Investigating the benefits and drawbacks of fair value accounting

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Benefits as well as drawbacks of fair value have been discussed the recently years by bank regulators, investors and accounting firms. Some argue that fair value despite the weaknesses is the best method to value financial instruments when followed by apposite disclosure as opposed others prefer the traditional, principal and seriously considered as an alternative to fair value, historical cost. To see the two mostly methods used, it should be given an answer to the following enquires.

Differences between the two of them?

What are the advantages of FVA against the traditional HCA?

Fair value is considered as a clear concept - simply, the value that a business could get by selling or settling the item at an accurate time. Fair value provides up-to-date information about financial assets and liabilities, consistent with market whereas increasing transparency and encouraging rapid corrective actions. Since fair value reflects current market conditions, it provides comparability of the value of financial instruments bought at different times. In addition, financial disclosures that use fair value provide investors with insight into prevailing market values, further helping to ensure the usefulness of financial reports. (BMA, ISDA, SIA, 2002)

The historical cost regime relies on past transaction prices and as a result accounting values are insensitive to more recent price signals. Fair value measures what a business would get by selling the asset today, whereby historical cost is based on what the business intends to do with the asset, namely, to keep hold of it and receive the interest and if necessary impair the asset. This lack of sensitivity to price signals induces inefficient decisions because the measurement regime does not reflect the most recent fundamental value of the assets (Plantin, Sapra, Shin, 2008).

Accountants from England and Wales point out that under historical cost accounting, derivatives used to be often off-balance sheet. Fair value brought them on the balance sheet. To report these items at historical cost are uninformative but even a subjective fair value measurement is likely to provide a better measure of business performance and balance sheet strength than historical cost (ICAEW, 2009).

On the other hand, financial statements, produced under historical cost convention, provide a basis for determining the outcome of agency agreements with reasonable certainty and predictability because the data are relatively objective. Various parties who deal with the enterprise, such as lenders, will know that the figures produced in any financial statements are objective and not manipulated by likely subjective judgements made by the directors. (B & J Elliott, p.23, 2008). Therefore the traditional regime is reliable. But is it relevant as well? Below a simplified example presents the treatment of historical cost and why it is not relevant.

If a company purchases an asset for 1000 and the estimated depreciation is 100 per year for 10 years time, the cost of asset after the first year will be 900. If the market (fair) value of this asset was 950 after the first year in the market, the company would not write up the asset after that year. Rather, the asset would remain at original cost (historical) less the depreciation until the asset is sold. If the company sells the asset at 950, it is recognised directly realised gains of 50. Hence, investors and users of financial statements understand where the assets are coming from.

In terms of the above information reliability, obviously, the historical cost is reliable since everyone can agree on the original price. But reliable does not mean relevant. An asset X purchased, if it is recorded on balance sheet at historical cost, does not reflect the current market price. For this reason, users argue that fair value is more relevant than historical cost.

Readers of financial statements obtain a fairer and truer outlook of a company's financial situation due to fair value that reflects the economic conditions of markets and the nonstop changes in them. The traditional method, on the other hand, shows the market conditions existed when a transaction took place and changes in the price do not appear until asset is sold.

Furthermore, fair value is more consistent and comparable, because financial instruments are measured at the same time and under the same principle. In accordance to historical cost, users and investors cannot formulate comparisons and if so, difficult to be made. For instance, if two entities hold similar financial instruments, they may show different values if based on the time they have bought them.

The transparency of information given by fair value is another advantage because it is relied on the quoted prices in liquid market. At this point, it is worth to be mentioned that the best indicator to price financial instruments is the quoted market price on an active market. Active market is characterized by quoted prices that are readily and regularly available from exchanges, dealers or brokers. The quoted prices reflect current and market transactions. Bid and ask prices represent proper market prices for assets and liabilities (KPMG, 2006, p.76). Also, it is transparent in the sense that the position- good or bad- of an entity is open to the public.

Some commendable positions in favour of fair value

''why is fair value a better method of accounting for financial instruments than amortised cost?''

Mr Haddrill [1] : Simply because it is the best reflection you can get of the value at the time rather than the value at the point at which the asset was acquired.

Mr Picot [2] : It is if you are trading, but it is not if your intention is to hold them long-term.

Ms Murrall [3] : Historic cost is an arbitrary point in time. If you record assets at historic cost, accounts will not be comparable.

Mr Cronin [4] : An historical cost is a rear-view mirror exercise. It is also subject to the management judgment of when you put a write-down in or not, whereas fair value gives you an instant appraisal of what is going on from the collection of the market and an unbiased market.

Mr Izza [5] : it has got the news out much faster than other methodologies might have done, leading to speedier actions to deal with the situation. It is very important that we do not seek to shoot the messenger, in these circumstances.

(ICAEW, 2009)