Asset Revaluation and Earnings Management - Pros and Cons, Advantages and Disadvantages of Fair Value - Case Study Example

Asset Revaluation and Earnings Management by (Name) Course: Tutor: Institution: Location of the Institution: Date: Introduction With the revaluation model the non-current assets are carried at cost at its revalued total amount. This is its fair value on the revaluation date less accumulated subsequent depreciation and impairment losses on condition that fair value is reliably measured. Whereas under cost model the non-current asset is carried at net book value and accumulated impairment s. Under revaluation model approach, continuous revaluing of non-current assets at regular intervals is necessary to confirm that the carrying amount will not vary from the fair value. Companies use the financial approach of fair value accounting in measuring and reporting the amount money they can receive if the assets are sold and if relieved from all financial liabilities. Pros and cons of fair value Using fair value, businesses obtain and report the worth of various assets and liabilities based on the existing or estimated market prices which are fair. Variations in asset or liability prices over certain period of time can generate unexpected gains or losses for assets that are held and liabilities which are outstanding and this may consequently increase or reduce the net income, and affect the balance sheet equity. Fair value accounting has been a topic of debate and has supporters as well as critics. It has both its advantages and disadvantages as has been extensively discussed; Advantages of fair value i It gives the correct valuation. Fair value accounting is more accurate when finding current valuations of assets and liabilities. When there is an expected increase or decrease of prices, the valuation can respond the same way. If sales are done, there will be no discrepancies to be charted in case there is difference between the valuation and the transaction. Businesses can realise where they stand depending on the current market prices. ii It is a measure of true income. Using the fair value accounting approach there are less chances of manipulating the accounting data. The price variations are tracked on the basis of exact or estimated value but not by use of assets sale to influence gains or losses. The income change is a result of changes in the asset value and it is reflected in the final income. iii It provides more information unlike historical cost. The fair value gives more information in financial statements than other accounting methods like historical cost. Since financial accounting needs an entity to give information of methodology used, all assumptions made, exposure of the risk, sensitivities involved and all other factors that lead to comprehensive financial statements. Such financial systems increase transparency of the company which is important to lenders and shareholders as they have confidence of the stability of the company. Disadvantages of fair value accounting i It leads to value rehearsal. Fair value in accounting can pose difficulties to businesses and users of the financial statements. The market environments from which assets and liabilities are transacted can vary repeatedly and may turn out to be volatile. Accounting in fair value, even in volatile markets, businesses revaluate current value of assets and liabilities and this potentially creates large swings of their value. When the market stabilises, the values may reverse to the normal previous standards and this makes reported losses or gains to be short-term and this means that fair value accounting would have given misleading information. ii It can reduce Investor satisfaction. Various investors not all the times know that a business is applying the fair value accounting method. This consequently results to investor dissatisfaction since loss of value of the income is a loss to the income of the investors. Many investors trade the commodities rather than making investments with them and this can negatively affect their investment portfolio and make investors to abandon the business. iii It lacks conservatism. Many practitioners of accounting prefer conservative approach. The main advantages of conservatism are that; it offsets the bias by the management reporting higher incomes and it is essential for credit analysis and also for contracting debts since creditors have a preference to financial statements that shows downside risk. The enthusiasts of conservative accounting are startled that embracing the fair value model which reasons to be unbiased can cause financial statements to be aggressively prepared thus decreasing its usefulness to creditors who are the key users of the information in financial reports. Types of companies to use revaluation Non-current assets revaluation aims at finding true value of capital goods that a company has. Non-current assets are possessed by a company in order to produce goods or render services but not held for resale. Examples of non-current assets are buildings, patents or machines. Revaluation brings into the books the non-current assets fair market value. This is useful for the purpose of making a decision on whether to venture in another business. If a company decides to sell its assets, a revaluation is made to prepare for the sale negotiations. The main two types of companies that may choose to revalue their non-current assets are private company limited and public limited companies. Examples of such companies in United States of America are Koch industries and The Bank of New York Mellon. It is normal to find companies revaluing their non-current assets .There are various reasons as to why they may opt to use revaluation approach; i To save enough funds in the company to replace non-current assets at the close of their worthwhile useful lives. The historic cost provision for depreciation gives inflated profits and it results to paying excessive dividend. Consequently, this may destroy the image of the business especially if it is a listed company. ii In financial companies, revaluation reserves are prerequisite for regulatory reasons. In calculating funds of the firm they are included so as to give the fair view of resources. It is only a part of the total funds of the firm (normally about 20%) is loaned or can be in the hands of counterparty at any single time. iii In case a company plans to borrow a loan from financial institutions by use of mortgaging its non-current assets, appropriate