Table of Contents
Introduction Criticism of Fair Value in the Context of Financial Reporting Discussion Concluding Remarks References
Introduction
Fair Value Accounting is a subject of financial reporting; accordingly, the effect of this method on accounting and financial reports is deemed crucial. Initially, it was asserted that the fair value method undermines the fundamental concept of conducting a business, particularly for entrepreneurs whose businesses are dependent on net cash flows over time. Fair Value Accounting, on the other hand, is a vital aspect of the banking system. Consequently, the view of the financial reporting system is contingent upon the company paradigm and general reporting strategy.
Discussion
First, it must be mentioned that the Financial Accounting Standards Board completely enhanced the decision-making relevance of financial statements (FASB). This board has enhanced the financial accounting reporting system's fair value recognition by amending the generally accepted accounting rules (GAAP). As a result, a model of mixed accounting was established, which relies on the altered reporting structure. In their research on the new legislation, Plantin and Sapra (2008) underline the following concept: "The new regulation affords the financial industry a chance to enhance the financial reports for the third quarter. By applying reasonable assumptions to fair-value identification, corporations can repair excessive write-downs in the past and escape the vicious loop between distorted market pricing and diminishing asset worth, resulting in a better-looking bottom line over the past three months. However, fair-value accounting is really a symptom, not the cause, of the ongoing financial crisis. Even its suspension would not end the catastrophe." From this perspective, it should be mentioned that fair value accounting cannot be utilized for the analysis of economic processes; as a result, financial reporting, if used for data systematization, frequently appears distorted (Riahi-Belkaoui, 2004)
As for contemporary accounting rules, it should be noted that they are frequently discussed in the context of the growing acceptance of fair value and are frequently cited as a measuring attribute. Taking into account the financial accounting reports system, it is important to note that the transition to the fair value accounting model has not been devoid of controversy.
According to Ryan and Herz (2002), fair accounting information is frequently criticized for its poor level of dependability compared to the historical cost approach: "Estimation mistakes damage both the balance sheet and the income statement. In addition, unrealized changes in fair value from one period to the next, which are now required to 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. Lastly, fair value accounting needs the proper matching of assets and liabilities, which is much more challenging to implement than the matching of revenues and expenses under the historical cost model." Moreover, it is imperative to emphasize that the empirical evidence of financial accounting reports and findings on this topic generally suggests that the reliability of fair value differs depending on the extent to which the fair value estimations incorporate publicly-observed market-based information versus management-produced information (Scott, 2003).
Investment securities that are exclusively traded on active markets are required to provide the most accurate financial accounting proof pertaining to the notion of fair value's reliability. Moreover, the difficulties of reliability in various researches are often obtained from the examination of banks and other financial institutions for whom economic tools constitute basic operating benefits and charges. Anagnostopoulos (2005) underlines the following: "Such firms may be fundamentally distinct from companies holding inventory, property, plant, and equipment, and other assets whose value is derived from the execution of a business plan rather than fluctuations in market prices." Therefore, it is questionable to generalize these research findings to all economic sectors." From this perspective, it can be argued that the prerequisite for adopting fair value accounting is the availability of generally available market values for the assets and liabilities. Despite this, it is important to note that for numerous key classes of assets or liabilities utilized for fair value accounting and financial accounting in general, the prices at which transactions are frequently recorded do not correspond to the hypothetical perfect competitive market. Therefore, the overall system of financial accounting reports should be adjusted so that these reports and financial accounting match to actual transactions. In light of this, loans appear to be an excellent illustration, given they are not standardized and are not typically traded on deep and liquid marketplaces. Thus, financial reporting of the loans is more credible, as they are representative of numerous asset kinds that trade largely on the over-the-counter (OTC) market, where prices are determined by bilateral negotiation and matching. (2006) Martin and Rich. According to Hitz (2007), "currently, both US GAAP and IFRS require the disclosure of fair values for virtually all financial instruments" (IFRS 7, SFAS 107). The principles governing fair value accounting for financial instruments are also identical. IAS 39 and SFAS 115, 133 stipulate that trading securities and derivatives held for trading or as part of a fair value hedge must be assessed at fair value, with revaluation gains and losses recognized directly in income.
Financial Accounting reports, which are accessible for the sale of securities, are frequently prepared in the fair value format; however, the profits from historical cost reporting are regarded as other broad-based income until the exact realization phase.
Fair Value Criticism in the Context of Financial Reporting
First, it should be noted that fair value accounting has a high propensity to generate a declining value curve, as mandatory asset sales exacerbate the possible drop in the remaining assets. Consequently, the financial accounting reports will be based on these reduced numbers, which distort the true picture of financial activities.
Generally, the fair value losses reverse, as the required assets are often held until they become increasingly crucial. Thus, reporting focuses on losses, while the overall picture of transactions is frequently omitted.
Conclusion
Fair Value Accounting is the reporting method that can both improve and distort financial accounting reports. It has been stressed that everything depends on established norms and, in particular, the nature of financial operations and transactions.
References
The implications of historical cost versus fair value accounting in banking for oversight, provisioning, financial reporting, and market discipline. 109–127. Journal of Banking Regulation, Volume 6, Number 2, 2005.
The Decision Usefulness of Fair Value Accounting: A Theoretical Perspective, by J.-M. Hitz. European Accounting Review, Volume 16, Number 2, pages 323-364, 2007.
Martin, R. D., Rich, J. S., & Wilks, T. J. (2006). Auditing Fair Value Measurements: A Review of the Related Research 287 Accounting Perspectives, 20(3)
Plantin, G., and Sapra, H. (2008). Accounting for fair value and financial stability. 12th Financial Stability Review, Banque de France Evaluation and monetary security
A. Pollock (2008). The accounting theory of "fair value" presents conceptual difficulties. Commission of Securities and Exchanges.
Riahi-Belkaoui, A. (2004). Lessons for the United States in Value-Added Reporting Quorum Books, New York
Riahi-Belkaoui, A. (2005). Value-Added Performance Reporting Outcomes Westport, Connecticut: Quorum Books
Ryan, S. G., Herz, R. H., Iannaconni, T. E., Maines, L. A., Palepu, K., Schrand, C. M., et al (2002). Interest and Value Changes on Financial Instruments Reported at Fair Value 16(3) Accounting Horizons, page 259
W. Scott, Financial Accounting Theory, Prentice Hall, 2003.
Young, M. R., Miller, P. B., & Flegm, E. H. (2008). Fair Value Accounting's Role in the Subprime Mortgage Crisis 34, Journal of Accountancy 205(5).
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