1. 0 Introduction Using fair value accounting in preparing financial reports is often being argued. Starting from past few decades, the creator of accounting rules around the world are starting to abandon the very first model of accounting measurement which is historical cost model and practicing fair value of accounting (Elad 2007). In past 1938, it was necessary to banks and financial institutions to record their mortgages and financial holdings based on market value (Barlev & Haddad 2003).
In these years, recession caused decreasing in market value of these assets, therefore banks and financial institution forced to mark down their asset, report losses and reduce their capital (Barlev & Haddad 2003). Banks needed to maintain their minimum capital adequate ratio, so they had to limit their loans, which then affected business activities and lead to financial crisis (Barlev & Haddad 2003). Traditional measurement of profits did not prove sufficient task of registering and value of the financial instrument because there was zero cost in trading (Pita & GutiErrez 2006).
Consequently, it cant be recorded in historical cost basis because the valuation development of methodologies that were accepted and being used in financial market had undercut the credibility of historical cost based information which given in the financial statements (Pita & GutiErrez 2006). Accounting body agreed that to overcome this problem and to achieve transparency of financial instrument information was by introducing fair value (Pita & GutiErrez 2006).
However, until now there were still many arguments regarding how appropriate this valuation method was, considering it has high degree of subjectivity and will lead to unreliable financial statement (Pita & GutiErrez 2006). This report serves purpose to verify how far fair value accounting can influence user’s decision-making and analyze some limitations of fair value accounting as a measurement tool. In order to make clear comparison on the coverage of fair value application, annual report from two companies in ifferent industries will be provided. 2. 0 Discussion 2. 1 Definition of fair value accounting According to FASB 13 (FASB, 1976) definition of fair value accounting is an amount for which a property can be sold between the irrelevant parties within arm’s length transaction (Barlev & Haddad 2003). Fair value of accounting is being used to determine how much assets or liabilities can be liquidated in a transaction based on current market condition (Pita & GutiErrez 2006).
Some who support the practice of fair value of accounting argued that by using this measurement, user of financial statement could achieve a true and fair view of a company’s financial performance because it revealed the overcome of economic condition as well as any changes in them (Pita & GutiErrez 2006). Further, fair value of accounting caused increased in consistency and comparability valuation of framework because the institution valued at the same principle at the same time (Pita & GutiErrez 2006).
However, the most important was the impact caused by fair value of accounting for decision makers (Pita & GutiErrez 2006). Relevance can be obtained when the financial information was able to confirm expectation of decision makers and reduced any uncertainty associated with any decisions (Pita & GutiErrez 2006). 2. 2 How fair value accounting can help user to achieve useful information for economic decision-making? Fair value of accounting played important roles for financial statement’s user in making economic decision.
In financial instrument, credit portfolio held until maturity in balance sheet and which generated yields over the time, consequently, the difference between costs of financing and amount paid by customer occurred (Pita & GutiErrez 2006). However, in this case, return can be determined by considering whether the payments has been made and whether the historical cost that generate payment information as agreed or not (Pita & GutiErrez 2006). In the other hand, fair value of accounting method offered the result that relevance to opportunity cost compared to the essence of banking service (Pita & GutiErrez 2006).
In the end of the day, asset fair value kept changing over their life span (Pita & GutiErrez 2006). Nevertheless, if the asset was not being sold or redeemed within a time, these variations of figure in profit and loss account misrepresented the figure of profits and provided fictitious instability (Pita & GutiErrez 2006). As the result, user got confused in interpreting the financial statement and took the wrong economic decision. Nowadays, economic condition in real world expected to fulfilled the separation criteria in principle, which can’t be enclosed thru capital market transactions (Hitz 2007).
But, value in use still was representing the standard attribute of measurement from measurement perspective (Hitz 2007). However, fair value in the specific market was not always equal with value in use (Hitz 2007). In addition, there was no functioning markets exist for intangible assets forming competitive advantages (Hitz 2007). Where firm sum up all the value in use of all particular assets and liabilities, it provided an unrealistic condition, which underestimates firm value (Hitz 2007).
