Assessed Coursework BUSM107 The use of fair value accounting has become increasingpopular in financial reporting as an alternative to historical cost accounting.This report will discuss how, dependent on the situation and type of asset,either of these methods could be the most applicable. A range of research haslooked into the appropriateness of fair value and historical cost accountingwith regard to different forms of assets to give a variety of arguments for andagainst each.
Some would argue that the use of both in conjunction with oneanother could be a beneficial way of taking advantage of each method (Penman,2007: 35), but alternatively other perspectives could argue that this wouldeliminate the more prominent benefits of using fair value or historical costaccounting on their own. The following, will examine three scenarios for thecompany ‘Combo applications’, and suggest the most suitable accountingtreatment for each scenario, and their implications on the balance sheet andincome statement. Scenario 1 On the 1st of February 2017 Combo applicationsbought a building for £500,000 but in August 2017 the announcement of alandfill to be created adjusted to the building resulted in impairment of thebuilding. Subsequent to this, the building was revalued to £200,000. The IAS 36for the impairment of assets, and the fair value, will be used as the relevantaccounting treatment for this scenario.
For this accounting standard, the assetthat has been impaired is the building bought by Combo application. Theindication of impairment is defined by the external source that the marketvalue has declined. Upon revaluation by the agent, the recoverable amount ofthe building was found to be £200,000. This has been based on the reliablesource that is the independent estate agent, this source can be deemed reliableas the agent is unbiased towards Combo applications.
Thedecrease in value of the building should be disclosed in both the incomestatement and the balance sheet. The impairment loss, due to the municipalityof Tower Hamlet’s decision to build the landfill, should be disclosed as aloss, which comes under the expenses, in the income statement, and as adecrease in the equity and assets in the balance sheet. Although it has been suggested that historical costing canbe beneficial for many accounting applications, it has also been said that“historical costs do not reflect the current fundamental value of an asset”thus proving to be less useful than fair value (Laux and Leuz, 2009: 828).Building on this, it has been argued that the use of fair value is most suitablein financial reporting as it “increases transparency by providing more timelyinformation” which is most useful to allow a manger to understand the currentfinancial state of a company (McDonough and Shakespeare, 2015:96). Reliabilityis also a critical factor of any form of financial reporting, and has beendefined by “three primary characteristics” which are “predictive value,feedback value, and timeliness”, that are all represented with far morestrength by fair value in comparison to historical costing (Herrmann,Saudagaran and Thomas, 2006: 49). The use of revaluations of a property andfair value reporting are also incredibly useful in the predictive forecasting“of future earnings” and are therefore a much more beneficial method ofexplaining “current returns and prices” over the use of historical costing –proving to offer a more incremental “predictive value” to financial reporting(Herrmann, Saudagaran and Thomas, 2006: 49). Considering this, it is important to emphasisethe “feedback value” that comes from the use of fair value over historicalcosting, as fair value allows one to strengthen their understanding of thefinancial situation of a company by confirming or correcting “priorexpectations formed by users based on current economic conditions and the mostrecent revaluation” thus providing important information when assessing thesituation of a company such as Combo applications after the impairment ofassets (Herrmann, Saudagaran and Thomas, 2006: 50).
The most prominent issue whenopting for fair value instead of historical costing in financial reporting isthe “reliability of the valuations”, as emphasised in a paper about “the use offair valuation at Enron”, but as the revaluation has been made through anindependent estate agent in this scenario, the reliability can be deemed as credible(Gwilliam and Jackson, 2008: 244). Scenario 2 On the 25th of September, Combo applicationsbought shares of Petroleum for £2,000,000, but a fall in oil prices resulted ina plummet in the value of the shares to a new value of £780,000 on the LondonStock Exchange. The IAS 39 for financial instruments: recognition andmeasurement, and the fair value will be used as the relevant accountingtreatment for this scenario. The financial assets in this scenario will beclassified at fair value through profit or loss designated as held for trading.As stated in the IAS 39, after the initial recognition measurement, any futuremeasurements should be taken at fair value.1 The IAS 28 will not be used for this scenario, as it is assumed that Comboapplications are not associates, therefore IAS 28 for investments in associatesis not applicable.
The decrease in fair value, as a result of the fall in oilprices, should be shown in both the income statement and in the balance sheet.In the balance sheet, it should be disclosed as a decrease in the value offinancial assets, and in the income statement it should be shown as a loss fromthe change in value of a financial asset, which comes under expenses.It has been argued that historical cost accounting shouldnot be considered as an alternative for fair value accounting for “liquidassets (e.g., stocks) in banks’ trading books” and that it is “surprising” thatone would assume that “the liquidity of an asset should play no role” infinancial reporting, as such factors are critical in the ongoing determinationof “margin or collateral requirements” (Laux and Leuz, 2009: 828). In additionto this, it is important to “maximize the use of observable inputs” infinancial reporting to improve reliability and usefulness, therefore “quotedprices in active markets”, such as the London Stock Exchange, should be used as“fair value when available” for transparency and profitableness from suchreports for the most promising use by managers (Laux and Leuz, 2009: 827). Although,it must also be taken into account that fair value accounting can “introducevolatility in normal times” and “give rise to contagion effects in times ofcrisis”, thus various external factors, such as the overall economic conditionsof the company, should be considered when deciding between the use of fairvalue accounting and historical costing (Laux and Leuz, 2009: 832). In contrast,the use of fair value in regard to stock shares is one of the most advantageousand reliable uses of fair value accounting.
