International Financial Reporting Standards - Assignment Example

Accounting Research Essay Name Course Tutor Unit Code Date Question 1 Synopsis Barth (2007) highlights the importance of measurement in financial reporting. There exist many approaches through which the true value of an asset or liability can be arrived at in a business deal. Some of the approaches include: historical cost, replacement cost, and deprival method, among other measurement bases. The fair value method has been fronted as the best way to go. There is no conventional definition of fair value. The most common definition is that of the Financial Accounting Standards Board (FASB). According to the body, fair value is “the amount at which an asset or liability may be purchased or incurred or sold or settled in a transaction involving willing parties that is other than in an enforced or liquidation sale.” The model has been touted to play three key roles in financial accounting: (1) In mixed measurement approach; (2) As an exit value; and (3) As an entry value (Laux & Leuz, 2009). Introduction Barth (2007) highlights the importance of measurement in financial reporting. There exist many approaches through which the true value of an asset or liability can be arrived at in a business deal. Some of the approaches include: historical cost, replacement cost, and deprival method, among other measurement bases. The fair value method has been fronted as the best way to go. Below I look at the role that the method of fair value would engage in providing useful information for economic decision making. Part A According to Daske et al. (2008), “the purpose of the fair value approach is to approximate the price at which a business deal to sell an asset or incur liability would transpire in an open, lively and organised marketplace at the measurement date under existing market circumstances.” The model has been touted to play three key roles in financial accounting: (1) In mixed measurement approach; (2) As an exit value; and (3) As an entry value. There are various ways in which fair value is useful in a mixed measurement approach. Together with the historical cost approach, fair value plays a crucial role for approximating the value of the same asset/liability regardless of the time differences. For instance, fair value is used in (1) “fresh-start accounting that afterwards continues under historical cost,” (2) “impairment from historical cost to fair value,” (3) establishing historical cost for some transactions, such as barter and donations, and (4) allocating purchase price, such as concerning goodwill and tangible assets, among others (Nobes, 2006). The second most important role of fair value accounting is to produce exit value. This is the estimated price at which an asset would probably sale at. At this price, the assets/liabilities are revised each period to the most recent exit price. The resultant unrealised increases as well as decreases are documented as a portion of (comprehensive) income. The applicable price is that prevalent in a business deal with a different market participant meaning that fair value is dependable upon recognisable market conditions (Horton et al. 2008). Fair value accounting may well depend on unobservable inputs where discernible market data is lacking. FASB, through statement 157, Fair Value Measurements, approves the exit value functionality realised from using fair value measurement. The IASB supports this though with quite a few inconsequential objections. Taplin (2004) points out that “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” It therefore follows that fair value accounting is of great advantage to the shareholders. This is after observing that the moment value has been set solely via disclosure to market price. Daske et al. (2008), put this into perspective by retorting that “shareholder value is one-to-one with market prices.” For that reason, fair value accounting is proper. Shareholders to benefit from trading portfolio stocks where the use of fair value accounting gives them a return, “one-for-one, from the variation in market price.” Also fair value accounting gives an entry value, where, according to Chalmers et al. (2008), “assets are re-evaluated at their replacement cost, with updated costs then noted in the income statement with unrealised (holding) gains.” Losses are also documented. They continue to state that, “even if revenue recognition and matching is upheld, income, based on current costs, appears to be a superior pointer of the future and is not path-dependent.” US SEC backs the use of fair value accounting. In 2008, the body carried out a study on mark-to-market accounting standards. The findings of this study indicate that, “a lot of investors together with other users of financial reports prefer the use of fair value accounting since it clearly reveals, under the existing economic environment, the value of assets and liabilities of the businesses in which they put their money in.” They say that “fair value is the best relevant measurement quality for financial instruments in the predominant market situation.” According to Taplin (2004), “it too meets the conceptual framework measures