TOPIC 4

ISSUES ON THE APPLICATION OF

ACCOUNTING STANDARDS
Fair Value Accounting
Presented for:
Dr. Syahrul Ahmar Ahmad

Presented by:
Azlina binti Ahamat
Nazurah binti Bistamam
Nurul Syazwani binti Rosli
 Question 4

Critically discuss the use of FV

measurements on the assets and
liability in the financial statements
 Answer
Landsman (2007)
• According to Barth (1994), finds that investment
securities’ fair values are incrementally associated
with bank share prices after controlling for
investment securities’ book values.
• Barth et al. (1996) also find evidence that loans’
fair values are also incrementally informative
relative to their book values in explaining bank
share prices.
• Fair values of loans reflect information regarding
the default and interest rate risk of those loans.
• They consider requiring disclosure or recognition of
tangible fixed assets at fair value.
• Regarding managerial discretion in determination of
revaluation amounts, the study also finds little
evidence indicating independent appraiser based
revaluations are more relevant than director based
estimates.
• In contrast to the findings in Barth and Clinch (1998),
Muller and Riedl (2002) find evidence that the market
finds asset revaluations estimates made by external
appraisers are more informative than those made by
internal appraisers.
• Aboody et al. (2004), although both studies provide
evidence that employee option expense is value
relevant to investors.
 Answer : Georgiou & Jack(2011)
Use of FV measurement on the asset

• In IAS 16 Accounting for Property, Plant and Equipment, assets

acquired in exchange for other assets might be recorded at the fair
value of the assets given up, and a similar requirement applied to
assets acquired in exchange for shares.
 Use of FV on the asset
• IAS 18 Revenue Recognition, observed that the amount of revenue in an
exchange of non-monetary assets is normally determined using the fair
value of the assets exchanged, whilst IAS 22 Accounting for Business
Combinations also included reference to fair values.

• FRS 15 Tangible Fixed Assets, which permits a choice as to whether tangible

fixed assets are stated at cost or at a revalued amount. These standards
contained the concept of fair value which during the 1990s played an
increasingly prominent role in the standards of the IASC and several
national standard setters.

• Through IAS 40 Investment Property that applies FVA to non-financial

assets and IAS 41 Agriculture (both issued in 2000) requiring the FVA model
to be implemented by all enterprises that undertake agricultural activity.
Use of FV measurement on the liability
• first included the concept of fair value in the
1977 drafts of IAS 17 Accounting for Leases. In
IAS 17, fair value played a role in determining
the classification of a lease as either a finance
lease or an operating lease, as well as in the
determination of profit or loss in sale and
leaseback transactions.
 Issues of implementing FV measurement
• use of fair values will be emphasised wherever
necessary to obtain ‘faithful representation’.
• harmonisation of the reporting standards of
over 100 countries to those of the IASB,
implies a level of regulative legitimacy for FVA.
However, this legitimacy is limited by the
weak enforcement mechanisms in place.
• The IASB does not have the power to enforce
the standards it promulgates in practice and
FVA is resisted at the national level (especially
by code law jurisdictions).
 Question 5

