Fair Value (FV) Accounting and IFRS: Relevance and Reliability Perspective

Executive Summary
The use of fair value accounting has gained momentum and has proven to attract a level of attention rarely witnessed in the annals of accounting practice. One of the driving forces is the belief endorsed by some that fair value accounting initiated and aggravated the recent credit crisis. In light of these circumstances, it is considered timely to advance awareness in relation to fair value accounting and to clarify the competing arguments in favor of, and against, the use of fair value rules. It can be reasonably contended that:

At present, the global financial system does not embody a common set of accounting standards governing fair value measurement of assets and liabilities. The two critically important accounting systems U.S. GAAP (generally accepted accounting principles) and IFRS (international financial reporting standards) converge but do not fully do so in the matter of fair value measurement.

Only certain assets and liabilities are required to be measured at fair value. The degree to which unrealized gains and losses associated with fair value measurement are reflected in the financial statements also depends on the intended use of assets and liabilities in question.

Certain concerns of fair value measurement (particularly Level 3 inputs) present in the form of subjectivity and bias. However, Level 3 instruments constitute only a small proportion of assets and liabilities of the balance sheets of financial institutions. The two main arguments against fair value accounting exacerbated pro cyclicality and increased volatility of the financial statements are amply counterbalanced by arguments in favor of fair value accounting. The latter includes the significance of limitations associated with historical cost accounting, increased relevance of information presented to investors and lower expected likelihood of earnings management under fair value accounting. Taken together, these assertions lead us to affirm that fair value accounting imparts an appropriate

Fair Value (FV) Accounting and IFRS: Relevance and Reliability Perspective

direction forward given the speed of the globalization of capital markets and the increasing complexity of financial instruments in use today. The fact of the matter is that as imperfect as fair value accounting may be considered, we can appreciate that the historical cost model is likewise imperfect and that its defectiveness has become increasingly germane as the financial market environment evolves. In turn, the shortcomings of fair value accounting may well be mitigated by further fine-tuning of regulations and accounting standards.

Fair Value (FV) Accounting and IFRS: Relevance and Reliability Perspective

CHAPTER 1 INTRODUCTION

Origin of the Report

This paper was originated to make a study about the Fair Value Accounting as a part of our course titled Accounting based on IASs of MBA program of the Department of Accounting & Information Systems, University of Dhaka.

Fair value accounting is a financial reporting approach in which companies are required or permitted to measure and report on an ongoing basis certain assets and liabilities (generally financial instruments) at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities. Under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. Those losses reduce companies reported equity and may also reduce companies reported net income.

Although fair values have played a role in U.S. generally accepted accounting principles (GAAP) for more than 50 years, accounting standards that require or permit fair value accounting have increased considerably in number and significance in recent years. In September 2006, the Financial Accounting Standards Board (FASB) issued an important and controversial new standard, Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157), which provides significantly more comprehensive guidance to assist companies in estimating fair values.

There are some criticisms Reported losses are misleading because they are temporary and will reverse as markets return to normal; Fair values are difficult to estimate and thus are unreliable;

Fair Value (FV) Accounting and IFRS: Relevance and Reliability Perspective

Reported losses have adversely affected market prices yielding further losses and increasing the overall risk of the financial system.

While those criticisms have some validity, they also are misplaced or overstated in important respects.

Objective of the study

to understand the relevance and reliability of fair value accounting; to know the historical background of fair value accounting; to provide more clarity and increase consistency in fair-value measurements; to understand the recent issues and advancement of Fair Value Accounting; to identify the importance of Fair Value Accounting and the debate over the use of fair value accounting; to understand the valuation models to determine the fair value;

Scope and Methodology of the Study

The report is limited to the analysis of fair value accounting and its measurement and valuation techniques. It does not consider the application procedure in different countries and any comparison between them. We also does not discuss in the context of Bangladesh.

Data Collection:

Data are collected mainly for secondary sources. Secondary data are collected from different websites, different articles related to this issue.

Fair Value (FV) Accounting and IFRS: Relevance and Reliability Perspective

CHAPTER 2 OVERVIEW OF FAIR VALUE ACCOUNTING

Fair Value Concept The IASB defines fair value in the context of IFRS as the price would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e. an exit price).

Fair value is not an entity-specific measurement, but rather is focused on market participant assumption for a particular asset or liability. Therefore, when measuring fair value, an entity considers the characteristics of asset or liability, if market participants would consider those characteristics when pricing the asset or liability at the measurement date. For example, such characteristics may include the following-

The condition and location of an asset Restrictions, if any, on the sale or use of an asset (that would transfer with the asset)

In recent years, international standard setters and regulators such as the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have begun to favor the use of fair value accounting over historical cost accounting in financial reporting. A key reason for this shift in methodology is to improve the relevancy of the information contained in financial reports. The general principle underlying the shift is that up-to-date information improves investors' and regulators' abilities to make informed decisions.

