FAIR VALUE ACCOUNTING – PROS AND CONS

ISSN 1857-9973 657.92

Phd Olivera Gjorgieva-Trajkovska1, PhD Riste Temjanovski2, PhD

1
Faculty of Economics, University Goce Delcev, Krste Misirkov 10, Stip, Macedonia,
[email protected]
2
Faculty of Economics, University Goce Delcev, Krste Misirkov 10, Stip, Macedonia,
[email protected]
3
Faculty of Economics, University Goce Delcev, Krste Misirkov 10, Stip, Macedonia,
[email protected]

Abstract

Fair value accounting continues to be a topic of significant interest and debate among
the preparers and users of financial information. Fair value continues to be an important
measurement basis in financial reporting. It provides information about what an entity
might realize if it sold an asset or might pay to transfer a liability. In recent years, the use
of fair value as a measurement basis for financial reporting has been expanded, even as
the debate over its usefulness to stakeholders continues. Determining fair value often
requires a variety of assumptions, as well as significant judgment. Thus, investors desire
timely and transparent information about how fair value is measured, its impact on
current financial statements, and its potential to impact future periods. There are
numerous items for which fair value measurements are required or permitted. ASC 820
and IFRS 13 (“the fair value standards”) provide authoritative guidance on fair value
measurement.
The increased use of fair value requires companies to refresh measurement policies and
procedures. Companies should analyze how fair value is determined when no active
market exists, and establish procedures to develop the appropriate disclosures.
Valuation professionals may need to be involved early in the process.
Appropriate and robust disclosures in the financial statements are necessary to inform
investors about measurement methods and uncertainty. The increasing needs for
disclosures may require the establishment new processes and databases to record and
report the information.

Key words: fair value, accounting, measurement, policiesdisclosure

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1. Introduction

The recent financial crisis has turned the spotlight on fair-value accounting and led to a major
policy debate. Critics argue that fair-value accounting, often also called mark-to-market
accounting, has significantly contributed to the financial crisis and exacerbated its severity for
financial institutions in the US and around the world. On the other extreme, proponents of fair-
value accounting like Turner (2008) and Veron (2008) argue that it merely played the role of the
proverbial messenger that is now being shot. In our view, there are problems with both
positions. Fair-value accounting is neither responsible for the crisis nor is it merely a
measurement system that reports asset values without having economic effects of its own.
Fair value measurement has been a controversial topic in the United States and elsewhere for
more than a century. Advances in finance and accounting research, and much discussion, have
not reconciled the conflicting perspectives of supporters and critics of using fair value
measurement in financial statements. Indeed, after more than twenty years of research
documenting the decision usefulness of disclosures about the fair values of financial
instruments, standard setters are contemplating abolishing these disclosures for private
companies. The 2008 financial crisis increased public scrutiny and brought accounting
measurement to the forefront of policy debate, including debate characterized by polarizing
rhetoric.
With regard to empirical evidence on this issue, and despite some commentators’ belief that
accounting measurement, specifically measuring certain financial assets at fair value,
contributed to the 2008 economic crisis, to date no published empirical research documents a
clear causal relation between the fair value measurement attribute and systemic risk. Instead,
research suggests that holdings of certain financial instruments, business models, and
regulatory practices have a firstorder effect on systemic risk 1. Accounting may have second-
order effects, but research suggests that these primarily are the result of delayed loss
recognition on financial assets measured at amortized cost subject to impairment and gains
trading involving assets measured at amortized cost, for purposes of income recognition.
The fair value standards define how fair value should be determined for financial reporting
purposes. They establish a fair value framework applicable to all fair value measurements under
U.S. GAAP and IFRS (except those measurements specifically exempted). The fair value
standards require that fair value be measured based on an “exit price” (not the transaction price
or entry price) determined using several key concepts 2. Preparers need to understand these
concepts and their interaction. They include the unit of account, principal (or most
advantageous) market, the highest and best use for nonfinancial assets, the use and weighting
of multiple valuation techniques, and the fair value hierarchy. Preparers also need to understand
valuation theory to ensure that fair value measurements comply with the accounting standards

1. Fair value and its measurement

Fair value accounting is a financial reporting approach in which companies are required or
permitted to measure and report on an ongoing basis certain assets and liabilities (generally
financial instruments) at estimates of the prices they would receive if they were to sell the assets
or would pay if they were to be relieved of the liabilities. Under fair value accounting, companies
report losses when the fair values of their assets decrease or liabilities increase. Those losses
reduce companies’ reported equity and may also reduce companies’ reported net income.

