Unit-2 Corporate Accounting Assignment Help
Arguments for and against Fair Value
There are many people on either side of the debate over the advantages and the disadvantages of the fair value reporting system. Fair value is primarily based on the concept of market prices. It postulates that all value of any asset should be based on the price at which it will sell in the market. In the same vein, the price of any liability is the cost of transferring the liability to another party.
Hence, in a way, the fair value principle incorporates the market value of the item under consideration. Market prices, in principle, are meant to be unbiased. In the traditional way of accounting in which the fair value is not used, accountants use their own estimates to arrive at the estimated value of an asset or a liability. This leaves out a scope for biased estimates to be produced by accountants to dress up the financial statements.
Examples would include overstating the revenue, understating the cost of goods sold and increased reporting of assets like inventory etc. Hence, it is easy to manipulate the financial statements under the traditional approach.
The fair value system ensures that due to the unbiased nature of the market, the fair value of the asset or liability will also be unbiased and hence, be the true value of the asset or the liability (Power, 2010). The fair value rules are supposedly very clear and acceptable at a conceptual level, but are very hard to implement at the granular level when the actual accounting is done by the accountants for the financial statements (Hague, 2009). Also, sometimes the market may also be biased.
This would lead to asset and liability prices to be misleading and reporting of incorrect values on the financial statements. One prominent example with measurement issue was highlighted in the 2008 economic crisis. The fair value rules forced bankers and mortgage holders to write down the value of their assets which they were holding to low levels given the condition of the market, completely ignoring the future cash flows attached to the assets. This effect was seen on good assets as well, as due to bad and poor condition of the market, the good assets also took a hit, leading to a poor mark-to-market valuation for the same and valuing them lower than normal (McConnell, 2010).
The fair value standards do provide a good standard for valuation purposes when the markets are performing at optimum levels of liquidity and confidence.
But like in 2008, when liquidity had dried up and the mortgage backed security market had all but wiped out, the mark to market standard does not hold water and is impractical by all means. The 2008 crisis had many economists and bankers come out against the mark to market practise of the standard setters as it was supposed to be destroying capital when the markets were at their weakest and required support (Stines & Auteri, 2010).
It was in response to such perception that the standards and rules were eased by the FASB for assets which were not actively traded in the market and the market for which had eroded as was the case with the mortgage backed securities (Young, 2008).
One more issue at a conceptual level raised against the mark to market technique has been one of the going concern assumptions. The going concern assumption which is fundamental to the preparation of financial statements, assumes that an organization will live indefinitely and the accounting measurements are done in keeping with the same. When marking to market, it is basically assumed that the market value is the value that an asset will generate when sold or a liability will generate when transferred. Hence, this is a sale transaction, which goes against the assumption of the going concern principle. Hence, the fair value standards effectively give the financial position of the asset in the market, which is the position of the market itself, as against the financial position of the organization preparing the financial statements.
Another school of thought claim that the fair value treatment if unfairly blamed for the economic meltdown of 2008. The standard cannot be blamed for the excesses of borrowers who borrowed more than what they could repay, or the banks who extended lines of credit to such borrowers. It is the failure of the system of checks and balances rather than an accounting issue.
Factors driving measurements:
The major factors that drive measurement approaches are the revenue and the cash flows. Measurement approach is primarily arrived considering the financial position and the nature of the organization. A conservative organization which gives out conservative i.e. safe side financial estimates and guidelines may like to err on the side of caution and will not be aggressive in measuring revenue sources but will recognize costs as early as possible (Power, 2010).
As an example, consider an organization which follows the policy of recognizing revenue only at the time of delivery of actual goods to customer and the recognition of costs at the time the goods leave the organization. This is a conservative measurement approach. In a similar way, some organizations, owing to aggressive nature of revenue recognition may want to approach the same in reverse.
Another important factor to be included is some policies like if the company is not allowed to pay dividends below a certain level of retained earnings. In such a case, the management is forced to take a decision to maximize the profits by way of accounting and measurement techniques.
Some banks which give debts require that the company maintain a certain minimum level of liquidity ratios at all times. To meet such requirements, management accountants take decision on the valuation of inventory and the revenue and cash flow recognitions accordingly.
Given the current situation in the fair value standard world, although it seems to be more transparent and market oriented, the users of financial statements would like to know the position of the company with respect to its operations rather than the market valuation of their assets and liabilities. Hence, it is not recommended to implement the fair value system directly at one go. But, it should be proposed and discussed within the accounting and financial community regarding the pros and the cons and then only a rational decision should be arrived at.
Based on the research done and the analysis presented, the recommendation has been to not implement the mark to market model without subjecting it to a debate in the financial community. As with any other standard or law, it will have its pros and cons, but the cons for the same can be handled through some special amendments. Order Now
- Young, M. R., Miller, P. B. W. & Flegm, E. H. 2008, The Role of Fair Value Accounting in the Subprime Mortgage Meltdown, Journal of Accountancy, May 2008
- Stines, P. & Auteri, G. 2010, Fair Value 101-The ABCs of ASC 820, Benefits &Compensation Digest, April, 2010
- Power, M. 2010, Fair Value Accounting, Financial Economics, and the Transformation of Reliability, Accounting and Business Research, 40, No. 3