The Goal of the Accounting Standards - Case Study Example

Lecturer: Executive summary Asset and liability valuation is an essential function of finance and accounting departments oforganizations and businesses. However, valuation can be a daunting task if consistent and appropriate valuation framework is lacking. Lack of or poor valuation methods lead to asset and liability value inconsistencies and incomparability. Therefore, business organizations need to develop and apply reliable and consistent asset and liability valuation technique in order to be preserve good value of the assets and pay right value for the liabilities. Accounting standards have emerged to assist businesses and non-business organizations determine fair value of their assets and liabilities. The standards include Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The goal of the accounting standards is to eliminate the inconsistencies created by different valuation methods in the financial statements. The standards suggest three levels used to determine the fair value of various asset and liabilities on business and non-business organizations. Fair values are important for proper functioning of vibrant, dynamic and volatile domestic and global markets. Fair Value Assets and Liabilities According to FASB (p.9) and Nikolai et al (p.320) fair value is defined as a selling price of a specific asset or payment price paid for a specific liability held by a business or non business entity in current organized transactions between willing buyers and sellers. There are various assets and liabilities valuation approaches used to determine fair value of assets and liabilities. They include market approach, income approach and cost approach. The fair value approach to determining the value of assets and liabilities has gained ground as an appropriate measure for financial instruments. This is because it is more transparent as compared to historical cost based measurements. Fair value approach give the regulators, investors and depositors greater regulatory and market discipline. As a result, it has led to enhanced economic stability, thus minimizing the impact of losses experienced during economic down swings. Fair price must be rational and unbiased estimate of a market price of a particular product, service, liabilities and assets. Fair price should take into consideration the cost, utility and demand of a given asset or liability. There are various assumptions that applied in valuation process. The assumptions are referred to as inputs. Market participants use inputs (assumptions) to price their assets and liabilities (Epstein et al 2008 (193)). Fair value inputs are classified into observable and non-observable inputs. Observable inputs are based on the data available in the market obtained from independed sources other than the management or reporting entity. Examples of observable data include interest rates, yield curve and defaulting rates. While unobservable inputs are assumptions that are made by the management which is the reporting entity. Unobservable inputs are based on best available information in the organization under the circumstances. Active markets are markets that have high levels of volumes or transactions and are characterized with updated prices, little variations and sufficient information. Quoted prices are prices that have not been changed or altered. On the other hand, unquoted prices are prices that have been changed to suit particular scenario. Asset and liability valuations define three level applicable. The three level hierarchy was recommended by GAAP and are discussed below. Level one According to Epstein et al (194) level one as used in asset and liability valuation is the most reliable method of determining fair value of assets and liabilities. GAAP (p. 9) asserts that the inputs used in level one are quoted prices for identical assets and liabilities accessed on the date of measurement by the management and other parties involved. The inputs should be observable and readily accessible in the active markets for independed and reporting entities. A classic example is the company holding shares of stock in the New York Stock Exchange. The quoted price is the closing selling price of the investment stock in the New York Stock Exchange and should be accepted as the fair value of the company’s stock. The fair prices of the company’s shares are quoted because it is derived from direct observation of transactions for identical shares that are being valued. Level two FASB (4) Level 2 method is used when level 1 method can not be used because prices of identical assets and liabilities are not quoted. At level 2, the inputs are observable either directly or indirectly. However, the market price for identical assets and liabilities are not quoted. The inputs include the quoted prices of similar assets and liabilities in inactive markets. The input observable factors for level two include interest rates, volatilities, prepayment frequency, losses, credit risks and default rates .The data is derived by correlation from observable market data. Inputs in level 2 may be adjusted due to the following factors; condition of the asset, location of the asset, comparability to the asset or liability of the inputs and volume and level of activity of the markets. The example of level 2 asset and liability value measurement is as follows: A business organization owns a building whose value has been tampered with and it is planning to dispose it to a buyer who would like to renovate it. However, the active market for such buildings are uncommon and level 2 measurement would be appropriate to determine the fair value of the building because the market information is scanty. The fair value to dispose off the building to the new buyer would be determined by looking at the selling price of similar building under the same location. Level three Level 3 asset and liability measurement hierarchy is applicable when level one and level two fails. According to FASB (9); Epstein et al (196) asserts that inputs used to determine the value of the assets and liabilities are unobservable. This is applicable where there is no observable input in the market. Non-observable inputs and based on internal information and reflects assumptions of management. The third level input are deemed consistent with the assumption that would have been made by market participants. Unobservable inputs are developed based on best internal available information in the organization. However, third level information should be available without straining the companies resources, effort or even spending more money than necessary. Therefore, the cost of obtaining such input should not exceed the benefits that would have been derived from the fair valuation exercise. Unobservable information examples may include the company’s own database that covers its expected cash flows, profit and loss, estimated uncollectible accounts and its accounts receivable on the measurement date. For example, a company with accounts receivables whose value may be impaired may use financial forecast to determine its fair value. The company may use related future expected cash flows and net present value methods to determine the fair value of the trade accounts payables. The fair value asset and liability valuation method demands that the business organization should disclose certain information in the evaluation process. There are two type of disclosures, disclosure on recurrent items and disclosure of nonrecurrent items. Assets and liabilities disclosures on recurrent basis after initial recognition at fair value Assets and liabilities of level three measurements should be reconciled at the beginning and at the end of every financial period. Any changes affecting both assets and liabilities should be stated separately at the accounting period they occur. When losses and gains are reported in the income statements, they should be summed up and described within the period that segregated them. All the purchases, sales, issuances and settlement concerning the assets and liabilities under considerations in level three used should be reported and described as required. Assets and liabilities disclosures on non-recurrent basis after initial recognition at fair value The accounting standards require that the amount of fair value measurement and reasons that led to it should be recorded. In addition, the description of input used and information used to develop them should also be recorded. The significant assumptions or inputs used in the valuation technique are based upon inputs that are not observable in the market and, therefore, it necessitates the use of internal information. Work cited Epstein, Barry and Eva Jermakowicz. Wiley IFRS 2008: Interpretation and Application of International Accounting and Financial Reporting Standards 2008. New Jersey: John Wiley and Sons, 2008. Epstein, Barry, Nach Ralph and Steven Bragg. Wiley GAAP 2010: Interpretation and Application of Generally Accepted Accounting Principles. 8th ed. New Jersey: John Wiley and Sons, 2009. Financial Accounting Standards Board. “Accounting Standards Update January 2010.”Fair Value Measurements and Disclosures (Topic 820) No. 2010-06. 9th March 2010 . Nikolai, Loren and Jefferson Bazley. Intermediate Accounting. 11th ed. USA: Cengage Learning, 2009. Read More