Essay: How Fair is Fair Value?

Accounting across the world has been undergoing massive changes over the past two years with the introduction of International Financial Reporting Standards (IFRS). These standards seek to bring the financial statements of companies all over the world into line so that comparison of performance and financial positions can be compared and contrasted straightforwardly allowing the users of accounts to make greater informed management performance evaluations assess enterprise and make sound investment decisions.

One of the greatest changes being implemented is that of financial reporting measurements. Traditionally historic cost has been the measurement used when valuing assets, however new International Standards are moving companies towards fair value measurement. This has lead to a growing controversy surrounding the question of financial reporting measurement and has caused people to ask the question how fair is fair value? This essay aims to discuss measurements traditionally used (historic cost) and the now primary measurement of fair value and evaluating the impact this will have on financial statements and their users.

This raises the question does the fair value measurement of assets and liabilities follow the general rules accepted for financial statements to be useful?

Perhaps the most important of the four general rules, as stated by the IASB, are understandability, relevance, reliability and comparability. In order to evaluate if fair value is a suitable primary financial reporting measure and a fair one these rules must be examined.

In the case of reliability those that argue against fair value suggest that it is an unreliable measurement due to the fact that the information is not based on an arms length transaction. If the information is unreliable then it must surely be unfair to use this as a measurement in the financial statements. The information can also be seen to be unreliable in the case of hypothetical markets for fair value measurement, where there is room for manipulation of figures by management due to different hypotheses.

Relevance is also impacted upon by these hypothetical calculations of fair value of assets. In basic terms they are estimations, which will have a varying degree of accuracy and may therefore not be relevant. However, the argument here is that, compared to historic cost, fair value does offer more relevance as the accounts will be more up-to-date, consider for instance the extreme rising prices of buildings. There is also a case that as a result of fair value measurement accounts will be more volatile, however this may better reflect the economic reality. This then leads us on to the debate of relevance versus reliability.

Is the fact that fair value measurements are more relevant, more important than the fact that they may be unreliable compared to that of the traditional historic cost accounting? Colleen Cunningham CEO of Financial Executives International may have answered this in "Fair Value Accounting: Fair for Whom?" (Financial Executive, March/April 2004):

"Relevant information that is unreliable is useless to an investor. We must, therefore, be clear about the nature of the claim being made for an accounting number described as reliable."

Although there is an argument against decisions based on reliable but largely irrelevant information provided by historical cost accounting it must be pointed out that investors and other users of accounts have always used this method and for this reason it is understood and comparable. This may not be the case for fair value measurements which are still going through a transition period for this reason the standards are somewhat unclear on certain items and practices are being constantly added to and changed. This has fuelled the argument, as it has led to a poor understanding of financial statements, and with what appears to be estimations in some fair value measurements, a lack of comparability.

So what should standard setters do and is fair value fair? I think the answer here is no, it is not fair. It offers the chance for companies to make speculative gains through working to a mathematical speculative future it is this type of risk that makes fair value unreliable and therefore in my opinion unfair. Although fair value appears to be more relevant in the relevance versus reliability debate it would seem that for users of accounts reliability is more important. Also the fact that fair value does not meet the 'cornerstones' of accounting practice as set out by the IASB would suggest it should not be a primary financial reporting measurement.

New Fair Value Standards Stress How not Just What [journal], William M. Sinnett, Jan/Feb 2007

General

This piece of writing demonstrates the student"s ability to carry out effective research; to be critical; to explain and to produce a reasoned argument. It also shows the student"s ability to conclude, discuss, describe, evaluate, provide evidence and link ideas.

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Quality: Structure

This is a good opening sentence which contextualises the topic of the essay geographically ("across the world") and historically ("over the past two years") and also emphasises its significance ("massive changes").

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An acronym should always be written out in full the first time it appears, followed by the acronym in brackets. After this the acronym can be used on its own.

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This paragraph is helpful to the reader, showing clearly the way in which the essay has been organised. Signposting like this is good practice in any piece of writing, and notice that it doesn"t have to come right at the start, where it would have made rather a boring first sentence.

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This introduces the second rule. A better structure for this sentence might be "The relevance of measurements is also affected by hypothetical calculations of fair value of assets."

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This is a useful way of signposting that the essay is moving on to a separate but related argument.

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The writer suggests that this is the concluding paragraph by using the word "so" to gather up the previous arguments. Returning to the essay title is a good way of stressing that the arguments being summarised are relevant.

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Function: Describe

A very clear statement of the purpose of the changes.

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This sentence concisely expresses what has changed and why this has caused "controversy". Introducing hypothetical people who are asking whether the changes are "fair" makes the controversy seem more human and more immediate to the reader.

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Quality: Voice

It is good practice to use the present tense when a piece of writing refers to itself ("aims" rather than "will aim"). From the reader"s point of view, it has already been written!

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This sentence appropriately uses the passive form "must be examined", rather than the first person pronoun ("I will examine") which is usually to be avoided in academic writing. The term "must" also adds to the persuasive power of this short section.

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Again a rhetorical question proves a highly effective way to introduce the argument that follows. Questions of this kind create tension in the reader, who looks for the answer and has to trust the writer to provide it. This is a powerful way of putting the writer in control.

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Having analysed the case for and against the use of fair value as a valuation method the writer now moves towards a personal opinion with use of the first person singular ("I"). This is acceptable in a professional context such as accounting where individuals are called upon to take personal responsibility for their conclusions. It would be less usual in a scientific or social scientific paper.

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Function: Evaluate

Use of a question to lead the reader on to the next topic makes the essay more interesting, more fluent, and more persuasive. This particular question also shows evidence of evaluation, continuing into the following paragraph. The writer asserts that "fair value measurement" ought to be evaluated against general rules for financial statements

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Function: Analyse

This is a good analysis of fair value measurements in terms of reliability, weighing up the evidence on both sides. A definition of reliability within the context used (reliability i.e. "free from bias" Framework for the Preparation and Presentation of Financial Statements, IASC, 1989, para. 10) would be useful here.

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This section offers further analysis of fair value measurement, this time in terms of relevance. Again, evidence on both sides is carefully weighed.

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This analytical section assesses the historic cost valuation method in terms of the four characteristics of useful information outlined earlier. It is important when presenting an argument to consider the alternative courses of action. In this case historic cost is the main alternative to fair value measurement.

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There is an analysis here of why fair value is not fair (in the writer"s opinion), also providing a summary of the main points raised and forming a conclusion to the essay.

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Quality: Authority

By using a quote greater authority is given to this key point in the argument about whether fair value measurements are fair. Footnotes are an acceptable way of referencing in accounting essays, but this is not always the case in other subject areas. Check with your tutor or course handbook.

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