ACCT6007 Financial Accounting: Fair Value Accounting Report

This report provides a critical analysis of fair value accounting, examining its implications within a business environment. It begins with an introduction to fair value accounting, highlighting its core concept of measuring assets and liabilities at current values, contrasting it with the historical cost method. The report then delves into the pros and cons of fair value accounting, detailing how it can minimize net profits, provide realistic financial statements, and benefit investors. Conversely, it addresses the limitations, such as frequent changes in value, lower reliability, and the potential for minimized book value. The analysis extends to the three-tier process of fair value accounting, explaining the hierarchy of inputs from Level 1 (active market prices) to Level 3 (unobservable inputs). The report also explores the qualitative characteristics of financial information under fair value accounting, including relevance, materiality, faithful representation, comparability, verifiability, timeliness, and understandability. The conclusion summarizes the benefits and limitations, emphasizing the importance of considering both observable and unobservable inputs, and the impact of fair value accounting on financial reporting. The report is based on the provided academic article and aims to provide a comprehensive understanding of fair value accounting.

Running head: ACCOUNTING
Accounting
Name of the Student:
Name of the University:
Author’s Note:

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Table of Contents
Introduction......................................................................................................................................2
Pros and Cons of Fair Value Accounting........................................................................................2
The Three-tier process.....................................................................................................................4
Qualitative characteristics of financial information........................................................................6
Conclusion.......................................................................................................................................7
Reference.........................................................................................................................................8

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Introduction
The fair value accounting concept has been followed businesses for a long period of time
and the main idea behind the concept is that the assets and liabilities of the business are
measured at existing values. However, it is a requirement that the books of accounts which is
prepared by the management of a company needs to be presented following historical cost
method and not existing value method (Magnan, Menini & Parbonetti, 2015). This leads to
inconsistency in accounting practice which needs to be rectified. The main purpose of the
assessment is to analyze the article which is provided in the question and also analyses the
implications of fair value accounting system in a business environment.
Pros and Cons of Fair Value Accounting
As per the opinion of Chircop and Novotny-Farkas (2016), Fair Value Accounting is
accounting practice which is followed by businesses which allows the businesses to report their
assets and liabilities at prices which are identical to their fair value. The advantages which can be
identified for using this method are listed below:
Minimized Net Profits
In a business which follows FVA, there is a decline in the net profit of the organization
when the value of the asset for the business falls. Similarly, even if the liabilities of the business
rise slightly, the net profit of the falls. This fall in net profits helps the management of the
company to minimize the tax which is paid to the government. This can be considered to be an
advantage to the business (Bowen & Khan, 2014). As the assets and liabilities of the business
increases, the business equity falls. This also signifies that the management has lower amount of
cash in their hands which means that there is more cash in the hands of the management. To

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further enhance the savings which is at the hand of the management, employee bonusses can be
cut off. These decisions rely on the management of the company.
Realistic financial statements
The companies which follow FVA are able to formulate a more accurate financial
statement which is not the case for businesses. The assets and liabilities of the business are
recorded at their existing values which makes their presentation accurate. The businesses which
follow such a system effectively prepares financial notes for better understanding of the
disclosures by the users of the financial statements. It is to be noted that important decisions
regarding the business can only be taken by the management of the company if accurate financial
reports are available to the management.
Investor Benefit
The financial health of the business are better presented before the investors and they can
take sound decisions so that the position of the investor can be improved in the market (Palea
2014). However, FVA adaptation needs to have proper footnotes and disclosure so that the users
if the financial statements are able to understand different elements which are shown in the
annual report.
There are also some limitations of FVA and the are discussed below in details:
Frequent Changes
The value of any item can change frequently in case the market is volatile. This affects
the earning capacity and profits which are generated by the business and causes variances in the

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same. The investors of a public listed company face difficulties in valuing the organization with
some variance. It is also possible that the valuation might also get wrong.
Lower reliability
The accountants value the market at the time of finding new value for investment or
assets. In different region the valuation of an item differs and in such cases the accountant need
to make judgement calls on valuing the items. The overall reliability of the valuation method is
low as value of the items are different for different regions.
Minimised book value
The book value of an organization changes at the time of its purchase of new asset or sell
of assets. It is to be noted the FVA causes deviations the asset’s book value for no particular
reason. An example of the situation can be provided for an investment product which faces a fall
in the short-term value then it is necessary that modification must be made in accounting records.
In case there is an increase in the value, the changes did not conduct anything; instead the book
value falls in the short period.
The Three-tier process
As per the article which is considered of Marra (2016), the process of FVA follows a
three-tier test which has a clear preference for market-based measures. The hierarchy of the
three-tier system is briefly explained below:
Level 1 Input
These inputs are cited at unadjusted prices in the active market in relation to the assets
and liabilities judged. If the price is quoted in active market, then the price which would be