From measurement perspective, the theoretical case for fair value measurement was merely applicable for certain complete scenario and perfect markets that not demanding financial reporting (Hitz 2007). In well-developed market, fair value measurement caused undervaluation of firm (Hitz 2007). This was because the market value did not integrate with competitive advantages that result from particular intangible assets (Hitz 2007). However, usefulness decision-making in applying fair value measurement was poor at this point of view (Hitz 2007).
Assuming that fair value of accounting was adopting less restriction of decision model approach, there was an argument on whether it can improve the individual valuation on the distribution of future cash flows and feeds into the valuation model thru the provision of information (Hitz 2007). Potential usefulness of decision making of fair value measurement may establish for any activities that unrelated with lease and any other firm’s activities, therefore the valuation purpose can be separated (Hitz 2007).
By not taking cost into account, the separation model demonstrates on how fair value of accounting can improve decision-making and by allowing more accurate valuation, it provided more useful information (Hitz 2007). Based on information perspective, the contribution of fair value accounting evaluated judge from the ability to modify expectations and decisions or to comprehensive value-relevant information (Hitz 2007). The usefulness of fair value accounting most often argued from the value relevant point of view (Hitz 2007).
Based on the theoretical question, value relevant evaluated on whether the particular information was able to modify investor’s principle and actions on publication by assuming there was no any publicly available yet (Hitz 2007). Some researchers believe that fair value of accounting generated benefit for investors (Ryan 2008). Fair value of accountings has higher degree of accuracy, timely and comparably compares to other measurement attributes (Ryan 2008). Moreover, it also one of the measurement attribute that revealed the best information of future cash flow and current risk-adjusted discount rate (Ryan 2008).
Accounting researcher believed that measurement of fair value was the greatest policy of disclosure and for investor to be aware of particular management before making economic decision (Ryan 2008). It stated that in fair value accounting, investor may request for explanation of what went wrong or right from the management during the period (Ryan 2008). Furthermore, if the particular management was unable to provide sufficient reasons, the investor able to create the certain level of awareness and can decide on what actions to take in the future (Ryan 2008). . 3 Limitation of fair value accounting Besides to help user of financial statement to make economic decision, fair value of accounting also has some limitations as a measurement attributes. The changes from historical cost to fair value caused significant increment on accounting measurement evaluated from economic-based approach, where economic values reported in balance sheet (Hitz 2007). In theory of accounting, the asset and liability method highlighted vis-a`-vis the revenue and expenses method (Hitz 2007).
Judges from information perspective, it prohibited the evaluation of many different reporting formats, as the result the high level of aggregation related with reporting format of balance sheet reduced the assumption of present value essential agreement (Hitz 2007). However, the high level of aggregation mentioned above which also part of balance sheet attribute measurement will lead to an unconstructive measurement of potential useful decision (Hitz 2007). The previous outcomes of the evaluation in measurement perspective were not dependent on aggregation (Hitz 2007).
However, they can be applied to measurement of balance sheet (Hitz 2007). Contrasting with historical cost accounting, measurement of fair value removed the unknown reserves of asset and narrowed book value accounting and enterprise value’s gap (Hitz 2007). Due to theoretical reasons, this gap contributed could not be eliminated (Hitz 2007). Apparently, the fair value measurement was not providing direct picture and not able to measure the value of the firm directly (Hitz 2007). Concept of accounting income resulted in accumulated earnings that equal with the cash flow surplus (Hitz 2007).
However, the fair value income generated an equivalent amount between historical cost income and economic income (Hitz 2007). The main differences were the different scale of delayed and unfair recognition of accounting income (Hitz 2007). Recognition in fair value accounting was less delayed; therefore the establishment and recognition of accounting gap was smaller compared to historical cost of accounting (Hitz 2007). The recognition of income presented the market valuation and consequently, it linked to economic events directly (Hitz 2007).