It has been documented that thereis a “statistically significant association between stock prices and fairvalues of investment” over historical costing, thus justifying the “incrementalexplanatory power” that fair value has over the use of historical costs(Carroll, Linsmeier and Petroni, 2016: 5). Similarly, research has shown thatthere is a “statistically significant association between stock returns andfair value estimates of securities gains and losses” in financial reporting,hence signifying the importance and potency in the use of fair value accountingin conjunction with shares in an active market to ensure the most beneficialoutcomes from such reports (Carroll, Linsmeier and Petroni, 2016: 5). Thisscenario is particularly well suited to the use of fair value accounting as itis based on a level 1 asset and level 1 “fair value measurements are derivedfrom observable valuation inputs on quoted prices in active markets”,consequently this method of financial reporting is far more reliable than thatof historical cost accounting (McDonough and Shakespeare, 2015: 97). Thisoffsets one of the most prominent worries in the use of fair value overhistorical accounting, guaranteeing that “the estimates represent theunderlying economic transactions they are intended to represent”, thus provingfair value accounting to be the most appropriate and reliable method to use forfinancial reporting in this scenario (McDonough and Shakespeare, 2015: 99). Scenario 3 Combo application bought raw materials, with a value of£120,000 on the 1st of October 2017, that were kept in their warehouse,but due to a flood on the 2nd of October 2017 80% of the rawmaterials were destroyed. This 80% has a scrap value of £20,000, and newmaterial had to be bought with a replacement cost of £130,000. The IAS 2 forinventories, and historical cost accounting will be used as the relevant accountingtreatment for this scenario.
The historical cost andvalue of the asset in this scenario is £120,000. The £130,000 paid for thereplacement of the destroyed material is shown as an expense in the incomestatement, but will not be shown in the balance sheet.Although it has become increasingly common for financialreports to use fair value accounting over historical cost accounting, thelatter can still be the more applicable option in certain situations. It hasbeen suggested that with respect to inventory, the use of historical cost accountingcan be sufficient, as long as the projections of “future revenues” can beaccurately made by a manager (Baldenius and Reichelstein, 2005: 1039). Inaddition to this, if such forecasts cannot be made accurately, and “marketconditions are uncertain”, then the “lower-of cost-or-market rule” can be used,such that in scenario 3, this would result in the historical cost accountingmethod being used over that of the fair value Baldenius and Reichelstein, 2005:1039). The use of fair value has an ongoing issue of reliability of valuation, henceresulting in valuations that are “costly to determine and verify”, as a pose tohistorical costing which only relies on the amount that was initially paid forthe assets, making it a much better option for financial reporting in thisscenario (Benston, 2008: 103).
Looking at the use of historical cost accountingin contrast to fair value accounting from a managers point of view, it can besaid that unlike fair value, historical cost accounting “does not report the(present) value of expected outcomes” with regard to the business plan, butinstead it conveys the advances that have been made in “executing the plan”,while allowing the recognition of “value added (earnings)”, which can be a muchmore advantageous approach to financial reporting for a manager to be able togauge the position of a business and where improvements may be needed withregards to strategy (Penman, 2007: 36-37). Hence, conveying how this method offinancial reporting can bring much more knowledge and, in consequence,advantage for the future of a business. One disadvantage of using fair valuerather than historical value accounting in this scenario is that without apotential purchaser for the assets the “exit values would be zero or evennegative” if the assets would have to be disposed of, therefore “a substantialexpense” would have to be reported if fair value were to be used over the historicalaccounting value (Benston, 2008: 103-104). Lastly the issue of how products arepriced relates to the consideration of which accounting method should be used,historical or fair value. It is argued that the “raw material used inmanufacturing” gets its added value from the production of a product using theraw material, which is then sold to customers, not from “changes in its exitmarket”, therefore the use of fair value accounting (which focuses on the exitmarket) in this scenario would be inappropriate in comparison to that ofhistorical costing, which the pricing depends on (Penman, 2007: 39-40).
In conclusion, the relevant accounting treatment forscenario 1 would be to use IAS 36 with fair value accounting, for scenario 2would be to use IAS 39 and fair value accounting, and for scenario 3 would beto use IAS 2 and historical cost accounting. This conclusion was based on themost applicable international accounting standard for each scenario, inconjunction with the most suitable accounting method between fair value orhistorical cost accounting to develop the most useful report for a manager. Thelatter was decided upon using past research on various scenarios and their useof each accounting method, taking into account the pros and cons of each toreach a final decision of the most suitable accounting method for the scenarioat hand.