Fair value accounting
Introduction
The concept of fair value, as applied in economics and accounting, refers to the rational and balanced approximation of the potential market value of an asset. It is arguably evident that many financial instruments are evaluated and reported using the fair value (American Institute of Certified Public Accountants) 45. The evaluation of fair value takes into consideration factors such as acquisition costs, replacement costs, supply versus demand and actual utility at a particular time of its productive capability; all these are termed objective factors. Subjective factors that determine the fair value of an asset include the risk characteristics, the individually perceived utility, capital costs and returns on capital. In the context of accounting, the fair value denotes the certainty of an estimated market value of a particular asset for which its precise market value cannot be evaluated, which I most cases is due to lack of an established market for that particular asset (Arrunada 47). According to the United States Generally Accepted Accounting Practices (US GAAP), fair value denotes the price that the asset could be bought or sold in the present transactions between willing entities or in case it is transferred to a corresponding party that does not involve liquidation sale. Fair value accounting is deployed in the assets who carrying value depends on market-to-market valuations. Fair value is not adopted for assets whose values are determined by the historical cost (Brigham and Ehrhardt 15). The main purpose of this paper is to assess the applicability of fair value accounting, its financial implications and the issues surrounding the use of fair value accounting.
History of fair value accounting and its subsequent development
The use fair value as an accounting method was first adopted by traders engaging in future exchanges during the twentieth century. Fair value accounting became a common accounting method during the 1980s that saw its application being adopted by banks and other corporations (Geiger 89). The early 1990s saw the onset of financial scandals, which were mainly attributed to the use of fair value accounting. With the increasing adoption of fair value accounting within the corporations, it was perceived as a way of committing frauds. This was facilitated in scenarios whereby there was no objective approaches that could be deployed to ascertain the fair market price because of the unavailability of real day to day markets and cases whereby the fair value of the financial instruments were mainly determined by trade transactions of other similar financial instruments. This played an integral role in culminating the Enron Scandal (Gerard 145).
Uses of fair value accounting
Fair value accounting is viewed as method of accounting that is based on the fair value of a financial instrument as determined by the existing market price of the instrument, which can also be determined using objective assessments. Fair value accounting was incorporated into the US GAAP during the early 1990s and has been in used since its inception (Eddie and Peter 47). A notable impact of fair value accounting is that it adjusts the financial values found in the financial statements more frequently compared to the historical cost accounting, which bases on past transactions to ascertain the value of a financial instrument; this does not serve to indicate the present fair value. The historical cost accounting is based on a summary of the past transactions. In cases whereby the market prices adjust constantly in an unpredictable manner, fair value accounting may be inaccurate.
The fair value is a needed evaluation measure that is deployed in most financial instruments. The decision to deploy make use of fair value accounting in the financial statements of a firm is mainly determined by the underlying intent of the financial instrument and the type of institution that owns the financial instrument (Gerard 100). For instance, broker dealer must use fair value accounting due to the fact that most of its assets are traded regularly, implying that the assets must be accounted for using their fair value. Other firms make use of the fair value accounting mainly due to the purpose of the financial instrument or the kind of business that the firm engages in. For instance, if a firm has made a decision to hold a United States Treasury bond to maturity, the bond can be accounted for using its original cost. In case the institution opts to purchase other similar treasury bonds and has the aim of reselling them in the future, fair value accounting can be used to valuing the bonds. In the present day markets that are characterized by volatility and dynamism, the present value of an asset, an assertion that has gained support from the accounting research. The FASB considers fair value accounting as one of the most vital measures of financial instruments. Fair value accounting is more transparent compared to accounting (Zyla 147).
Fair value accounting is mostly used to ensure that there is compliance with the various public reporting standards. Firms can also make use of fair value accounting to facilitate numerous internal processes which may include investments and decisions relating to trade, risk management and evaluation, evaluating the amount of capital to be allocated to the business lines and the calculation of compensation. Fair value accounting is significantly relevant in facilitating the identified internal processes (Warren and Reeve 147).