Nevertheless, based on fair value accounting, any differences in value related to unrecognized intangible asset can’t be recognized until they transferred into cash (Hitz 2007). As one of the income measurement, fair value accounting differed scientifically with the concept of income (Hitz 2007). Even though fair value earning was the theoretically similar to economic income compared to historical cost earnings, the methodical difference disallowed any support of measurement perspective (Hitz 2007). Supporter of fair value income insisted that fair value had potential qualifications to illustrate economic reality by unconditionally take on conomic perspective on the income measurement (Hitz 2007). Yet, the methodical differences stated that this disagreement was unjustified because of the unrecognized asset (goodwill) impaired fair value income’s capability to accuracy, and reflect the economic reality (Hitz 2007). There were important arguments on why fair value accounting was the factors of procyclicality (Laux & Leus 2009). First of all, fair value accounting required writing up their asset that allowed banks to raise their control in booms that resulted in more vulnerable financial system and persistent financial crises (Laux & Leus 2009).
The next argument was fair value accounting caused corruption in financial market was due to banks forced to sell their assets below essential value (Laux & Leus 2009). As the result, price of this sale grew to be significant to other associations because the fair value accounting required them to remark their assets to market value (Laux & Leus 2009). The latest conflicts concerning fair value repeated many arguments exist in 1990 (Shuffer 2010). The critics argued that measurement of financial instruments using fair value will strengthen economic shock (Shuffer 2010).
Further, they also argued that fair value enhanced income volatility, damage confident of public and influence economic stability (Shuffer 2010). As happens to the recent crisis, more people judged the crisis was caused by fair value and the fair value itself was an error (Shuffer 2010). Studies conducted in determine the relationship between fair value accounting and financial crisis, which was focusing on large banking institution because they were operating fair value greater compared to smaller institution (Shuffer 2010).
However, the conclusion from this study was most banks have only small percentage of regulatory capital of fair value adjustments (Shuffer 2010). The investigation was unable to find any evidence in reporting financial data that indicated the suffering of activity during the period of crisis (Shuffer 2010). 2. 4 Fair value comparison in two Australia companies in different industry 2. 4. 1 Company Background Background of two Australian companies in different industry will be discussed in the next paragraph. Two annual reports (2009) of Harvey Norman Holding Limited and Qantas Airway Australia are being used as comparison.
Harvey Norman is an Australia limited company, which conduct business primarily in incorporate franchising, retails and property entity. The corporation first establish in Auburn, Sydney on October 1982. The owners are Gerry Harvey and Ian Norman. Currently, the corporation operates under franchise system of three leading brand name, which are Harvey Norman, Domayne and Joyce Mayne. It recorded that there are 613 Harvey Norman, Domayne and Joyce Mayne franchisees in Australia. Queensland and Northern Territory Aerial Service Limited or Qantas was first set up in 1920, Queensland.
The business has excellence reputation for security, reliable operational system, manufacturing and preservation as well as excellent customer service. In modern world, Qantas becomes one of the world’s first long distance airlines and one of the strongest brands in Australia. Apart from transportation, Qantas also operate in other subsidiary business such as business in specialist market (Qantas Holidays and Q Catering). 2. 4. 2 Measurement after Recognition The comparison between two above companies financial report are covering some areas of concern (AASB 2009).
Two types of measurement after recognition are cost model and revaluation model (AASB 2009). Qantas Airway Australia is adopting cost model in reporting their property, plant and equipment in balance sheet (Qantas 2009). In cost model, non current assets calculates at its cost (include purchase price of the asset, all taxes and any cost contribute to asset in order for it to operate) (AASB 2009). Further, AASB 116 requires property, plants and equipment to be depreciating separately. The depreciation method chosen must reflect the future economic benefit of an asset and must be reviewed once in a year (AASB 2009).
However, Harvey Norman Holding Limited is adopting revaluation model of fair value accounting in their annual report (Harvey Norman Holding Limited 2009). Revaluation model must able to be measured reliably and must be carry to revalued amount (AASB 2009). This model is being reviewed depending on asset value volatility which is means can be revaluing in a year or even three until five years (AASB 2009). In revaluation model, if carrying value of an asset is increasing, the increase amount will be noted as an element a part from comprehensive income and will be carried into equity account (AASB 2009).
