Fair Value Measurements
Fair value accounting is an accounting practice that measures liabilities and assets based on their current value estimates. In this case, fair value refers to the price payable for transferring a liability or receivable payment for the sale of an asset in a disciplined transaction involving market participants (FASB, 2011). Fair price, therefore, functions as an exit price that embodies the future cash outflow and inflow expectations linked to a liability or asset from the market participant's perspective.
The fair value measurement approach takes into account the characteristics of liability or asset. In this case, the goal is to assess whether market participants are likely to consider these characteristics when allocating prices to the liability or asset. These characteristics include the location and condition of the asset and existing restrictions in the use or sale of an asset.
The FASB has implemented a framework that classifies various types of liabilities and assets into 3 levels, resulting in a variation in their measurement. The hierarchical framework of fair value entails (i) liabilities and assets whose values can be observed by participants in an active market of identical liabilities and assets; (ii) liabilities or assets whose value may be quoted using internal-developed models, from an inactive market, of via input data retrieved from observable markets dealing with related items; and (iii) financial liabilities and assets whose value is based on valuation or prices techniques that demand significant and unobservable inputs relative to the all-inclusive fair value measurements (FASB, 2011).
The 2008 global financial crisis came under heavy criticism of fair value accounting by various firms, causing many financial and economic market participants to reassess their practices, standards, and governance (PwC, 2013). In particular, the global economic crisis has raised three pertinent issues regarding fair value accounting.
The first of these issues is what banking institutions have dubbed "procyclicality". They argue that a downturn fair-value system of accounting compels them to acknowledge losses simultaneously, a move that triggers the fire sale of assets but hinders capital, further driving valuations and prices down (KPMG, 2015). The association between fair value accounting and banking capital regulations has been identified as a likely means by which fair value accounting played a role in the global financial crisis. As the price of assets digresses from their basic values, banks are forced to write down their assets, thereby depleting their capital. Owing to such asset write-downs, banks could be compelled to sell these assets at what is known as a fire sale price, thus triggering a downward spiral. The ensuing contagion problem triggers other financial institutions to adopt similar write-downs.
The second issue involves the valuation of illiquid assets. The commonly practiced approach is to utilise banks’ own models in making such valuations, a move that investors are opposed to on grounds that it grants banks' managers a lot of discretion. This could be a real problem since highly illiquid assets tend to be comparatively large in comparison with the reduced market value of most banks (Ryan, 2008). The third issue involves the inconsistency that characterised the fair-value rules. The current practice on how a financial asset is to be treated is to base this on the firm's intentions. For assets that warrant active treatment, the idea is to use their market value. On the other hand, the "available for sale" assets are usually marketed on the company’s balance sheet, even as losses are not declared in the company’s income statement (Gulin and Hladika, 2016). Accordingly, various banks might hold the same asset at varying market values.
Fair price accounting hinders a firm's capacity to manipulate the net income they report. At times, management could intentionally arrange the sale of certain assets in order to use the losses or gains from the ensuing sales to decrease or reduce their net income over a given duration of time (Scott, 2010). However, fair value accounting requires that firms report the losses or gains from a change in the price of liability or assets in the period in which such losses or gains occur. Such losses are likely to reduce a firm's reported net income as well as reported equity.
Fair value accounting has also come under criticism from management on grounds that fair values are unreliable and difficult to estimate. They also cite the reported losses as being misleading on account of their temporary nature, not to mention that they are usually reversed once the market resume their normality. Despite these criticisms, fair value accounting is a more useful source of information for potential investors in comparison with other accounting approaches (Scott, 2010). This is because the approach permits or requires companies to report timely, comparable, and accurate amounts than would be the case if other accounting approaches were in use. Secondly, it permits or required firms to report amounts as they are updated, on an ongoing or continuous basis. Finally, losses and gains due to variations in fair value estimates signify economic events that investors and companies would find as warranting extra disclosures.
References
FASB., 2011 Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. [Online].
Gulin, D., and Hladika, M., 2016. Challenges in applying the fair value accounting during financial crisis. [Online].
KPMG., 2015. Fair Value Measurement Questions and Answers. U.S. GAAP and IFRS. [Online].
PwC., 2015. Fair value measurements 2015. Global Edition. [Online]. Available from:
Ryan, S.G., 2008. Fair value accounting: understanding the issues raised by the credit crunch. [Online].
Scott, I. E., 2010. Fair Value Accounting: Friend or Foe?, 1 Wm. & Mary Bus. L. Rev., 1(2), 489-542.