Computing the fair value
The evaluation of the fair value of a financial instrument is determined by the approaches that are used for price valuation of the instrument. Owing to the fact that fair value denotes the price that a potential buyer and seller consent to transact, determining the right price is a vital process when computing the fair value of a financial instrument. The most simple valuation method used to compute the fair value is to the quotation system, or research for the value of the financial instrument in a newspaper (Higson 148). The quotation system makes use of data sources including the newspapers, electronic systems that provide the prices of securities, broker quotes and subscription services that aim at offering data relating to particular financial instruments. The quotation system usually offers the updated prices that have been reflected in the secondary market. This is an effective approach due to the fact that listed prices are accessible for the financial instruments. In cases whereby the listed and published prices cannot be accessed for certain type of financial instruments, valuation models can deployed to compute the fair value. Valuation models usually take into consideration pertinent data like the present economic forecasts, the existing market conditions and the fair values of other similar financial instruments. The valuation model makes use of statistical techniques in order to approximate the fair value of a financial instrument. The pricing models are reviewed constantly in order to ensure that they represent the existing realities in the market. For instance, corporate bonds are usually traded in a predefined time duration compared to treasury securities that have the same maturity. In such cases, the transaction prices of the same period can be of help in computing the fair value of same securities. Market data can be integrated into the model to enhance the precision of computing the fair value of the financial instruments. Judgment is deployed in scenarios involving complex financial instruments that do not have market parameters and their associated prices (Brigham and Ehrhardt 89).
Despite the fact that the determination of the fair value involves judgment, internal control processes are deployed basing on reasonability and consistency. The management review and oversight are required in order to guarantee accuracy the accuracy when computing the fair value. Valuation models should be reviewed independently an integral element of the internal control processes; this is deployed with the main objective of ensuring that the fair value reflects the existing market conditions. It is also imperative to compare the fair value established using the valuation models with the actual values in order assess the reasonability of the estimates. Comparing the fair value estimates with the value of the financial instrument at the time of termination can also be used as tool for carrying out independent verification of the fair value (Arrunada 89).
It is important to note that fair value accounting offers vital information relating the firm’s financial instruments when compared to accounting models that are based on historical costs. Due to the fact that fair value accounting serves to denote the existing market conditions, it offers a framework for comparability of the value for the financial instruments that are acquired at different times. Additionally, financial disclosures based on fair value accounting offers significant insight relating to the present market valued to the investors; this makes significant contributions regarding the importance of financial statements.
Fair value accounting according to SFAS 157
Fair value accounting is increasingly adopted by firms in financial reporting with the consensus that fair value accounting meets the criteria provided by the conceptual framework when compared to other accounting methods such as historical cost and amortized cost accounting. Despite of this, a major concern relating to the use of fair value accounting is the underlying difficulty of evaluating the fair value based on subjective estimates, especially in cases whereby the financial instruments cannot be traded in active markets. The SFAS (Statements of Financial Accounting Standards) 157 and IAS (International Accounting Standards) 39, developed by FASB and IASB respectively, offer the guidelines that can be deployed in order to compute fair values of financial instruments in cases whereby there is difficulty in evaluating the subjective estimates.
The SFAS framework provides the guideline that can be used in the computation of the fair values for companies that report their financial statements using the United States GAAP. Before the development of this accounting standard, diverse definitions of the concept of fair value were available yet there were limited guidance practices relating to the applicability of the concept of fair values. The SFAS 157 offers a steady definition of the concept of fair value and the different valuation techniques that can be deployed to compute the fair value of a financial instrument, which requires the companies to disclose the various valuation inputs with the main objective of increasing their uniformity and comparability of the techniques used in measuring the fair value (Gibson 45).
According to the SFAS, fair value is denoted by the price that would be attained to trade an asset or transfer a liability in a systematic transaction between the various participants during the date of measurement. This approach focuses on the exit price and not the price that would be paid during the acquisition of a financial instrument or the entry price for assuming a liability. Systematic transaction implies that the company has adequate time in order to market the financial instrument. This implies that the fair value should not be based in a situation characterized by forced liquidation or cases involving distress sale. According to the SFAS, there are three valuation methods for computing the fair values of financial instruments. They mainly include the market approach, income approach and the cost approach. The market approach makes use of the quotation system, which involves the quoted values in active markets. Other valuation methods that are make use of valuation techniques similar to the market approach include using market multiples obtained from set of comparables and the use of market pricing whereby firms value their security without taking into consideration the quoted prices (Eddie and Peter 78).