If carrying amount of an asset is decreasing, the decrease amount will be recognized in profit and loss (AASB 2009). By comparing two different measurements of property, plant and equipment above, several analyses can be concluding. Measure property, plant and equipment by using fair value accounting (Harvey Norman Limited) will enable investor to predict acquisition price and liquidating assets in the firm compare to historical cost (Qantas Airway) (Herrmann, Saudagaran & Thomas 2006).
Further, fair value may change over time; therefore it may provide useful feedback to the users if the changes of these assets recorded in financial report (Herrmann, Saudagaran & Thomas 2006). In contrast, book value in historical cost provides limited feedback to the user in terms of acquisition because it is remain constant over time (Herrmann, Saudagaran & Thomas 2006). Changes of reporting in fair value have a prospective of providing timely information for the financial information’s user (Herrmann, Saudagaran & Thomas 2006).
Users decisions may also being influenced by historical cost as long as the asset’s book value estimate the fair value reasonably (Herrmann, Saudagaran & Thomas 2006). If the book value of historical cost has a huge differ from fair value, the ability to influence user decisions will also declining (Herrmann, Saudagaran & Thomas 2006). 2. 4. 3 Employee Benefit Qantas provides liabilities of employee benefit in term of wages, salaries, annual leave and sick leave. Those benefits must be to be settled within 12 months (Qantas 2009). Moreover, the liability will be calculating based on remuneration of wages and salaries rate (Qantas 2009).
The rate will cover on-costs such as reimbursement insurance for worker, superannuation and payroll tax (Qantas 2009). The provision of long leave represent current rate of predicted future cash flow and resulting from employee’s service provided to balance date (Qantas 2009). In the other hand, Harvey Norman provides provision of employee benefit in terms of wages, salaries, annual leave and long service leave, which must be able to, measured reliably (Harley Norman Holding Limited 2009). There are two ways to calculate employee benefit provided by Harvey Norman (Harley Norman Holding Limited 2009).
Firstly, provision that completed in behalf of employee benefit must be settled within 12 months and must able to be measure at nominal value of remuneration rate, which applies at the time of settlement (Harley Norman Holding Limited 2009). However, provision completed that not to be settled within 12 months will be measured within current value of estimate future cash outflow and resulting from employee’s service up to reporting date (Harley Norman Holding Limited 2009). 2. 4. 4 Financial Instrument – Recognition and Measurement
AASB 7 and AASB 139 required all financial assets and financial liability under fair value of accounting through profit and loss to be disclosed together with how it satisfy the conditions (AASB 2009). However, for those investments that cannot be measured reliably and no estimate market price in active market should not be assigned through profit and loss as at fair value (AASB 2009). There are four classification of financial asset in Harvey Norman Holding, which are financial asset at fair value through profit and loss, loans and receivables, held to maturity investment and available for sale financial asset (Harvey Norman Holding 2009).
By using fair value though profit and loss to disclose financial asset, it will help company to eliminate the measurement inconsistency that may arise from measuring asset, liability, gain and losses on different bases (AASB 2009). Additionally, it also may help company to provide on the basis to the entity’s key management personnel (AASB 2009). 3. 0 Conclusion Based from the analysis above, several conclusions can be made. Fair value accounting has some advantages and limitation as a measurement tool. As ften argued, using fair value as measurement tool is contributing to financial crisis in 2008 (Laux & Leuz 2009). A study has proven that there are only little reasons to consider whether fair value accounting participated to major problem in US banks and financial crisis (Laux & Leuz 2009). Fair value accounting did not play an important role for income statements and regulatory capital ratio in banks, unless for banks with large trading positions (Laux & Leuz 2009). In overall, study that claiming fair value accounting as a caused of financial crisis is not proven (Laux & Leuz 2009). Word Count: 3,329 words