Template for Bachelor thesis in International Business

Income Statement		Cash Flow Statement					Balance Sheet
Revenues		Net Income					Cash
(-) COGS		Non-Cash Adjustments					Other current asses
Gross Profit		Net Working Capital					Non-Current Assets
		CFO					Total Assets
SG&A
R&D		CFI					Current Liabilities
Impairments		CFF					Non- Current Liabilities
Depreciation							Total Liabilities
Operating Expenses		Cash Flow -Total
		Beginning Balance					Common Share & APIC
Operating Profit -EBIT			Free Cash Flow					Share Buybacks
							Retained Earnings
Realized gains/losses							AOCI
from Sale of Assets							Total Shareholder's Equity -B.V.
interest income
interest expenses
Pre-Tax Income
(-) Taxes
Net Income

Figure 8 Fair Value-Based Financial Statement Flow

Income Statement		Cash Flow Statement			Balance Sheet
Revenues		Net Income			Cash
(-) COGS		Non-Cash Adjustments			Other current asses
Gross Profit		Net Working Capital			Non-Current Assets
		CFO			Total Assets
SG&A
R&D		CFI			Current Liabilities
FV Adjustments		CFF			Non- Current Liabilities
Impairments					Total Liabilities
Depreciation		Cash Flow -Total
Operating Expenses		Beginning Balance			Common Share & APIC
		Free Cash Flow			Share Buybacks
Operating Profit -EBIT					Retained Earnings
					AOCI
Realized gains/losses					Total Shareholder's Equity -B.V.
from Sale of Assets
interest income
interest expenses
Pre-Tax Income
(-) Taxes
Net Income

The fair value charges are enormous for financial institutions and REITS, but they also considerably distort earnings for non-financial firms.

Fair value accounting also allows loss /gain revaluation, creating other complex accounting procedures for the accountants. There are two possibilities to adjust subsequent gains and losses in fair value, and that is.

1. 
   If the revaluation of the Asset initially decreases the carrying amount on the balance sheet, then the loss is reported on the income statement. Suppose the fair value increases in the subsequent revaluation, then unrealized gain equal to previous loss reported on the income statement is written on the P&L statement. Any further increase in value beyond the last loss is not reported on the income statement and is adjusted directly to equity under the revaluation surplus account (Robinson, 2020).
   
2. 
   But if the fair value increases, then the increases go straight to the revaluation surplus account under shareholder's equity on the balance sheet. Later, if the fair value decreases, it reduces the value no more than the previous gain the revaluation surplus. Anything beyond the last gain is then reported on the income statement as unrealized loss (Robinson, 2020)
   

The unrealized earnings and impairments are reversed on the cash flow statements and, therefore, do not impact. But according to (Miroslav Škoda and Peter Bilka, 2012; Robinson, 2020; Zhang and Zhang, 2020), when a firm under IFRS choose to value the assets and liabilities at fair value, then all the assets having disclosure under fair value measurement are reported and revalued even one asset needs to be evaluated. The combined revaluation of all assets maintains the transparency and consistency of the balance sheet. This revaluation of assets creates high volatility of cash flows through working capital.

The other problem is cash flow measurement under fair value accounting. The fair value should be based on the future cash flow estimations discounted at the relevant discount rate. But fair value estimates are based on relative valuation instead of true cash flow generation capacity of the assets. This relative value of the asset fluctuates during bullish and bearish financial markets making it more difficult to establish the true value of the asset.

Thus, excess revaluations and loss reversal, including impairments, create highly volatile earnings and cash flow records. The investors face extreme difficulty keeping track of the earnings and cash flows and cannot effectively forecast future earnings and cash flow estimates. Added complexities through impairments, unrealized gains and losses, and loss reversals create a problem for accountants and reduce their efficiencies.

4. Lost Management Performance and Volatile Financial Ratios

One of the better advantages of following the historical cost method was its ability to track historical and current performance. Most of the assets and liabilities, excluding financial instruments and pension liabilities, were reported at historical cost and later amortized or depreciated (Ayres, Huang and Myring, 2017). The assets and liabilities somehow showed less volatility due to the more straightforward accounting treatments. The net income or earnings per share reflected actual operational capacities and many impairments, unrealized gains/losses considered one-time charges and excluded from earnings to arrive at adjusted earnings and operating profits (Barron, Chung and Yong, 2016). Many important financial ratios that the investors effectively use, credit analysts and appraisers to track financial and operational performance, are highly skewed under fair value accounting systems. Ratios like ROE, ROA, financial leverage, dividend payout ratios, dividend per share, and retention ratios showed high deviations that make it challenging to assess investors' total returns and actual financial and operational performance (Robinson, 2020; Stephen G. Ryan, 2008).

