fair value

This document is concerned with the relationship between the financial crisis and fair value accounting.

Its purpose is to make an understanding of the strengths and limitations of fair value accounting. The report also gives some examples of fair value accounting measures used in several Australian companies. In this report, City Weat Water LTD and JB HI-FI LTD are used to explain that. Introduction With the modern transportation and communication technology development, in the industrial society, the segmentation of market is going to be narrow and towards the integration of world economy.

The traditional historical cost based on the transaction price measurement is no longer the only reliable source of information. Fair value accounting due to the high relevance information will become increasingly important in the new century and the future accounting measurement. With the financial crisis, more and more professionals and bankers believed that the fair value accounting was the principal reason that the U. S.

financial system melted down in 2008.By contrast, some investor groups and accounting interests emphasize that the fair value accounting gave investors an early warning of the looming financial crisis and continues to give them useful information. This report is a brief analysis about fair value accounting. It is divided into three parts.

In the part A, this report briefly discussed the role of fair value accounting in providing useful information for economic decision making. In the part B, this report has critically discussed the limitation of fair value accounting.For the last part, part C, two Australian companies from different industries been given as examples to indentify and discuss the extent to which fair value accounting is being applied. Part A The role of fair value accounting relates to provide useful information for economic decision making.

FAS 157 defines “fair value as the price received to sell an asset or the price paid to transfer a liability in an transaction taking place in an active market. ”(Curtis,J. 2009) This is sometimes referred to as “exit value”.In the futures market, fair value is the equilibrium price for a futures contract.

Fair value is a dynamic reflection; embody the spot true value of assets or liabilities. Fair value can provided accounting information which has predictive value to assess the entity’s future cash flow for the investors and creditors. Supporters of fair value accounting believe that the regime provided a beneficial early warning of the financial imbalances and generally provides investors with useful information.The strength of fair value accounting to provide information for economic decision making can briefly divided into four aspects: the benefit of the capital maintenance, improve the relevance of financial information, the attribute of the measurement and the reflection of entities’ profit.

Fair value accounting is benefit of capital maintenance Capital maintenance can be divided into two big concepts: physical maintenance and financial maintenance. Physical maintenance can only recognized when the total investment amount at the end of the period greater than the investment that can maintain the same capacity at the beginning of this period.Financial maintenance means if the total investment at the end of this period equal to or more than the monetary unit of measurement of the initial investment amount, the capital has been maintained, and the over parts can be recognized as income. In the time of inflation, the fair value accounting can assure all the two concepts of capital maintenance, and can avoid holders of monetary assets lose in real term.

It can provide a more real situation of an entity. The use of fair value accounting reduces the possibility of income smoothing.Fair value accounting can better reflect a company’s exposure towards risk, when the changes in market conditions cause the income and equity become more volatile. Improve the relevance of financial information Something is relevant if it influences decisions on the allocation of scarce resources.

In other words, it means the information provided by the company can actually affect the decision making of information users and satisfied the needs of information users.Compared with other accounting methods, fair value accounting can get a more accurate disclosure of a company’s cash flow, and better reflect the company’s operation ability, solvency and financial risk assumed. So that the users of financial report can be better informed of the entity’s financial position and operating performance, to help them to make the right decision. As fair value accounting provides information about current market conditions, it is the most relevant measure for assets and liabilities.

For one thing, fair value accounting measure can obtain intangible assets in to financial reports, such as intellectual property rights, human recourses and goodwill etc. make the information of financial report more complete to reflect the financial position, profitability and the ability to face risk. For another, fair value represents the present value of future cash flows, so investors just need the fair value of assets or liabilities and estimates the market interest rate, they could calculated the expect value of assets or liabilities in a certain point in future.Moreover, fair value accounting is a market-based accounting, so it more relevant to the decision making.

In an effective market, fair value is reflecting market price of assets or liabilities in a specific time and specific economic conditions. The transaction price is fully reflecting all the latest unbiased information, and the changes in fair value reflect the recognition changes of assets and liabilities. Therefore, the accounting information according to fair value accounting measure can reflect the changes of economic situation timely. Timely is one of the aspects of relevance.

To sum up, the fair value accounting can provide more relevance information to decision makers. The attribute of the measurement In the financial report, the revenue is recorded by the current market prices; cost and expense are recorded by their historical cost. The attribute of measurement are not same, so there is a need to implement the fair value accounting measurement to matins the financial information’s correlation, stability and consistency. To make sure the financial provided by the company are useful for users.

The reflection of entities’ profit The fair value accounting can give a more truly reflection of entities’ income.Currently, company’s income is calculated by income minus the relevant cost and expense. The income of enterprise is computed at current market prices. However, the cost and expense are measured at historical cost.

