fair value accounting chapter one finance major

1. CHAPTER ONE
THE HISTORY AND EVOLUTION
OF FAIR VALUE ACCOUNTING

2. Lecture contents:
1. History of fair value Accounting.
2. Definition of fair value.
3. The difference between Fair value &
historical cost.
4. Advantages and drawbacks of FVA.

3. The history of fair value
Characteristics of accounting are: identification,
measurement, and communication of financial
information about economic entities to
stakeholders. Financial statements are the
principal means for communicating a company's
financial information to outsiders. Financial
statements importance lies in information they
provide to reports' users, who include: investors,
creditors, managers, unions, and government
agencies.

4. Selection of measurement base, used in
financial statements preparation, is one of the
most significant problems in accounting. For
example, investors may wish to know the
amount of income earned over a given period of
time. Various amounts of income would be
determined, depending on the method used to
measure income as several methods are
available. Accordingly, measurement is a key
aspect of financial reporting.

5. Traditional basis of accounting has, for long, been
historical cost, although it has been modified in
various ways. Over the past years, financial
accounting has been moving away from measuring
certain assets and liabilities at historical cost toward
fair value. A mixture of both measurement types as
well as other measurement bases are required (or
allowed) under U.S. GAAP and IFRS. Although
financial reporting is unlikely to entirely get away
from mixed attributes, accounting standard setters
change their emphasis on fair value accounting
because it is more relevant information.

6. Accordingly, accounting standard setters believe
that, in today's rapidly changing business
environment, financial statements should reflect the
companies' underlying economic reality rather than
summary of past transactions. Information supplied
by fair value balance sheets and income statements
has the following features:
• Balance sheet is a complete accounting for value;
therefore valuation objective is satisfied i.
• Income statement reports "economic income"
because it is simply the change in value.

7. • As an evidence of fair value accounting importance,
it is indicated that using this measurement basis
(i.e., FVA) leads to increase future estimates
inclusion in today's financial statements. This
increase is consistent with standard setters' belief
that assets and liabilities measurement that reflect
current economic conditions and future up-to-date
expectations will result in more useful information
for economic decision-making, which is a financial
reporting objective.

8. Fair value accounting is a step in convergence toward
standards developed by IASB. Under the new
standards, assets and liabilities will be valued at fair
value instead of either book value or historical cost.
Consequently, fair value is increasingly being
recommended by financial information regulators and
users as a basis of accounting measurement.
However, one criticism of using fair values is related
to their potential unreliability when there are no
market prices for asset or liability.

9. The trends toward of fair value
Why The Trend Toward Fair Value Accounting?
1. The Changing Economy
2. Globalization
3. Relevance and Transparency

10. 1. The Changing Economy
• The economy around the world has undergone
tremendous changes over the past quarter century
due to a rapid rate of technological innovation.
• One product of technological innovation that
contributed to economic change is the
commercialization of the Internet, which resulted in
what some call the information revolution.

11. • This economic change has led to a growing
recognition that the value driver of many business
entities lies within their intellectual property, not just
in their inventory, plant, and equipment.
• The reason is that existing accounting principles
require internally created intellectual property to be
expensed as research and development.

12. 2. Globalization
• Globalization refers to the increasing integration of
economies around the world, particularly through
the movement of goods, services and capital across
borders”.
• Globalization has accelerated since the 1980s as a
result of technological advances that made
international financial and trading transactions
easier and quicker.

13. • The FASB and the International Accounting Standards
Board (IASB) recognize that users of financial statements
would benefit from having one set of international
accounting standards that could be used for domestic and
international, cross‐border financial reporting.
• As a result, both organizations have been working for
several years to jointly create accounting standards and to
converge U.S. GAAP with international accounting
standards (IAS).
• Historically, IAS have been more principal based, requiring
more fair value measurement than U.S. GAAP, which are
considered more rules based, requiring more cost-based
measurement.

14. 3. Relevance and Transparency
• An important characteristic of efficient capital markets is
that prices are the result of the market’s correct
assessment of all available information.
• The FASB recognizes that better financial reporting leads
to stronger capital markets by helping investors make
informed decisions.
• Transparency in financial reporting is the unbiased, clear,
complete presentation of a company’s financial position.
• When financial reporting is transparent, investors are
better able to make decisions and avoid surprises.

