Fair Value accounting Essay

Custom Student Mr. Teacher ENG 1001-04 28 September 2016

Fair Value accounting

The squabble on the issue of what accounting measurements will be used as the standard for financial instruments had caused the on-going debate with various proponents of accounting standard; even today, proponents of every side argues on the basis of their advantages over the others. Among these contending parties are the proponents of the fair value accounting and those who favored accounting standard based on the historical costs. Hitz (2007, p. 324) pointed out the increasing importance of fair value as an accounting measurement attributes.

Hitz stated that today, the “cost and transaction-based reporting model is in decline and a new market value and event-based model is on the rise” (Hitz, p. 324). Citing the significance of fair value accounting, Hitz mentioned that starting out as a specific remedy for the iniquities of the reporting model for certain financial instruments “fair value has manifested it self as a dominant measurement paradigm for financial instruments and, more recently, has increasingly been implemented for measurements of non-financial items” (Hitz, 324) such as investment property.

On the other hand, while Hitz adhere to the tenets of fair value accounting, he recognized the views of the opponents of fair value accounting particularly the criticism regarding the questionable reliability of fair value measures notably for model-based estimates relying on management’s expectation and projections. However, Hitz asserts that results on empirical research regarding value measurement “support the incremental value relevance of fair value disclosure for securities (Petroni and Wahlen, 1995; Barth et al., 1996 as cited by Hitz).

The Australian accounting standards Board (AASB) though recognizes other accounting standards it recognizes fair value accounting as the main financial instruments which applies in various financial processes and transaction within AASB. The AASB defines Fair value as “the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arms length transaction” (p. 21) Fair value has been the standards in evaluating and managing the performances of a group financial assets or financial liabilities. In the ASSB 7, paragraph 9 to 11 and B 4 the ASSB require the entity to provide disclosures about financial assets and financial liabilities it has designated at fair value through profit or loss including how it satisfied these conditions (ASSB, p. 17).

This clearly indicate that fair value accounting as a financial standard instrument have been effectively use and provide significant contribution to the financial situation. This is clearly reflected in the following statement from the ASSB as follows: “investment in equity instrument that do not have a quoted market price in an active market, and whose fair value cannot be reliably measured shall not be designated as at fair value through profit or loss” (p. 18). The Fair value of any investment plays an important in determining market condition as the fair value of a particular financial instrument is based on the following factors a. the time value of money, b. the credit risk, c. foreign currency exchange prices, d. commodity prices, e. equity prices, f. volatility, and g. payment risk.

Regardless of the accounting standard used, accounting plays an important role in financial reporting. While M. J. Milne’s discussion focus on the importance of accounting in financial management including accounting standards that lead to increases in reported earnings,  citing the arguments of Watt and Zimmerman Milne (2002) puts it

“Managers have greater incentives to choose accounting standards which lower earnings thereby increasing cash flows, firm value, and their welfare, due to tax political, and regulatory considerations than to choose accounting standards which reports higher earnings and, thereby increase their incentive compensation” (p. 372).

Obviously, accounting standards contributes to the financial situation not only of the firm that uses such standards but the entire financial realm. In this case, Milne partly hinted as to why trillions of dollars went off the global financial market balance sheets and why asset values experience decline. Milne seem to mean that managers choose accounting standards that reported lower earning yet, it increase the firm’s cash flows, the firm value, and their welfare, due to higher tax and political pressures. In this case the real market value as well as the real earnings were reassigned to somewhere else or as Milne suggest, to cash flows and their value.

Given this accounting standard, it is no wonder that management will lobby financial instrument that reduce reported earnings to avoid taxes, regulatory procedures, and all other costs. As Milne stressed,

“ordinarily, managers are predicted to have greater incentives to lobby for accounting standards that lead to increase in reported earnings and thereby management wealth. However, since changes in cash flows and stock prices can also be affected by taxes, regulatory procedures, information costs and political costs, managers also have to consider the effects of reported earnings might have on the likelihood that such costs could be imposed on the firm” (p. 372).

The trillions of dollars that were written off the global financial market balance sheets and the massive decline of asset values can therefore be attributed to these factors accompanying this accounting standard, and the commentators were partly right in their opinion regarding this massive decline of asset values. However, this does suggest that that money going to taxes, regulatory procedures, political costs, and information costs are lost money and that regulatory procedure should be viewed as negative for business activities. Regulatory procedures should be viewed in even broader terms that include all forms of social control and influence.

Michael Greiffin emphasized that this should also include “not only the corporations legislative requirement but also other rules and directions, such as professional accounting standards and stock exchange requirements” (p. 2 par. 3). Graffikin pointed out that regulation is considered desirable “where there windfall profits” – where through some fortuitous event is able to make above “normal” profits. Regulations should be seen as necessary in the rationalization and coordination of economic activity so as to organize behaviour of industries in an efficient manner (graffikin, p. 3).

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