The different between these two parts are profit. It comes from the net profit created by workers and the price difference cause by economic factors. The fair value accounting can avoid the economic factors reflection of financial report and information, give the information users a more realistic financial situation and helpful them to make decision.Part B The limitation of fair value accounting As the statement stated “Measurement by using fair value accounting have played an instrumental role in the creation of global financial crisis.

Therefore, we should abandon the use of fair value accounting as a measurement tool,” there is highly questionable about fair value accounting. The questions most focuses on whether fair value accounting could recover the gap between the entity’s book value and the market capitalization, if all assets and liabilities are measured at fair value.With the worsening financial crises, some insurance firms and banks argued that FAS 157 and fair value accounting measures exasperated the effects of the financial crisis. They argued that FAS 157 and fair value accounting forces holders to severely write down distressed or illiquid assets, these were often mortgage backed securities, to levels far below their “true economic values.

” Below this report will describe some key limitations and arguments commonly about fair value accounting. The issue of reliability A central goal of accounting is that accounting standards demonstrate a certain degree of reliability, a quality of information that assures that information is reasonably free from error or bias and faithfully represents what it purports to represent. ”(Magnan, M. 2009) Fair value is recognized by the market.

However, the environment of market is complex, some accounting elements or accounting transactions can be recognized or find a similar market price, some cannot recognized in this way. These accounting elements or transactions can only be recognized by the judgment or estimation of the accountant.It will reduce the reliability of the financial information. For the users and preparers of financial statements, due to the acquisition of fair value accounting information is uncertainty, the information about risk and benefit of assets or liabilities is not asymmetry.

The quality of information cannot be guaranteed. If there is no independent auditor or other outside supervisors, the statement preparers will have great opportunities to control the estimate of fair value and make personal interest, and also make the statements users cannot use the existing information to fully judge the fairness of fair value.Due to the personal judgment plays a important role in the valuation process of fair value accounting when market prices are not available, the reliability of the financial information will become questionable. The issue of operation Financial statements contain many financial instruments which do not have related market price, so their fair value is not easy to determine.

If there is no liquid market, managerial judgment, private information, and uncertain assumptions about future will unavoidable when estimate the fair value, such as use future cash flows and discount rates.Because the amount of future cash flows, timing and the time value of money is uncertain, the measurement operation is often faced with great difficulties. Overall, the operation of fair value accounting is great difficulties. The issue of volatility “Within the use of fair value accounting, more and more assets and liabilities are measured on a continuing basis which reflects market conditions at the balance sheet date.

” (Han, D. 2005) After initial recognition, the asset or liability fair value changes will be reported as a gain or loss if the firm chooses the fair value model.If assets are measured on a continuing basis that reflects market conditions, regular depreciation costs will be uncommon. “The result may be a new development where write-offs with a regular pattern are replaced by annual impairment tests with an irregular pattern, such as goodwill.

” (Han, D. 2005) But compare with the annual depreciation costs, the annual impairment tests are less predictable. And this will lead to more discussion between accountants and management and more volatility in earnings. This will make the financial report readers more confused about the financial information, and more difficult to make a decision.

Investor groups and accounting interests emphasize that the sole goal of accounting is to provide reliable information to investors, and that fair value gave investors an early warning of the looming financial crisis and continues to give them useful information. Therefore, even though the fair value accounting is not perfect and has some limitation, it can provide more reliable information to investors. There is no necessary to abandon the use of fair value accounting. We can perfect this fair value accounting by development to reduce the negative effect of the limitations.

Actually, the developments related to fair value accounting are continuing. “On October 10, 2008, FASB issued a clarification of its fair value accounting rules that gave guidance to financial firms on how to value illiquid assets in distressed markets. ” (Curtis,J. 2009)It built on a statement FASB released with the SEC on September 30, 2009, by providing an illustrative example of how companies should use their best judgment to value assets that have no active market.

In early 2009, FASB announced that it was going to reexamine several debatable areas involving fair value accounting by the ending of 2009.This reexamine will include “guidance on determining when a market for an asset or a liability is active or inactive and when a transaction is distressed; applying fair value to interests in alternative investments, such as hedge funds and private equity funds; and improving disclosures about fair value measurement. ” (Curtis,J. 2009) Part C The extent to fair value accounting being applied in City West Water LTD and JB HI-FI LTD International Accounting Standards in the fair value applied to a wide range of areas, mostly the areas of real estate investment, impairment of assets and financial instruments.

Meanwhile, the fair value in business combination, property, plant and equipment, and intangible assets is also widely used. This report will give two actual examples below. City West Water LTD City West Water is one of the three retail water businesses in Melbourne, it is a State owned company. City West Water according to the Corporations Act 2001 (Cth) and applicable Ministerial Directions prepared its general purpose financial report with Australian Accounting Standards, Interpretations and other authoritative pronouncements of the Australian Accounting Standards Board (AASB).

