Financial Accounting - The Pros and Cons of Choosing Fair Value Method - Essay Example

MAA716 Financial Accounting T1 2017 Part A Contents MAA716 Financial Accounting 1 T1 2017 1 Part A 1 Contents 2 Introduction 3 The pros and cons of choosing fair value method 3 Advantages 3 Correct Valuation 3 Accurate Income 3 The best approved accounting standard 4 Disadvantages 4 It reduces investor approval 4 Value Reversal 4 Market Effects 5 Two types of companies that is likely to choose to revalue non-current assets 5 Firms with High debt 5 Large firms 6 Any managerial discretions available to the firms when revaluing/devaluing non-current assets 6 The economic consequences of asset revaluations 7 Bibliography 9 Introduction Fair value accounting is the financial report methodology also considered as the market-to-market accounting practices. Under the GAAP, the use of fair value accounting, firms evaluate and report the value of special assets and liabilities based on their actual or estimate of the fair market price. Change in assets or liabilities value as time goes by generating unrealized income or loss for the asset held and liabilities outstanding, growing or reducing net income and equity in the statement of financial position. The pros and cons of choosing fair value method Advantages Correct Valuation The main benefit of fair value accounti is that it creates correct assets and liabilities appraisal on the continuing basis to users of the annual reports. When the price of the assets or liabilities grows or is anticipated to grow, the firm marks up the value of the assets or liabilities to the current market prices to depict what it might acknowledge if the sells the assets or might have to pay to relive itself from its liabilities. Accurate Income Fair value accounting restricts the ability of the firm to manipulate its reported net income. The administration might on purpose plan some assets disposal, for instance, to make use of the gains or losses from the disposal of assets to grow or decrease the net income as reported, as times needed time (Anton, 2006). With the use of fair value accounting, gain or loss from whichever price changes for assets or liabilities are accounted for in the time that it occurred. Whilst the growth in assets value or a decline in liabilities value adds to the ne income, a decline in asset value or a growth in liabilities value reduces the net accounted income. The best approved accounting standard Rather than using the historic cost value, which is normally inaccurate after some time, fair value accounting precisely trails every class of assets, from equipments to building to land. This makes fair value account the best-approved accounting standards since it set price, as much as is correct in value, it is not similar due top monetary inflations. Disadvantages It reduces investor approval Some speculatiors do not normally realize that a firm uses the fair value accounting standard. This will make a speculator less content since the loss of value in the net income turns to be an income loss for speculator also. Because many speculators trade this commodity rather using them for venture, it might lead to tough hit for the investor’s portfolio and makes some investors shunt from business in totality. Value Reversal Fair value accounting might as well despite some cons to firms and users of the financial reports. Situations of the market in which some assets or liabilities are traded might change frequently and even turns to be risky. With the use of fair value accounting, firms might re-appraise the current value of some asset or liability even in a risky Market situation, potentially developing large changes in the value of the asset or liabilities (Calder, 2008). Nevertheless as market stables, value changes probably will reverse back to the past current level, which makes the reported loss, or gains temporary implying that fair value accounting might be incorrect. Market Effects Using the fair value accounting might further affect the down market unfavorably. For instance, subsequent to an asset being revaluated downward due to a decline in the current market price, the least value of the asset might activate great sell of an asset at dejected price (Ehrhardt, 2016). Devoid of appraisal markdown as mandated by fair value accounting, firms might not feel the importance e of selling an asset at a down market to get rid of further decline in assets valuations. Lack of extra selling forces will make the market stable, which might aid in preserving the value of the assets. Two types of companies that is likely to choose to revalue non-current assets Firms with High debt It is commonly assumed that firms with high debt level will have a chance of revaluating its assets upward to lose the debt constraints. Hence, they might get rid of penalties or re-negotiate expense if they violate their debt agreement (Connolly, 2006). In this regards, it is a positive rejoinder since it permits firms to take advantage by getting rid of the cost at the expense of the shareholders. In addition, the firm will realize that revaluation permits managers to access reserves debt capacity and grow financial slacks, by upward revaluation of net assets to minimize information imbalance and signify that the firm asset is undervalued. Large firms Large firms depict the tendency of having greater incentive to apply asset revaluation unlike small firms. Firms will be visible more specially to terms of existing wealth and large firms will depict greater incentive unlike small firms in adopting there accounting approach that provides a conservative