Fair Value Accounting: Improving and Distorting Reports

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Introduction

To begin with, it should be stated that Fair Value Accounting is the matter of financial reporting, consequently, the impact of this approach on the accounting and financial reports is regarded to be essential. Originally, it is claimed that the fair value approach essentially threatens the very concept of operating business, especially for those entrepreneurs, whose business is relied upon net cash flows over time. On the other hand, Fair Value Accounting is an integral part of the banking system. Consequently, the very outlook of the financial reporting system depends on the business paradigm and approach towards reporting in general.

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Discussion

To begin with, it should be stated that the decision-making relevance of financial statements was completely improved by the Financial Accounting Standards Board (FASB). This board has added more fair value recognition to the financial accounting reporting system by reforming the generally accepted accounting principles (GAAP). Consequently, a mixed accounting model was developed, which relies on the changed reporting structure. As for the new regulation, Plantin and Sapra (2008) emphasize the following notion in their research: “The new regulation offers the financial sector an opportunity to improve the 3rd quarter’s financial reports. By applying reasonable assumptions to fair-value identification, companies may seek remedy for overly stringent write-downs in the past, and escape from the vicious cycle between distorted market prices and shrinking asset value, hence having a better-looking bottom line for the last 3 months. However, fair-value accounting is just an indicator, rather than the root, of the ongoing crisis. Even its suspension wouldn’t put an end to the disaster.” From this point of view, it should be stated that fair value accounting can not be used for the analysis of economic processes, consequently, financial reporting, if used for the data systematizing often appears to be distorted (Riahi-Belkaoui, 2004)

As for the matters of recent accounting standards, it should be stated that these are often mentioned in the context of increasing acceptance of the fair value and often as a measurement attribute. Taking into account the financial accounting reports system, it should be stated that the shift towards the fair value accounting model has not been without controversies.

As Ryan and Herz (2002) stated, fair accounting information is often criticized for its low-reliability level in comparison with the historical cost approach: “Estimation errors introduce distortion not only into the balance sheet but also into the income statement. Furthermore, unrealized changes in fair values from one period to the next, which must now be reported as gains and losses in financial statements, distort the results of operations, if and when they flow through the income statement each period. And finally, fair value accounting requires proper matching of assets and liabilities, which is even more difficult to implement than the matching of revenues and expenses under a historical cost model.” Moreover, there is a strong necessity to emphasize that the empirical evidence of financial accounting reports and findings on this matter generally suggest that the reliability of fair value diverges with the extent to which the fair value estimations entail the publicly-observed market-grounded based versus management-produced information (Scott, 2003).

The most reliable financial accounting evidence, touching upon the matters of reliability of fair value concept is stipulated for the investment securities, which are traded only in active markets. Moreover, the issues of reliability in various researches are generally derived from the analysis of banks and other financial institutions for which economic tools comprise core operating benefits and charges. Anagnostopoulos (2005) emphasizes the following: “Such firms may be fundamentally different from companies holding inventory, property, plant and equipment, and other assets whose value comes from an execution of a business plan rather than fluctuations in market prices. Therefore, a generalization of these research findings to all sectors of the economy can be questioned.” From this point of view, it should be stated that the pre-condition for applying fair value accounting is closely related to the matters of market values, which are generally available for the assets and liabilities. Nevertheless, in the light of this fact, it should be pointed out that for numerous significant classes of assets or liabilities used for the fair value accounting and financial accounting in general, the prices at which the transactions are generally registered, do not correspond with the ideal hypothetical competitive market. Consequently, the allover system of financial accounting reports should be modified, for these reports and the financial accounting could correspond with the actual transactions. In light of this fact, loans seem to be a good example, as they are not standardized, and they are not generally traded in deep and liquid markets. Thus, financial reporting of the loans is more reliable, as they are typical of many types of assets that trade primarily through the over-the-counter (OTC) market, where prices are determined via bilateral bargaining and matching. (Martin and Rich, 2006). Hitz (2007) in his turn, states the following: “At present, both US GAAP and IFRS require the disclosure of fair values for virtually all financial instruments (IFRS 7, SFAS 107). Guidance on fair value accounting for financial instruments is also identical in principle. IAS 39 and SFAS 115, 133 require trading securities and derivatives held for trading or as part of a fair value hedge to be measured at fair value with revaluation gains and losses taken directly to income.

Financial Accounting reports, which are available for the sale securities are often performed in the fair value format, nevertheless, the gains by the historical cost reporting are regarded as other wide-ranging revenue until the very realization phase.

Criticism of Fair Value in the Context of Financial Reporting

First of all, it should be stated that fair value accounting has a strong tendency to create a curved of decreased values, as compulsory asset sales aggravate the potential decline in the rest of the assets. Thus, the financial accounting reports will be based on these decreased values, which distort the real image of financial transactions.

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The fair value losses generally reverse, as the required assets are generally held until they become increasingly essential. Thus, reporting touches upon the matters of losses, while the general image of transactions often stays unmentioned.

Conclusion

In conclusion, it should be stated that Fair Value Accounting is the reporting approach that may both improve and distort the financial accounting reports. It has been emphasized that everything depends on the accepted standards, and, mainly o the character of the financial operation and transactions.

References

Anagnostopoulos, Y and Buckland, R. (2005) Historical cost versus fair value accounting in banking: Implications for supervision, provisioning, financial reporting and market discipline. Journal of Banking Regulation, Vol. 6, No. 2, 2005, pp. 109–127

Hitz, J-M. (2007) The Decision Usefulness of Fair Value Accounting – A Theoretical Perspective. European Accounting Review Vol. 16, No. 2, 323–362, 2007.

Martin, R. D., Rich, J. S., & Wilks, T. J. (2006). Auditing Fair Value Measurements: A Synthesis of Relevant Research. Accounting Horizons, 20(3), 287

Plantin, G. Sapra, H (2008) Fair value accounting and financial stability. Banque de France, Financial Stability Review, No. 12 – Valuation and financial stability

Pollock, A. (2008). Conceptual Problems with “Fair Value” Accounting Theory. Securities and Exchange Commission.

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Riahi-Belkaoui, A. (2004). Value Added Reporting: Lessons for the United States. New York: Quorum Books.

Riahi-Belkaoui, A. (2005). Performance Results in Value Added Reporting. Westport, CT: Quorum Books.

Ryan, S. G., Herz, R. H., Iannaconni, T. E., Maines, L. A., Palepu, K., Schrand, C. M., et al. (2002). Reporting Fair Value Interest and Value Changes on Financial Instruments. Accounting Horizons, 16(3), 259.

Scott, W. (2003) Financial Accounting Theory. Prentice Hall..

Young, M. R., Miller, P. B., & Flegm, E. H. (2008). The Role of Fair Value Accounting in the Subprime Mortgage Meltdown. Journal of Accountancy, 205(5), 34.

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BusinessEssay. "Fair Value Accounting: Improving and Distorting Reports." February 16, 2022. https://business-essay.com/fair-value-accounting-improving-and-distorting-reports/.