1. INTRODUCTION
The aim of this paper is to critically evaluate the extent to which the objectives of the international accounting standard board (IASB) of having single set of high quality, understandable, transparent, reliable, relevant and comparable information in financial statements has been achieved. Therefore this paper will briefly give history about the board, then it will introduce two reporting models, cost accounting model which was previously used and fair value which the board has increasingly recommended in favour of cost. Next this report will critically discuss practical implication of implementing fair value in banking industry, auditors view and impairment loss. Then, this paper will critically discuss arguments for and against fair value before concluding and give recommendation.
2. INTERNATIONAL ACCOUNTING STANDARD
IASB/C came into existence in 1973 with only nine members. According to Elliot, B. and Elliot, J. (2008) this board has benefited stakeholders by offering accounting technical guide to companies on how to report information which is comparable, relevant, reliable and easy to understand. Moreover this board made difficult for companies to choose accounting policy which will give them a favourable result. Since the aim of the board is to have single set of financial statements with high quality, understandable, transparent, relevant, reliable and comparable in order to help users to make economic decision, the board has increasingly required the use of fair value in favour of cost model accounting model.
3. ACCOUNTING MODELS
According to the accounting standards, fair value and cost accounting model are the two accounting model mostly used by companies all over the world in favour of replacement cost and net realisable value. Cost accounting model is the method where assets and liabilities are recorded using historical cost. Another model is fair value which IASB has increasingly require the use of it. Chopping, D. And Stephens, M (2005) pg556, defined fair value as “the amount at which an asset or liability could be exchanged in an arm’s length transaction between informed and willing parties, other than in a forced or liquidation sale”. This means that fair value is using market value of the assets and liability instead of historical cost as cost accounting model do. The standard set the hierarchy as guideline to companies when reporting their financial statements using fair value.
Table1.
Fair Value Hierarchy
Level 1 | Observable market- quoted price for the same asset or liability |
Level 2 | Observable inputs such as quoted price for the similar asset or liability |
Level 3 | Unobservable market input for the asset or liability- entity’s own assumptions |
Walton, P (2007)
Companies should use level one if there is market for their assets or liabilities, in case there is no market for their assets or liabilities but there is market for the similar asset or liabilities then they can use level two where they will report by using the price of the similar asset or liability. Level three should be used only when there is no observable market for the asset or liability and therefore, the company should make assumptions on the price of the asset or liability.
4. IMPLICATIONS OF IMPLEMENTING FAIR VALUE
4.1 Banking industry
This industry has been in debate for long time with accounting standard setters on the way of reporting financial instruments. According to joint working group of standard setters (JWP), they advised banking industry to use fair value since their profit which comes from lending and receiving deposits would not be reported basin on whether the payments were made according to the contract and cost of funding, but it will be reported basin on economic model based on notion of opportunity cost. However, implementation of fair value to some extent does not meet the framework for preparation and presentation of financial statements. Chisnall, P. (2001) argued that fair value is not relevant in reporting customer loans since they held to maturity or expiry date without change in original contractual terms, therefore historical cost accounting model should be used instead of fair value. Moreover, fair value is not reliable since it needs assumptions and estimation to be made in case of absence of readily market for loans, assets and liabilities. Therefore, even though fair value provides an important power for bank share prices due to the estimation on securities, loans and long term debt, it is too theoretical and does not meet the framework for reporting financial statements, and hence it does not provide investors with better reflection on economic substance of the transaction in the banking book.
4.2 Auditors
Jayalakshmy, R. et al (2005) argued that the use of fair value helped auditors to make correct judgement and increases investors trust towards auditors. Since the use of fair value enables financial statements to possess characteristics such as relevance, understandable and comparability, this enables auditors to examine the real situation of the company at the reporting date of the accounting period. Therefore auditors will be able to make better assessment of the financial position of the company by comparing the figure shown in the statements with the one in the current market, and by doing so; auditors will be able to detect any fraud or errors made in the financial statements. However this has been criticised and highlighted by fall of big companies such as Enron, WorldCom and Parmalat which has been argued was due to the use of fair value which helped the directors of those companies to manipulate their statements without being identified by auditors. This has been acted positively by the accounting standard board by introducing the new standard known as the statement on auditing standards (SAS 99) which helped auditors to re-gain the trust lost by stakeholders since the auditors are required by the standard not to trust directors and to act actively by considering and identifying where the fraud may be glooming within the organisation.