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Although fair values have played a role in U.S. generally accepted accounting principles (GAAP)
for more than 50 years, accounting standards that require or permit fair value accounting have
increased considerably in number and significance in recent years.
The goal of fair value measurement is firms to estimate as best as possible the prices at which
the positions they currently hold would change hands in orderly transactions, based on current
information and conditions. To meet this goal, firms must fully incorporate current information
about future cash flows and current risk-adjusted discount rates into their fair value
measurements. When market prices for the same or similar positions are available, the fair
value standards generally require firms to use these prices in estimating fair values. The
rationale for this requirement is market prices should reflect all publicly available information
about future cash flows, including investors’ private information that is revealed through their
trading, as well as current risk-adjusted discount rates. When fair values are estimated using
unadjusted or adjusted market prices, they are referred to as mark-to-market values. If market
prices for the same or similar positions are not available, then firms must estimate fair values
using valuation models. IFRS generally requires these models to be applied using observable
market inputs (such as interest rates and yield curves that are observable at commonly quoted
intervals) when they are available and unobservable firm-supplied inputs (such as expected
cash flows developed using the firm’s own data) otherwise. When fair values are estimated
using valuation models, they are referred to as mark-to-model values 3.
The European Commission has endorsed IFRS 13, Fair Value Measurement, which sets out a
single framework for measuring fair value and provides comprehensive guidance on how to
measure it. IFRS 13 is the result of a joint project conducted by the IASB together with FASB,
which led to the same definition of fair value as well as an alignment of measurement and
disclosure requirements to FAS 157. Both FAS 157 and IFRS 13 define fair value as the price
that would be received to sell an asset in an orderly transaction between market participants at
the measurement date. This definition of fair value reflects an exit price option, which is the
market price from the perspective of a market participant who holds the asset. Moreover, fair
value must be a market-based, not an entity-specific measurement, and the firm’s intention to
hold an asset is completely irrelevant. For instance, the application of a blockage factor to a
large position of identical financial assets is prohibited given that a decision to sell at a less
advantageous price because an entire holding, rather than each instrument individually, is sold
represents a factor which is specific to the firm. If observable market transactions or market
information are not directly observable, the objective of fair value measurement still remains the
same, that is to estimate an exit price for the asset, and the firm shall use valuation techniques
4 .
Fair value accounting is the practice of accounting that values certain assets and liabilities at
their current market value, and it seeks to capture and report the present value of future cash
flows associated with an asset or a liability. IAS 39 establishes the principles for recognising and
measuring financial assets, financial liabilities and some contracts to buy or sell non-financial
items. This standard includes provisions about the classification of financial instruments, when
financial instruments should be recognised and derecognised. In financial statements fair values
are used in the three circumstances:
 to measure some assets and liabilities at each balance sheet date;
 to measure some assets and liabilities on their initial recognition in the financial
statements or on transition from national to IFRS; and
 to determine some asset impairments.
Only the first of these conditions should be described as fair value accounting. IFRS require
measurement at fair value at each balance sheet date and the recognition of unrealised gains,
in other words, fair value accounting only for derivatives, equity investments, investments in

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debt securities, other financial assets and financial liabilities that are held for trading, some non-
financial liabilities (provisions), and some biological assets. IFRS allow, but does not require,
measurement at fair value at each balance sheet date and the recognition of unrealised gains
for investment property, property, plant and equipment, intangible assets, and financial assets
or liabilities that otherwise would be measured at amortised cost 5. Overall, the objective of fair
value measurement is to determine the price at which a transaction would take place. Because
prices quoted in active markets are preferable to other valuation methods, this type of
accounting essentially might enhance the transparency of financial data in volatile times. The
reliability of fair value depends on the inputs in the measurement procedure.
An ordinary method of valuation for assets is the discounted cash flow (DCF), but the reliability
of this valuation technique is questionable, because it uses forecasting. However, DCF is
generally used in measuring fair value for intangible and long-lived assets, and fair value
information is more preferable for liquid assets, such as marketable securities. Estimating future
cash flows always carries risk and fair value for long-term and intangible assets is even more
subjective and less reliable, even if other techniques were used 6.
To grab the difficulty in measuring risk, we could consider some of the valuation problems for
debt securities backed by subprime mortgages. The uncertainty in measuring risk illustrates the
difficulty in making accurate predictions for purposes of fair value. The current pressure on
corporate cash flows means that liquidity risk is likely to be a material risk for many firms.
Because of the lack of market information and uncertainty in recent months European
companies are facing challenges, and therefore in October 2008 the IASB has issued a draft
report to provide useful information and educational guidance for measuring and disclosing fair
values. Besides dealing with increased liquidity risk, the other major outcome of these off-
putting changes is expected to be about going concern assumption. If this concept is not
applicable there will often be a material and negative impact on the financial statements. It is the
governing body or the management that is required to make an assumption about whether or
not the enterprise is a going concern for the foreseeable future when it prepares its financial
statements.

