Investigating the usefulness of the FVA system

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Laux (2009) states in his article that FVA brings volatility to the system. And the tradeoff between liability and transparency needs to be further researched.

Penman (2007) points out that FVA works well for investment funds in which the value of assets or liabilities closely related to the FVA. But when this situation fails, for example, for some companies, their assets are used to produce value in the future, the FVA often confuses financial statement users.

Jones, J. C. (1988) stated that under FVA, the balance sheet becomes the primary sources of information instead of the income statement in the Historical Value Accounting (thereafter referred as "HVA") case. With all assets and liabilities recorded at fair market value, the income is no longer predicting changes of value and earnings are no longer predicting future earnings. They just add value to stockholder's equity.

Cocheo, S. (2009).stated several shortcomings of adopting FVA:

1. FVA brings bubbles into the financial statements;

2. FVA does not comply with matching principle;

3. The option of a different value system for a company creates room for deliberate manipulation;

The adoption of FVA gives the company managers more opportunities to manipulate numbers by choosing a different accounting method. Consequently, it requires analysts to have much more knowledge, wisdom and time to analyze those data. And this means the adoption of FVA will make the current system even more complicated. .

To evaluate stewardship, what is better, the FVA or HCA?

Stewardship, in a broad sense, is defined as accountability, the company's performance. A lot of it involves management's strategy to achieve stabilized increases of entire company's value. These strategies include the sale of subsidiaries which constantly generates operating loss; the opening of new shop or subsidiary in a highly developing countries or cities; the decision of when and how to make sales to prompt the income and so on.

I think, from most of the manufacturing companies, HCA is more relevant to evaluation when compared with using FVA.

In the old system (HCA), the inventory, Property Plant and Equipment, and liabilities were recorded when they were acquired at cost. After acquisition of these assets, their cost are either expensed or capitalized depending on whether they contribute to generate future income. By reading financial statement, under GAAP--- Historical Method, we are able to see a better matching of cost and benefit, expense and revenue relations in financial reports.

After introducing FVA into accounting reporting system, the income statements are no longer the key report which investors and creditors will take look at. Instead, the balance sheet becomes the main report which most investors and analysts will concentrate on.

However, if, in here, with the premises we previously concluded, the financial reports are used limitedly between comparable companies instead of being used for among undefined entities, the HCA application is good enough for satisfying this requirement. The introducing FVA to the system brings noises to the evaluation of a company's performance because it includes the gains and losses from price fluctuation into the net income and some other ratios. Not only people need to take extra effort to analyze what percentage is literally from operating activities and what are from other activities, but also the financial report preparers need to take extra effort to make such adjustments every season to the value of these entities. So, from a Cost and Benefit point of view, is the benefit of adopting FVA really worth the cost? (McCarthy P. D. 2004)

In the case of various types of companies

When evaluating a manufacturing company, the consideration of its performance usually has to do with how management can maximize profit by lowering the inventory purchasing prices, improving on production efficiency and streamlining of procedures, quality controls and performing better selling strategies, etc. All of these, however, have little relationship with adjusting the value of its balance sheet accounts due to market fluctuation. Even if there is a huge increase in value of property, plant and equipment, the company cannot sell them because they are used as assets to generate future profit.

On the other hand, the Historical Value Accounting system depreciates the cost of property, plant and equipment over their lives because they are used for production of future value. This adoption fits perfectly into the matching principle --- expenses are recorded in the same period when revenue is generated. This provides a better information for investors and creditors.

Furthermore, the application of FVA introduces more noise when evaluating the companies' performance. Because the increase or decrease of value by adopting FVA do not contribute to the accountability of companies, it functions as noise to the analysts, and they have to take extra steps to eliminate these factors in order to have a clean picture of a company's performance.

Therefore, FVA is not feasible for manufacturing company.