4.3 Impairment loss
IASB defined intangible assets as unidentified non monetary assets without physical substance. Goodwill is one of the intangible assets and it has been argued by Wines, G. Et al (2007) that fair value is the appropriate measure of goodwill since goodwill is the difference between fair value of the identified assets acquired and the amount paid for those assets and it should be tested for impairment annually. The use of fair value helps the company to charge the correct amount impaired and hence gives a true and fair result to investors since the company will be comparing the carrying amount of the goodwill with the current recoverable amount of the assets in order to arrive at the impairment loss figure. To some extent this would lead to a manipulation of information especially when the company has to use the third level of fair value hierarchy, where they have to assume the value of the asset, they can assume high value in order to charge low amount of impairment so that to show good financial position or they can assume low value in order to reduce the profit and hence charged low tax as argued by Walton P. (2007). Therefore fair value plays an important role in charging impairment loss to the extent where the company uses first or second level of fair value hierarchy.
5. ARGUMENTS FOR FAIR VALUE
5.1 Relevance
Relevance means “capacity of information to make difference in a decision making by helping users to form prediction about the outcomes of past, present and future events or to confirm or correct prior expectations” (Kirschenheiter, 1997 pg 8). Fair value is argued to be more relevant compared to cost model because it gives investors information which is closer to the information users wishes to know. This is because fair value by the use of current market value, it gives a clear picture about the current organisation’s financial position and therefore investors will be able to comment and make decision basin on the information given to them. However to some extent this is not the case because according to the level three of fair value hierarchy companies are required to assume on the price of the assets if there is unobservable market for that asset, this may encourage companies which are not in good financial position to manipulate their financial statements and therefore investors will make a wrong decision basin on the manipulated information, hence information is irrelevant as argued by Chisnall, P. (2001). Therefore fair value is relevant to the extent that it gives investors true and fair information with the capacity to make difference in decision making.
5.2 Accuracy
Walton, P (2007) argues that fair value accounting model is more accurate compared to cost model. This is because fair value by the use of current market price, it gives investors a true picture about the current company’s real state of affairs. For example, machine bought 10 years ago will not have the same value this time, therefore by using fair value, the company will report the amount which machine worth this time, while by using historical cost model, the company will report the same value and then reduce the depreciation charge which is an estimation of the value of the machine lost or used during the year. Hornby, 2006 defined accuracy as “the state of being exact or correct” therefore from this definition it can be argued that fair value is not accurate since it is not free from errors especially when the company uses the third level of the fair value hierarchy where they have to assume the current value of the assets and liabilities due to absence of observable market. Therefore, fair value is more accurate compared to the cost accounting model to the extent where it uses the current quoted price for the same or similar assets and liabilities.
5.3 Understandable
ACCA, (2007) argued that fair value is easier to understand and less complicated than cost accounting model. This is because in fair value accounting model there is no complication such as depreciation charged to assets which is difficult for non accounting experts to understand. For example, the value of the furniture last year was £2000 and this year the value of the same furniture has gone down to £1800, in the financial statements by using fair value, this loss will be shown as impairment loss of 10% which is easy for anyone to understand. While by using cost model, this loss will be charged as depreciation at the fixed rate which the company set, it can be 20% or 15% which to some extent will not be showing the true value of the furniture and it will not be easy for non accounting experts to understand since it is complicated. However, sometimes fair value needs the company to make some assumptions when there is no observable market for the assets and liabilities which to some extent it’s complicated and therefore difficult for investors to understand as argued by Chisnall, P. (2001). Therefore fair value is easy to understand and less complicated compared to cost model however it can be complicated when there is no observable market for the assets and liabilities.
5.4 Comparable
Walton, P (2007) argued that fair value accounting is more comparable than the cost accounting model. This is because fair value is reporting assets and liabilities at their current market price and not historical cost. Therefore it will be easy for investors to compare financial statements of different companies with different starting date. For example, by using cost model, two companies which are charging depreciation to their assets at the rate of 20% and 10% straight line method, it will be difficult for investors to compare them since they charge different rate and therefore the company with low rate will show good financial position compared to the other which in reality would not be true. Therefore by using fair value, both companies will be showing their assets basin on their current market prices and hence easy to compare them. However, this argument is more theoretical than practical since apparently not all companies are using fair value, and they do not have intention to change to fair value especially Chinese companies as reported on accountancy age (Feb 12, 2009), therefore at the moment fair value is still not comparable.
6. ARGUMENTS AGAINST FAIR VALUE
6.1 Reliability
Reliability means “quality of information that assures that the information is reasonably free from errors and bias and faithfully represents what it purports to represent” (Kirschenheiter, 1997 pg 8). Kirschenheiter in 1997 argued that fair value is not reliable compared to cost model since it is not free from errors. Fair value sometimes it uses estimation to calculate the amount of assets and liabilities where there is no observable market, this makes fair value to be not free from errors since estimation is not a hundred percent correct and therefore investors cannot rely on it to make decision. Moreover some companies may try to influence the price of their assets in the market by either increasing demand over supply or encouraging producers to decrease supply over demand (Economist, 2008). In addition, companies may manipulate the information by assuming high value of the asset which will show good financial position of the company. However investors can rely on fair value to the extent where it uses the true and fair market price of the assets and liabilities with the quality and assurance of being free from errors and bias and faithfully.
