Impact of Fair Value on Financial Statements - Article Example

Fair value accounting Introduction Fair value is a concept used in accounting and economics, which provides an unbiased value of the market price of an asset. It is an estimation of the market value of an asset for which an asset’s market price cannot be determined. It is the amount that an asset can be bought or sold at current market conditions between willing parties. In accounting, fair value is used as an estimate of the liability and market price of an asset. The liability of an asset is the market value of that particular asset. Under the accounting guidelines the fair value is used for assets whose value is based on the mark to market valuations and for those assets which have historical costs fair value is not used. Impact of fair value on financial statements The use of fair value for measuring assets has been controversial. The use of this measure on financial statements will reflect the impact of current market conditions on financial instruments. This will lead to greater transparency, as investors will have more information on which assets are valuable and which are not and will benefit from knowing the market liquidity. There is the belief that fair value provides the most relevant information but concerns are about the reliability of their estimation. The impact caused by increasing the use of fair value is increasing the volatility of financial statement amounts. If financial statements are based on fair values then the amounts will change from period to period in the balance sheet as well as the income statement. The less volatile historical costs will then begin to change also in a fair-based value accounting system. The primary objective of providing financial reporting is the information relating to uncertainty of future cash flows. If financial statements overstate the economic volatility investors will assess risk premium to the entity’s cost of capital that is higher than what is justified by the economic situation. Maintaining stability and soundness in the financial system is made difficult because of this volatility. The purpose of financial statements is to provide the financial position of an entity so that the users can make a variety of decisions based on the changes in the financial position to make decisions. Fair value provides more transparency than historical cost based measurements. Regulation and market discipline is achieved when all financial instruments are measured at market value. This is because losses achieved by investors and taxpayers alike are avoided. The interests of the investors and depositors are protected when financial instruments are measured at fair value. This way losses that are incurred by investors during the previous downturns in the economy is avoided. The financial instruments will reflect the impact of the current market conditions on financial instruments. Fair value is therefore the best way to reveal these conditions. Whether positive or negative, fair value is the result of market forces. This is good news to investors because they benefit when companies reveal their views on the impact of the market liquidity in their financial statements. Adopting fair value in accounting short-term assets and liabilities in the business will improve in disclosures. Fair value is an indicator of the risk exposures that and helps in risk management. The risk hedging techniques will find more usage in businesses to hedge against financial risk. Recording all financial assets and liabilities at fair value in the balance sheet may add to the financial risk because changes in fair value are recorded in earnings whether realized or not. Bies, 2004, while speaking at the international association of credit portfolio managers general meeting in new York said that the verifying values that are not based on market values that are observable is very challenging. She says that these values are based on selected methods by management and such methods are difficult to verify. This difficulty in verification leads to the question of reliability of the valuations and yet decisions are supposed to be made on them. The question of management being biased whether intentionally or unintentionally may result in the gross misstatements of fair value estimates. An over calculation may occur which may cause the overvaluation of a security. This may happen, if the market for such a security has not been active in the recent years. The biasness of management may affect the financial statements prepared by fair value because the misstatements will be greater. The value of a financial instrument has tangible and intangible value. The tangible value being the good or service received while the intangible value being the contractual right to perform the service or deliver the goods over the period of time for a fee. The accounting procedure however does not provide the procedure of how these should be treated. This lack of framework on disclosure for the treatment of financial and non-financial components has lead to the issues in the recognition of revenue in fair value accounting systems Financial instruments have undergone significant development as they have been used to hedge against the exchange and interest rate risk. This widespread use of financial instruments led to the importance of capital markets as a source of finance and investment Guitierez, 2006. Changes in the traditional practices of preparing financial statements needed to change also. Guitierez, 2006 says that this traditional method of valuing assets had somewhat failed because investors and taxpayers suffered losses despite their existence. To restore credibility in the financial markets anew system and way of doing things had to be adopted. Transparency had to be the main emphasis in reporting financial statements. The valuation of financial instruments by their fair value allows users of financial information to obtain a true and fairer view of the company’s real financial condition at the prevailing economic conditions Guitierez, 2006. Its application offers a consistent framework of valuation of financial instruments. Cerrato, 2008 says fair value provides an appropriate accounting base for financial instruments. Appropriateness of final value on financial instruments Financial statements are prepared with different accountings frameworks. These frameworks have different guidance on the measurement of fair value of financial instruments. In active markets, regular market transactions determine fair value. The credit crisis affected the performance and risk exposure of financial and non-financial institutions and this brought the focus on financial instruments. Financial instruments though are not amortized at fair value because net gains and losses go into the income statement. The exception is for equity statements because they are accounted at fair value in the comprehensive income statement. This standard eliminates the requirement for embedded derivatives. Final value accounting on financial instruments is important because it makes banks to evaluate the risk nature of their customers before lending them any money. This is because the action by banks to ignore the market valuations will be stopped. Banks will not attempt to meet unreasonable earnings expectation by extending their existing loan portfolio. The liquid nature of financial instruments makes them receive considerable attention. The implication of regulatory capital requirements and fair value application on a wider range of financial instruments has emphasized the need for a robust management of these instruments. The valuation of financial institutions practices through control processes around fair value measurement and reliability is important. These reveal the soundness of the banks practices in terms of financial prudence and accountability. Fair value hierarchy ensures that the financial reporting designation during periods of stress and normal market conditions is done. Fair value will then apply to all financial instruments regardless. This is because the supervisory expectations set forth that provide guidelines promote strong governance process around valuations within a financial institution that promotes the articulation and communication both internally and externally. Application of fair value to other classes of assets The International Financial Reporting Standards are principles based standards that have been adopted by the International Accounting Standards Board. This board is responsible for setting the standards of accounting in the world. It operates by setting the principles of presenting and reporting of financial statements. Its objective is to create a firm base for the future of accounting standards with principles that are internationally converged. In Australia, the Australian Accounting Standards Board has issued equivalents of the guidelines set by the IFRS together with their interpretations. It is these guidelines that determine the use of the fair value and on which classes of assets and determines what should and should not be disclosed in financial statements. Fair value accounting does not have application to financial instruments alone but to other classes of assets. In the real estate market their appraisals and valuation is done on market on values. The value of properties is determined by their heterogeneous nature and location. Investment property is usually held to earn rental income for the appreciation of capital. For investment property, fair value is normally used because real estate constitutes the primary source of income for the company. The real estate industry uses fair value for investment property more because of the liquid markets for comparable property. In cases, whir contracts require performance measurement fair value is used because it is closely linked to the performance of a company. Creditors demand disclosure and are normally interested in a company’s liquidation value and so companies that apply fair value to investment property are able to access debt more easily. Property and plant equipment The price protection encourages companies to select accounting methods that reduce agency costs. This is because agency conflicts cause management to impose huge costs on the company in form of price protection. Choosing historical costs over over fair value is an upward asset revaluation. This way creditor curbs the shareholders motivation to overstate assets and so seize their wealth. Under the International Financial Reporting Standards, companies can choose between historical and fair value accounting for plant, property and equipment. Intangible assets For intangible assets, companies can choose whether to use historical value or fair value accounting value. Read More