Pros and Cons of Fair Value Accounting: A Critical Analysis

This paper critically analyses the pros and cons of fair value accounting method. It discusses the three-tier process and qualitative characteristics of financial information. It also evaluates the advantages and disadvantages of fair value accounting method.

Running head: FINANCIAL ACCOUNTING THEORY AND PRACTICE
Financial Accounting Theory and Practice
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1FINANCIAL ACCOUNTING THEORY AND PRACTICE
Table of Contents
Introduction:....................................................................................................................................2
1. Pros and cons of fair value accounting (FVA):...........................................................................2
2. The three-tier process:.................................................................................................................4
3. Qualitative characteristics of financial information:...................................................................6
Conclusion:......................................................................................................................................7
References:......................................................................................................................................8

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Introduction:
For above the last two decades, the fair value accounting concept is followed. The idea
behind it is measuring assets and liabilities at their existing values. This has been a significant
deviation from the fact that the books of accounts need to be valued at historical cost and not at
their existing values. However, this concept leads to a debate, as certain factors need to be taken
into consideration for undertaking investment choices and management decisions. This paper
would aim to explore the various aspects related to fair value accounting by critically analysing
the provided academic article.
1. Pros and cons of fair value accounting (FVA):
As commented by Chircop and Novotny-Farkas (2016), FVA is a kind of accounting
where the organisations gauge and report their assets and liabilities at prices identical to their fair
values. There are certain advantages of this method, which are enumerated as follows:
Minimised net profit:
At the time of using FVA, when asset values fall, the net profit of the organisation
declines. Even with the increase in liability values, the calculated net profit of the organisation
falls as well. Net profit signifies the amount on which the company incurs tax. This is deemed to
be an advantage for the business, as minimised net profit leads to lower tax payments. Similarly,
increase in assets and liabilities results in fall in business equity. When there is lower equity, an
organisation has lower amount of money to decide for its business operations. As a result,
employee bonuses are reduced leaving more money in the pocket of the organisation (Demerjian,
Donovan & Larson, 2016).

3FINANCIAL ACCOUNTING THEORY AND PRACTICE
Realistic financial statements:
The companies using FVA have more accurate financial statements compared to those
not using the method. At the time assets and liabilities are reported for actual values, it leads to
realistic financial statements. The organisations using this method need to reveal information
about changes in the financial statements through financial notes. They have the chance to
investigate their financial statements with the real fair values, which enable them to undertake
wise choices about future business operations.
Investor benefit:
As FVA lists liabilities and assets for their real values, the financial statements represent
a better overview of the financial health of the organisation. This enables the investors in
undertaking sound decisions about their investment alternatives with the organisation (Dong,
Ryan & Zhang, 2014). The needed footnote disclosures assist the investors in investigating the
impact of variations in statements because of fair values of assets and liabilities.
However, FVA suffers from certain drawbacks and they are described briefly as follows:
Frequent changes:
The value of an item could change frequently in volatile markets. This results in
significant variations in the value and earnings of the organisation. The accountants’ write-off
item losses compared to the earnings of an organisation. The public listed organisations find it
complex, as the investors might face difficulties in valuing the organisations with such variations
in place. Moreover, the potential for wrong valuations could result in audit issues.
Lower reliability:

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The accountants view the market at the time of finding new value for investments or
assets. When the value of an item differs from region to region, the accountants need to make
judgement call on valuing book items. If an organisation with identical investments or assets
values items differently compared to another, the issues might arise due to the valuation method
of the accountant.
Minimised book value:
From the historical perspective, there would be change in the book value of an
organisation at the time it purchases new assets or sells old assets (Durocher & Gendron, 2014).
On the other hand, FVA changes the book value of an organisation for arbitrary issues. For
instance, if an investment encounters a major fall in value for short-term, it is necessary for the
organisation to undertake accounting modifications. When the value increases, the modifications
did not conduct anything; instead, the book value of the organisation falls for a shorter
timeframe.
2. The three-tier process:
According to the provided article of Marra (2016), fair value estimation follows a three-
tier process having a stringent preference for market-based measures. The hierarchy is described
briefly as follows:
Level 1 Input:
These inputs are unadjusted cited prices in the active markets in relation to items similar
to the asset or liability gauged. If the price is quoted in an active market, the price is used by the
organisation without adjustment at the time of gauging fair value (Georgiou, 2018). Thus, it

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becomes necessary for the organisation to access the market at the date of measurement. The
active markets are those, in which transactions occur with adequate volume and frequency for
providing pricing information. If necessary, an alternative technique could be used and the
standard establishes criteria, in which it might be applicable. For instance, there might be a
situation, in which the price quoted in an active market does not depict fair value at the date of
measurement. This situation might happen when an important event like business combination or
reorganisation occurs after the market closure (Goh et al., 2015).
Level 2 Input:
These are the inputs except the quoted prices in level 1, which could be observed for that
asset or liability. They are described as quoted liabilities or assets for identical items in active
markets or supported with the help of market data like credit spreads, rates of interest and yield
curves. Adjustments might be required to these inputs and if they are important. it is necessary to
categorise the fair value in the form of level 3.
Level 3 Input:
These inputs could not be observed and they need to be used as a minimum. Under
situations where it is not possible to observe the relevant inputs, they are needed to be developed
for reflecting the assumptions that the market participants would utilise at the time of
ascertaining an effective price for asset or liability (Lachmann, Stefani & Wöhrmann, 2015). The
organisation is required to increase its utilisation of pertinent observable inputs along with
reducing the utilisation of unobservable inputs. For instance, cash flow estimations might be
used for valuing an unlisted organisation. All the measurements of fair value are categorised
based on the lowest level input, which carries greater significance.