Asset revaluation, i.e., increase in value, makes assets or firms more solvent and might falsely adjust the ratios downward to report a clear picture. This is the case with the long-lived depreciable assets valued, which can be used by the management to report reduced leverage. This might also fool investors by assigning lower risk to specific assets or firms considering the lower financial leverage. Similarly, return on equity and assets ratios are highly skewed due to reporting of impairments, revaluations, and fair value unrealized gains and losses on the income statement, directly affecting the bottom line (Net Income / Earnings). Under highly skewed circumstances, management performance cannot be reliably measured and cannot be forecasted reliably in the foreseeable future. Investors' return metrics like dividend pay out ratio also show high deviation, making it difficult to find a pattern.

5. Pro-Cyclicity and Problem of Goodwill Recognition

According to (Ian E. Scott, 2010; KPMG, 2021), fair value accounting causes pro-cyclical downward pressure on assets value which is more profound and evident during times of illiquidity and bearish market environment. Fair value accounting had its fair share of criticism considering its involvement in the financial crisis of 2008. The blame lies in the inherent complexities of fair value measurements, and according to critics, fair value accounting creates high volatility in earnings and assets revaluations on the balance sheet (KPMG, 2021; Leslie D. Hodder et al., 2006). During the illiquid market conditions or the bearish markets on the economic downturn, if the valuation of the assets falls below its actual economic or fundamental value (B.V.), then the write-offs occur concurrently. The concurrent write-offs create a market panic and create downward pressure in asset pricing. And the decreased asset value on the balance sheet causes a lack of confidence among the investors causing a reverberation effect from one market to another (Ian E. Scott, 2010; Schildbach, 2011; Song, Thomas and Yi, 2010; Zhang and Zhang, 2020) The effect is more profound on financial statements of financial institutions such as commercial banks where the decrease of assets impacts their required capital ratios. Many believed that fair value accounting procedures were the root cause in creating the credit crisis of 2008 due to its ability to develop pro-cyclicity.

The other problem with loss of asset value is the estimation and reporting of goodwill on the balance sheet after a market transaction. Goodwill is an indefinite intangible asset with no observable market, so the excess purchase price after distributing to definite assets is reported on the balance sheet. If the asset is purchased for a price over the fundamental value, that excess price after distributing to PP&E and finite intangibles is reported as goodwill on the balance sheet. But if fair value accounting creates the downward asset devaluation pressure and the prices of the assets fall below the fundamental value, then there can be no goodwill in an arm's length transaction. The fair value accounting has lost sight in recognition of goodwill in the case of asset's write-offs – as to how to deal with the negative or no goodwill if the asset value is below the fundamental value or book value.

6. Increased Asset Price Volatility

According to (Damodaran, 2012), investors, in their pragmatistic view, would like to see little or no variation between the market value and actual fundamental value of the Asset. Damodaran (2012) found out that even replacing the historical price of the assets with the fair values of the assets, the firm value cannot be derived, which could corroborate with the current market price. So, it is difficult to establish the firm's market value through fair value measurement of both assets and equity. The inherent discern increases the volatility and variation between fundamental value and overall market value. According to (Damodaran, 2012; Dudycz and Praźników, 2020) found out that the variation has increased instead of decreasing. Thus, a fair value accounting balance sheet cannot help constituting the firm's actual intrinsic value by marking assets at fair value.

Fair value accounting is acclaimed to provide vital information to investors to make better economic decisions. Still, the fair value of the assets obtained through relative valuation adds little or no data for the investors. Remembering it is the investor who needs to get the information and set the market, which is not fair value accounting. Fair value accounting has complex issues and creates substantial loopholes that cannot outperform the historical cost accounting system.

7. Fair Value Accounting and Impact on Liabilities

Companies have the option to carry the debt liabilities at fair value under both accounting systems. Once the debt or liabilities are reported under fair value they are designated as financial liabilities at fair value through profit & loss under IFRS and liabilities under fair value option under US GAAP. The book value of the debt is based on market interest rates when the company uses the effective interest to amortize bond discounts and premiums. If the market interest rates fluctuate over the life of outstanding debt, the book value of the bond also deviates from the market value. So if the interest rates rise in the market, then the current market value of the debt will fall and the reported book value of the debt will be higher overstating the leverage (Greenberg et al., 2013; Robinson, 2020). Thus it will also create problems in the horizontal analysis as two companies with identical debt levels might be in different economic positions. One might have issued debt at lower interest rates and the other at newer and higher interest rates, then later would be in a much better economic condition as the true economic obligation is much lower compared to the competitor.