15. • The FASB’s Accounting Standards Codification (ASC) is the
single, authoritative source for U.S. GAAP today. ASC
superseded all previously issued U.S. GAAP accounting
standards and reorganized them by topic. ASC became
effective for the interim and annual period beginning after
September 15, 2009.
• ASC 820, Fair Value Measurement, superseded the original
FASB accounting standard SFAS 157 that was issued in
2006.
Fair value and accounting standards

16. • Fair value accounting is not a new requirement in
financial reporting. Fair value has been a standard of
measurement in financial reporting for decades.
• The concept of value contained in these statements
is from a market perspective.
• Therefore, measuring fair value requires financial
statement preparers to use judgment and to make
assumptions consistent with those made by other
market participants.

17. • In September 2006, the FASB issued SFAS 157
(now ASC 820) to clarify the concepts related to the
measurement of fair value and to provide further
implementation guidance.
• SFAS 157 did not introduce any new accounting
requirements. Instead, it applied to all existing
accounting statements that require assets or
liabilities to be presented or disclosed in financial
statements at fair value.

18. Development Of Fair Value Concepts
• The FASB ultimately decided on a unique definition
for fair value; therefore, the terms fair value and fair
market value are not interchangeable.
• The fair market value definition found in the
International Glossary of Business Valuation Terms is
the same as the tax definition of fair market value in
Revenue Ruling 59-60, which states that :

19. According to FASB
“It is the price, expressed in terms of cash
equivalents, at which property would change hands
between a hypothetical willing and able buyer and a
hypothetical willing and able seller, acting at arm’s
length in an open and unrestricted market, when
neither is under compulsion to buy or sell and when
both have reasonable knowledge of the relevant
facts”.

20. The FASB also has defined fair value as "the price
at which an asset or liability could be exchanged in
a current transaction between knowledgeable,
unrelated willing parties." Besides, it indicated that
the “objective of a fair value measurement is to
estimate an exchange price for the asset or liability
being measured in the absence of an actual
transaction for that asset or liability”.
“willing parties” presumes that there is no
compulsion, and therefore, the appropriate fair
value estimates would exclude prices from any
forced liquidation or distressed sale.

21. Consequently, the Securities and Exchange
Commission, (2001) asserted that “the
judgment exercised in arriving at fair value by
deviating from a market quote may result in
different entities measuring the same financial
instrument at a different fair value amount”.
• “At the measurement date” means that fair
value should reflect the conditions that exist at
the balance sheet date.

22. • An “orderly transaction” is one that is unforced
and unhurried. It means that fair value is the value
that would be received in an orderly transaction
rather than in a forced liquidation in which the
parties were compelled to transact in a market.
• “Market participants” are knowledgeable,
unrelated, informed buyers and sellers in the
relevant market, who are independent of the
reporting entity and are able and willing to transact
for the asset or liability that is subject to fair value
measurement .

23. IAS 39 generally defined fair value of a financial
asset or liability as “the amount for which an asset
could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s length
transaction”.
While this definition is generally similar and
consistent with SFAS No.157, it is not fully
converged in the following respects:
• SFAS No.157 is explicitly an exit price, whereas
the definition in IFRS is neither explicitly an exit
price nor an entry price.
• SFAS No.157 explicitly refers to market
participants, which is defined by the standard,
whereas IFRS simply refers to knowledgeable,
willing parties in an arm’s length transaction.

24. The difference between Fair value &
historical cost.
Accordingly, regarding the fair value accounting
debate, there are many issues of argument
including subjectivity, volatility, comparability,
recognition and measurement, and verification
that will be discussed briefly in the following
paragraphs.

25. Subjectivity:
standard setters, including the FASB, have asked
companies to more accurately reflect changes in the
value of assets and liabilities using comparable
transactions in the marketplace and management’s best
understanding and estimates of the fair values.
Accordingly, all non-market-based fair values are
subjective because they are based on and sensitive to
the estimates, assumptions and measurement methods
management uses to determine fair value. However,
subjectivity should not be an obstacle to using fair value
accounting. Whether it is accepted or not, estimated fair
values are the bases of current economic decisions
based on the changing environment.

26. Volatility:
Many believe that fair value will bring a level of
volatility to financial statements that will make it
more difficult for investors to make sense of them.
However, historical cost is not the solution; it is a
problem because it hides a significant amount of
actual volatility in the marketplace. Therefore,
there is more market volatility today, and fair value
reporting will better reflect this actual volatility.