To date, the fair value concept is applied in several IASB standards, such as IAS 16Property, Plant and Equipment; IAS 37 Provisions, Contingent Liabilities and Contingent Assets; IAS 38 Impairment of Assets; IAS 39 Financial Instruments; IAS 40 Investment Properties; IAS 41 Agriculture; IFRS 2 Share-based Payment; and IFRS 3 Business Combinations.

Fair Value (FV) Accounting and IFRS: Relevance and Reliability Perspective

Standard setters define fair value as the amount for which an asset or liability can be exchanged between knowledgeable, willing parties in an arm's length transaction. In an active market, fair value equals observed market price. If there is no active market, fair value is an estimate of value in use. The FASB distinguishes between three levels for estimating fair value:

Using quoted prices for identical assets or liabilities in active markets whenever that information is available (market values);

If quoted prices are not available for identical assets or liabilities, fair value should be estimated using quoted prices of similar assets or liabilities (market equivalents);

If quoted prices of identical or similar assets or liabilities are not available or not objectively determinable, fair value should be estimated using valuation methods based on present value techniques of future earnings, or cash flows and valuation techniques.

Fair value based on the judgment of future cash flows is entity-specific, which means that the same asset can be measured differently for two companies because of different borrowing rates and managerial appraisals. Thus, the reliability of fair value estimates declines with the shift from liquid markets to non-traded items.

Fair Value (FV) Accounting and IFRS: Relevance and Reliability Perspective

Why continue to argue and using fair value accounting now?

We are all well aware of the many instances where derivatives trading have contributed to the severe losses incurred by large and established companies, much to the horror and surprise of investors and other users of financial statements. In 1994, example Procter & Gamble lost $157 million resulting from their unsuccessful use of swap options i.e. options that relate to interest rate swaps. The company recognized the losses and disclosed the facts only when the transaction was closed. According to Lynn Brewer, the whistle-blower of Enrons case, the US Securities and Exchange Commission (SEC) currently receives some 400,000 whistle-blowing reports every month. Numerous happenings exist that have created an urgent need for better guidance on estimating fair values and auditing those estimates, including:

The economy has become more high-tech and service oriented and, thus, the need for reliable fair value amounts is becoming progressively more important;

The practitioners and certain other regulators have seen and continue to see problems that are attached to unreliable estimates of fair value;

Over the years, standard setters have required measuring assets and liabilities at fair value without providing detailed "how to" valuation and auditing guidance for estimating those fair values; and,

Various accounting projects are underway that would require more assets and liabilities to be measured at fair value.

In light of these conditions, there is no time like the present to quicker execute more guidelines for fair value measurements instead of keep standing at the step of moving forward.

Fair Value (FV) Accounting and IFRS: Relevance and Reliability Perspective

CHAPTER 3 THE EVOLUTION OF FAIR VALUE ACCOUNTING

Historical Evolution of Fair Value Accounting

1975: The recent standard-setting history of fair value accounting under U.S. GAAP began with guidance issued by the Financial Accounting Standards Board (FASB) in 1975 that requires that marketable securities be recorded at lower of cost or fair value.

1991: FASB complemented that original fair value standard in 1991, when it issued guidance requiring the fair value of financial instruments be disclosed in a companys financial statements.

1993: In 1993, FASB expanded the fair value recognition requirements by issuing a standard that required debt and equity securities that were held for trading or held for sale to be carried at fair value in the balance sheet and required changes in fair value to be recognized in the income statement or in a category of equity referred to as other comprehensive income.

1998: This was augmented in 1998, when FASB standards were adopted that required derivatives to be measured at fair value.

2006: In 2006, FASB issued a new standard, FAS No. 157, Fair Value Measurements, which provided a single, consistent definition of fair value, established a common framework for developing fair value estimates, and required expanded disclosures about those estimates. FASB issued FAS 157 to address the complexities caused by differing definitions of fair value. Stated differently, FAS 157 itself does not prescribe any particular accounting treatment or require fair value accounting but does specify how fair value is to be determined when fair value is required by another standard.

Fair Value (FV) Accounting and IFRS: Relevance and Reliability Perspective

2011: In May 2011, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) amended their rules so that the term fair value would have the same meaning under U.S. generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). FASB and IASB also used the opportunity to clarify the meaning of fair value and to require additional disclosure. Two weeks later, the Securities and Exchange Commission (SEC), the ultimate decision-maker regarding financial accounting standards for public companies in the United States, issued a paper describing a possible future role for FASB in light of the SEC's previously stated belief that one set of high-quality accounting standards for all companies was desirable.

