Understanding Fair Value Accounting: Importance and Application in Financial Statements

In this document we will discuss about Understanding Fair Value Accounting and below are the summary points of this document:- Accountants worldwide play a crucial role in accounting measurement and the preparation of financial statements for decision-making purposes. Fair value, defined as the exchange value of an asset among informed parties, is an alternative approach to accounting measurement that captures changes in asset and liability values over time. Fair value accounting improves the presentation of the balance sheet by reflecting the assets and liabilities' true values, especially for quoted investments like bonds and equities. Valuation hierarchies are used to determine fair value measurement.

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Table of Contents
Part A – Essay............................................................................................................................2
Part B – Case study....................................................................................................................6
Introduction............................................................................................................................6
Discussion..............................................................................................................................6
Conclusion..............................................................................................................................9
Reference..................................................................................................................................10

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Part A – Essay
Accountants from all over the globe play crucial role in the process of accounting
measurement while evaluating the liabilities and assets in preparation of the financial
statement. As the financial statement is further used by various users like investors, creditors
and shareholders for decision making purposes, choice of the accounting measurement
approach are clearly reflected in 4 financial statement procedures. These financial statements
include profit and loss statement, balance sheet, cash flow statement and statement for
changes in the equity (Khan 2018).
As per IASB (international accounting standards board) fair value is the value at
which the asset can be exchanged among the willing and well-informed parties under arms
length price transaction. It is considered as an alternative approach for the purpose of
measurement that tries to capture the changes in the liabilities and asset value over the period
of time. As per the fair value approach, the liabilities and asset are re-measured in regular
interval for reflecting the changes in fair value with the resulting changes that have an impact
on net income or the comprehensive income for the concerned period (Barth and Landsman
2017). It leads to better presentation of balance sheet as the assets and liabilities value are
better reflected. The concept of the fair value accounting is considered as perceptive while
applied to the quoted investment like bonds, equities, commodities; those are presented in the
balance sheet of the firm at market value. Form of the fair value accounting is generally
termed as mark-to-market approach of accounting. However, the 1 aspect of the fair value
measurement is used increasingly for describing the measurement through other means (Xie
2016). As per IFRS 13 regarding the fair value measurement, it is applied to different
valuation hierarchies. These hierarchies are – (i) level 1 – fair values are generated from the
quoted prices in the market with regard to identical liabilities or assets from the active market

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for which the organisation has immediate access (ii) level 2 – where market prices of similar
type of assets are available (iii) level 3 – if the values for level 1 or 2 are not obtainable, fair
value is projected through valuation approaches (Magnan, Menini and Parbonetti 2015).
Most frequently the fair value approach is applied to the financial liabilities as well as
assets as the market prices or the reliable estimates for that are expected to exist for such
elements. It is argued that the fair approach for liabilities and assets reflects the current
market scenario in better way and therefore provides the information in timely manner. On
the other hand, it is argued that the fair values are irrelevant and misleads the users for
different reasons. For instance, some argues that the fair value is irrelevant for the items those
are held for the long term period as the investors are least bothered regarding the changes in
the interim value (Lachmann, Stefani and Wöhrmann 2015). On the other hand, others argue
that the fair values can be distorted through the liquidity problems, market inefficiencies or
the investor’s irrationality and the projected value generated from the models may lack the
reliability. Further, the fair value approach is criticised for its contribution towards pro-
cyclicality in financial system through exacerbating arguments that focus on level 1 as well as
level 2 valuations makes it tough to deviate from the market prices irrespective of when the
prices are lower than the fundamentals or they generate the contagion impacts (Goh et al.
2015).
Under both IFRS as well as US GAAP, the fair value accountings are used most
frequently for assets as well as liabilities. However, for the financial liabilities and assets
mixed attributes are there with multiple stipulated rules that some of the items are recorded at
the fair values and other items are recorded at the historical cost. Further, the unrealized
losses and gains from the items those are reported at the fair values may or may not have an
impact on the net income, based on the classification. For instance, as per FAS 115, that is
implemented in the year 1994, needs that available for sale securities as well as the trading

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securities both are reported at fair values in the financial statement. However, under the
income statement the unrealized losses or gains those are the changes in the values are
reported only for the trading securities. On the contrary, financial instrument held for
maturity are recognised at the amortised cost and the fair values can be used for determining
the impairments of the items. Apart from this, fair values are utilized for the purpose of
making disclosures in notes to financial statements (Cpaaustralia.com.au 2019).
Practice of the private as well as public companies regarding closing of its account
books is accomplished through using the accounting periodicity for number of years; Over
the decades the entities use the historical cost approach that is the traditional double entry
approach that records the transactions at original prices. While this method has various
advantages like reliability, ability of providing conclusive evidence and objectivity, it is
criticised on the basis that it does not consider the changes in the price level of the assets of
the entity over the period of time. Owing to that, sometimes the assets are recorded at the
price that is significantly lower than the realizable value that leads to the reduction in
relevance and reliability of the accounting information. It is further observed that this
approach is not good while used in inflationary market. Owing to these drawbacks involved
in historical cost approach the entities shifted to the fair value accounting approach
(Cpaaustralia.com.au 2019).
While discussing the issues with fair value accounting, it is crucial to consider
alternatives to that. To be neutral, relevant alternative is dependent upon the assets in the
question. Few people may argue that the historical cost approach is the alternative for the
liquid asset in trading books of the bank. However for many others, historical cost approach
(HCA) is the alternative for loans, particularly if they are held for maturity (Laux and Leuz
2009). In the same way, if FVA is to be suspended for the liquid assets during times of crisis
non-liquid assets applying alternative for FVA will be problematic. Even if any person is