27. Comparability:
Historical costs are never comparable. As a result,
financial ratios, other investment metrics and
inputs for valuation models are confounded. The
FASB move to fair value will significantly increase
comparability. Inadequate disclosures present
additional problems. Therefore, the best way to
fully explain balance sheet items is to report fair
values accompanied by substantive footnote
disclosures that explain the procedures that
management used to arrive at their best estimates.

28. Relevance, Reliability and Measurement:
Central to the discussion of fair value is the balance
between relevance versus reliability. FASB Concepts
Statement, Qualitative Characteristics of Accounting
Information provides conceptual guidance to make
trade-offs between relevance and reliability.
The qualities that distinguish “better” (more useful)
information from “inferior” (less useful) information
are primarily the qualities of relevance and
reliability…[T]he objective of accounting policy
decisions is to produce accounting information that
is relevant to the purposes to be served and is
reliable.

29. To be relevant, CON 2 states that information must
be timely and have predictive or feedback value. To
be reliable, information must have representational
faithfulness and be verifiable and neutral.
With respect to relevance, some believe that fair
value is relevant when an entity manages its risk
exposure of assets and liabilities on a fair value
basis, while some believe it is the only relevant
measurement for financial instruments. Some others
believe the lower of cost or market approach is the
most appropriate and that fair value may result in
values that may be out of date at a financial
statement issue date. However, the IASB believes
that fair value is a more relevant system in a world
where financial markets are deep, liquid and efficient

30. Verification:
As the variety and complexity of financial instruments
increase, therefore there is a need for independent
verification of fair value estimates. However,
verification of valuations that are not based on
observable market prices is very challenging. Many of
the values will be based on inputs and methods
selected by management. Estimates based on these
judgments will likely be difficult to verify. Both auditors
and users of financial statements, including credit
portfolio managers, will need to place greater
emphasis on understanding how assets and liabilities
are measured and how reliable these valuations are
when making decisions based on them.

31. Advantages of FVA & Corresponding Weaknesses of HCA:
There are several events that have contributed
to the increased importance of fair value
accounting (FVA) for financial reporting of
financial institutions during the past decade, the
following are among these events :
(1) The inability of historical cost accounting to
reflect the financial health and practicability of
financial institutions
(2) The capital inadequacy problems of many
banks during the late 1980s and the early 1990s;
and
(3) The Securities and Exchange Commission
(SEC) support of FVA and the Financial
Accounting Standards Board (FASB)
pronouncements requiring a piecemeal approach
for adopting.

32. Issues of Debate Regarding Historical Cost Accounting
and Fair Value Accounting
Concept/Issue Historical Cost Accounting Fair Value Accounting
Relevance and
Reliability
The reliability of the reported values is
arguably more important than any lack of
relevance of historical cost figures. Historical
costs based on ad hoc allocations may be
irrelevant.
The relevance of fair value estimates
arguably compensates for any lack of
reliability. Fair value estimates based on
inactive markets may prove to be unreliable.
Conservatism Conservatism results in early recognition of
losses and a higher threshold of verification for
reporting gains, potentially leading to credible
earnings numbers.
However, the voluntary nature of asset
impairment write-downs has sometimes
resulted in more aggressive accounting
practices.
Fair value approach is expected to result in
more symmetric recognition of gains and
losses.
Ideally, the symmetric recognition should
maintain (and possibly improve) the
conservatism in loss recognition, but could
lower the verification standards for gain
recognition.

33. Revenue
Recognition
Earnings are measured at discrete points
when the revenue recognition criteria are met,
using the matching principle to measure
expenses.
Earnings could be measured more
continually, based on changes in the
economic values of rights and obligations.
Complex
Business
Transactions
Historical cost system selectively records
certain rights and obligations based on
observable historical costs.
Ideally, a fair value accounting system would
impose discipline on the corporation and its
accountants to identify, measure, and
disclose all the rights and obligations that are
embedded in complex business transactions.
Measurement Historical cost system reports arms' length
historical transaction prices. However,
subsequent measurements may be based on
ad hoc allocations.
Reported values in fair value accounting may
range from market prices in actively traded
markets to values based on valuation
techniques such as discounted cash flow
and option pricing model.
Financial
Reporting
It is sometimes argued that the historical cost
system focuses more on the income
statement with the balance sheet being
relegated as a holding place.
The fair value model being developed is
balance sheet focused, with limited
discussion of income statement reporting.
Earnings
Management
Historical cost accounting creates
opportunities for earnings management.
Academic research on fair values and recent
scandals indicate that fair value accounting
is not resistant to earnings management.