in terms of qualitative characteristics of accounting information better than other measurement bases. That is relevance, faithful representation, and comparability besides being neutral and timely.” The International Public Sector Accounting Standards Board (IPSASB) accepts that fair value (as used in IFRS 13) is a relevant measurement basis for evaluating a financial return. Assets stated at fair value can be used to assess financial performance considering the return contained in market values. Also, regarding to the valuation objective, fair value accounting is a seamless accounting for value (in the balance sheet) and affords information as regards risk exposure and stewardship (in the income statement) (Goodwin & Ahmed, 2006). Conclusion Measurement is an important aspect in financial reporting. The measurement basis used should satisfy the criteria of relevance, comparability, faithful representation, verifiability, understandability, and timeliness. Financial bodies have relevance as the most important criterion of evaluating financial information. Out of the several measurement bases that exist, fair value has been embraced as the one that gives relevant information. The method plays an important role in financial reporting in mixed measurement approach, exit value and entry value (Chalmers et al. 2008). References Insert references for question 1 here (I have attached them separately). Question 2 Synopsis The role of fair value accounting is important in financial reporting. Nonetheless, its adoption has been very much controversial (Ball, 2006). It faces a number of challenges that limit its usage. Some of the probable challenges of fair value reporting include market illiquidity, verifiability, and probable indirectness. Introduction The issue of measurement in accounting has elicited much controversy in recent times, particularly after the global financial crisis 2007-09. At the centre of this controversy is the approach to be used by regulators as well as the accounting standard setting bodies “in measuring (recognising) the value of an asset or liability in the everyday financial transactions” (Christensen & Nikolaev, 2009). Fair value accounting is not a panacea. It faces a number of challenges that limit its usage. Some of the probable challenges of fair value reporting include market illiquidity, verifiability, and probable indirectness. Below I look at the drawbacks of the method as a measurement tool. Part B Pozen (2009) argues that fair value accounting has some flaws that are risky, mainly “in the absence of active markets.” This arise from the recent example of the 2007-09 global financial crisis. Some of the probable challenges of fair value reporting include market illiquidity. Its definition also lacks adequate specificity to warrant regular application. There has also been concerns regarding the verifiability of fair value, particularly “in relation to assets and liabilities that do not have observable market prices.” Therefore, fair value for such assets/liabilities ought to be assessed. However, Laux and Leuz (2009) notes that “this increases the probability that the approximations may well not be verifiable.” The other issue distressing fair value accounting is the probable indirectness. According to Laux and Leuz (2009), “it is doubtful that even if all documented assets and liabilities are measured at fair value, acknowledged equity would be the same as the market value of stocks.” The reason for this is that only assets and liabilities which fall under the definition of the Conceptual Framework qualify for recognition. Market value of stocks indicates the investors’ estimations of growth options and administrative ability, among other things, that do not fall within the definitions of the assets. Just like many other international as well as national standard setting bodies, IPSASB has referred to fair value measurement basis extensively in its literature. There are many distinctive assets in the public sector and variances in entry and exit prices are consequently momentous. Given the instance at which an asset is expected to offer prospective service or other economic reimbursements that exceed its exit price, a measure indicating exit values has no much relevance. If the fundamental resourceful option is to sell the asset (owing to the prospective service or other economic reimbursements that it will offer does not equal or exceed what can be gained from sale) the measurement basis with great relevance is not necessarily the selling price, with indicative costs of sale (Laux & Leuz, 2009). In addition, the IPSASB notes that “IFRS 13 definition of fair value is openly an exit value.” As a result, “the relevance of fair value in the public sector is expected to be narrow in meeting the objective of reporting allied information on financial dimensions, as opposed to making available information on the cost of services as well as the operating capacity” (Daske et al. 2008). They continue to state that “even in the private sector, fair values are a detriment the minute the firm arbitrages market prices, meaning that fair value is incorrect once the firm adds value (for shareholders) by