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sympathetic for the arguments stand against FVA, it will not follow HCA automatically,
though various opponents of FVA explicitly or implicitly may assume so. Sometimes FVA
do not deliver the relevant information, however, in various cases the amortized historical
cost does not deliver the relevant information too (Aaapubs.org 2019).
FVA and the application through business cycle is subjected to significant debate.
Main concern is that FVA is pro-cyclical that is it exacerbates the swing in financial system
and it may cause the downward spiral in the financial market. 1st arguments here is that the
asset write-ups and FVA allows the banks to enhance the leverage during boom period that
may lead the financial statement towards more vulnerability and the financial crisis to more
severity. On the contrary, the HCA prohibits the write-up of assets during the boom period
and generates hidden reserves that can be drawn during the crisis times. However, the
argument does not consider the early warning signal provided for the impending crisis and
therefore may force to take required measures in earlier stages (Barth and Landsman 2018).
Hence, actually the FVA may reduce the crisis severity. The 2nd argument states that FVA
may provoke the contagion in te financial market. Basis idea behind that is the assets may be
sold at the price that is lower than the fundamental value and price generated from these sales
may become irrelevant to the institutions those are required to mark their assets to the market
as per FVA. It requires that some indirect or direct arguments are there those are tied to
accounting system that triggers sales of asset (McInnis, Yu and Yust 2018).

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Part B – Case study
Introduction
The aim of the report is to focus on the corporate value reporting regarding fair value
for 2 ASX listed entities. The report will consider Evolution Mining and BHP Billiton, 2
ASX listed mining company for analysing the requirement. The report will further focus on
the disclosures made by the company regarding fair value and fair value hierarchies, tiers and
the approach used to differ the classes of assets by these entities (Lodh 2018).
Discussion
Three fair value hierarchies of the input data to determine the liabilities or assets fair
value are –
(i) Level 1 - fair values are generated from the quoted prices in the market with
regard to identical liabilities or assets from the active market for which the
organisation has immediate access
(ii) Level 2 – market prices for similar asset where is available
(iii) Level 3 – if the values for level 1 or 2 are not obtainable, fair value is projected
through valuation approaches. However, in this scenario the valuation of market
value becomes significantly subjective (Lodh 2018).
Evolution mining –
The company prepares its financial report based on the historical cost except for
derivative financial instruments and the assets available for sale those are measured at the fair
values. Disclosures made by the company for different assets those are measured at the fair
values are as follows –

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 Revenues – revenues generated from selling of the goods is reported by it while
transfer of rewards and risks to the customers already taken place and further dealing
is not required by the organisation, quantity and quality of the goods are determined
with the reasonable accuracy, price of the goods is determinable or fixed and the
collection for same is probable. Revenue amount is measured at fair value of
consideration receivable or already received. Further, the revenue expected from the
provisionally priced sales is reported on estimated fair value for the total
consideration that is receivable (Evolutionmining.com.au 2019).
 Property, plant and equipment – plant and equipment of the entity is carried out at the
cost reduced by the amount of impairment and depreciation. Cost here is equal to fair
value at the acquisition date and it includes the expenses attributed directly for
acquiring the item (Evolutionmining.com.au 2019).
 Impairment on asset – while assessing the value in use for estimating the future cash
flows, the cash flows are discounted to present value through the post-tax rate of
discount that reflects the assessment for current market. While determining the fair
value reduced by disposal costs, discounted cash flow approach is used on the basis of
consistent methodology applied by the company to determine the value. All these
computations are classified as the level 3 hierarchy on fair value and are compared
with the valuation multiples or with other multiples for valuation or indicators for fair

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value, wherever available, for assuring the reasonableness (Evolutionmining.com.au
2019).
 Derivatives – initially the derivatives are recognised at the fair values on the
derivative contract date and subsequently are re-measured to the fair values at closing
of each reporting period (Evolutionmining.com.au 2019).
BHP Billiton –
The entity prepares its financial statement based on the historical cost approach except
for derivative financial instruments and specific financial assets those are reported at fair
values (BHP 2019). Disclosures made by the company for different assets those are measured
at the fair values are as follows –
 Revenues – revenues are determined at the fair value of the consideration receivable
or received. Further, the revenue expected from the provisionally priced sales is
recognised on estimated fair value for the total consideration that is receivable (BHP
2019).
 Trade receivable – initially the trade receivables are recognised at the fair values and
subsequently it is recorded at the amortised cost through using effective approach of
interest reduced by the amount of impairment allowance, if any (BHP 2019).

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 Property, plant and equipment – PPE are recognised at the cost reduced by the amount
of accumulated depreciation and the charges for impairment. Cost here is fair value of
consideration paid for acquiring asset at time of construction or acquisition (BHP
2019).
Conclusion
It is concluded on the basis of above discussion that both the companies are following
the fair value hierarchies while disclosed different items recognised at fair values in their
respective financial statements. Further, the items those are recognised at fair value are
disclosed through notes to accounts separately.

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Reference
Aaapubs.org., 2019. American Accounting Association - . [online] Available at:
http://aaapubs.org/doi/10.2308/accr.2009.84.2.281 [Accessed 5 Feb. 2019].
Barth, M.E. and Landsman, W.R., 2017. The contribution of bank regulation and fair value
accounting to procyclical leverage.
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Value. Accounting Horizons.
BHP., 2019. BHP | A leading global resources company. [online] Available at:
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%2013%20-Fair%20Value%20Measurement) [Accessed 5 Feb. 2019].
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Sector?. Contemporary Accounting Research, Forthcoming.

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lending?. Journal of Accounting Research, 54(1), pp.235-274.

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