement. In addition, during the sub-prime banking crisis, financial assets that are measured using fair value worsen the crisis. This phenomenon is known as the procyclicality (Deegan, 2012). Laux and Leuz (2009) also critique that FVA caused contagion when exacerbates swings occur in the financial system and causes overreaction among investors and creditors. This caused market prices of unrelated assets to fall along with the prices of truly distressed assets (Allen 2009).
In response to this, FASB eased the accounting rules to give banks more flexibility in applying mark-to-market accounting to their toxic assets. However, it is claimed that this agreement would not come without significant pressure.
Furthermore, an argument have made by Magnan and Thornton (2010) for the purpose of marking all assets and liabilities in the financial statement to their market values. There is no need to use fair value even when the markets run efficiently. This is because they feel that financial statements are present to reflect the actual value of the entity in operation or in liquidation. They debated that investors and creditors are actually more interested in the long run earning power of the entity rather than just the current value. Power (2010) supported the statement by giving logical analysis that if financial statement and financial market could perfectly reflect each other, then accounting would be unnecessary.
Critics also present that wider use of FVA will be an obstacles for the auditors. While FVA provide users of financial statement with relevant information, it also resulted in new area f audit risk (Grant Thornton, 2008). For example, auditors will have to assess the process and assumption made by the management when the entity's assets and liabilities are valued at level 2 or 3 measurements. This require that auditors to place much more reliance on estimates from external experts (Magnan and Thronton, 2010). Meanwhile, accountants are now become the "compilers rather than valuers" of financial information (Power, 2010).