City West Water’s Department of Treasury and Finance announced that they will adopt fair valuation of qualifying assets for 2009/10 or 2010/11 financial year, depending on direction from DTF. Higher depreciation will appear in their financial report as a result of the adoption of fair value accounting. All their financial assets and financial liabilities are recognized at fair value. According to City West Water Company’s annual report of 2009 Note 2, this report list several aspects using the fair value measurement.

Infrastructure, property, plant and equipmentIn this company, all acquisition of assets is recognized use the cost accounting method. The cost is determined as the fair value of the assets at the date of acquisition plus any other acquisition cost. In the case of gifted assets, which do not have actual cost, the cost is determined on the basis of a schedule of rates determined by the Company based on historical cost information to calculate the fair value of gifted assets. If asset’s carrying amount is greater than its estimated recoverable amount, the carrying amount of the assets will be written down immediately.

The revaluation of land and buildings, infrastructure, property, plant and equipment are all use fair value accounting. Expected land is not depreciated, the depreciation on other assets is calculated using the straight-line method and using their fair value. Receivables and Revenue Recognition In City West Water’s financial report, the receivables are initially recognized at fair value and subsequently measured at fair value less provision for impairment. They will write off the debts which are known to be uncollectible.

The amount of the impairment loss by using the fair value accounting is recognized in the income statement as doubtful debt. Revenue is measured as the fair value of the consideration received or receivable, and recognized when the amount of revenue can be reliably measured. Borrowing and Finance Costs City West Water recorded the interest bearing liabilities at their fair values, in other words, principal amounts. If the interest expense payable in arrears incurred, it should be accrued and charged to the income statement.

This company stated that the fair value of financial assets and financial liabilities must be estimated for recognition and measurement or for disclosure purposes. Due to the short-term nature, the carrying value less impairment of trade receivables and payables with the provisions are assumed to their fair value. “The fair values of financial liabilities for disclosure purposes are estimated by discounting future contractual cash flows at the current market interest rate that is available to the Company for similar financial instruments. JB HI-FI LTD JB is one of the biggest HI-FI products retailers in Melbourne; it offers speakers, televisions, DVD’s, computers, video games and other HI-FI products and continues to stock an exclusive range of specialist HI-FI products.

JB HI-FI according to the Corporations Act 2001 (Cth) prepared its general purpose financial report with Accounting Standards, Interpretations and other requirements of the law. The Accounting Standards hold in the group includes Australian equivalents to International Financial Reporting Standards.Their financial report has been prepared on the basis of historical cost, and use the fair value in the revaluation of certain financial instruments. According to the annual report of 2009 Note 2 of JB HI-FI, this report list several aspects using the fair value measurement: Business combinations According to Notes 2 (c) of JB HI-FI’s financial report, purchases method is being used to account the acquisitions of subsidiaries and businesses.

The Group’s identifiable assets, liabilities and contingent liabilities that meet the conditions for recognized under AASB 3. AASB stated that business combinations are recognized at their fair values at the acquisition date, except for non-current assets. Intangible assets acquired in business combination. The non-current assets are recognized and measured at fair less costs to sell according to AASB 5.

Goodwill arising on the acquisition is recognized as an asset and initially measured at fair value and being the additional cost of the business combination. Derivative financial instruments Their financial report stated that the financial instruments included erivatives financial instruments are initially recognized at fair value on the date a derivative contract is entered into and are subsequently remeasured to their fair value at each reporting date. The Group also designates certain financial instruments as hedges of highly probable forecast transaction (cash flow hedges) or hedges of investments in foreign operations. Finance lease and Borrowings Finance leases and borrowings are initially recognized at their fair value.

Borrowing is subsequently measured at amortized cost. The financial leased assets are amortised on a straight-line basis by using its fair value.Share-based payments According to their financial report, the fair value accounting measures are also used when equity-settled share-based payments with employees and others providing similar services. The fair value determined at the grant date of the equity-settled share-based payments is expensed on a straight-line basis over the vesting period, based on the Group’s estimate of shares that will eventually vest.

Conclusion This report has been prepared to make the readers have a brief understanding of fair value accounting.It is hoped that by careful analysis of the information presented within the report that the reader has a knowledge frame about the advantages and limitations of fair value accounting. The report has hopefully provided on interesting insight into the use of fair value accounting through some real companies applied. The City West Water and JB HI-FI are two different industries as examples of the actual use of fair value accounting.

It is suggested that the reader may be interested in looking at the extensive information referred to in the bibliography to widen their knowledge about fair value accounting.

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