2. Accounting and financial reporting topics impacted by the fair

The fair value standards apply in all circumstances where accounting pronouncements require
or permit fair value measurements, measurements based on fair value (such as fair value less
costs to sell), and disclosures about fair value measurements, with limited exceptions, as
specified 3. Significant accounting standards affected by the fair value standards include the
following:

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 Table 1 - Significant items that call for the use of fair value in accordance with ASC 820,
excluding industry specific topics
Asset retirement and Financial assets/liabilities Distinguishing liabilities
environmental eligible for fair value from equity (ASC 480)
obligations (ASC 410) option (ASC 825-10)
Business combinations Financial instruments Property, plant, and
(ASC 805) (ASC 825) equipment (ASC 360)
Debt and equity Goodwill and Stock compensation
investments (ASC 320) intangibles (ASC 350) (ASC 718)
Derivatives Guarantees Nonmonetary
(ASC 815) (ASC 460) transactions (ASC 845)
Employee benefits Hybrid financial Transfers and servicing
(ASC 715 and ASC 960) instruments (ASC 815-15) (ASC 860)
Exit and disposal costs Troubled debt
(ASC 420) restructurings
(ASC 470-60)

Table 2 - Significant items that call for the use of fair value in accordance with IFRS 13
Business combination— Employee benefits— Intangible assets—
assets acquired and postemployment benefit revaluation model (IAS 38)
liabilities assumed obligations (IAS 19)
(IFRS 3)
Financial instruments: Investments in associates Property, plant and
recognition and and joint ventures—held equipment—revaluation
measurement— by mutual funds and model and exchange of
assets/liabilities eligible similar entities (IAS 28) assets (IAS 16)
for fair value option
(IAS 39)
Noncurrent assets held Business combinations— Financial instruments:
for sale and contingent consideration recognition and
discontinued operations (IFRS 3) measurement—derivatives
(IFRS 5) (IAS 39)
Business Business combinations— Financial instruments:
combinations— previously held interest presentation—hybrid
noncontrolling (IFRS 3) financial instruments
interests in (IAS 32)
an acquiree (IFRS 3)

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Revenue (IAS 18) Financial instruments: Consolidated financial
recognition and statements—investments in
measurement—financial subsidiaries by investment
guarantee contracts entities (IFRS 10)
(IAS 39)
Financial instruments:
recognition and
measurement—debt and
equity investments
(IFRS 9 and IAS 39)

As illustrated by the figures above, there are numerous accounting and financial reporting topics
impacted by the fair value standards.

3. Fair value accounting pros end cons

As with any accounting method, there are several advantages and disadvantages that must be
considered before adopting the fair value accounting 7.

3.1. Pros of fair value accounting

 Timely information

Since fair value accounting utilizes information specific for the time and current market
conditions, it attempts to provide the most relevant estimates possible. It has a great informative
value for a firm itself and encourages prompt corrective actions.

 It provides an accurate valuation

This method of accounting helps to provide more accuracy when it comes to current valuations
from assets and liabilities. If prices are expected to increase or decrease, then the valuation can
do the same. If sales occur, then there aren’t discrepancies that must be charted if the valuation
differ from the transaction. The current market prices allow individuals or businesses to know
exactly where they stand.

 More information in the financial statements than historical cost

Fair value accounting enhances the informative power of a financial statement as opposed to
the other accounting method - the historical cost. Fair value accounting requires a firm to
disclose extensive information about the methodology used, the assumption made, risk
exposure, related sensitivities and other issues that result in a thorough financial statement.
Inclusion of more information is possible whenever there are 4:

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 - observable market prices that managers cannot materially influence due to less than
perfect market liquidity;
- Independently observable, accurate estimates of liquid market prices.

This way produced financial statements therefore increase transparency of a firm, which is
particularly useful to potential investors, contractors and lenders, as they have a better
perception of the stability of a given firm and insight into its.

 It provides a measurement of true income

There is less of an opportunity to manipulate accounting data using the fair value approach.
Instead of using the sale of assets to affect gains or losses, the price changes are simply
tracked based on the actual or estimated value. The changes to income happen with the
changes to the asset value, reflected in the final net income numbers.

 It is the most agreed upon standard of accounting

Instead of the historical cost value that isn’t always accurate after a long period of time, fair
value accounting accurately tracks all types of assets, from equipment to buildings to even land.
This makes it the most agreed upon standard of accounting because set prices, even if still
accurate in value, aren’t the same because of monetary inflation. $10 today is not worth the
same $10 from 2001. That’s why fair value can be so beneficial.

