Recently, fair value accounting suffers heated debate because the financial crisis. The purpose of this article is to evaluate and understand fair value both in literature analysis and practice. This paper emphasizes the advantages and disadvantages of the fair value measurement. Proponents believe that fair value can provide timely information that reflects current financial market conditions, and information supplied is reliable. On the other hand, critics argue that fair value accounting results the problem of volatility, limited verifiable and reliable information and procyclicality trend.
After evaluating the fair value method, two companies were selected which are Qantas and BPH Billion to reflect the real application of fair value and other alternative methods in their 2011 financial reports. The dominant measurement is still historical cost, but firms still widely use fair value in derivative financial instruments, employee share plan and so on. This article also comments the differences and similarities between two companies.
The last part shows the future development of fair value, and the opinion is not to abandon this measurement. Suggestions are also provided to solve particular problems, for example, firms can disclosure sufficient and relevant information and assumptions in Level 1, 2 and 3, and regulators should continue to issue fair value measurement standards and make modifications.
There are some heated debates about fair value merits and demerits and whether it has future development in financial report. Fair value is also called mark-to-market accounting and it is defined as the value of assets and liabilities could be exchanged between knowledgeable and willing parties in arms length transactions. The research methods of this article are based on some empirical evidences and analysis of literature. In the first part, it critically evaluates the fair value accounting by addressing the pros and coins, and draw a conclusion that fair value measurement is not a perfect
method and will trigger many problems like inaccurate estimation, but issues still exists when using other methods like historical cost. Secondly, Qantas and BHP Billion that listed on ASX were selected to analyze how they used fair value and other methods in their 2011 financial reports. The conclusion is that their major measurement is still historical cost, but they still applied fair value in derivative financial instruments, employee share plan and cash et al. The differences are how they revalue property, plant and equipment, and how they recognize revenue. The last part illustrates the existing issues related to fair value and suggests some recommendations for future development. For example, the estimation of fair value contains errors and unreliable information when the market is inactive and leads too much management discretion. It is suggested that regulators have to consider how much latitude should give to managers, and also firms can provide sufficient information to investors no matter in Level 1, 2 or 3. Overall, the main idea for the last part is the fair value will not be abandoned in the future.
Definition of fair value
According to AASB 13, it defines the fair value as the estimation of price that would be received from the sell of asset or payment of transfer liability in an active market between willing parties at the measurement date (AASB, 2011). The fair value measurement encompasses three hierarchies, in level 1 if the quoted prices for the same assets or liabilities in active markets are available, fair value measurement should be used based on Level 1 inputs. If not, it should consider Level 2 or Level 3 inputs. Level 2 inputs are observable, including quoted prices for similar assets or liabilities in active markets, quoted prices for same or similar assets in inactive markets, and other relevant market data. In terms of Level 3, the inputs are unobservable for assets and liabilities; then mark-to-model approach will commonly be used to determine the fair value (Laux & Leuz 2010).
Advantages of the fair value measurement
One of the advantages of the fair value is that it can provide up-to-date and
most relevant information than historical cost because it determines the value of assets and liabilities based on current market conditions. Therefore, the fair value measurement increases the transparency and encourages prompt corrective actions (Skoda & Bilka 2012).
Unbiased measurement and reliable information
Fair value is a market-based measurement, thus it can provide unbiased measurement which is not influenced by factors related to the particular entities and the measurement is also consistent from period to period and cross entities (Penman 2007). Furthermore, the market-based measurement can supply verifiable and neutral information data, it also means the information is reliable because firms will disclose methodologies and measurements they applied and relevant information (Skoda & Bilka 2012).
Disadvantages of fair value measurement
The fair value accounting will result the problem of volatility, which contributes to excessive leverage in boom periods and leads to excessive write-downs in busts because the changes of assets and liabilities follow with the market environment. Moreover, the existence of volatility of a market possibly has more risks and unfavorable implications on companies’ investment capacity (Laux & Leuz 2010).
Limited verifiability and reliability
Some opponents argue that fair value measurement cannot provide verifiable and reliable information. According to Magnan, ML (2009), standard-setters should focus on providing verifiable and conservative information. Nevertheless, FVA cannot always provide verifiable or conservative information especially for nonfinancial assets that companies using estimation to measure values rather than the actual market prices in Level 2 and 3 values. Then the situation will facilitate manipulation for management and reduce the reliability of information.
