Introduction about Fair Value Measurement - Assignment Example

Case Study Name Course Institution Date Introduction about Fair Value Measurement Much has happened in the accounting profession especially in the last decade or so. Part of it has been mentioned by the author in the case study. This in relation to multinational companies that have collapsed as a result of manipulation of financial statements by the people mandated to prepare them (Soderstrom & Sun 2007, p. 680). Some of these companies include WorldCom, Enron and Parmalat. Besides the issue of manipulating financial statements, the 2008 financial crisis led to the collapse of a series of high-profiled companies. Most of the companies that were affected were from financial services sector. At the end of it, most of them could not recover the full amount of the money that had been loaned to various customers. To a large extend, fair value accounting was highly criticized for its failure to enable the financial institutions to recover the required amount of money (Holthausen & Watts, 2001, p. 41). Therefore, this in itself points to the fact that this indeed is an issue of great contention in the accounting profession. The whole issue of measurement and valuation of financial instruments remains of great concern. Stakeholders have been involved in debates aimed at coming up with a measurement technique that is supposed to meet the needs of financial instruments and related assets and liabilities. What are the essential features of the ‘Fair value’ accounting, as laid out in IFRS13/AASB13 Fair Value? How are assets and liabilities valued under the Fair Value accounting system? (6 marks) Indeed there are many features that are explained under Fair Value measurement technique. It all begins with definition of the term of fair value. According to this standard, fair value is the amount that will be received if an asset is sold at arms-length negotiation in a competitive market at a specific date. In the same way, fair value represents the amount paid to transfer a liability at arms-length negotiations. Therefore, the key feature is the market in which the price is determined since fair value is a market-based measurement. Another key feature of this standard is the fact that it is applicable on initial recognition as well subsequent valuations. In addition, another feature that is significant when dealing IFRS 13 is disclosure. This deals with situations where disclosure is expected when the fair value of an item is not the same as the book value as given in the books of account. The following are some of the examples where disclosure is expected: IAS 40 requires fair value disclosure for investment assets valued using the cost model IFRS 7 requires fair value disclosure of financial instruments previously valued at amortized cost Essentially, fair value measurement recognizes changes made in the balance sheet which are communicated through the income statement. This is very important in providing information regarding the level of risk and exposure. At the end of it, the returns gained using fair value method are considered to be the measure of project’s performance. Measurement of Assets & Liabilities under Fair Value Valuation When measuring assets and liability under fair value, several factors are taken into consideration. All this is done to ensure that exit price can be accurately placed on the item whether it is an asset or a liability (Benston 2006, p. 465). In order to agree on the ultimate price of the item, all characteristics that can be taken into consideration by the players in the current market conditions. The sale of a non-financial asset takes into consideration the highest and best use of the item. On the other hand, transfer of a non-financial liability assumes that the transfer is done at the measurement date. Having scanned through the various considerations necessary for measurement of assets and liabilities, the following are three common approaches used for measurement: Market approach: this involves using the market price of a related asset or liability to estimate the value of the item being considered for sale. Cost approach: this method uses replacement cost for the item being considered to arrive at the value of the item Income approach: this translates future expected earnings into current value in order to estimate the value of the item for sale According to Rayman, how is the Income Statement and Balance Sheet affected by the Fair Value accounting system? (4 marks) The transactions that surround fair value valuation must be reflected in the balance sheet and income statement. Nevertheless, Rayman has some issues in relation to presentation of fair values on the income statement and balance sheet. In most cases, fair values are arrived at after considering merely opportunities that are present in relation to the assets being owned by the company. The challenge, according to Rayman is that opportunities are much different from actual transactions. According to Rayman, reflecting fair values on the balance sheet is more of reporting mere ‘wishes’. This is because the increase in value of the assets or items on the balance sheet represents an opportunity that was in real sense discarded. If the opportunity had been seized by the company, then the item could not be appearing on the financial statement since it could have been sold. Therefore, Rayman raises the concern pertaining recognizing an opportunity that was never taken by the company. Since the fair value ignores the reality that increase in value of an item that has not been liquidated, financial statements of the firm will be recognizing values that are somehow fictitious in nature. Having pointed out the above points, it is possible to allude to the inability of the financial statements to reflect a true and fair view of the financial performance of the company. 3. How does Fair Value accounting contradict with the Historical Cost accounting? (4 marks) Fair value accounting is almost completely in contrary to the historical accounting method. According to historical accounting, the value of an item is determined by its nominal price/value. Therefore, the value of an asset is actually the original price attached on the item during acquisition. The method allows items on the balance sheet to be carried down at the stated values. On the other hand, fair valuation recognizes the changes in the value of the asset based on changes taking place in the market. By using fair valuation, a lot of judgment is very critical (Ali & Hwang, 2000, p. 2). This is because the factors that influence the value of the asset or liability are diverse and varied. Historical cost is insensitive to the changes in the value of the asset over time regardless of how the change affects the value of the asset. At the end of it, it is until the asset is sold when the difference between the sale price and book value is considered as income on disposal. This sounds a bit realistic since the company will be reporting the increase in income which has been received in actual sense. This is completely contrasted with the fair value accounting system. The approach recognizes the increase in value of the asset even if the increase is simply perceived as an opportunity. In this case, the opportunity has been disregarded yet it is being reflected in the books of account of the company. This has caused a lot of debate among the key stakeholders for quite some time now. 4. Are the changes resulting from applying the Fair Value accounting principles a change increase/decrease) in assets or a change (increase/decrease) in income? Is change in assets and change in