Is Fair Value Measurement A False Accounting Essay


For the past several decades, fair value accounting becomes main method of measuring assets and liabilities. This marks a major different from the centuries-old tradition of keeping books at historical cost. It also has implications across the world of business, because the accounting basis-whether fair value or historical cost-affects investment choices and management decisions, with consequences for aggregate economic activity. The argument for fair value accounting is that is Fair value accounting really a suitable way for measurements of assets and liabilities of entities? Looking back into the financial crisis in 2008, it brought fair value accounting under fire again. Some practitioners and scholars believe that just because using fair value accounting this measurement method, it made the data on the financial statement cannot be a truth reflection of the entities' value, then resulted in blind optimism and investment, leaded to the crisis. Specifically, as asset prices rose through 2008, the fair value gains on certain securitized assets held by financial institutions were recognized as net income, and thus sometimes used to calculate executive bonuses. And after asset prices began falling, many financial executives blamed fair value markdowns for accelerating the decline.

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The author argues that the fair value accounting required by the international standard on financial instruments (IAS 39) will institutionalize 'false accounting on a global scale' and gives a numerical example to show how it can mislead accounts users. Believes that reporting an increase in present value as a gain or loss is wrong, since opportunities are not the same as transactions; and that the market value fallacy has contributed to the pensions crisis and the housing bubble. Quotes the UK Theft Act 1968 to show that reporting misleading gains is a breach of criminal law and sees IAS 39 as 'calculated to bring the profession into disrepute'

In this report, it tries to explain that what Fair value in IFRS13/AASB13 is; how are assets and liabilities valued under the Fair Value accounting system. It also compares the different between historical cost and fair value accounting. Argue how the Income Statement and Balance Sheet affected by the Fair Value accounting system; is there any change in assets or a change in income resulting from applying the Fair Value accounting. Thinks about what is the fundamental value in accounting.

2. Discussions

2.1. What are the essential features of the 'Fair value' accounting as laid out in IFRS13/AASB13 Fair Value? How are assets and liabilities valued under the Fair Value accounting system?

IFRS 13 Fair value measurement establishes guidance that fair value measurement is a single source required under IFRS; sets out a framework about how to measure fair value for financial reporting purposes and requires enhanced disclosures about fair value measurements (McCarroll & Khatri 2012). Under AASB 13(2011) and IFRS 13(2012), they define fair value on the basis of an 'exit price' that would be received from selling an asset or paid to transfer a liability at the measurement date. That definition emphasises that fair value is a market-based measurement, not an entity-specific measurement. In another words, the fair value of a financial liability is the amount at which it could be settled between knowledgeable, willing parties in an arm's-length transaction. As a result, an entity's purchasing a non-current asset is not relevant when measured by fair value. (Godfrey, et al 2010).

Maris (2013) explains that, the Key features of AASB 13 in determining fair value are including as follows:

• Use of exit market (principal or most advantageous)

• Highest and best use for non-financial assets

• Block discounts not permitted

• Liquidity considerations incorporated into the valuation

• Liabilities and equity instruments considered from the perspective of market participants who hold these as assets

• New disclosures.

Furthermore, Sections 11 to 14 of AASB 13 settle the principles about fair value measurement for a particular asset or liability. When measuring fair value an entity shall take into account the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following: (a) the condition and location of the asset; and (b) restrictions, if any, on the sale or use of the asset. The effect on the measurement arising from a particular characteristic will differ depending on how that characteristic would be taken into account by market participants.

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The asset or liability measured at fair value might be either of the following: (a) a stand-alone asset or liability (eg a financial instrument or a non-financial asset); or (b) a group of assets, a group of liabilities or a group of assets and liabilities (eg a cash-generating unit or a business).

Whether the asset or liability is a stand-alone asset or liability, a group of assets, a group of liabilities or a group of assets and liabilities for recognition or disclosure purposes depends on its unit of account. The unit of account for the asset or liability shall be determined in accordance with the Standard that requires or permits the fair value measurement, except as provided in this Standard. (AASB 13, 2011)

2.2. According to Rayman, how is the Income Statement and Balance Sheet affected by the Fair Value accounting system?

Says IAS 39,' A gain or loss on a financial asset or financial liability classified as at fair value through profit or loss shall be recognised in profit or loss. However, in Rayman's opinion, there is nothing wrong with fair value in the balance sheet; there is everything wrong with fair value changes in the profit and loss account. In a balance sheet intended to present a 'true and fair view' of a firm's financial position, the disclosure of fair value is a development to be welcomed - as an indication of the available market opportunities. But opportunities are not the actual transactions. The very fact that an item appears in a balance sheet, means that by definition it has not been exchanged. Its 'fair' market value represents a rejected opportunity. The fundamental mistake is to report 'value change' as a 'gain or loss'. For 'value change' may simply be the difference between hypothetical opportunities that have actually been discarded. The main point is the relevance of fair value for reporting financial performances. Sum up, it is calculated to bring the profession into disrepute. ( Godfrey, et al 2010).

According to the example, a gain of $10 million is a 'true and fair view' of the result on one assumption only: that the fair value is realised and actually consumed at the balance sheet date' the most common reason for investing, however, is to save for the future. Of all the assumptions that could have been chosen, immediate consumption is the least likely. It is ruled out almost by definition.