6.2 Misleading picture
ACCA (2007) argued that the use of fair value accounting model sometimes it leads to misleading picture while cost model does not. This argument was raised from the definition of fair value which says that fair value is the amount in which assets or liabilities can be exchanged in an arm’s length transaction without being forced. This means that, company by using fair value, it is recording the amount at which the asset will be sold at that time which in reality may not be true since the company may not have any intention to sell the asset and therefore information given to investors will be misleading them. To some extent this argument is not true since the aim of preparing financial statements according to Elliott, B. And Elliott, J (2008) is to show investors performance, current financial position and change in financial position of the company. This means what the company worth if it has to be liquidated or purchased by other company. Therefore, the company should use fair value since it will show investors how much their assets and liabilities worth if the company has to sell them on the reporting date.
6.3 Fluctuation
Allat, G. (2001) argued that the use of fair value accounting model will lead to more fluctuations compared to cost accounting model. He argued that since the fair value uses current market value, in a country with high price fluctuation may result to a big change in the value of assets and liabilities from year to another which to some extent will not make sense or will give investors unclear state of affairs of the company. For example in a country like Zimbabwe which inflation is more than 500 quintillion per cent, this means that the value of the assets and liabilities this year will not be the same as the one next year. Therefore if the country managed to reduce inflation by 20% this means the value of assets and liabilities of most of the company in Zimbabwe will go down by 20% and when the inflation go up by 30% this means accountants have to adjust their values again by adding up the increase figure and therefore fluctuations from one period to other. However this argument does not fit in countries with fixed monetary system since there will be no change in the value of money over a period of time (Walton, P. 2007).
6.4 Political issue
It has been argued by Walton, P (2007) that IASB is recommending the use of fair value in order to favour politicians who their countries are in bad economic climate. This means that, the use of fair value will help banks and other big companies in such country to show high profit and good financial position, hence show good economy of the country which in reality it’s not true. However to some extent this is not the case since most of the European politicians are involved in stopping the use of fair value due to the fact that the board is not giving enough information on how to calculate value of assets and liabilities. This can be referred to the statement made by the France president who recommends the board to suspend the use of fair value since it leads to misleading information to investors from bank’s financial statements. Politicians argued that there is not clear information on how to calculate fair value to some extent it is no true since the first and second level of fair value hierarchy gives clear information on how to report the value of assets and liabilities. Therefore, fair value looks to be favouring politicians within countries with bad economic condition while other politicians who are in countries with good economic conditions keep arguing against it.
7. CONCLUSION
To sum up, fair value has improved the quality of information to the extent where it offers participant in world’s capital market and other users’ information which is accurate and with the capacity to make difference in decision making. Moreover, fair value offers investors information which is easy to understand and less complicated which enables them to compare different information from different companies. However, fair value has been restricted to the extent it has improved the quality of information since it is related to political issues and also it is not reliable due to the use of estimation and assumptions, moreover, it can sometimes gives misleading picture by recording assets by using the amount that will be received once the company sells it on reporting date while sometimes the company does not have plans to sell. Furthermore, fluctuation to some extent has restricted the improvement of information reported by using fair value accounting model due to the fact that it will be showing massive fluctuation in countries with fluctuating monetary system. The objective of the IASB has been achieved in some industries such as auditors and in charging impairment loss since it helps companies to report the true current value of intangible assets, this makes the information given to public to be accurate, relevant and reliable for decision making. However IASB’s objective has not been achieved in banking industry since fair value does not meet the framework of preparing and presenting bank’s financial instruments such as loans, securities and long term debts.
8. RECOMMENDATION
In the light of these conclusions, this report is recommending to international accounting standard board to fix the issues rose in banking industry by recommending the use of mixed cost and fair value accounting model in order to make it easier to report those financial instruments which can measured in cost by using cost model and for those which can be measured by fair value by fair value model, however this may lead to complexity in reporting financial statements. In addition this report recommends to the board to remove the third level of fair value hierarchy since it is the one which causes fair value to be unreliable, to some extent irrelevant, complicated and difficult to understand. Therefore until these issues have been solved, it is recommended that the board should allow the use of mixed or different accounting models in different industries even though it will make it difficult for investors to make comparison of different companies in different industries. This should be taken as challenge by the board.
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Alpha Bisimba
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