FASB and IASB both assert that their most recent guidance on fair value accounting does not affect the scope of fair value accountingthat is, they claim that they did not expand the use of fair value accounting to new assets or liabilities. Rather, they state that they simply were more clearly defining fair value to ensure a comprehensive disclosure process and to standardize language so that GAAP and IFRS would be consistent. The SEC, in its most recent guidance, does not indicate how, or whether, it will choose to implement IFRS.

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CHAPTER 4 RELEVANCE AND RELIABILITY OF FAIR VALUE ACCOUNTING

The primary qualities of accounting information are relevance and reliability, the two criteria to enhance the usefulness of financial report. Fair Value Accounting (FVA), thus, fair value measurements have placed greater function in financial statements because this information is perceived as more relevant to investors and creditors than historical cost information. However, the difficult question for implementing FVA is the reliability of fair-value estimates. Reliability concerns are particularly serious for instruments that are not market traded, since the management is the one that evaluate them.

Is fair value relevant? In today's dynamic and volatile markets, whether it is to buy or sell, what people want to know is what an asset is worth today. Fair value measurements provide more transparency than historical cost based measurements. Maybe, if companies had measured all financial instruments at fair value, regulators, shareholder, and investors could have achieved greater regulatory and market discipline and avoided some of the losses that investors and taxpayers have had to pay during previous downturns in the economy.

Accountants presently use a wide array of accrual and deferral methods in preparing financial statements. Those methods are essentially mathematical calculation even to a minute cent to get the precision. Nevertheless, Robert R. Sterling notes: Accountants who continue to seek more precision are to be admired and encouraged. However, those who seek absolute precision might be instructed by considering what has been learned in the so-called exact sciences.

Robert R. Sterling, An Essay on Recognition (1985), Depreciation accounting is an example. But would those measures faithfully represent the economic importance of the asset and its depreciation during the period? Such precision in the depreciation accounting is not open to question (reliability does not imply precision), but the relevance and reliability of those measures is open to question.

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Preparers must be concentrating on adjustment of overall economic value when measuring economic growth and productivity. In practical terms, that generally means reporting the fair value of or marking to marketassets and liabilities whenever it can be reliably determined. Due to the whole attraction of market value accounting, many balance sheets items already are carried at fair value, and some, such as property, plant, and equipment, probably should be. It is hard to argue with the theoretical qualities of fair value as the most relevant measurement attribute. But to those who say that accounting should better reflect true economic essence, fair value, rather than historical cost, would generally seem to be the better measure.

The relevance and reliability of fair value also defending by criticizing that historic cost numbers are reliable and relevant only on the day they are recorded. Bear in mind that in the fair-value debate, each side agrees both qualities are important, but fair-value supporters emphasize relevance, while historical-cost supporters place greater weight on reliability.

Reliability is as important as relevance because relevant information that is not reliable is useless to an investor. Reliability, therefore, should not be the dominant characteristics of financial statement and at least have an equal standing with relevance.

Nonetheless, relevance and reliability of fair value measures is often held back with difficulty for publicly traded companies whereby some might require to disclosing hundreds, if not thousands, of valuation assumptions and how they were derived. In addition, there is also a trouble in the possibility of underlining total company value at the expense of measuring management performance.

The other unspoken argument against fair value is that regularly measuring the effect of market movements on a company's assets and liabilities can introduce huge volatility into financial statements. Fair-value proponents, by contrast, believe volatility may be the price of investor confidence.

In order to create fair value accounting to have reliable information for decision-making, markets has to be transparent for all assets and liabilities. However, because many assets and

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liabilities do not have an active market, the methods for estimating their fair value are more subjective and, therefore, the valuations less reliable. Measurement and interpretation of fair value accounting will remain highly discussed till to-date but poorly understood on how the measurement can be set.

Another issue that adds to our concerns about reliability is the management integrity in the judgment of the valuation process. Management bias, whether intentional or unintentional, may result in inappropriate fair value measurements and misstatements of earnings and equity capital. The possibility for management bias exists today. We continue to see news stories about how management communicates with shareholders by obscuring the facts instead of demonstrating the full transparency, even under the historical cost accounting framework. Ultimately, without reliable fair value estimates, the potential for misstatements in financial statements prepared using fair value measurements will be even greater.

The debate about fair value accounting versus historical cost accounting often revolves around the divergence between relevance and reliability. As fair value accounting provides information about current market conditions, it contains a superior basis for expectations than outdated historical cost figures. The fair value approach is the most relevant measure for assets and liabilities; however, some argue that historical cost accounting is the most appropriate way to measure assets or liabilities that are held to maturity.