It is believed by many opponents that FVA creates asset bubbles and
aggravates the effects of crisis and leads to procyclicality trend, which increases the systematic risks in financial market (Jaggi et al. 2010). Because the FVA dependents on market situations, when fair value increases, it is boon to banks’ balance sheets at the top of the cycle and decreases will weaken the banks’ balance sheets at the bottom cycle which also cause the market to panic and affect the development of future market and even the whole financial system (Veron 2008).
Evaluation of fair value
After the discussion of pros and coins of the fair value, it is clear that the merits of fair value are providing timely and reliable information, while the demerits of fair value are resulting high volatility, limited reliable and verifiable information and trend to procyclicality. Thus it is obvious that FVA remains imperfect and also it is hard to decide whether fair value makes beneficial improvements in accounting measurement (Skoda & Bilka 2012). For example, it has been discussed that fair value measurement causes problems when estimate the illiquid assets, whereas is it making situations better if companies using different measurements like historical-cost accounting (Laux & Leuz 2010)? If there is no other measurement can solve the problems triggered by FVA, it is still useful and should be applied to some extent.
Fair value measurement in Qantas 2011 annual report
Qantas is regarded as one of the most leading brands in Australia and it provides domestic and long distance airline. The annual report shows that the company used historical-cost, realizable value, present value and fair value measurements. Fair value measurement is widely applied in Qantas report. Firstly, derivative financial instruments are measured at fair value both initially and on an ongoing basis (Qantas, p56). Moreover, financial guarantee contracts are also stated at fair value when the guarantee is issued (Qantas, p58). The fair value of cash, cash equivalents and non-interest-bearing financial assets and liabilities approximate equal to their carrying amount as result of the short period maturity. As for interest-bearing liabilities, they are valued initially at fair value minus attributable transaction costs (Qantas, p61). Secondly, some revenues for
example passenger and freight revenue and redemption revenue use fair value method to some extent. Passenger and freight revenue is carried at the fair value of the consideration received, while the redemption revenue is depending on management’s estimation of the fair value of the expected awards for which the points will be redeemed (Qantas, p57). Furthermore, the assets classified as held for sale are measured at the lower of carrying amount and fair value less costs to sell (Qantas, p58). Besides, share-based payment is valued at the fair value method (Qantas, p60).
Alternative measurements used in Qantas
Qantas not only applies the mark-to-market measurement but also uses alternative methods in its report. The company prepared the Consolidated Financial Statements based on historical costs except some assets and liabilities should measured at fair value that consistent with the accounting policies (Qantas, p55). When the firm reports the property, plant and equipment, they are initially measured at cost or stated at deemed cost less accumulated depreciation and impairment losses, and then use cost model in revaluation for the subsequent year (Qantas, p58). The inventories are carried at the lower of cost and net realizable value and the basis of weighted average costs is used on the costs of engineering expenditure and consumable stores (Qantas, p58). Moreover, leased assets and liabilities are reported to the present value of the minimum lease payments (Qantas, p59). In addition, non-current receivables and provision are measured at present value (Qantas, p58, 60).
Fair value measurement in BHP Billion 2011 annual report
BHP Billion is a world’s largest producer that major running the business in mining and petroleum. It is clear that the dominant method used by BHP Billion is historical cost measurement, and it also uses fair value and net present value methods. BHP Billion applied fair value in each class of financial instruments. All financial assets and liabilities except derivatives are initially reported at fair value of consideration paid or received, and recognized at fair value or amortized cost subsequently (BHP Billion, p211). The fair values of derivatives are based on quoted market prices (BHP Billion, p211). Available for sale and trading investments are
measured at fair value (BHP Billion, p171). Also, the share-based payments are measured on the fair value at grant date (BHP Billion, p168).
Alternative measurements used in BHP Billion
According to BHP Billion 2011 annual report, the financial statements are drawn up on the basis of historical cost, while derivative financial instruments and other particular financial assets are carried at fair value (BHP Billion, p166). Besides, the valuation of property, plant and equipment are carried on cost less accumulated depreciation and impairment charges, and the recoverable amount of them are measured at the higher of fair value less costs to sell and value in use (BHP Billion, p169, 172). Inventories, including work in progress, are valued at the lower of cost and net realizable value. Moreover, leased assets are capitalized at the lower of the fair value of the property, plant and equipment or the estimated present value of the minimum lease payments (BHP Billion, p169). Additionally, closure and rehabilitation provisions are measured at the expected value of future cash flows, discounted to their present value (BHP Billion, p171).