2.3 How does Fair Value accounting contradict with the Historical Cost accounting?

Casabona & Gornik- Tomaszewski (2007) state that FASB has been adding more fair value recognition, measurement, disclosure standards to the body of IFRS adopted countries such UK generally accepted accounting principles (UK GAAP). FASB follows a similar approach. Thus, a mixed accounting system has been created and developed, which the historical cost still the primary base but with an ever increasing application of fair value accounting. As a result, a shift has occurred towards using the balance sheet instead of the income sheet as the primary financial statement conveying information to shareholders, and the income statement reporting economic income as simply the change in value over a period of time.

Shamkuts (2010) indicates that for Historical Cost the company carries the asset on the balance sheet at the purchase cost less any depreciation taken.   At the time of sale, the company records a gain or a loss against the purchase cost of an asset less any depreciation if applicable. In another words, assets on the balance sheet are recorded at historical costs until sold. The historical cost principle follows the accounting quality of reliability since everyone can agree on the original purchase price of an asset. On the other hand, fair value is used as a certainty of the market value of an asset (or liability) for which a market price cannot be determined. From the definition, it is means clearly that fair value method is used for assets whose carrying value is based on mark-to-market valuations, but not for assets carried at historical cost. The measurement requirement is that profit is only measured when an external transaction is realised.

Due to the principle, the problems are:

liquidation vs. going concern concept

recognition before confirmation by sale

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definition of profit and meaningful profit

problems of obtaining selling prices

value in use concept of an asset.

2.4 Are the changes resulting from applying the Fair Value accounting principles a change increase/decrease) in assets or a change (increase/decrease) in income? Is change in assets and change in income the same thing? Why, or why not?

Under the fair value accounting, changes in the value of assets are reported as expenses or revenues arising from holding the assets. This is entirely consistent with the accrual accounting approach ,but inconsistent with historical cost conservatism and the realisation concept, the incremental recognition of changes in assets values is less of an issue where there are ready to markets for assets, such as shares in publicly traded companies. However, it becomes problematic when market values or reliable inputs to valuation models are not readily available.

An asset is a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow into the entity. Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants, it includes revenue and gains. A company's assets consist of items such as cash, buildings, equipment and patents. They are a company's resources with which it generates sales and profits. The amount of a company's assets changes over time as it buys and sells assets, and as it reinvests profits in its business. A company reports its assets on its balance sheet. It can be calculated the change in a company's assets between accounting periods. A greater amount of assets can help a company generate higher profit. Capital = Assets - Liabilities, income is an event of capital. When a firm purchases a non-current asset, it changes its ability to adapt. If the asset is purchased for cash, the reduction in the firm's cash balance diminishes its freedom to lay out cash for other investments. If the asset is bought by credit, this reduces the firm's ability to obtain further credit. (Godfrey, et al 2010)

Rayman uses the return on investment argument and no adaptive behaviour to support his case. That is if interest rates fall and investors do not realise the capital gain, then they are no better off. This is true as the rate of return has dropped to 5.5% from 8% and no realisation has occurred. However, the opportunity is there to realise the investment and adapt the investment to other classes of assets which will benefit from a fall in interest rates (e.g. stock market, housing). Is unrealised income an increase in wealth or income or not is answered by economists who define increases in wealth as income.

Deegan (2010) gives one example that if ABC Corporation purchased a two-acre tract of land in 1980 for $1 million, then a historical-cost financial statement would still record the land at $1 million on ABC's balance sheet. If XYZ purchased a similar two-acre tract of land in 2005 for $2 million, then XYZ would report an asset of $2 million on its balance sheet. Even if the two pieces of land were virtually identical, ABC would report an asset with one-half the value of XYZ's land; historical cost is unable to identify that the two items are similar. This problem is compounded when numerous assets and liabilities are reported at historical cost, leading to a balance sheet that may be greatly undervalued. If, however, ABC and XYZ reported financial information using fair-value accounting, then both would report an asset of $2 million.

From above, it can be concluded as that, under the fair value accounting system, the value of asset has been increased. But how about the changing in profit? Is it the same? No, this is not easy to inference, because the profits are also affected by expense

2.5 How does 'value in exchange' differ from 'value in use'? Which of the two should be the fundamental value in accounting? Why?

Any labor-product has a value and a use-value, and if it is traded as a commodity in markets, it additionally has an exchange value, most often expressed as a price.

Value in use is the utility of consume service in classical political economy.The worth of a property in a certain use, typically a good; the want-satisfying power of a good or as it is currently being used. This amount may be greater or less than its market value. It is the net present value (NPV) of a cash flow or other benefits that an asset generates for a specific owner under a specific use.

Value in exchange means that value, which is satisfaction, is obtained indirectly through the acquisition of something else. It is the amount of other assets, goods and services for which a unit of a specific good can be exchanged in a market. The price often is one measure of value in an exchange. For an item to have value in exchange it need NOT have value in use, value obtained directly from the consumption of a good or service, such as the money.(Deegan 2010)

If the firm has assets that are mixed - financial, operating, intangible - then valuation would require the utilisation of different fundamental value concepts. This appears to be the way that standard setting bodies are headed. However, the problem is that the conceptual nature of the system becomes more and more complex and the solution more vague. Moreover, any standard that attempts to address the problem gives the impression that the output is a result of compromise rather than being driven by one conceptual general model. Moreover, users must be sophisticated enough to understand that different components of fundamental value and because the solution may be a mixed system, the additive principle may be questioned.

3. Conclusion

Through the above analysis, we can get such a conclusion as using of fair value could drastically help a company get more money from investment by shareholders , inflating the value of their assets may help them acquire the financial aid they need but it may not help the business turn a profit. In a volatile market with unstable price fluctuations, fair value may not be such a good idea