Advocates of historical cost accounting refer to reliability of information that is reasonably free from error and bias. If markets are not liquid, estimation of fair value will inevitably be subject to managerial judgment, private information, and uncertain assumptions about future values, such as future cash flows and discount rates. Critics of fair value accounting emphasize the role personal judgment plays in the valuation process when market prices are not available, and reliability continues to be a topic of debate.

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CHAPTER 5 THE CONVERGENCE OF GAAP AND IFRS

Background

Despite FASB and IASB's new common guidance around fair value accounting and disclosure, there are still major hurdles to overcome before the SEC can realize its stated goal of creating a single, high-quality set of global accounting standards. The common guidance for fair value lists differences in measuring the fair value of investments in investment companies and deposit liabilities, as well as differences related to disclosures for derivatives categorized as Level 3 items.

For several years, the SEC has indicated that IFRS might be the basis for universal accounting standards. Further, it has stated that it will decide before the end of 2011 whether to incorporate IFRS into the U.S. financial reporting system. (In 2010 the Office of the Chief Accountant of the SEC issued a work plan on how the current U.S. financial reporting system might change to a system based on IFRS.)

At the same time, the SEC's role is to protect U.S. investors, maintain the capital markets, and facilitate capital formation under the federal securities laws; thus, it must decide how (or whether) adoption of IFRS would be in the best interests of investors, markets, and corporations. To that end, the SEC has been exploring several possible approaches to incorporating IFRS in the reporting standards for issuers of U.S. securities, including the following:

The SEC could require full adoption of IFRS, as issued by IASB, on a specified date. The SEC could require full adoption of IFRS, as issued by IASB, following a severalyear transition period. For example, in the SEC's 2008 report, Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International

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Financial Reporting Standards by U.S. Issuers, it proposed that large accelerated filers begin IFRS filings for fiscal years ending on or after 12/15/2014, accelerated filers begin IFRS filings for years ending on or after 12/15/2015, and non-accelerated filers, including smaller reporting companies, begin IFRS filing for years ending on or after 12/15/2016. The SEC could allow (but not require) U.S. issuers to prepare financial statements in accordance with IFRS. Because not all U.S. issuers will prepare their financial statements in accordance with IFRS, however, financial statements based on IFRS and those based on GAAP would coexist.

The SEC could retain GAAP but have FASB make efforts to converge GAAP with IFRS over time. The People's Republic of China uses this convergence approachit has moved its standards closer to IFRS but has not incorporated IFRS completely.

The SEC could require that FASB, after some study, incorporate IFRS into GAAP, assuming, however, that FASB found that IFRS met the stated criteria, designed to protect investors and other stakeholders. The European Union and Australia use this endorsement approach. There is always the risk, however, that a local endorsing body might change an IFRS, which could create a non-uniform set of global standards that may or may not be high-quality and could prompt lags in adoption.

After a transition period in which FASB could eliminate differences between existing IFRS and GAAP, FASB could incorporate newly issued or amended IFRS into GAAP, pursuant to an established endorsement protocolwhat the SEC staff refer to as the condorsement approach. This approach is different from convergence because there would be an end date associated with the transition.

It differs from endorsement because FASB would no longer have the principal responsibility for developing or modifying accounting standards under GAAP. Instead, FASB would participate in the process for developing IFRS. In the end, however, the SEC would retain its ability to set accounting standards for U.S. publicly traded firms.

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Remaining differences between US GAAP and IFRS

While much of the guidance has been converged, differences remain between US GAAP and IFRS, including US GAAP does not require a quantitative sensitivity analysis for level 3 financial instruments. US GAAP includes a practical expedient for measuring certain alternative investments (e.g. investment in hedge fund, private equity funds) in an investment company without a readily determinable fair value. US GAAP does not restrict the recognition of day one gains and losses when fair value is determined using unobservable units.

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Recent Changes in Common Guidance of FASB & IASB

With the May 2011 common guidance related to fair value accounting, FASB and IASB are recommending the following: When measuring an asset, a liability, or an instrument classified within shareholders' equity, a firm should focus on the principal market (or most liquid market) for the item, not on the reporting firm's transactions related to that item in a particular market. When an observable market price for the transfer of a liability does not exist, the fair value of the liability should equal the fair value of an asset whose features mirror the liability (assuming an exit value in the same market and an efficient market). A firm should measure the fair value of instruments classified in shareholders' equity (for example, any equity interests issued as consideration in a merger) in the same way that it would measure the fair value of liabilities. When a firm holds a group of financial assets and liabilities and manages its financial assets and liabilities on the basis of the net exposure to market risks or to a particular credit risk, it should measure a net long position as an asset and a net short position as a liability. A firm should incorporate a premium or discount into its fair value measurements only if it does not have Level 1 data (quoted prices), and if market participants would take premiums or discounts into account in the transaction for the asset or liability for example, a control premium or a non-controlling interest discount. A firm should not include a blockage factor, which relates to an insufficient market volume for the sale or transfer of the entire position.

