Fair Values in the Preparation of Financial Statements - Essay Example

Fair Values in the Preparation of Financial Statements A number of arguments have been levelled for and against the use of fair values in the preparation and presentation of financial statements. Arguments in favour of fair value accounting The proponents of fair value accounting states that fair value accounting is important for a number of reasons: They provide the information that is very relevant to users of financial statements; and they ensure comparability of financial statements. Relevant Information Information needs to be relevant to the needs of users in order to serve its purpose. However, there are also other fundamental qualities that financial statements need to have. These qualities include comparability, faithful representation, consistency, completeness, understandability and reliability (BPP 2009a). Information is useless if it is not reliable and in a number of cases the values described as fair values in the accounts does not provide a reliable estimate of the value of assets and liabilities. According to Bath (n.d.) concerns also focus on this matter. It should also be noted the more reliable the information is the less relevant it will be. Relevant information has predictive value, feedback value and timeliness. Reliable information is verifiable Comparability of financial statements Financial statements need to be comparable from one year to the next and between one company and another. However, even though fair values may be said to be current and therefore more comparable, the fact that judgement need to be exercised brings subjectivity into play. In addition to that, those judgements on which investors and other stakeholders depend have their own agenda. In some cases they may exercise their judgement in such a way as to manipulate the accounts. This therefore brings us back to the reliability of the figures in the financial statements. Arguments against fair value accounting The arguments against fair value accounting appear to outnumber those in favour. Most of the arguments against essentially relate to the classification of financial instruments the fair value hierarchy. According to Ernest and Young (2009) the 2008 amendment of the International Financial Reporting Standards (IFRS) requires that the classification of financial instruments be recorded at fair value in a hierarchy consisting of three (3) levels. The first level (level 1) relates to quoted prices that have not been adjusted for identical assets and liabilities in active markets. The second level (level 2) relates to input prices but excludes quoted prices which are included in the first level and which can be observed directly for assets and liabilities, in the form of prices or in the form of derived prices indirectly. The third level relates to both assets and liabilities that are not based on market data that can be observed. IASB concluded that this would result in improvement for comparability purposes as well as assist in the convergence process of the IFRSs to the United States generally accepted accounting principles (GAAP). The basis that was given for that conclusion relates to the disclosures required by IFRS 7 and ASC having no differences in terms of their application. Khalik (2008) in his paper entitled ‘The case against fair value accounting’ indicated that its critics have suggested that in times of poor economic conditions fair value (FV) accounting leads to the generation of pessimistic assumptions that further result in significant reductions in asset values as well as major reductions in earnings because of the fact that unrealised losses is taken into account in the income statement. As a result of this they put forward the following arguments: It is rather subjective and arbitrary It reflects poorly on the performance of the company and presents no evidence to support it It may result in a significant increase in the volatility of the earnings that is reported It may result in investors being misled into thinking that poor financial conditions will continue into the future. According to the critics those conditions have resulted in investors dumping their shareholdings in 2008 during the financial crisis and also caused a run on banks as it occurred in the 1930s during the great depression. However, Khalik (2008) points out that when it suits them they do not mind fair value but when it does not they are totally against it. Khalik further indicates that when prices were rising, these opponents of FV had no concerns or even second thoughts about these unrealised gains that they benefited from. Subjective and arbitrary In relation to this point subjectivity directly contravenes the concept of objectivity. However, objectivity is not one of the fundamental accounting concepts and so the fundamental accounting concepts take precedence. While it may be seen as arbitrary the persons who apply them should have knowledge of accounting and accountants are expected to use their professional judgement is making decisions. The accounting standards framework provides a basis for the exercise of this judgement. Of course businesses operate in different industry sector and in different environments so these subjective factors will come to play in issues relating to valuation of assets and liabilities. Poor reflection on the performance of the business It is important that prudence be exercised in accounting for unrealised losses. According to BPP (2009a), although prudence is no longer a core concept in IFRS accounting losses should be recognised more readily than gains. Therefore it is important that unrealised losses are provided for, and this is especially so in an environment where businesses are not performing well due to a downturn in the economy, as happened in 2008. If the business is not performing well then it makes no sense to allow bad debts and other items to remain on the books, thus overstating assets when it should be written off or provided for where necessary, as a matter of prudence. If this is not done then it may appear as if profits are being made when it is not really so and dividends might be paid out of income which may never be realised. If things are not identified in the correct period then the impact on the financial statement will be great in the next financial period so it is always best to make provision in advance. This will help to lessen the volatility in income Significant increase in the volatility of the earnings that is reported According to BPP (2009b), the more volatile the fair value the more frequent is the revaluations. This may or may not affect the income statement. If a loss on revaluation was previously expensed than a subsequent gain would be included in the income statement. However, if there was no previous loss on that particular asset then any gains would be carried to the surplus. This means that care is taken not to overstate income but to exercise prudence in providing for unrealised losses. According to Bath (n.d.) volatility will occur because of the fact that fair values and therefore a change in an expected stream of cash flows changes the fair values. Bath (n.d.), further states that understanding the sources of volatility is very important and stresses that financial statement volatility is in no way a representation of financial reporting that is flawed. As a matter of fact Bath makes reference to the fact that historical accounting masks underlying economic volatility and is therefore not the result of superior accounting Investors being misled that poor conditions will continue into the future Financial statements that are prepared using FV accounting indicate factors that affect the performance of a business. Therefore, if there is an economic downturn and it is impacting on the business then investors would like to know. Additionally, the figures should reflect any changes that impact their values. The statements would also indicate the current outlook in order to indicate to investors that based on where we are now. References Bath. (n.d.). Fair Values and Financial Statement Volatility. Retrieved http://www.iasb.org/NR/rdonlyres/721AD4A0-42BB-4A09-9A91-140D27D65B84/0/FairValuesandFinancialStatementVolatility.pdf. Last accessed 6th May 2011 BPP. (2009a). F3-Financial Accounting. 3rd ed. London: BPP Learning Media Ltd BPP. (2009b). F7-Financial Reporting. 3rd ed. London: BPP Learning Media Ltd Ernest & Young (2009). Classification of Financial Instruments Within the IFRS 7 Fair Value Hierarchy. Retrieved: http://www.ey.com/Publication/vwLUAssets/Fair_Value_Hierarchy_GL_IFRS/$File/Fair_Value_Hierarchy_GL_IFRS.pdf. Last accessed 6th May 2011 Khalik, A (2008). The case against fair value accounting. Paper: Paper : CGA conference in Ottawa, Canada. Retrieved: http://www.sec.gov/comments/4-573/4573-229.pdf. Last accessed 6th May 2011 . Read More