EXPLORING THE PROS AND CONS OF FAIR VALUE ACCOUNTING
The speed of globalization in the capital markets and the increasing complexity of financial instruments have caused financial statement users to question the relevance and usefulness of historical cost accounting (HCA). The propensity to use fair value accounting (FVA) is imminent as we enter into a borderless economy and as financial markets evolve that require more current and relevant financial information. The U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) joint effort to establish a uniform accounting standard has caused alarm to U.S. companies and ...view middle of the document...
Clearly, there are limitations and flaws of both methods. However, the pressure toward the use of fair value is exacerbated by the increasing use of IFRS around the world. According to Lefebvre, Simonova, and Scarlat (2009), “some 112 countries use IFRS, with Canada, Japan, India, Brazil, and Korea set to adopt IFRS by 2011 or sooner” (p.5). The percentage of market capitalization of exchange listed companies that are using IFRS is significant. The data on market capitalization are presented in the chart below.
Source: http://www.cga-canada.org/en-ca/ResearchReports/ca_rep_2009- 12_fair_value_accounting.pdf
The chart above shows that 31% of market capitalization is comprised by listed companies that use IFRS and these numbers are expected to grow in the future. As a result, the United States is placed in an extreme pressure to adopt IFRS. One of the driving forces to adopt IFRS is the need for a global financial system to embody a common set of accounting standards. The current convergence between IFRS and U.S. GAAP only applies fair value accounting to financial instruments that are readily measurable but excludes tangible assets (property, plant and equipment) and long-term liabilities. Financial information using historical cost are irrelevant, less useful, and less meaningful (Parrino, Kidwell & Bates, 2011).
Benefits of Fair Value Accounting
Central to the idea of financial reporting is to provide relevant information so that investors and regulators will be able to make informed decisions. Fair value accounting improves the relevancy of information because it portrays the underlying economic position of the company and reflects the genuine economic fluctuation of the business cycle (Chea, 2011). Fair value accounting is aligned to this purpose than historical cost because it allows for financial statements to be more relevant and easily comparable across different periods (Lefebvre, et al. 2009). Additionally, the field of finance argues that using fair value prohibits managers to conceal a failing business or hide realized gain or assets (Parrino, et al. 2011). In the field of finance, financial statements are more valuable if they are measured in current values because investors and managers care about how the company will do in the future. The value today of long-term assets and long-term liabilities is more helpful for investors and managers to be able to predict expected cash flows and create value to the company.
Limitations of Fair Value Accounting
One of the major limitations of fair value accounting is that it can induce a pro-cyclical pressure in asset prices. According to Emerson, Karim, and Rutledge, “pro-cyclicality is generally understood as amplification of otherwise normal cyclical business fluctuations, both in booms and busts, creating preconditions for increasing instability and vulnerability of financial system” (2010). Criticism over fair value was intensified during the recent financial crisis...