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A firm using a present-value analysis may adjust for risk by changing the expected cash flows or the discount rate but not both. In either method, the firm adjusts for systematic (non diversifiable) risk based on portfolio theory. For Level 2 (observable) and Level 3 (unobservable) measurements of recurring and nonrecurring assets or liabilities, the firm must describe the valuation technique and data it used. For Level 3 measurements, ASC 820 now explicitly requires quantitative, not qualitative, information in a tabular format about significant unobservable data. A firm must disclose how it selects the valuation policies used for Level 3 measurements and how it analyzes changes in those fair value measurements from period to period. The firm must provide a narrative that describes, by class of asset or liability, the sensitivity of recurring fair value measurements using Level 3 data to changes in the inputs, if a change in the inputs would result in significantly different measurements. The firm must also describe any interrelationships among Level 3 data. The firm must report any transfers of assets or liabilities into or out of Levels 1 and 2. For financial instruments not measured at fair value in the financial statements, the firm must disclose their fair value. Hence, for loans reported at amortized cost, the firm must also disclose their fair value in the financial statement's notes. For all assets and liabilities not measured at fair value, the firm must disclose which level of inputs it would have used to measure fair value.

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CHAPTER 6 VALUATION AND MEASUREMENT TECHNIQUES OF FAIR VALUE

Valuation
IFRS 13 describes three different valuation techniques that may be used to measure fair value.

Market Approach

Uses prices and other relevant information from market transactions involving identical or similar assets or liabilities.

Income Approach

Converts future amounts (e.g; cash flows or income and expenses) to a single current (discounted) amount.

Cost Approach

Reflects the amount required currently to replace the service capacity of an asset (frequently referred to as current replacement cost, which differs from the cost incurred).

Management must use valuation techniques that are appropriate in the circumstances and for which sufficient data is available. In some cases, this will result in more than one technique being used (for example, using both an income and market approach to value a business or cash generating unit). Regardless of the technique(s) used, entities are required to maximize the use of observable inputs and minimize the use of unobservable inputs. When multiple valuation techniques are appropriate, management evaluates the results and selects the point within any indicated range that is most representative of fair value in the circumstances.

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Effects on Valuations

One result of the new guidance from FASB and IASB is that analysts preparing business valuations will know more about firms and their risk profiles. They will also know more about the subjectivity of firms' fair value measurements. If, for example, a firm has venturecapital investments that it values using discounted cash flows, market comparables, and Level 3 (unobservable) data, the firm may need to disclose:

The weighted average cost of capital. Long-term revenue growth. Long-term pretax operating margin. Discounts for lack of marketability. Control premiums. EBITDA 3 multiples. Revenue multiples.

Valuation preparers may not be able to replicate the firm's Level 3 measurements, but they will be able to compare their own assumptions and data (e.g., weighted average cost of capital and probability of default) with those used by the firm. Additionally, they will have more information about the firm's valuation processes (e.g., the frequency with which it calibrates and tests its models) and any changes in management's views on valuing various assets or liabilities. They will also be better able to compare the data of one firm with that of another firm owning the same assets or liabilities.

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Measurement

When measuring fair value, an entity is required to maximize the use of relevant observable inputs and minimize the use of unobservable inputs. IFRS 13 includes Fair Value Hierarchy which prioritises the inputs in a fair value measurement.

Fair Value Hierarchy

Level 1 Definition Quoted prices (unadjusted) in active markets for

Level 2 Inputs other than quoted prices included within

Level 3 Unobservable inputs for the asset or liability

identical assets or liabilities level1 that are observable that the entity can access at the measurement date. for the asset or liability, either directly or indirectly. Example Quoted prices for an equity security that trades on the Stock Exchange. Interest rates and yield curves observable at commonly quoted intervals, implies volatilities and credit spreads. Projected cash flows used to value a business or noncontrolling interest in an entity that is not publicly listed.

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Models of Fair Value Accounting

Models A. Equity Approach B. Mixed Approach C. Income Approach D. Full Fair Value

Unrealized Gains Equity Equity Income Income (+internally generated goodwill)

Realized Gains Equity Income Income Income (+internally generated goodwill)

Essentially, we can distinguish between four fair value models with respect to the incorporation of realized and unrealized holding gains and losses. The key characteristics of each model equity, mixed, income, and full fair value are outlined below.