8. Impact of Fair Value Accounting on Pensions

There are two types of pension plans such as defined contribution plan and defined benefit plan. Under the defined benefit plan , the fair value accounting requires fair value measurement of defined assets and liabilities. The deviation are recorded in the other comprehensive income under the fair value acoounting(Greenberg et al., 2013; Robinson, 2020). Once again, the fair value revaluations create an impact on the equity side which presents distorted financial ratios.

9. What lies ahead for Fair Value – Future Challenges

Although fair value accounting is boasted to provide highly reliable information to investors to make better economic conditions, the data used to close the gap by corroborating accounting balance actual value to market value failed to achieve the required result. It has suffered significant obstacles in terms of reliability, number of input levels, and valuation techniques. The problems would further exacerbate if another credit crunch or global pandemic profoundly impacts economic and business activities. The COVID -19 declared as a global pandemic has already halted international business activities, making it difficult to revive economies and financial markets. Many firms have already filed for bankruptcy due to the worldwide pandemic (PWC, 2020). COVID – 19 constitutes a highly negative impact on firms using fair value accounting. The present global pandemic has rendered the financial market illiquid, which will have complex implications for financial reporting. The pandemic has affected the global supply chain and would lower demand for multiple services and goods, including financial institutions, tourism, transport, entertainment, retail, etc. As already mentioned, problems of fair value accounting, fair value accounting may have to comprehend challenges under global pandemic, which are discussed below.

1. 
   The COVID-19 pandemic has directly impacted financial markets and observable inputs (quoted prices). Due to the decline in financial market activities and trading volume, it will be hard to access the observable inputs required for fair value measurements.
   
2. 
   Data or observable inputs related to the pre-pandemic market transaction will be useless to value assets based on fair value measurements.
   
3. 
   It will become challenging to forecast earnings and cash flows due to added volatility from fair value measurements.
   
4. 
   Excessive use of judgments and estimates will be used to adjust the fair value of the assets, which will make fair values more unreliable.
   
5. 
   Significant changes in Asset’s value on the balance sheet will report unprecedented unrealized losses on the income statements, which will lead to highly synthetic and negative earnings.
   
6. 
   Suppose assets' fair value is less than the fundamental values. Then, in that case, investors might lose their confidence and might witness another downward pressure on assets price, leading to pro-cyclicity due to fair value accounting.
   
7. 
   More risk in forecasting fundamental as the duration of the ongoing pandemic is uncertain.
   
8. 
   Credit spread or credit risk might also increase, as many firms might find it difficult to operate under going concern basis (KPMG, 2021)
   
9. 
   Under limited financial market working conditions, the volatility of the stock prices has increased (PWC, 2020). It will affect fair value measurements.
   

10. Recommendations

These are some of the challenges that firms using fair value accounting are facing considering the ongoing COVID -19 Pandemic.

1. 
   Firms need to mitigate these risks and problems to provide better and more inclusive disclosure to the investors. Since more and more judgments and estimates will be used for inputs to measure fair value, firms will be required to provide more disclosure regarding the computation of those inputs. This disclosure will provide better insights to the investors to establish a favourable notion for asset values.
   
2. 
   The firms under fair value accounting need to make sophisticated stochastic models to build risk scenarios to understand better the impact of uncertainty on forecasting future earnings and cash flows.
   
3. 
   Valuation models and fair value measurement methods need to be updated to better incorporate options under calamity and pandemics.
   
4. 
   Fair value accounting needs to revisit goodwill if the fair value of the assets is less than the fundamental value.
   
5. 
   It is better to use the cash flow valuation method instead of relative valuation to base fair value on cash flows, which will help investors properly.
   
6. 
   The unrealized gains and losses, including impairments, should have a limited income statement to separate operational activities from balance sheet adjustments.
   

4. Discussion & Conclusion

Many critics, academics, investors, and appraisers considered fair value accounting much superior to historical cost accounting. The fair value accounting held in high esteem as it vowed to offer the following substantiated benefits and reasons for adopting the historical cost accounting method.

