Fair Value Measurement Fair Value Hierarchy Accounting Essay

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IFRS 13 seeks to increase consistency and comparability in fair value measurements and related disclosures through a fair value hierarchy. The hierarchy categorises the inputs used in valuation techniques into three levels (Deloitte Global Services Limited, 2013).

Level 1 includes measuring assets and liabilities of the company based on quoted price in an active market of identical assets or liabilities at measurement date. This is the most reliable source available to measure fair value without adjusting its value. Even though the daily trading volume is low, it does not affect the fair value measurement as the fair value is obtained from the active market.

Level 2 is the input that could be observed directly or indirectly to value the assets and liabilities. These inputs include quoted market price for corresponding assets and liabilities regardless of whether the market is active or inactive. For instance, observable inputs such as interest rates and yield curves, implied volatilities and credit spreads. In other words, the level 2 inputs are also known as market-corroborated inputs which can be observed by mutual relationship within the market data.

On the other hand, level 3 inputs are unobservable inputs used to measure the fair value of asset and liability. This input will be used when the observable inputs cannot be obtained at the measurement date. As such, the firm could only use the best available information taking into consideration the reasonable assumptions of the market participants and also the firm's own data.

Overview of Fair Value Measurement Approach

Basically the fair value measurement is used to value the assets and liabilities based on the price given under the current market conditions. Entity is required to follow the fair value measurement by determining the assets or liabilities to sell or transfer between market participants. Besides, when dealing with non-financial assets, the best location for measurement should be considered. The firm is also required to determine the principal market for the asset or liability as well as the method used to price the asset or liability by looking into the inputs categorized under the fair value hierarchy and the market participants' assumptions.

Guidance on Measurement

The measurement of fair value is governed by IFRS 13 whereby the company will look into the characteristic of the asset or liability used by market participants when valuing the asset or liability at measurement date. In addition, it is assumed that a transaction will be made in a systematic manner between market participants and in the primary market. In the absence of primary market it will be traded in the best available market for the asset or liability at measurement date. To add on, it is also assumed that the financial or non-financial liability or firm's equity instruments which were measured at fair value were transferred to a market participant without any activities undertaking. The non-performance risk of the entity can be seen through the fair value of the liability before and after transaction. The market risks can be offset provided additional disclosures were made for certain financial assets and financial liabilities.

Valuation Techniques

Moving on to the valuation technique, the firm should focus on the availability of adequate data for the fair value measurement by the highest usage of significant observable inputs and minimal usage of the unobservable inputs. The three most common techniques used by the entities to measure fair value are the market approach, cost approach and income approach. Market approach is the prices and other information from the transactions in market for the similar assets, liabilities or the group of assets and liabilities whereas, for cost approach is the figure calculated to replace the service capacity of an asset. Income approach on the other hand is to foresee the future cash flows relying on current market expectations to value the assets and liabilities. The valuation technique used depends on the circumstances of the situation.

Disclosure Objective

The users of financial statements should be able to assess the information such as the techniques and inputs used to measure the assets and liabilities at fair value as well as the impact on the profit or loss or other comprehensive income if the measurement of fair value are to be based on substantial unobservable input in order to make a wise decision.

Disclosure Exemptions

On the other hand, certain information are not required to be disclosed such as assets that were planned and retirement benefit plan measured at fair value in line with IAS 19 Employee Benefits and IAS 26 Accounting and Reporting by Retirement Benefit Plans respectively. Recoverable amount of assets which was obtained using fair value less costs of disposal is also not required to be disclosed.

For disclosure purposes, assets and liabilities were required to be classified into classes based on nature, characteristics and risks of asset or liability as well as fair value hierarchy. The classification into classes of assets and liabilities requires the use of judgment and with that, the classes of assets and liabilities and those fair value measurements categorized in level 3 needs to be disaggregated further.

Benefits of the Use of "Fair Value" in Accounting

Even though, mark-to-market valuation is said to have worsen the sentiments of jittery world market, many companies changed their mindset and recognize the benefits of fair value accounting for the good of their companies (The Star Online, 2009).

Fair Value Reflects Current Market Price

The values of assets and liabilities fluctuate significantly causing the historical cost used in the preparation of financial statements not reflecting the current values of entities' assets and liabilities. By having fair value accounting, users will be able to obtain accurate and up-to-date information consistent with market on an ongoing basis. Therefore, the fair value approach will be more useful and accurate to reflect the current values of assets and liabilities that an entity would receive if it were to sell the assets or to pay to be relieved from liabilities.

True Income

In order to increase the net income or decrease the income for certain period, the management could manipulate the reported net income by arranging the sales of certain assets. As the gain or losses are reported at the period in which assets or liabilities are sold or transfer using fair value accounting, management could hardly manipulate its reported income (Jay Way, 2013).