With the equity approach, all unrealized fair value changes are admitted in a revaluation reserve. When the transaction is realized, fair value changes are disclosed in equity. Realized holding gains do not affect the income statement. IAS 16 is an example of this approach.

With the income approach, all holding gains and losses resulting from changes in fair value will be reflected in the income statement. In the full fair value model, all fair value changes are reflected in the income statement, including internally generated goodwill. Self-produced goodwill is the difference between the equity value of the firm (or discounted future cash flows of the firm) and the book value of equity, where fair values are used to measure separable assets and liabilities. Internal goodwill refers to the organizational efficiency of a firm and should be distinct from purchased goodwill, which is recognized on the balance sheet as an intangible asset. The measurement and capitalization of self-produced goodwill is not recognized because of a lack of reliability.

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CHAPTER 7 CRITIQUE & ARGUMENTS OF FAIR VALUE ACCOUNTING

Arguments in Support of Fair Value Accounting

The proponents of fair value accounting often cite three advantages associated with the method: the significance of limitations associated with the alternative accounting framework (i.e. historical cost), increased relevance of information presented to investors under fair value accounting, and lower likelihood for earnings management.

Limitations of Historical Cost Accounting

The primary, and polar, alternative to fair value accounting is historical cost accounting. Under the historical cost method, the asset is recorded on the companys financial statements at cost i.e. its historical cost, less adjustment (e.g. depreciation), or market price in the event of a permanently impaired asset.

Persistence of the historical cost method over time is often justified by its simplicity and low administrative costs; however, a number of other advantages can be identified. The main among them is its conformance to the matching concept which prescribes that costs of resources recognized in the income statement should be matched with corresponding revenues reported in income. This principle allows greater evaluation of actual profitability and performance as it correlates, albeit imperfect, expenditure with earned revenue. The presence of an actual as opposed to a hypothetical transaction, and lesser likelihood of measurement error are two other traditional strengths of historical cost accounting.

The list of shortcomings, though, is much longer. One of the major shortcomings of the historical cost method is that it does not reflect the true economic value of financial instruments and the aligning of the accounting value of an asset or liability with its market price takes place only in certain situations, primarily when the company can demonstrate that

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the value of the asset or liability has been altered permanently. Other shortcomings may be summarized as follows:

The method is insensitive to changes in purchasing power of the currency, overstating earnings in periods of rising prices and understating the degree to which capital assets maintain their value. Correspondingly, historical cost accounting becomes futile in economies exhibiting hyperinflation.

The historical cost method includes a substantial number of subjective estimates such as judgments regarding economic life of the asset, allocation of indirect and joint costs, bad debt reserves, warranty liabilities, etc.

Historical cost accounting assumes a going concern (i.e. the company will remain in existence for and beyond the foreseeable future) whereas many companies may fall into the grey area between going concern and exit (liquidation) values.

The method is too simplistic for complex transactions. For instance, the firm may have an interest rate swap obligating it to pay large amounts even though the historical cost of the swap is zero.

Advantages and disadvantages associated with both historical cost and fair value accounting lead to the existence of fundamental trades-off between the insensitivity of historical cost to more recent price signals (and, thus, inefficiency of investors decisions due to lack of information on recent, more fundamental balance sheet values) and the disfiguration of current information provided by fair value accounting for illiquid assets.

It seems, though, that fair value accounting is associated with less inefficiency than the historical cost method. Specifically, recent research analyzed the economic effects of the both measurement regimes and concluded that for sufficiently short-lived and/or sufficiently liquid assets and/or sufficiently junior assets, fair value accounting induces lower inefficiencies than historical cost accounting. In turn, for assets that have a long duration, are traded in very

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illiquid markets or feature an important downside risk, the pure historical cost regime may dominate. However, this domination fades under historical cost when impairment

measurement (which is prevailingly used) is activated and we can be permitted to appreciate that fair value accounting may regain its superiority depending on the nature of the impairment of the asset.

Fair Value Accounting and Accuracy of Information for Investors

The central aim of financial reporting is to portray the underlying economic position of the company and to faithfully reflect the genuine economic fluctuation of the business cycle. This, in turn, improves the relevancy of the information contained in the financial statements and improves investors and regulators ability to make informed decisions. Fair value accounting is seen to better align itself to this purpose than historical cost as it allows for financial statements to be more relevant and more easily comparable across different companies and periods. For instance, under fair value accounting, the value of financial assets acquired by two different firms at different points in time may be easily comparable whereas under historic measurement, the accounting value of these assets will more likely be recorded differently on the balance sheets of the two firms.