purchasing at (input) market prices and trading at (output) market prices.” It is also not correct while “there is a top-line view of a buyer from whom value is expected in an exit price, with value addition above an input price.” According to Barth (2007), “fair values carry price bubbles into financial reports.” Exit fair values are limited. “If the one-to-one requirement is fulfilled, fair values bring value to stock holders if market prices are ‘efficient’. However, in a price bubble bungling prices are taken on the balance sheet, with bubble gains rolling over to the income statement” (Barth (2007). Even though this may not be troublesome for trading portfolios where investments are held in a short period, it is problematic in the long run. A good example are pension assets, when manifest through bubble prices they possibly will appear satisfactory to fund imminent pension commitments. Insurance assets could appear adequate or even superfluous reserves against prospect insurance losses. Another limitation is that “fair value accounting fails minus asset and liability matching” (Goodwin & Ahmed, 2006). In business deals, assets along with liabilities work together to produce value for investors. Therefore, the individual fair value of an item is not really important. There is need to match fair values of all the items that generate value together so as to seizure value added. It is particularly dangerous if the “fair value of an asset is not matched with the fair value of a related liability whose price variations are negatively correlated with those of the asset.” This will result in “recognition of gains and not offsetting losses (or vice versa)” (Goodwin & Ahmed, 2006). Negative correlation yields ‘excess volatility’ in incomes about which one can certainly protest. Conclusion Even though fair value measurement plays an important role in financial reporting, it faces some limitations. The challenges of fair value reporting include market illiquidity, verifiability, and probable indirectness (Brown & Tarca, 2007). References Insert references for question 2 here (I have attached them separately). Question 3 Synopsis Fair value has been embraced as the one that gives relevant information. As of 2005, following the introduction of IFRS, companies have tended to embrace fair value accounting (Chalmers et al. 2008). Using the example of BHP Billiton and Macquarie Bank in Australia, it is clear that there is more use of fair value accounting. Introduction Fair value has been embraced as the one that gives relevant information. As of 2005, following the introduction of IFRS, companies have tended to embrace fair value accounting (Chalmers et al. 2008). Below I put this into perspective by looking at the application of fair value accounting in two Australian corporations; BHP Billiton and Macquarie Bank. Part C In recent times, the IASB and FASB have shown a tendency to support fair value accounting. This is because fair value accounting is perceived to be more relevant for the decision making by users of financial statements. Moreover, through the expanded use of International Financial Reporting Standards (IFRS), there has been a significant impact in the use of fair value accounting than the national Generally Accepted Accounting Practices (GAAP). Australian companies have been in the forefront in the adopting IFRS, and hence, fair value accounting (Horton et al. 2008). Below, I probe how fair value accounting is embraced in Australia through two Australian companies operating in different industries. The companies are (1) Rio Tinto (Extractive Industry); and (2) Macquarie Bank (Financial Services Industry). The information for this study was sourced from the companies’ annual reports. Reporting on Plant, Property and Equipment (PPE) and Investment Property According to Laux and Leuz (2009), “the option to use fair value at each balance sheet date is permitted under IFRS and Australian GAAP.” A look at the annual reports indicate that both companies used one-off revaluations to fair value at transition date as IFRS estimated costs for property. This was similarly observed for plant and equipment as the companies employed fair value measurements at transition date as IFRS estimated costs. IAS 40 Investment Property articulates a clear inclination for the fair value model. However, companies are gratuitous to use fair value measurement or not. From the annual reports, it is clear that the two companies use fair value measurement under the wider “definition of investment property in IAS 40” (Laux & Leuz, 2009). Reporting on Intangible Assets (other than goodwill) IFRS and Australian GAAP require that “intangible assets acquired and generated internally be recognised on the balance sheet as assets either at the cost of acquisition or production.” The standards require that subsequent balance sheet values be measured by means of either a cost model or a revaluation model, though in very limited situations. “Fair value measurement is manifest under the revaluation model, that is, stuffs are measured at fair value minus any amortisation and impairment losses afterwards the revaluation date” (Horton et al. 2004). This