Compare the measurements between Qantas and BHP Billion
Comparing two companies, the similarities are that historical cost method is their major measurement and they both use fair value in derivative financial instruments, share-based payments and financial assets and liabilities. Because the fair value can reflect the up-to-date information of the current market, companies both apply this method in derivative and share-based payments. Also, for some short period maturity assets and liabilities, fair value can be seen as equal to carrying amount. Moreover, they both apply same method to measure inventories. As for the differences, Qantas calculated passenger and freight revenue and redemption revenue in fair value method, while BHP Billion recognize the sales revenue when economic entity has passed control of the goods or other assets to the buyer. Item of property, plant and equipment, Qantas used cost model to revalue them, whereas BHP Billion recorded the initially cost and then determine recoverable amount at the higher of fair value less costs to sell and value in use.
Future development of fair value
According to the discussion of merits and demerits about the fair value measurement, and presentation on how Qantas and BHP Billion applied the fair value in their annual reports, it is still difficult to determine whether fair value method contributes benefits in accounting. Some argues that fair value accounting in financial reporting may accelerate its disconnection from a firm’s business reality, while standard-setters and accounting academics believe there is no alternative measurement or reporting model better than FVA (Magnan 2009). As mentioned by Jaggi et al. (2010), regulation on fair value is significant for offering reliable, transparent, and accurate information on asset values to investors, and information is useful during stable market conditions, while it fails to be usefulness when the financial market is unstable and volatile. The advantages of fair value can support this statement that it provides timely information, which is more useful and reflect current market conditions than historical cost for investors, that is the reason why Qantas and BHP Billion both use this method to measure the shares, derivatives and some financial instruments. However in an unstable financial market, for example, when facing the financial crisis, companies’ values written down dramatically using fair value measurement. Another severe problem of the fair value is that the estimation of assets and liabilities contain errors and the information is not reliable compare to true market value because it based on unobservable information and will lead too much discretion for the management, then it is suggested that the value of assets should not be based on a model that provides some theoretical value (Jaggi et al. 2010). Moreover, regulators have to consider how much latitude to give managers when they estimate fair value. It is suggested that firms can extend disclosure of the underlying assumptions when use fair value estimation no matter in Level 1, 2 or 3. For instance, in Level 2 estimation, companies should provide sufficient information to investors that can help them to determine which assets or liabilities are applied as the basis for comparison, and in Level 3, all relevant model inputs should be provided to investors (Landsman 2012).
Even the measurement of fair value is not accurate; other alternative method still contains errors such as historical cost. Therefore, fair value
accounting should not be abandoned and in order to improve it, modification to the fair value accounting should be concerned to solve the specific problems. It is a challenge for regulators to provide guideline for the valuation of financial assets that can prevent the companies from financial collapse and avoid greater uncertainty in the financial markets (Jaggi et al. 2010). Fortunately, academic accounting researchers like IASB and FASB continue to make effort in issuing standards relating to fair value measurement, disclosure and recognition that aim to provide ample opportunity for future research (Landsman 2012). Additionally, the regulation setters will have a good opportunity to examine the efficiency and usefulness of disclosed information comparing in different adopted firms.
Although the fair value is far from perfect now, it is not necessary to abandon this method and all criticism can encourage further explore to settle these issues and urge related institutions to modify the regulation in order to make improvements in fair value measurement (Skoda & Bilka 2012).
Fair value measurement suffered many critics after the result of the financial crisis. It clearly shows the strengths and limitations of the FVA in this article. The pros are that FVA supplies up-to-date and reliable information; also it is an unbiased measurement because it is not affected by factors related to other entities. Even though FVA will cause many problems like high volatility, limited verifiable and reliable and procyclicality trend, it is still useful to some extent because other alternative methods may not perform better than the FVA.
In Qantas and BHP Billion 2011 annual report, they both reported elements like derivative, some particular financial instruments, and share-based payments on the basis of fair value. The fair value can best reflect the current market conditions, which is useful to make decisions for investors. There are also some differences existing in two companies. They recognize property, plant and equipment in different method, Qantas used cost model
while BPH Billion measured on the basis of revaluation model. Besides, Qantas recognized some revenue like passenger and freight revenue and redemption revenue in fair value, while BHP Billion was not.
As for the future development of the fair value, fair value accounting should not be abandoned. When facing the problem of fair value estimation, it is suggested that extend disclosure of the underlying assumptions to users whether in Level 1, 2 or 3. In order to improve the measurement, regulators should keep issuing and modifying standards related to fair value measurement and fix imperfect in the system. Additionally, regulation setters can examine the efficiency and usefulness of fair value among different adopted firms.
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