Fair Value Measurement: Literature Review and Contextual Issues

This article provides a literature review on fair value measurement and discusses the contextual issues of implementing this method. It covers the benefits of fair value measurement, its drawbacks, and the challenges faced in emerging economies. The article also suggests ways to overcome these challenges.

Accounting Theory & Contemporary Issues
1

Task 1: Literature Review
Fair Value Measurement
Livne & Markarian (2018) stated that there has been increase in the use of concept of fair
value measurement for the process of financial reporting during the last decades after its
adoption in the international financial reporting standards by the IASB. There has been the use of
historical cost accounting model from many years for measuring the economic value of the key
financial items. International Accounting Standard Board (IASB) has introduced the model of
fair value measurement in the financial reporting in 1970’s as an alternative method to historical
cost. This was done mainly to improve consistency and comparability in the financial reporting
process and related disclosures. The historical method of cost accounting records the value of a
financial asset on the basis of its original cost at the time of its acquisition by a firm. As such, the
method suffers from the drawback of not taking into account the change in the value of an asset
due to market fluctuations or deprecation if any. Therefore, it can lead to depicting incorrect
value of company’s assets to the end-users (Livne & Markarian, 2018).
As such, according to Alexander (2012) in order to overcome from such drawbacks IASB
has promoted the use of fair value method of accounting for depicting the realistic value of
financial assets. The use of fair value measurement for financial reporting has been stated by the
IFRS 13 standard. The standard has defined fair value as the price that would be realized for
selling an asset or transferring a liability in an orderly transaction on the date of its measurement.
Thus, the use of fair value measurement method helps in overcoming the drawbacks of historical
method as it is market-based measurement approach rather than being specific to an entity. It has
been argued by various experts in the field of accounting that the sue of fair value approach is
more relevant as it reflects the actual price at which an asset can be sell or purchased. Therefore,
it provides a better picture of the financial position of a company to its stakeholders and thus
facilizing them to take right decisions (Alexander, 2012).
Contextual Issues of Implementing Fair Value Measurement method
General Issues
2

In the views of Gulin & Hladika (2016), the use of fair value measurement method
though have contributed to improving the quality of financial reporting process but yet it has
received criticism in the financial industry. It has been argued that fair value accounting has
contributed to the occurrence of financial crisis. This is due to high leverage provided by it in
boom markets and writing-down excessive value of assets during a bust. The inactivity of the
market during the period of the crisis can result in excessive write-down value of assets. The
decline in the market prices during the period of crisis can lead to depleting the bank capital and
thus forcing the banks to sell assets at fire sale prices. It is highly significant during the period of
financial crisis to determine the liquidity in the market as compared to predicting the future
earning potential. The illiquid markets during the period of financial crisis can lead to reporting
the value of assets by the use of fair value method to be incorrect as it does not indicate its future
earning potential (Gulin & Hladika, 2016).
As such, it has been stated by Livne & Markarian (2018) that the use of fair value
accounting has lead to the occurrence of crisis in the financial market. This is mainly because of
the difference caused in the market value of certain securities during the period of crisis and the
value that they reflect by holding them to maturity. The major contextual issue that the method
of fair value measurement has faced is that it is unable to determine the true value of an asset in
the absence of available of information from the active markets. As such, it can result in
reporting increased equity or losses during the period of illiquid markets by reporting increase or
decrease in the fair value of asset. The period of financial crisis has caused the necessity to
introduce reforms in the model of fair value measurement. The standard setters such as IASB and
FASB need to provide flexibility to the management in adoption of accounting rules for avoiding
the potential issues faced during the use of fair vale accounting in certain context. The use of fair
value measurement method does not seem adequate in the context of financial distress, illiquid
markets and when assets are held for longer period to maturity (Livne & Markarian, 2018).
Emerging Economy Issues
Hellman & Patel (2010) stated that the use of fair value measurement method in the
merging economies is also impacted by the contextual issues such as legal systems, taxation
policies, inflation and political system that can cause diversity in the accounting practices.
Emerging economies are regarded to be the countries that have not yet achieved full developed
3

status and is prenatal in the phase of attaining the status of a developed nation. For example,
Germany, China, Malaysia, India and other countries that are progressing by means of rapid
industrialization. There has been emphasis in the past few years regarding the convergence of
accounting standards for developing a universal set of accounting rules and regulations. As such,
the process of adoption of IFRS has been accelerated in the recent years in the merging
economies also. However, there are arguments in relation to the usefulness of IFRS adoption for
the developing economies (Hellman & Patel, 2010).
According to Duhovnik (2007), the major contextual issue that is faced in relation to the
adoption of fair value measurement approach in emerging economies is that there is lack of asset
market valuation in such countries. As such, the adoption of IFRS standards of fair value
measurement becomes quite irrelevant in improving the quality of financial reporting in a
developing economy. The measurement of fair value of assets and liabilities can become quite
difficult in the developing countries in the absence of an active market. There is lack of certified
professionals for managing the valuation methods and applying it in the financial reporting
processes of business organizations within these economies. As such, it can be said that
impossibility in determining the fair value in these markets is largely due to the absence of an
active market. In addition to this, there also exist a possibility of recording the wrong value with
the use of fair value method due to lack of certified accounting professionals. This can lead to
misinterpreting of financial information which can influence the decision-making process of end-
users. The absence of technical skills required for adequate adoption of fair value method of
accounting is the most significant obstacle faced in its adoption in the merging economies
(Duhovnik, 2007).
As per the views of Bendovschi (2016) the development of high quality accounting
system complying with the IFRS standards also requires higher costs for the emerging
economies. The cost has to be incurred in upgrading the accounting systems and also to provide
necessary training to the accounting experts so that they are able to comply with IFRS standards.
In this context, it is recommended to the emerging economies to adopt a proper planning process
before the implementation of IFRS. This would help in identifying the implementation issues in
advance so that they can be resolved before the process of IFRS adoption begins. The planning
process should analyze and identify the difference between the national accounting standards and
4

the IFRS fir addressing the required changes in the financial reporting process. As such, the
necessary training can be provided to the staff in accordance with the changes to be implemented
and thus leading to effective compliance with the IFRS standards. The necessary training and
knowledge provided to the staff at all level in advance will help in ensuring that the use of fair
value method is done in a correct manner and minimizing the chances of error occurrence
(Bendovschi, 2016).
5

References
Alexander, D. 2012. Fair value measurement in financial reporting. Procedia Economics and
Finance 3, pp. 84 – 90.
Bendovschi, O. 2016. IFRS In Emerging Economies: The Global Perspective And The Case Of
Romania. International Journal of Management and Applied Science 2(1), pp. 52-57.
Duhovnik, M. 2007. The Problems Of Fair Value In Small Emerging Market Economies.
Journal of Economics and Business 10(2), pp. 61-81.
Gulin, D. & Hladika, M. 2016. Challenges In Applying The Fair Value Accounting During
Financial Crisis. Retrieved 29 August, 2018, from
http://www.uni-miskolc.hu/~microcad/publikaciok/2016/F_feliratozva/
F_6_Danimir_Gulin.pdf
Hellman, A. & Patel, C. 2010. Contextual issues of the convergence of International Financial
Reporting Standards: The case of Germany. Advances in International Accounting 26, pp.
108–116.
Livne, G. & Markarian, G. 2018. The Routledge Companion to Fair Value in Accounting.
Routledge.
6