fair value under IFRS is “determined from an active market for the asset.” This has however prohibited the use of revaluation model in many cases. Under Australian GAAP, the fair value ought to be founded on either a directors’ valuation or a market valuation. Neither BHP Billiton nor Macquarie Bank measured intangible assets at “fair value at transition date or any earlier date.” This could possibly be due to the limitations that “fair value should be determined from an active market” (Taplin, 2004). Reporting on Financial Assets and Liabilities The measurement of financial assets and liabilities under IFRS is determined by IAS 39. The managers’ stipulations of their plans relating to financial assets dictates the measurement of those assets. Measurement at fair value is grouped into two measurement categories: (1) at fair value over profit and loss (comprising every held-for-trading item and every derivative); and (2) available-for-sale financial assets. Also, the managers’ stipulations of their plans relating to financial liabilities dictates the measurement of those liabilities. However, they are recognised at fair value at only one measurement category: at fair value through profit and loss (comprising every held-for-trading item and every derivative) (Goodwin & Ahmed, 2006). In a review of readings proposing that fair values of financial instruments are relevant to financiers, Landsman (2007) provides a basis for the choice of fair value measurement by a number of companies before 2005. However, quite a few financial statement preparers have been intensely opposed fair value measurement of financial assets. The opposition could as well arise because financial instrument standards may perhaps limit companies’ flexibility in handling their financial portfolios. As a result, Penman (2007) notes that “lots of derivative financial instruments are not documented as assets and liabilities in the balance sheet and the unrealised gain or loss on these instruments is not documented in the income statement.” It is for this reason that firms are mandated to make known information relating to the instruments, together with the intents of holding or allotting derivative financial instruments (AASB 1033). Moreover, firms are mandated to publish information regarding hedging activities, if they employ financial instruments to contain the risks concomitant with expected forthcoming dealings (Christensen & Nikolaev, 2009). Also, AASB 1033 mandates companies to divulge the net fair value of financial assets and liabilities, together with unrecognised derivative financial instruments. The techniques adopted plus any major rules made in defining net fair value ought to be disclosed. Paragraph 5.7 calls for additional info once one or more financial assets are recognised at a sum exceeding their net fair value together with the explanations for not decreasing the carrying amount. “Voluntary fair value measurement for other financial assets and liabilities (financial assets and financial liabilities that would or else not qualify for the fair value through profit and loss classification) is scanty” (Brown & Tarca, 2007). Both companies reported financial assets and financial liabilities under IFRS using fair value. Conclusion Measurement is an important aspect in financial reporting. As of 2005, following the introduction of IFRS, companies have tended to embrace fair value accounting (Chalmers et al. 2008). Using the example of BHP Billiton and Macquarie Bank in Australia, it is clear that there is more use of fair value measurements. References Brown, P. and Tarca, A. 2007. Achieving high quality, comparable financial reporting: a comparison of independent enforcement bodies in Australia and the United Kingdom. Abacus, vol. 43, no. 4, pp. 438–473. Chalmers, K. Clinch, G. and Godfrey, J. 2008. “Adoption of international financial reporting standards: impact on value relevance of intangible assets.” Australian Accounting Review, vol. 18, no. 3, pp. 237–247. Christensen, H. and Nikolaev, V. 2009. Who uses fair value accounting for non-financial assets after IFRS adoption? University of Chicago Booth School of Business. Working paper, no. 09-12. Goodwin, J. and Ahmed, K. 2006. “The impact of international financial reporting standards: does size matter?” Managerial Auditing Journal, vol. 21, no. 5, pp. 460–475. Horton, J. Serafeim, G. and Serafeim, I. 2008. Does mandatory IFRS adoption improve the information environment? Working paper London School of Economics, Harvard University and University of Piraeus. Landsman, W. 2007. “Is financial accounting information relevant and reliable? Evidence from capital market research.” Accounting and Business Research, 19–30, [Special issue]. Laux, C. and Leuz, C. 2009. “Fair value accounting: making sense of the recent debate.” Accounting, Organizations and Society, vol. 34, no. 6–7, pp. 826–834. Penman, S. 2007. “Financial reporting quality: is fair value a plus or minus?” Accounting and Business Research, 33–44, [Special issue]. Taplin, R. 2004. “A unified approach to the measurement of international accounting harmony.” Accounting and Business Research, vol. 34, no. 1, pp. 57–73. Read More