Essay: How Fair is Fair Value?
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