The use of fair value

measurements provides more
relevant information. Discuss.
 Answer
Ball (2006)
• According to Ball (2006) has stated that the FV
accounting rules aim to incorporate more-timely
information about economic gains and losses on
securities, derivatives and other transactions into the
financial statements, and to incorporate more timely
information.
• Fair value incorporates more information into the
financial statements.
• Incorporating more information in the financial
statements by definition makes them more
informative, with potential advantages to investors,
and other things equal it makes them more useful for
purposes of contracting with lenders, managers and
other parties.
 Answer
Landsman (2007)
• According to Landsman (2007) the fair values would
mitigate the use of accounting motivated-transaction
structures designed to exploit opportunities for
earnings management.
• Fair value accounting for all financial instruments
would reduce the complexity of financial reporting
arising from the mixed attributed model.
• The research findings suggest that disclosed and
recognized fair values are informative to investors, but
that the level of in formativeness is affected by the
amount of measurement error and source of the
estimates – management or external appraisers.
 Answer
Oncioiu et al. (2012)
• Each of the current values measures a current rather than an historical
attribute of the asset and looks to the market rather than the specific
transaction for evidence, but this leads, in each case, to a degree of
estimation, because the current measures are not based on actual
transactions but upon transactions that might take place in markets
that are far from perfect and, in the extreme, may not even exist.
• These decisions are assumed to be primarily those made by an
investor, and they therefore relate primarily to the prediction of future
cash flows. However, prediction does not imply merely forecasting,
and the concerns of stewardship are also assumed to be included in
the objective.
 Answer
Oncioiu et al. (2012)
Continued…
• However, when the cost measure used is the historical
cost, it could be argued that such measures cannot be
compared in an economically meaningful way because
the measure is dependent on the time of acquisition,
which will differ across different assets.
• It may still be helpful to users to have a common
valuation objective, imposing consistency of
purpose, even if the techniques used to achieve it
may vary according to asset type.
 Answer
Deans (2007)
• The fair value information to vary in relevance depending on
sector which price-to-book measures are widely used for
valuation purposes, and therefore fair value information for
balance sheet items to be more value relevant in these
sectors.
• The extent of usefulness of fair value information to depend
on the types of assets and liabilities.
• The FV frequently involve adjusting for the value of
investments, associates, minority interest share of the
business, options outstanding, pension fund deficits.
• There are some fair value measurements that
investors routinely incorporate into their company
valuations, though not necessarily relying on
information in the accounts and this fair value is
relevant.
• The fair value information would only have to be a
little bit relevant and a little bit reliable to be more
useful than the alternatives.
 Answer
Qudah (2012)
• The fair value measurement and disclosure supposedly
provide appropriate information to rationalize the
decision making process
• The greater quality of accounting information and best
informative content of the financial reporting for
managers on various organizational levels or other
stakeholders associated with the organization.
• Poon (2004) reported that fair-value accounting
provides more suitable and meaningful information to
decision-maker than the historical cost accounting.
• The fair value depends more on many estimates such as
future monetary flows and discount rates in cases of illiquid
markets.
• Penman (2007) stressed on the advantages of the fair value
from perspective e of proponents arguing that investors are
much concerned with value rather than cost, so fair value
should be reported.
• The fair value has been issued considering its perceived
features and the meaningful information they provide to help
market partners make different decisions.
• The fair value also considered as more relevant compared
with historical costing provides better indication to current
risk, and as a result enable investors take corrective actions
with respect to corporate decisions.
• The fair value is an ideal model reflecting present market
conditions; provide timely information which increases
transparency, and encourages instant corrective action.
 Answer:
Penman(2007)
Benefits of FVA
• Investors are concerned with value, not costs,
so report fair values.
• With the passage of time, historical prices
become irrelevant in assessing an entity’s
current financial position. Prices provide up-
to-date information about the value of assets.
 Benefits of using FVA(con’t)
• Fair value accounting reports assets and
liabilities in the way that an economist would
look at them; fair values reflect true
economic substance.
• Fair value accounting reports economic
income
• Fair value is a market-based measure that is
not affected by factors specific to a particular
entity;
 Answer
Penman(2007)
FVA
 the balance sheet becomes the
primary vehicle
f or conveying information to
shareholders;
•the income (profit and loss) statement
reports economic income’ because it is
simply the change in value over a
period;
•income reports the stewardship of
management in adding value for
shareholders.
HCA
• the income statement is the primary
vehicle for
conveying information about value to
shareholders
•current income forecasts future
income on which a valuation can be
made;
•earnings measure the stewardship of
management in arbitraging input and
output markets, that is, in adding value
in markets.
 Penman(2007) ..con’t
FVA
(unexpected) earnings, being a shock to
value, reports on the risk of the equity
investment.
Volatility in earnings is informative for value
at risk;
the P/E ratio is Price/Shock-to-value, that is,
a realisation of value at risk (with a very
different interpretation to that under historical
cost);
income reports the stewardship of
management in adding value for
shareholders.
HCA
earnings do not report shocks to value,
but shocks to trading in input and
output markets;
the P/B ratio is typically not equal to
1.0 and the P/E ratio takes current
earnings as a base and multiplies it
according to the forecast of future
earnings;
earnings measure the stewardship of
management in arbitraging input and
output markets,that is, in adding value
in markets.
 Answer: Song & Hang Yi(2010)

Source of information used in fair value measurement:

Level 1- Valuation based upon quoted prices for identical instruments traded
in active market.

Level 2 – Valuation based upon quoted prices for similar instruments in active
markets, quoted prices for identical or similar instruments in markets that are
not active, and model-based valuation techniques for which all significant
assumption are observable in market.

Level 3 – Valuation generated from model-based techniques that use

significant assumption not observable in the market. These unobservable
assumption reflect our own estimates of assumption that the market
participants would use in pricing the assets or liability.

Valuation techniques include use of option models, discounted cash flow

models and similar techniques.
1) Value relevance of level 1 and level 2 fair value is greater
than the value relevance of level 3 fair values.

- Level 3 fair values are less observable. The more subjective

nature of level 3 fair value lead to greater estimation error by
management.
- Less reliable accounting information reduces the ability of
investors to monitor managerial behaviour, potentially
reducing the firm’s operating performance and future cash
flow.
- As the quality of information is reduce, investor lose their
ability to link the activities of the manager to firm
performance. This means, manager will act less accountable
for their actions and operate the firm less efficient.
- Therefore, investor are likely to decrease the weight they place
on less reliable Level 3 fair values measurement in their equity-
pricing decision. Investor will choose Level 1 fair value
measurement because it can be easily verified by investor.
2) Value relevance of fair value (especially Level 3
fair values) is greater for firms with strong corporate
governance.

-This is because, firm with independent boards, highly

financial literate audit committees, active audit
committees, the presence of institutional investors,
audit by auditors from large office, and no material
control weaknesses are less likely to engage in financial
reporting biases.
-Managers may manipulate inputs for fair value for
their own interest. However, with a good corporate
governance, this can be reduce and the information
provided will be more relevance.
3) Fair value hierarchy disclosure disaggregating type
information with level information will increase value
of relevance to the information

-Matrix format for reporting fair values based on

assets/liability type and level of input will provide more
relevance information.
-This will depends on how investors differentially value
inputs across the three levels and whether the firms
report sufficient fair value assets and liability types.
 Conclusion
• Fair value is the best available methodology for
determining and reporting the value of financial
instruments compared to historical accounting
• However, if it had been implemented poorly,
both FVA and HCA can produce misleading
information and lead to risk accumulation
problems and the potential for market
distortion(Greenberg et.al,2013)
• Thus, improving the quality of both FVA and
HCA information in financial statements should
be a priority consideration for policymakers.