Realistic Comparison of Financial Statements

Fair value method enables investor to have a better comparison of financial statements regardless of the date on which the assets were acquired. This better quality disclosure and consistency will enable investors to understand and interpret complex financial and the risks associated with a particular entities. As such, better comparison of financial statements not only enables investors to know the current financial condition and performance of the investing entities but also helping potential investors to make investment decision.

Greater Transparency of Information in the Financial Statements

Fair value accounting provides more information in the financial statements than other accounting method such as historical cost. This is because fair and transparent reporting framework requires the firm to disclose substantial information about the inputs and valuation techniques used to develop the fair value measurements, related exposure, related sensitivities and other issues resulted in a thorough financial statement. Therefore, the transparency of firm helps potential investors, creditors and lenders to analyze the company in terms of the company's stability and current financial position.

Reliable Valuation of Financial Instruments

Mark-to-market accounting which is another term for fair value accounting suggest than market verifiability is vital element of fair value accounting. Since the fair value of assets is obtained from the quoted price of the given asset and the relevant assumptions of market participants in the absence of observable inputs, the value obtained is verifiable and neutral. Thus, fair value method provides reliable valuation of financial instruments by reference to market inputs and be easily accessible.

Issues and Problems in the "Fair Value" Measurement Debate

One of the current issues is the proposals from the IASB that have constantly defined fair value as a current market exit value. This could be a significant definition that could be used in many fair value cases. However, this definition might not be applicable to all other cases as it might need different measures to ensure appropriate measurement such as when it is used in the case of substitution cost. Fair value is one of the family of current-value measurement bases while others include replacement cost or value in use. Fair value principle has certain objections. It is the value a business can gain from selling an asset at the balance sheet date but this may be the value that it may chose not to sell. As a result in the current circumstances fair value measures the value of the business by the sales of the asset at the particular period. However, the historical cost model is based on the intention related to do with the assets of the business. This subsequently gives a higher chance for the fair value to overstate values and profits in order to give strong and positive outcome balance sheets when markets are rising but at the same time also has a tendency to overstate the declines in value giving a weaker balance sheet. This has led to criticism that fair value adds to so-called'procyclicality' by amplifying the effects of the business cycle. Financial institutions have complained that fair value accounting has effectively been driving business behaviour rather than reflecting it by encouraging banks to borrow over the limit in good times while exaggerating their financial problems when the business cycle turns down. Even though in true facts, this gives the tendency to allow the market to have advantage of giving transparency to investors, it may not produce the financial information most suitable for prudential supervision purposes (Gary Cokins, 2013).

In fact, the biggest problem in fair value measurement could be the widespread concern over the reliability of values in illiquid markets. Another problem is associated with the fair value treatment for 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 fair value of a company's bonds liabities issues for instance and if fair value was included then this would create a profit at a time when the company's performance or prospects is at the worse stage. This is clearly seen in cases in which banks amid the wash of red ink arising from their asset write-downs. There have also been major gains for some as their bond values have declined. This may be an example of how users of financial statements are still not used to fair value accounting and does not appreciate all its effects. As a result, they may not interpret fair values properly when analysing the company's results. The IASB is working on a form of financial statement where the different types of gain and income are separately presented so the users can understand the figures better. Another big issue with fair value is also the widespread concern over the reliability of the values being used. Although few problems occur where there are quoted prices in liquid markets and transactions are taking place on a regular basis. Besides, another issue of valuation is in the banking crisis where markets become illiquid or even close down, leaving the valuations even more uncertain as there may be only few trades being done. In simple, when fair values move away from quoted prices in liquid markets the problems of reliability of these values grows to be even bigger problems (Gary Cokins, 2013).

Fair value measurements have been used for a long time frame, so the critics are not correct when relating against Statement No. 157. As these debates go, being wrong is insufficient for stopping the rhetoric. One should notice that not many peeps were heard during the 1990s when fair value accounting produced huge gains on the income statements. The immediate consequence of rejecting fair value accounting is to ponder what would replace it. Seemingly, we would have to return to historical cost accounting because there aren't too many other possibilities. The problem with that alternative is that historical cost accounting provides virtually no information about financial instruments until they are settled up..The larger problem, however, is that the criticism of fair value accounting extends to the management of financial instruments as well as the financial reporting issues. Any executive who buys or sells a financial instrument without comprehending its current value today and estimating its future value is being irresponsible to the firm's investors. Those managers who decry and vilify fair value accounting are confessing that they have committed malfeasance. It has long been a tenet of management accounting that you cannot manage what you do not measure. If you cannot measure the value of financial instruments or any other vehicle, then you cannot manage them ( ACCA Global,2013).

Finally, another consequence is that criticizing fair value accounting discloses the hypocrisy of American managers. This business of fair value accounting is a queer business. While fair value accounting does have problems, both conceptual and practical, the arguments that are being put forward have greater deficiencies. One cannot just consider fair value accounting but must consider it as one of several alternatives for use in the financial reports. Likewise, one must confess that the inability to measure fair value accounting is an admission that firms should discontinue their use of derivatives and structured finance because of the inability to manage them (ACCA Global, 2013).