WHAT IS FAIR VALUE ACCOUNTING, ITS USEFULNESS AND LIMITATION

October 20th, 2009 Comments off
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Question:

 I understood historical cost accounting but what is fair value accounting. How useful or how is fair value accounting been justified and are there any limitations when accounting experts use such accounting basis?

 

Answer:

 (a) What is fair value accounting:-

  • Fair value accounting is a financial measurement methodology permitted by accounting standards which allows companies to measure certain assets and liabilities at fair value or market value.
  • For accounting treatment and disclosure/presentation purposes, please note that under fair value accounting, when the fair value of the company’s assets decrease or liabilities increase, the company will treat and report such gains or losses directly into the Income statements or sometimes in the Statement of Equity changes.

(b) How useful is fair value accounting:-

  • To understand how useful is fair value accounting, we first need to understand the limitation of applying the historical cost accounting concept/principle.
  • Applying historical cost accounting enables the company’s balance sheet to be reliable and not subjective as it is based on verifiable historical costs. However, it  mean that the financial statements might not useful for decision making as assets acquired years ago and newly acquired assets do not have the same costs and hence have different carrying values even though their respective current values may be the same. Historical cost information for assets has no economic relevance to the buy, sell, hold decisions hence is not useful to managements for making the relevant decision making.

© Why fair value accounting:-

  • The main support for fair value accounting is mainly based on relevancy.{ note that the four attributes of a financial statement are able to be understand, relevance, reliable and comparable} as the assets or liabilities are based on market valuation.
  • It is interesting to note that during periods of growth and downturns, fair value account accentuates the volatility of the financial statements. {rising and falling prices of assets or liabilities}. However, accounting experts felt that Balance sheet using fair value as a basis of measurement gives a better reflection of actual worth of the company.

(d) Limitations of fair value accounting:

Fair value accounting is drastically limited when the assets and liabilities are not quoted in an active market or when there are infrequent or no transactions for the kind of assets or liabilities held by the entity.

  • In such situations, financial reporting standards suggests the use of acceptable valuation models to estimate fair value(mark-to-model measurement).

(e) Salient point when an entity uses fair value accounting:-

  • It is important that when companies using fair value accounting basis of measurement need to make adequate and robust disclosures in their financial statements as to the valuation processes and methods used in determining the fair values, what the significant estimates are and the assumptions used as inputs.
 

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