overview of profitability since their annual report is probably attracting the vital attention of the media and the states (Ehrhardt, 2016). Revaluation is an efficient approach to minimizing the threats, by reducing the firm’s returns in capital employed. Furthermore, political expense is frequently linked to the size of the firm. Large firms are under scrutiny by the public and will mostly likely revaluate its assets to report low rates of returns. Because large firms acknowledges great attention unlike small firms, large firms is susceptible to revaluation to report low rates of return. In this regards, the size of the company might be a factor that affects the verdict of the firm to revaluate their assets. Any managerial discretions available to the firms when revaluing/devaluing non-current assets Management discretion for asset revaluation or devaluation of its assets is justified in two ways; one, the management may decide to revalue its asset upward to get rid of technical defaults that might lead to company incurring huge debt violation expense or re-negotiating cost. It is steady with debt assumptions that justifies that companies with high debt to equity level will have more incentives to choose accounting process to reduce its susceptibility to violation of the contracts. The revaluation cost must be less than the economic advantages that is due from the revaluation of assets (Madura, 2007). The second justification for managerial discretion of asset revaluation is that the management might conclude on upward revaluation to signify the chances of expansion and firms enhancement in liquidty to minimize information imbalance. The managerial discretion to revalue or devalue the asset will be met with mixed reaction. First, one would be to evaluate the manner to which speculators or ether-interested parties in the company financial performance will, react to the asset revaluation or devaluatuion. Secondly, the question of whether the asset revaluation depict an effect on the loan approval verdict. Third, one will examine the possibility of actual performance and growth of the revaluating company will in reality enhance subsequent to revaluation or devaluatuion of it’s assert. The economic consequences of asset revaluations The two serious intrinsics fault of the fair value accounting is the default that relates to non-compete existence, that is, the mandatory fair value might not exist under some situation. The primary consequence of the default is the he fair value trap might be developed by fair value accounting when there is no existence of the fair value. Another default of the fir value accounting is the self-growth that is; the fair value accounting will make the share price volatile based on normal net income from the operations of listed companies. The volatility might afterwards be large unlike the original income. For a single entity, it is likely to dispose its asset at fair value but is normally impractical for every firm to dispose their assets at similar market price within a short period. From the point of view of the entire market, fair value accounting act as a number game, whilst its book value lose any link with cash flows (Madura, 2007). All of the above defaults of fair value accounting might be risky to speculators in the financial market and eventually provoking worldwide financial crisis and economic crunch. Even though many of the proofs or the association involving the fair value accounting information and the stock price or the stock return exist from the past research, there is need for an empirical research that anticipate to confirm the presence of fair value trap and economic impacts of the self expansion model. Fair value accounting depicts a serious Economic crunch that occurred in untied states, which further spread, to the rest of the world. This made the US parliament to adopt the Paulson plan, which bestowed the stock exchange commission the authority to postpone or put on hold an application of fair value for justification of public interest and the steadiness with the safety of the investors (Sarnat, 2007). The Paulson plan required a research on the economic impact of the fair value accounting to be udertaken. In response to critiques of fair value accounting on the economic crisis, FASB permitted financial agents to evaluate some financial assets that is not on their market value at a value approximated through the financial appraisal model, a report by G30 condemn the fair Value accounting for its duty in developing systematic risk, low pliability and financial instability that lead to economic crisis. Bibliography Anton, D. (2006). Business Finance: The Fundamentals of Financial Management. New York: Cengage Learning. Calder, A. (2008). Corporate Governance: Principles, Policies, and Practices. London: Pearson Education. Connolly, M. (2006). International Business Finance. London: John Wiley $ Son's. Ehrhardt, M. (2016). Corporate Finance: A Focused Approach - Page 575. New York: Springer. Industrial Systems Research . (2013). The Business Finance Market: A Survey - Page 76. London : Pearson Education . Madura, J. (2007). International Financial Management - Page 483. London: Cingage Learning . Moyer, C. (2015). Contemporary Financial Management - Page 561. London: Cengage Learning. Narayanan, V. (2004). Finance for Strategic Decision-Making: What Non-Financial Managers. New York: Cengage Learning. Sarnat, M. (2007). Financial Decision Making Under Uncertainty. New york: Springer. Sison, A. (2010). Corporate Governance and Ethics: An Aristotelian Perspective. Sydney: Springer . Read More