IS FAIR VALUE ACCOUNTING TRULY FAIR? (Term Paper Sample)

IS FAIR VALUE ACCOUNTING TRULY FAIR? by [Student Number] Course Professor’s Name Institution Location of Institution Date Is Fair Value Accounting Truly Fair? Introduction Fair value is useful for getting a realistic estimation of the value of an asset or a liability. According to McDonough et al. (2020, p.308), fair value refers to the price that assets would fetch if an entity sells them or the amount it can get if it transfers a liability "in an orderly transaction between market participants at the measurement date." Mora et al. (2019) pointed out that fair value only applies to a few accounting standards. As such, preparers of accounting information should use it selectively for estimating values in the most appropriate cases. For instance, while fair value can be appropriate for measuring plan assets under IAS 19 employee benefits, it should not be used to estimate plan liabilities (Mora et al., 2019). Furthermore, IFRS 5 and IAS 36 require a fair value to be used for measuring the value of impaired assets to determine their recoverable amount. Entities are free to choose whether or not to use fair values for investment properties, intangible assets, as well as property, plant, and equipment (Mora et al., 2019). While fair value accounting is truly fair in some cases, such as when determining the recoverable amount for assets that are about to be disposed of or have been impaired, its use in other cases can be unfair to users of financial information (Mora et al., 2019; Ahn, 2021). For instance, fair values can increase the volatility of the profit and loss statement (Ahn, 2021; Mora et al., 2019). Moreover, it creates a great information asymmetry between preparers and users of financial information. Mora et al. (2019) and Ahn (2021) have also argued that fair values give analysts and investors a hard time, especially when the reporting firm fails to make sufficient disclosures. The following paper aims to discuss whether fair value accounting is truly fair. Fair Value Accounting Organisations should record their transactions using the right measurement basis. According to McDonough et al. (2020), historical cost accounting has been the most popular accounting basis, despite the ongoing debate on whether fair value accounting could be a more appropriate basis. Proponents of fair value accounting argue that it provides more relevant information than historical-cost based accounting. Fair value accounting reflects reality since transactions by entities occur at real values as opposed to historical costs (Ahn, 2021). Mora et al. (2019) explained that fair value accounting presents information from a market participant’s perspective. As such, the figures that organisations report when they use fair value accounting are likely to be the most current. As ACCA (2009) pointed out, fair value is a clear concept that makes sense to many entities. Furthermore, business entities can get a better estimation of the value of their liabilities and assets when they use fair values. For instance, fair value accounting helps banks to get a realistic estimation of the value of their loans since it contains information about the interest rate and default risks (Ahn, 2021). At the same time, fair value is a more-information rich concept since it is a market value that captures the views of diverse market participants (ACCA, 2009). On the contrary, the fairness of information reported using fair value accounting is questionable, given the subjective judgments involved in estimating values. As Ahn (2021) noted, fair accounting values contain measurement bias, which makes them less reliable when compared to estimates measured using traditional accounting methods. Furthermore, Ahn (2021) and Mora et al. (2019) noted that managers can manipulate fair value accounting and end up with estimates that portray a business favourably. Since management beliefs are a critical aspect in estimating fair values, such values might be misleading if managers of a firm hold different beliefs from other market participants (ACCA, 2009; Ahn, 2021). Mora et al. (2019) also noted that the level of enforcement in a country can affect the fairness of fair value accounting. The enforcement environment determines the extent to which fair values are managed numbers. Firms operating in low enforcement environments can use managed fair values or less informative measurements, which affects the verifiability of their information (Mora et al., 2019). The banking industry is one of the most affected sectors, where fair accounting can lead to unreliable reports. Banks have numerous financial instruments measured at fair value (McDonough et al., 2020; Ahn, 2021). Comparability of financial statements in the banking industry might be unreliable due to the use of fair value accounting. According to Ahn (2021, p.3), comparability refers to the quality of information that allows financial users to identify differences and similarities "between sets of economic phenomena." Comparability enhances the usefulness of financial information. Users compare the performance of one entity against its peers to evaluate its relative financial performance and status (Ahn, 2021). The increased lack of comparability when using fair value estimates can lead to high costs when users analyse accounting information. Ahn (2021) explained that great comparability of financial information leads to reduced costs of analysis and interpretation of accounting reports. The subjectivity involved in estimating the values of various financial instruments can lead to measurement errors (McDonough et al., 2020). Users of information might arrive at different conclusions when relying on financial data that have measurement errors. As Ahn (2021) indicated, investors might not be able to compare the financial statements of banks with their peers, especially in cases where financial institutions have used complex fair value estimates. Additionally, fair value accounting is associated with high volatility. Figures generated using fair value accounting tend to show high volatility when compared to historical cost-based figures (Ahn, 2021; McDonough et al., 2020). In some cases, fair value-based income can be more than net income, especially when measurement errors in fair value liabilities fail to offset errors in asset figures. At the same time, a mismatch between liabilities and assets when using fair value creates artificial volatility, which makes it difficult to predict future earnings (Ahn, 2021). According to Mora et al. (2019), the use of fair value accounting can lead to a significant rise in reported earnings, which are purely attributable to a change in accounting rules. Mora et al. (2019) illustrated this by citing the case of Alphabet, which reported a significant increase in profit despite an increase in expenses. The introduction of fair value accounting for non-marketable securities in the first quarter of 2018 gave Alphabet’s earnings a significant boost. Mora et al. (2019) observed that the change in accounting rules made Alphabet’s earnings increase by three billion US dollars. The surge in profit defied market expectations, given that many analysts had forecasted Alphabet’s earnings using other accounting methods (Mora et al., 2019). Moreover, fair value accounting puts the users of financial reports at a disadvantage due to increased information asymmetry. Most of the users of financial reports lack the sufficient information and knowledge that preparers have regarding the inputs used in fair value estimation models (Ahn, 2021). As a result, some of them find it difficult to understand the estimates that managers when preparing financial reports. Such information asymmetry can have significant negative impacts, as was the case in the 2008 financial crisis, which was linked to banks’ fair value assets (Liao et al., 2013). McDonough et al. (2020) noted that fair value accounting was blamed for amplifying the severity of the 2008 crisis. However, Mora et al. (2019) disagreed that fair value accounting was largely to blame for the crisis. They argued that bank regulatory requirements were more responsible for the crisis than fair values. In addition, information asymmetry associated with fair value accounting can also make various analysts evaluate financial statements differently (Ahn, 2021). Mora et al. (2019) illustrated the difficulties that analysts go through when trying to make sense of financial reports prepared using fair values. They cited the case of Noble Group in 2015 in which an independent research firm outlined how the company was relying on fair values to provide misleading reports about its commodity contracts. Noble Group used to mark to market its commodity trading contracts, thus producing favourable accounting reports (Mora et al., 2019). As a result, the company’s profits showed the business was doing well while its cash flows showed a different pattern. Analysts could not understand the discrepancy between the company’s profit and cash flow patterns since Noble Group did not make full disclosures of how it generated its reported values (Mora et al., 2019). The use of fair values should be highly limited to appropriate areas and backed by sufficient guidance and regulations (Ahn, 2021; Mora et al., 2019). Accounting bodies should identify a way to address the problem of verifiability of fair values (Mora et al., 2019). While it is easier to verify fair values based on market prices, users of information are usually at a disadvantage when they rely on other fair values. However, market prices can be unreliable, espe...