revaluation of the assets should be done for the company to get a high amount of loan. iv To give the fair market value of non-current assets which have significantly appreciated from the time they were purchased for example land and buildings, and in case of sale or leaseback of the assets the fair market value will be used. Managerial discretions available when revaluing/devaluing fixed assets Revaluation of fixed assets has a positive association with accruals discretions. This is in line with other scholars’ findings that non-current assets’ revaluation shows high agency problems depicted by increased earnings of the management (Fang and Percy, 2015). This study also showed higher discretional accruals to the firms that reports their fixed assets evaluated by directors, as opposed to firms that uses external assessors. The corporate governance power and choice of auditors limits the unprincipled conduct of managers when revaluing or devaluing non-current assets. For instance, companies will unscrupulously sell the non-current assets to increase reported incomes (Black et al, 1998). AASB 116 outlines that non-current assets’ revaluation is done on the base of independent valuers or valuations of directors. The accounting rules provisions for asset revaluations, when it comes to revaluing the assets of a firm, managers are indifferent. Nevertheless, from the agency point of view, agency costs can increase as a result of asset revaluations when the internal directors are not as much autonomous as external independent appraisers and this provides the directors with openings to involve in remunerations of the management (Du et al., 2014). Benston, 2008 asserts that opportunistic and insincere CEOs and CFOs are expected to find fair value accounting a boon to their efforts to influence stated net income. Usually, external valuers are more reliable in approximating the value of assets since they are autonomous (Cotter and Richardson, 2002). Thus, independent appraisers will limit opportunistic revaluations. According to AASB 1010, non-current assets should be recorded at a worth that does not surpass its recoverable amount. Nonetheless, there are some discretions that managers have, that dictates how recoverable amount can be calculated thus leaving substantial discretion that relates to scheduling and extent of write downs to the managers. US data, researchers found substantiation that in the year of write downs managements acts opportunistically the to increase future earnings (Rees and Gill, 1996) The economic consequences of asset revaluation There are a number of economic consequences that are contributed by the asset revaluation such as; When contracts that are in progress are tied to the reported profits that is management compensation or debt, the management of the business could have inducement not to revalue. Nevertheless, when the assets are increased, the revaluation would relax the limits like debt to assets constraints. The companies that are prone to political inspection are more likely to carry out an upward revaluation leading to a fall in the profits. Furthermore, as the perceived capability of the valuers rises, the auditing duration might fall The asset revaluation has also an impact on balance sheet. Although assets revaluation does not directly have an impact on cash flow, it is possible to obtain benefits from asset revaluation. Economic situations uncertainties and sluggish growth of the economy, decreases the profit of the entity. Asset revaluation model, allows a company to increase the fixed asset value, thereby improving its leverage. Associating fair value accounting and banking capital regulation would have contributed to 2008 crisis (Laux and Leuz, 2010). That is, the prices of the assets diverge from the fundamental values, and this makes the financial institutions write down the assets and finally it drains its capital. Subsequently, written down assets can accelerate the banks to sell the assets at a loss resulting to downward spiral. Thus, this is a contagious problem which can make other banks to have the similar value. Therefore, fair value accounting is blamed for subprime crisis since it created complications to measure the worth of subprime positions. It therefore contributes to extreme leverage that the banks use.Wesbury and Stein in their “Economic Commentary” suggested that the root of 2008 crisis was as a result of bad mortgage loans, but possibly 70% of the real crisis that was faced was caused by mark-to-market accounting in an illiquid market. Conclusion Accounting in fair value remains to be a topic major interest and argument among the preparers, scholars and the users of financial information. In financial reporting, it remains to be an important measurement. Even as the debate continues on its usefulness, its use in financial reporting has been expanded. To determine the fair value it requires various assumptions and sound judgement. The investors need updated and clear information on how fair value is measured. Due to increased use of fair value accounting, companies should refresh the measurement policies and analyse how it can be determined when there exists no active markets. Also, they should establish procedures on how to develop suitable disclosures by engaging valuation professionals in the entire process. References Stefan and Professori, K .2013.Is fair value accounting really fair? A discussion of pros and cons with fair value measurement.Finland: Finance and accounting journal. Benston, G.J. 2006.Fair value accounting: A cautionary tale from Enron: United States: Goizueta Business School, Emory University Atlanta, GA 30322. Black, E.L., Sellers, K.F., and Manly, T.S. 1998.Earnings management using asset sales: An international study of countries allowing non-current asset revaluation. Journal of Business Finance Business and Accounting. Hu, Fang, Percy, Merjella, and Yao, D.2015. Asset revaluations and Earnings management: Evidence from Australian companies. Corporate Ownership and Control, 13(1), pp.930-939. Nicola Moscariello.2012.Fair Value Disclosure, External Appraisers, and the Reliability of Fair Value Measurements:journal of Modern Accounting and Auditing, University of Naples II, Italy. Whalen, R. Christopher. 2008.The Subprime Crisis Causes, Effect and Consequences:Networks Financial Institute Policy Brief No. 2008. Laux and Leuz, C.2010. Did Fair -Value Accounting Contribute to the Financial Crisis?:Forthcoming in the Journal of Economic Perspectives 2010 Read More