However, there are certain limitations to this advantage. For instance, the participants of the mentioned consultation also suggested that the situation reverses when markets are in distress and fair value accounting leads to less relevant and reliable financial information due to the volatility of market pricing used for fair value measurements. Another pitfall of the information provided by fair value measurement is the subjective judgment which unavoidably appears when determining values of assets or liabilities for which inputs are unobservable (i.e. Level 3 inputs). This subjectivity manifests itself through managerial judgment, use of private information, and the inherent uncertainty regarding the validity of the assumptions used in valuation.

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Fair Value Accounting and Reduced Opportunity for Earnings Management

It is said that fair value accounting can alleviate the use of accounting-motivated transaction structures designed to exploit opportunities for earnings management created by the model of mixed attribute (part historical cost, part fair value). In bad economic times, management can influence reported income under historical cost accounting through the sale of assets for example, as a profit is reported if the net selling price of an asset is meaningfully greater than the book value reported under historical cost. This in practice should not be attainable under fair value accounting as the underlying asset is reported at fair value and the result is reflected in the income statement, thereby reducing the possibility of income smoothing.

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Critique of Fair Value Accounting

The relatively long history of using fair value accounting has naturally brought with it a wave of criticism. Although, the criticism has intensified significantly during the current financial meltdown, its malfunction can be attributed to two main arguments against its use: its pro cyclicality to exacerbate pro cyclicality and its contribution to the increased volatility of information presented in financial statements.

Fair Value Accounting and Pro cyclicality

Pro cyclicality is generally understood as amplification of otherwise normal cyclical business fluctuations, both in booms and in busts, creating preconditions for increasing instability and vulnerability of the financial system.

Significant concerns have been raised that fair value accounting can induce a pro cyclical pressure in asset prices. In booms, overstatement of profits and write-ups in assets measured at fair value allow financial institutions to increase their leverage (as borrowing tolerance is typically linked to asset value) and limit their incentives to create reserves that may be drawn on in times of crisis. In busts, fair value accounting puts a downward pressure on pricing in already weak markets which results in further declines in market prices. In order to counteract the write-downs caused by fair value accounting, financial institutions may have to sell securities in illiquid markets although the original intentions may have been to hold those investments to maturity. Such forced or motivated sales become observable inputs for other institutions that are required to rely on fair value accounting to mark their assets to the market. At the same time, the low interest of non-distressed sellers to enter such markets does not allow the prices to recover to, or above, the fundamental value.

The modeling analysis conducted by the Centre for Financial Studies shows that the use of mark-to-market accounting in a time of crisis may indeed cause financial institutions to liquidate their assets unnecessarily and to render asset price dependent on market liquidity rather than on future earning power of the asset. However, the argument regarding pro

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cyclicality tends to ignore the fact that measuring assets and liabilities at fair value may reveal early warning signals for an impending crisis and hence may actually reduce the severity of a crisis and the intensity of price decline.

Fair Value Accounting and Increased Volatility of Information in Financial Statements

Companies activities during the reporting period will naturally be reflected through the changes reported in financial statements. However, researchers21 also identify three other potential sources through which fair value accounting may introduce volatility into financial statements. First is the inherent volatility which is driven by the change in underlying economic conditions and is reflective of the changes in the value itself. Second is the estimation error volatility caused by the simple fact that value is estimated (as opposed to observed), but also due to model specifications and assumptions that may incorrectly reflect reality. And the third type is introduced by way of the mixed-model volatility. It manifests itself because some assets and liabilities are measured at fair value whereas others may be at historical cost, while some others could be at current value. As a result, the effect of economic events is not fully recognized in the financial statements; at least not congruently.

The increased volatility of information presented in financial statements may erode relevance and reliability of information for investors. More specifically, the volatility may negatively affect investors ability to confirm or to correct expectations and to form an understanding of past and present events. Moreover, the use of unobservable and estimated inputs for fair value measurement may affect reliability of information as it reduces verifiability. As such, the use of fair value accounting may diminish the investors ability to assess economic risk of company operations.

It should also be noted that historical cost accounting which is viewed as the main alternative to the fair value regime may also be associated with volatility in financial statements. This happens when gains and losses that are attributable to unrecognized increase in assets value over several years are recognized in financial statements in a single period. This volatility is often referred to as delayed recognition of economic events.

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CHAPTER 8 RECOMMENDATION

SFAS No. 157 should be improved, but not suspended. The guidance in SFAS No. 157 does not determine when fair value should be applied. SFAS No. 157 only provides a common definition of fair value and a common framework for its application. Suspending SFAS No. 157 itself would only revert practice to inconsistent and sometimes conflicting guidance on fair value measurements.

