The concept of Fair Value
Fair value is defined as “the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction”.
Prior to the introduction of Fair Value Accounting (FVA), accounting was carried out on a historical cost basis. However there were many limitations of Historical Cost accounting (HCA). HCA assumes money holds a constant purchasing power. It ignores specific price-level change, general price-level change and fluctuations in exchange rates. During inflationary periods, HCA can become irrelevant and can lead to an erosion of operating capacity.
IASB framework states “the objective of financial statements is to provide ...view middle of the document...
Although the fair value paradigm has evolved greatly, historical cost is still used in places. For example, securities which are held-to-maturity, non-securitised financial assets and obligations, with the exception of derivatives, are valued at cost. The main reasons for this mixed-model approach are both the reluctance of standard-setters and the resistance of affected parties to the implementation of total FVA. IFRS is at a more progressed stage in the implementation of FVA than FASB, which have a more cautious stance, particularly in the measurement of non-financial items. Although fair value is supposed to be measured at exit prices, entrance prices and value in use are utilised.
The estimation of fair value is carried out in three different ways, depending on particular market circumstances:
• Level 1 - Market prices provide the most reliable estimate of fair value. This will be possible when there is regular trading of the item in a liquid market.
• Level 2 - In the absence of directly observable market prices, or market prices of adequate quality, the observable price of a similar item that is traded can be substituted.
• Level 3 - In an illiquid market, where there is no observable price for the item, or a similar item, the price is calculated using internal subjective estimates. This is a last resort technique, and is the root of most criticisms of FVA.
With regard to the current financial crisis, the valuation of assets and liabilities that is very relevant. IAS16 deals with fair value accounting method of measurement of property plant and equipment. In August 1980 an exposure draft for the standard was issued for Accounting for Property Plant and Equipment in the context of the historical cost system. However as this became outdated and its flaws became evident, it has been replaced by the fair value method.
The main issues of IAS16 are:
• The recognition of assets
• The determination of their carrying amount
• The depreciation and impairment losses to be recognised in relation to them
Benefits of Fair Value Accounting
An ACCA fair value policy paper issued in February 2009 sets out a number of the advantages of fair value accounting: More transparency, more clarity, it accounts properly for derivatives and it provides additional information. An SEC report in 2005 recognises two main benefits of FVA :
• It alleviates the use of accounting-motivated transaction structures created by a mixed attribute model. For example it gets rid of the incentive to utilise asset securitisation to achieve gain on sale accounting.
• It reduces reporting complexity. For example, without FVA, the hedge accounting model for derivatives would have to be abandoned. It could also decrease the cost of record-keeping.
Transparency is of huge importance in financial statements; they must portray a true and accurate view of the financial position and provide all relevant information. FVA achieves a greater level of transparency than HCA...