income the same thing? Why, or why not? (8 marks) The use of fair value accounting definitely causes a change in the value of the asset. On the other hand, the change in income is not recognized in the income statement because the item has not been sold yet. The aim of fair value accounting is to try as much as possible to present items on the financial statement that reflect their market value as opposed to nominal values. The company will often use to ensure that valuation of the worth of business is made even simpler considering the fact that the market value of assets and liabilities has been used. This will also depend on the nature of the item. In the case study given, Rayman has given illustrations of how the total value of the asset increases as a result of fair value accounting. This is because this accounting standard ensures that at all times the assets are reflected as per their estimated market values. The continuous increase in value of assets is the reason balance sheet of companies applying IFRS 13 keep on ballooning especially when market performance is good. During the seasons when the economy is improving steadily, the value of most of the assets will tend to increase in value during the same period (Krishnan 2003. p. 14). When it comes to recession, the vice versa is applicable. The asset will tend to reduce in value and therefore the overall or total value of assets on the financial statement will decline. During recession periods, the most affected elements of the balance sheet are debtors. The money being held by debtors may not attract sufficient returns to constitute profit on that. The company may be forced to collect exactly the amount owed or even less in terms of the present value of money. When it comes to income, it is given different accounting treatment. The income cannot be reflected on the income statement for a number of reasons. First, the asset or item in question has not been liquidated and therefore there is no income that has been realized from the use of fair value accounting. It can be conflicting if the company was to reflect the value change on the balance sheet onto the income statement. It may simply inflate the profits unnecessarily yet the real income remains constant. Nevertheless, if the item on the balance sheet is sold at the current market price, this one will constitute an income that will be represented on the income statement. This is done with what is considered to be features that meet the definition of the term income. Putting all these factors into perspective, it is clear that fair value accounting does not allow accounting for income increase or change as a result. Change in asset and change in income represents two different transactions and they are not the same. To begin with, there are so many factors that can cause an increase in value of assets on the financial statement. One way of increasing the value of assets is purchasing new assets. When an entity buys new assets, the accounting entries will recognize increase in the value of asset and decrease in the other asset cash. At the end of it, such transaction does not affect the income. Income comes into perspective because there is the element of profit. That is to say, an item has been sold at a price higher than its market price. The difference between the transactions above is the income. 5. How does ‘value in exchange’ differ from ‘value in use’? Which of the two should be the fundamental value in accounting? Why? (5 marks) Value in exchange is a rather common term used in financial conversations. This represents the ability to exchange an item for another asset with the objective of satisfying the needs of those involved. In other words, consumers seek to exchange what they have with another one that will satisfy a certain want or need. This sounds somewhere normal if any consumer is considered rational (Begley & Freedman, 2004, p. 80). It is obvious that one can use what they have to get what they do not have in order to meet their needs. Items with this feature are the ones that facilitate the movement of products in the market. They provide the required platform for exchange of goods and services across different participants in the same market. In the current world, the value in exchange is almost becoming limited or viewed from a monetary viewpoint. This indeed is a limited view which must be adjusted. Apart from value in exchange, another phrase is value in use. It represents the net present values of cash flows. It is derivation of satisfaction by directly consuming goods or services. This represents the value that is in some of the assets that are of concern in this discussion. Therefore, an individual consumer may have an interest in a commodity for two main reasons. First may be the use of the commodity to satisfy the need. In the same way, the consumer may be interested in further trade which will end up acquiring an item that is in position to satisfy a need. Much of this can be traced to the history and development of barter trade from the ancient times. People had mastered the importance of exchanging goods mainly for satisfaction of their needs. In as much as we call it trade, most people never had the mind of trade. People used to exchange products as way of gaining access to what they didn’t have initially in order that they may meet their needs. Therefore, value in use is closely linked to the way in which barter trade was being done. From the above comparison, it is clear that not all the two are very suitable when it comes to use in accounting. From the information provided in relation to the two phrases, value in exchange is more suitable to be used in accounting. The value in exchange emphasizes a lot on monetary value of the transaction. This in itself points to the ability of a transaction being quantifiable in nature. For all accounting transactions, the issue of monetary valuation is very critical. All items that are presented in the financial statement have monetary value attached on them. The transactions relating to value in exchange emphasizes on the fact that a particular good has a monetary value and therefore very suitable for trading purposes. Conclusion A lot has been discussed indeed mainly pertaining measurement of assets and liability. From what is currently ongoing, it is unlikely that this debate is near to conclusion. Accountants and other stakeholders are concerned about the use of fair value accounting standard. Inasmuch as many of them are in agreement of the challenges posed by the adoption of historical costing, they are even more concerned if indeed fair value accounting is the perfect replacement. The standard targets to deal with the issues facing historical costing but end up leaving a lot of gaps in the preferred standard. Rayman is one of the many professionals who are genuinely concerned about the issue of fair value accounting. His main concern is the realization of the increase in value of the item on the balance sheet based on what is considered as the market price of the product. According to Rayman, such simply represents opportunities that were never exploited and therefore there is absolutely misplaced to try and recognize such differences. This is indeed an area of great concern where every organization must take very seriously. References Soderstrom, N. S., & Sun, K. J. 2007. IFRS adoption and accounting quality: A review. European Accounting Review, 16, 675-702 Watts, R. L. 2003. Conservatism in accounting part II: Evidence and research opportunities. Accounting Horizons, 17, 287-301 Holthausen, R. W., & R. L. Watts, 2001. 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