The income approach makes use of the valuation models for converting the future amounts to compute the present fair value. Examples of this approach are current value discounting cash flows, multi-period excess earnings method and option pricing methods. The cost approach method of computing the fair value bases on the amount that is needed to replace the service capacity of a financial instrument (Warren and Reeve 100).
The SFAS 157 fair value hierarchy emphasizes the concepts of the standard, which implies that the hierarchy ranks are based on the quality and reliability of the data that were used to compute the fair values. With regard to this, level 1 input are considered most reliable while level 3 inputs are considered to be the least reliable. Data that is collected from first hand observation of the financial transactions such as quoted prices of similar financial instruments are considered superior in terms of reliability when compared to the use of assumptions. On the other hand, inputs that derived from data that has not been observed or basing in the reporting assumptions of the market participants are deemed least reliable. Inputs in this context can be used to mean the assumptions that are used to compute the fair value of a financial instrument by the market entities. The SFAS 157 emphasizes more on the use inputs that can be observed from sources that are not related to the firm, and lays less focus on the use of inputs that cannot be observed, that is the inputs that serve to indicate the assumptions undertaken by the firm relating to how the market participants would assign a fair value to a financial instrument (Higson 254).
When making use of fair value accounting, the company must make use of the level 1 inputs, which are quoted values in active markets that have not been adjusted; this is based on the assumption that the quoted value in an active market offers high degree of reliability for the fair value. As such, firms are required to make use of level 1 inputs whenever they access them except in cases whereby they cannot readily access the quoted prices and that they do not serve to indicate the fair value during the date of computation. In such a case, the firm should make use of level 2 inputs, which refers to other inputs that can be observed apart from quoted prices. This may include quoted prices of similar financial instruments in the active and inactive markets, interest rates, credit risks and observable market data that can be attained using correlation. In cases whereby a firm cannot access the level 2 inputs, especially cases whereby the market activity of the financial instrument during the valuation date is limited, the firm can make use of level 3 inputs, which refers to the assumptions undertaken by the firm relating to how other market entities would value the financial instrument (Warren and Reeve 100). Using level 2 inputs requires the firm to disclose all the data used in the valuation of a financial instrument, qualitative information that highlights the valuation techniques for arriving at the fair value. Potential issues are likely to come forward when the market method does not serve to indicate the true value of an asset. An example is when a firm is forced to compute the fair value of a financial instrument during times of economic volatility like the recent 2008 financial crisis.
Fair value accounting according to the IAS 39
IAS 39 provides the guideline that can be used for the recognition and valuation of financial instruments for firms that use the International Financial Reporting Standards (IFRS) for reporting their financial statements. According to IAS, fair value refers to the amount that a financial instrument could be exchanged or the amount that could be used in setting a liability between entities that willing in an arm’s length transaction. A notable difference between the SFAS 157 and IAS 39 is that SFAS 157 explicitly relies on the exit price, while the IAS 39 does not involve the exit and entry price (American Institute of Certified Public Accountants 124). The SFAS 157 also relies on market participants while the IAS 39 is based on the willingness of the buyer and seller. In either the cases, computing the fair value does not require the use of a forced transaction, unintentional liquidation or cases associated with distress sale. Another consistency between the IAS 39 and the SFAS 157 is that they both consider best approach to computing a fair value is to use price quotations in active markets. There are no hierarchy classifications in the IAS 39, although it specifies that the selected method for computing the fair value must mainly use the market inputs with little reliance of specific inputs that are based on the assumption of the firm (American Institute of Certified Public Accountants 130).
Conclusion
The increasing adoption of fair value accounting cannot be reversed. This method of accounting requires that the values represented in the financial statement reflect a fair value, which is likely to impose adjustments in the financial statements affecting the stockholder equity and the income statement. The FASB standards for computing the fir value can be argued to be the most effective approach toward the computation of fair values for financial instruments. Nevertheless, a lot of work is required in order to ensure that there is reliability, verification and auditing of the fair values. As such, the managers have to take into account the portfolio movements that are related to fair value accounting in order to ensure that there is effective financial reporting.
Works cited
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