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3. Qualitative characteristics of financial information:
All business organisations require considering certain qualitative characteristics of
financial information when fair value accounting is used. The initial characteristic is relevance,
which needs financial information to be pertinent so that the users of the financial statements
could undertake appropriate decisions (Livne & Markarian, 2018). The second characteristic is
identified as materiality, which needs the accountants and auditors to concentrate on financial
information expected to influence the decision-making process of the users. The third
characteristic is faithful representation that ensures true and fair depiction of the financial
information, especially; it should be free from misstatements. The fourth characteristic is
comparability that needs the financial information to be distinguished across organisations and
periods (Magnan, Menini & Parbonetti, 2015). The fifth characteristic is verifiability, which
includes communicating the underlying economic information of the business operations of an
organisation. The sixth characteristic is timeliness, which requires disclosure of financial
information within stipulated time by avoiding any delay. The final characteristic is
understandability, which needs to ensure that the users understand financial information
effectively having sound knowledge of economic and business activities.
All these characteristics deem to possess relationships with the fair value accounting
method. In this method, the prices of all items need to be relevant and fair for representing their
fair values. Moreover, it is necessary to provide such disclosures in a timely manner to the
various users of the financial statements (Palea, 2014). Moreover, in fair value accounting, it is
necessary that the financial statements do not contain materiality issues so that right information
could be delivered to the users of the financial statements. Along with this, it is noteworthy to
mention that the application of fair value accounting is made especially for assets and liabilities,

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as these items possess particular characteristics. As per the assumption of fair value accounting
method, the market participants follow a particular order in relation to transactions of assets and
liabilities with the intention of transferring or selling the assets (Xie, 2016). Moreover, the fair
values of assets and liabilities could be transferred to the upcoming years.
Conclusion:
It is apparent from the above discussion that fair value accounting method has certain
benefits like investor benefit, realistic assumptions and minimised net income. However, it
suffers from certain drawbacks like frequent modifications, lower reliability and minimised book
values of assets and liabilities. Moreover, it has been evaluated that the method follows a three-
tier process in order to have strict preference for market-based measures. Thus, three levels of
inputs are discussed in this paper, which include both observable and unobservable inputs.
Finally, it has been analysed that the fair value accounting method follows all the essential
qualitative characteristics of financial information so that accurate and timely information could
be provided to the various users of the financial statements of the business organisations.

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References:
Chircop, J., & Novotny-Farkas, Z. (2016). The economic consequences of extending the use of
fair value accounting in regulatory capital calculations. Journal of Accounting and
Economics, 62(2-3), 183-203.
Demerjian, P. R., Donovan, J., & Larson, C. R. (2016). Fair value accounting and debt
contracting: Evidence from adoption of SFAS 159. Journal of Accounting
Research, 54(4), 1041-1076.
Dong, M., Ryan, S., & Zhang, X. J. (2014). Preserving amortized costs within a fair-value-
accounting framework: Reclassification of gains and losses on available-for-sale
securities upon realization. Review of Accounting Studies, 19(1), 242-280.
Durocher, S., & Gendron, Y. (2014). Epistemic commitment and cognitive disunity toward fair-
value accounting. Accounting and Business Research, 44(6), 630-655.
Georgiou, O. (2018). The worth of fair value accounting: dissonance between users and standard
setters. Contemporary Accounting Research, 35(3), 1297-1331.
Goh, B. W., Li, D., Ng, J., & Yong, K. O. (2015). Market pricing of banks’ fair value assets
reported under SFAS 157 since the 2008 financial crisis. Journal of Accounting and
Public Policy, 34(2), 129-145.
Lachmann, M., Stefani, U., & Wöhrmann, A. (2015). Fair value accounting for liabilities:
Presentation format of credit risk changes and individual information
processing. Accounting, Organizations and Society, 41, 21-38.

9FINANCIAL ACCOUNTING THEORY AND PRACTICE
Livne, G., & Markarian, G. (Eds.). (2018). The Routledge Companion to Fair Value in
Accounting. Routledge.
Magnan, M., Menini, A., & Parbonetti, A. (2015). Fair value accounting: information or
confusion for financial markets?. Review of Accounting Studies, 20(1), 559-591.
Marra, A. (2016). The Pros and Cons of Fair Value Accounting in a Globalized Economy: A
Never Ending Debate. Journal of Accounting, Auditing & Finance, 31(4), 582-591.
Palea, V. (2014). Fair value accounting and its usefulness to financial statement users. Journal of
Financial Reporting and Accounting, 12(2), 102-116.
Xie, B. (2016). Does fair value accounting exacerbate the procyclicality of bank
lending?. Journal of Accounting Research, 54(1), 235-274.