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considered by the business would be without adjustments at the time of evaluating fair value.
Therefore, it is necessary for the business to access the market at the date of measurement.
Active markets can be recognised as markets where appropriate volume and frequency of
transactions takes place for providing information regarding pricing. An alternative technique
which could be applied as per the criteria which is established by the standard. An instance can
be provided that the price which is quoted in the active market does not fairly represent the fair
value which is considered. This situation takes place when significant events takes place such as
business combination or reorganisation takes place in a business after market closure.
Level 2 Input
These are inputs which are different from quoted prices in level 1, which can be
evaluated from the assets and liabilities of the business. These are described as quoted liabilities
or assets which for similar items or the same is supported with different analysis tools available
to the management of the company. Alterations needs to be done on such inputs and if the same
are important it is necessary to categories the same on fair value in level 3 form.
Level 3 Input
These inputs are difficult to observe and the same used to a minimum extent. In certain
situations, where it is impossible to analyze the inputs which have relevance, there is a need to
develop the inputs for reflecting the assumptions that would be utilized by the user at the time of
ascertaining the price in the market for assets and liabilities (Lin et al., 2017). The business needs
to require to increase its observation inputs along with reducing the utilization of unobservable
inputs. For instances, in order to value unlisted organizations cash flow valuation might be

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applied by the business. All the measurements related to fair value are categorised based on the
lowest level input, which carries greater significance.
Qualitative characteristics of financial information
The financial information which is depicted in the annual reports of the business needs to
have certain qualitative characteristics when fair value accounting is used by the business. These
characteristics are segregated as fundamental and enhancing characteristics of the financial
information. The firs characteristic is relevance which states the information should be relevant
to the nature of the business on the basis of which users can take appropriate decisions. The
second is materiality which requires financial information to be significant enough that they
influence the decision-making capacity of the users (Jiang, Wang & Xie, 2015). The three
characteristics is faithful representation which requires the business to appropriate show the
financial information and the same should be free from any material misstatement. The fourth
characteristic is comparability which requires the information to be comparable with across
organizations and also with previous year’s performance of the business. The fifth characteristic
is verifiability which states that accounting information should be verifiable as important
decisions are to be taken on the basis of such information (Okamoto, 2014). The sixth
characteristic requires timely disclosures of information to the users so that the same can be used
in decision making process of the business. The last characteristic is understandability which
states that the financial information should ve depicted in such a way that it is easily understood
by the users of the financial statement.
The characteristic which are required to be present in financial information are posseses
by fair value accounting method. The prices under this method need to be relevant and fair in
order to effectively present the same in financial statements. In addition to this appropriate and

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timely disclosures are also required in the fair value accounting system. There is also an
requirement that materiality of the information should be there which is being represented. The
assumption which is made while following fair value accounting method, is that the market
participation follows a particular order while including transactions of assets and liabilities.
Conclusion
The above discussion shows that fair value method has certain benefits such as investor
benefit and lower net incomes which makes the method a useful technique. However, there are
limitations as well which should be considered by a business such as frequent modifications,
lower reliability and minimised book values of assets and liabilities. The method is also
evaluated on the basis of three-tier test which includes observable and unobservable inputs. The
discussion above also shows qualitative characteristics which is associated with the financial
information which is presented in the annual report of the business.

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Reference
Bowen, R. M., & Khan, U. (2014). Market reactions to policy deliberations on fair value
accounting and impairment rules during the financial crisis of 2008–2009. Journal of
Accounting and Public Policy, 33(3), 233-259.
Jiang, J., Wang, I. Y., & Xie, Y. (2015). Does it matter who serves on the Financial Accounting
Standards Board? Bob Herz’s resignation and fair value accounting for loans. Review of
Accounting Studies, 20(1), 371-394.
Lin, Y. H., Lin, S., Fornaro, J. M., & Huang, H. W. S. (2017). Fair value measurement and
accounting restatements. Advances in accounting, 38, 30-45.
Magnan, M., Menini, A., & Parbonetti, A. (2015). Fair value accounting: information or
confusion for financial markets?. Review of Accounting Studies, 20(1), 559-591.
Okamoto, N. (2014, September). Fair value accounting from a distributed cognition perspective.
In Accounting forum (Vol. 38, No. 3, pp. 171-183). Taylor & Francis.
Palea, V. (2014). Fair value accounting and its usefulness to financial statement users. Journal of
Financial Reporting and Accounting, 12(2), 102-116.