For banks

However, in the case of investment banks, it will be a totally different story. FVA provides a better platform for assessing and evaluating the performance of banks. Khurana, I. K., Kim, M. S. (2003)

The banking industry is closely related to the general economy. Banking is profited though investments and loans. Image what would happen to the banks if all of their investments (real estate properties and land) and liabilities were recorded at historical value? It would totally distort the financial picture. At times such as now when the entire economic environment is going through a downturn, historical value would present a completely false picture where people may think things are fine but the reality is that the true value has significantly decreased from its book value. Should we keep these properties and loans at their historical value? No. In this situation, FVA better presents useful information for both the management and financial reports users.

From a Manager's point of view

From a manager's point of view, the adoption of FVA can shrift his or her concentration away from improving company's performance. Instead, he may focus on enhancing earnings through buying and selling inventory and property investment. We can learn something from an empirical example happened recently in China. Although the Chinese economy has been booming, it is distorted. The GDP increases at an annual rate of 10%, but it is not the same rate with manufacturing companies. Closely following the booming is the rise of the capital market prices.

Facing the international fierce competition, Chinese manufacturing companies cannot win the battle through having advanced technologies or multinational chains. What they have is cheaper costs. And they are losing their only advantage when the national capital market price starts to rise. As a result, they are struggling for survival. While this is going on, some company owners realize that it is more profitable to invest in the stock market than to invest their time and effort into building their companies. Furthermore, the investment turnaround time in the stock market can be much shorter comparing to running a manufacturing company. So some of the owners choose to close their companies and used the money from selling the plants to invest in the stock and real estate market.

Although this situation may not repeat in the United States, it is possible that the managers may consider shifting their attention from striving to improve manufacturing performance to investment activity because of the tradeoff of the easy money.

The idea of FVA enhancing comparability among different companies and making consolidated financial statement reporting easier for multinational companies should not be traded off with the stabilization of the entire capital market.

Concerns of Market stability -- The main change toward the system is the reliability and faithful representation

HITZ, J. M. (2007) stated that the adoption of FVA actually eliminate the possibilities of tradeoffs between relevance and reliability. This means the only concern remaining for financial statement is its relevance.

Watts, R.L. (2003) stated that the closely related concept of conservatism has influence on accounting practice for more than 500 years. And he says that the long survival of conservatism and the ability to stand for criticism strongly suggest that its benefits exceed its pitfalls.

The benefits of conservatism bring to the system includes:

1. Conservatism limited earning management;

2. Conservatism provides efficient financial reporting mechanism;

3. Conservatism keeps the companies from overstating their assets, which is a major cause of potential litigation;

4. For regulators, they have the incentives to favor conservatism.

Other than the above, we have to take consideration of the stability of the stock market. If the stock market is a key indicator of a economy's condition, its stableness should be the most important factor to be taken into consideration by regulators. The current U.S. financial system, developed through long period of time, adopts the Conservatism as the fundamental principle to stabilize stock market and to protect investor's right. Now the introducing of FVA into the financial reporting system inevitably eliminates some of these solid, supportive sustainers from the capital market.

What is Fair Market Value approach?

FVA is to measure assets or liabilities according to a price. And the price is defined by FAS 157 "either received or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Further guidance was given for adoption FVA:

Level 1 input: When a quoted price for identical assets and liabilities in an active market is available, the quoted price should be used;

Level 2 input: When level 1 condition is not available but a quoted price for similar assets and liabilities in an active market is available, that price should be adopted.

Level 3 input: When last two approaches are not available, a modeled approach should be used to decide the value. (Penman, S. H. 2007)

How does the adoption of FVA affect the current U.S. financial system?

The adoption of FVA is introducing the "real value" to assets and liabilities. For example, the inventory and the property, plant, equipment are going to be recorded at current effective market value and the gains or losses generated subsequently is presented in comprehensive income. Some proponents argue that by introducing more relevant information to the financial report will enhance transparency and provide more timely information.

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