Existing fair value and mark-to-market requirements should not be suspended. Fair value and mark-to-market accounting has been in place for years and abruptly removing it would erode investor confidence in financial statements. Fair value and mark-to-market accounting do not appear to be the cause of bank and other financial institution failures. Mark-to-market accounting is generally limited to investments held for trading purposes and for certain derivative instruments; for many financial institutions, these represent a minority of their total investment portfolio. Investors generally agree that fair value accounting provides meaningful and transparent financial information, though improvements are desirable.

Additional measures should be taken to improve the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates). Fair value requirements should be improved through development of application and best practices guidance for determining fair value in illiquid or inactive markets. This includes consideration of additional guidance regarding (a) How to determine when markets become inactive (b) How to determine if a transaction or group of transactions is forced or distressed (c) How and when illiquidity should be considered in the valuation of an asset or liability, including whether additional disclosure is warranted (d) How the impact of a change in credit risk on the value of an asset or liability should be estimated (e) When observable market information should be supplemented with and / or reliance placed on unobservable information in the form of management estimates (f) How to confirm that assumptions utilized are those that would be used by market participants and not just by a specific entity.

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Existing disclosure and presentation requirements related to the effect of fair value in the financial statements should be enhanced. FASB should assess whether the incorporation of changes in credit risk in the measurement of liabilities provides useful information to investors, including whether sufficient transparency is provided.

The accounting for financial asset impairments should be readdressed. For many financial institutions, financial assets marked-to-market through the income statement represent a minority of their investment portfolio. Current impairment standards generally preclude income recognition when securities prices recover until investments are sold.

Implement further guidance to foster the use of sound judgment. SFAS No. 157 is an objectives-based accounting standard that relies on sound, reasoned judgment in its application. Sound judgment is a platform from which to foster the neutral and unbiased measures of fair value desired by investors.

Accounting standards should continue to be established to meet the needs of investors. Investors, and most others, agree that financial reportings primary purpose is to meet the information needs of investors. Most appear to agree that fair value measurements provide useful information to investors, meeting their information needs. Beyond meeting the information needs of investors, general-purpose financial reporting has secondary uses that may be of additional utility to others, such as for prudential oversight.

Address the need to simplify the accounting for investments in financial assets. Many investors feel that clear disclosure of the inputs and judgments made when preparing a fair value measurement is useful. While a move to require fair value measurement for all financial instruments would likely reduce the operational complexity of U.S. GAAP, the use of fair value measurements should not be significantly expanded until obstacles related to such reporting are further addressed.

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CHAPTER 9 CONCLUSION
The fair value regime represents an evolving accounting system which has now permeated the regulatory environment and made its way into the social landscape. With the globalization of capital markets and the advent of complex financial instruments in use today, it has become apparent that fair values of assets and liabilities are of greater interest to investors than their historical costs. This will only become more intense as economic borders evaporate, as economies mature, as financial markets evolve, and as the public commands heightened accountability largely resulting from improved comprehension and confidence. While neither fair value accounting nor its main alternative historical cost are free from shortcoming, the arguments presented herein intend to show fair value accounting in a positive light having the distinct advantage of being able to best reflect the reality of current financial and economic conditions.

Inherently complex and instinctively responsive to the marketplace, the success of fair value accounting will nevertheless reside in the worlds ability to harness its potential. In so doing, the fine-tuning of standards and of regulatory supervision will bear significantly on the ultimate end state. As the financial crisis portrays, there is a need to enhance clarity and to promote transparency and robustness about disclosures as the methods and assumptions used in valuation become critical to maintaining the accuracy of information provided to investors.

A certain simplification of the accounting standards for financial instruments may also be beneficial to preparers, to analysts, to investors, to regulators, and to the broader public. And this may be complemented by shifting to a single, high-quality global standard to ensure consistent application and enforcement. Moreover, it is imperative that we stabilize market behavior with a system befitting of the confidence that the financial markets seek to re establish.

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REFERENCES

1. The Evolution of Fair Value Accounting, Elizabeth A. Evans and Hong Qiao;
2. Consideration of the Arguments Against Fair Value as the Measurement Basis, CFA

Institute;
3. Fair Value Measurement Guidance Converges, IFRS Development-issue-2; 4. Fair Value Accounting, Fact sheet, Center for Audit Quality;
5.

Fair Value Accounting: The Road to be most travelled By Rock Lefebvre, Elena

Simonova and Mihaela Scarlat;

6.

Study on Mark-to-market Accounting, Report & Recommendation by Staff of the U.S. Securities and Exchange Commission.

7.

www.google.com