 It provides a method of survival in a difficult economy

In the historical method, the same value goes of an asset goes on the budget line every year.
When there’s a difficult economy and prices are reduced, this can become a cumbersome
financial burden. Fair value accounting allows for asset reductions within that market, so that a
business can have a fighting chance.

3.2. The cons of fair value accounting

 It can create large swings of value that happen several times during the year

There are some businesses that do not benefit from this method of accounting at all. These
businesses typically have assets that fluctuate in value in large amounts frequently throughout
the year. Volatile assets can report changes in income that aren’t actually accurate to the long-
term financial picture, creating misleading gains or losses in the short-term picture.

 Misery typically loves company

If one business is seeing a reduction in net income thanks to asset losses, then this trend
typically creates a domino effect throughout a region or an industry. Downward valuations are

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contagious and often trigger selling that is unnecessary because of the volatility of the market.
When this method of accounting isn’t used and downward valuations don’t have to happen,
there is more investor stability that can, in turn, keep a region or industry’s overall economics
stable as well.

 It reduces investor satisfaction

Some investors don’t always notice that a company is using the fair value approach to
accounting. This creates investor dissatisfaction because the loss of value in the net income
becomes an income loss for the investors as well. Since many investors are trading these
commodities instead of using them for an investment, it can create a tough hit for their portfolio
and cause many investors to stay away from the business altogether.

 Misleading Information

It is possible that sometimes the observed value of an asset in the market is not indicative of the
asset’s fundamental value. Market might be inefficient and not reflect in its estimates all publicly
available information. There are also other factors that could cause that this market estimate to
be deviated such as investor irrationality, behavioural bias or problems with arbitrage among
others. Ball (2006) also points out that market liquidity is a potentially important issue because
spreads can be large enough to cause substantial uncertainty about fair value and hence
introduce large overall value deviations (“noise”) in the financial statements.

 Manipulation

Manipulation of the price by the firms themselves also presents a risk in obtaining a fair value
estimates, because in illiquid markets, trading by firms can have an effect on both traded and
quoted prices.

 It loses the historical perspective

Although current accounting is important to measure, there must also be a general sense of
what has happened historically for accuracy in tracking results 8. Because assets may have a
down year and reduce net profits, it can artificially lower the successes that a business may
have had. For example, if a small business has assets of $100,000 that suddenly become
valued at $60,000 due to market losses and there were $50,000 worth of net profits outside of
the asset reduction, the company’s net profits would actually be just $10,000.

 Contribution to the procyclicality of the Financial System

Following the recent financial crisis, there has been a debate about the potential contribution of
fair value accounting. Many believe that it exacerbated the effects of the crisis, through
increasing the inherent procyclicality of the financial system. (Procyclicality refers to the ability to
exaggerate financial or economic fluctuations.) Fair value accounting and its dependency on the
development of the market situation could cause that a market that experiences a slump is

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closely followed by a deterioration of a firm’s financial situation that in turn causes the market to
panic, bringing it closer to an outbreak of a crisis. Since financial institutions are closely related
to firms and the business cycle in general, if fair values indicate a fall, losses will also be
reflected on the banks´ capital 9.
The fair value accounting pros and cons show that for the most part, businesses can have a
transparent and accurate method of tracking profit and loss. As long as investors are kept in the
loop and know what is going on, the benefits will typically outweigh the risks in this matter.

5. Conclusion

Historical cost provides investors with the cost of the investment, while fair value gives a
measure of what the management expect to get in return from a certain investment. Knowledge
of fair value is important, although it is not enough. Users also need to know the cost of the
investment. In fact, knowing how much resources have been sacrificed to obtain that fair value,
they could effectively evaluate stewardship.
According to the advantages and disadvantages of the concept of fair value in accounting, it is
quite obvious and clear that this concept is far from being perfect. It is very difficult to determine
whether its contribution to the improvement of accounting is really beneficial. On the one hand
there are many reasons why the users of this method are better off, but on the other hand there
are also several reasons why they are worse off. In fact, many of relevant sources express their
mixed views about the extent to which IFRS are becoming imbued with the current IASB/FASB
fascination with fair value accounting. Although the fair-value discussion seems to be far from
over now, the current crisis provided an interesting setting to further explore these issues,
understand them better and hopefully urge responsible institutions to fix the imperfections within
the system to make it work correctly and more effectively.

References
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370, 1999
2. Barlevy, G.: Economic Theory and Asset Bubbles. Economic Perspectives.Third Quarter
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5. Cairns, David, Fair value accounting in IFRS financial statements, Accountancy Magazine,
December, p.53, 2008
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2008
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Jersey , USA, 2009