1. 
   The financial statements provide added information to the investors and reflect current market movements.
   
2. 
   The high variation in earnings and cash flows offers true market perception about the value of the assets.
   
3. 
   The information provided through financial statements offers timely information for investors to make better economic by using three levels of the valuation hierarchy.
   
4. 
   To better reflect actual financial markets environment by marking assets and liabilities to market which will reduce volatility and valuation gap by using three levels valuation hierarchy.
   
5. 
   To make it easy for accountants to present the latest market and financial information to the investors through financial statements and make accounting value much closer to its actual value.
   
6. 
   There will be less uncertainty regarding the actual value of the firms if the assets are market to market. Fair value accounting will reduce stock price volatility.
   
7. 
   Fair value accounting will provide additional information to the investors to make better economic decisions.
   

So, the vital part of the research question is, "Is Fair value accounting Fair? The answer to this question lies in comparing and corroborating the reasons for adoption with current valuation and reporting dilemmas. We will do it one by one to better understand if fair value accounting succeeded in achieving the desired benefits.

1. 
   Under historical cost accounting, the investors combined future growth expectations for earnings and cash flows to establish market prices. Investors and appraisers also used to incorporate future management strategies, micro and macro-economic conditions to value the assets – which then used to drive market trading momentum. But according to (Ian E. Scott, 2010; Schildbach, 2011), the market transaction data used to value the assets adds no further helpful information for the investors and appraisers alike.
   
2. 
   According to (Hitz, 2007; Ryan, 2009), the fair value earnings & cash flows have five times more volatility than historical cost earnings and cash flows. This makes it very difficult for the investors and appraisers to forecast future earnings and cash flows. This also makes it challenging to convert the future estimates into the applicable market price for the assets. In historical cost accounting, payments are operational base centric. The percentage of non-operational charges is significantly less, making it even more reliable and easy for the appraisers and investors to forecast future earnings and cash flows.
   
3. 
   One crucial drawback of fair value accounting lies in its valuation hierarchy. Under the fair value hierarchy, if the markets are illiquid and observable inputs cannot be obtained in level III valuation, Investors assign 0.98$, 0.97$ and 0.68$ to each value obtained through three levels of hierarchy, where 0.68 $ is set to level III valuations which are most opaque and unreliable. Whereas under historical cost the valuation is based on future cash flows including relative valuation.
   
4. 
   In level I and II valuation techniques, relative valuation is used under fair value accounting. According to (Da and Warachka, 2009; Schildbach, 2011), the relative valuation technique used under fair value measurement IFRS – 3 can be used to value a firm, but it is difficult to convert those numbers into adequate cash flows from respective assets. Second, the fair value measured through relative valuation will add little or no value when the same value comes through financial statements after a delay of a month or so.
   
5. 
   According to (Damodaran, 2010) one of the central aims of fair value accounting is to bring the accounting balance sheet closer to actual market value and thus minimize the volatility and variability in market price, which is not the case. Damodaran (2010) found out that the volatility and variability of the stock prices have increased. Secondly, observation under his findings revealed that marking the assets to market on the balance sheet still does not effectively convert into the market price. The results remain like historical cost accounting as none of the systems converts or brings the B.V closer to M.V.
   
6. 
   Financial statements are meant to provide the historical and current performance of the assets and firms, which is much better represented under historical cost accounting. Reporting huge revaluations, unrealized gains /losses on P&L statements makes it difficult for investors to analyze time series and project future performance effectively. It is also very cumbersome for the investors and appraisers to benchmark important return metrics such as ROE, ROA, dividend payout ratios, etc. due to high fluctuations in shareholder’s equity, total assets, and net income (Robinson, 2020; Tkachuk, 2019)
   
7. 
   Asset revaluations and impairments help manipulate financial ratios such as leverage (Avg. Total Assets / Avg. Shareholder’s equity) unlike the historical cost method. Lower leverage ratios can show lower risk associated with the assets and can help in further borrowing from creditors.
   
8. 
   Many critics believed that fair value accounting has its fair share of hand in the 2007~2008 financial crisis due to its pro-cyclicity. In pro-cyclicity, the assets' fair value falls below the economic value of the assets, which creates downward pressure on asset prices in one industry and then to another sector. Any transaction taking place during pro-cyclicity will have to register negative goodwill, which is meaningless. Fair value accounting needs a fair bit of review to tackle this situation.
   
9. 
   Finally, under financial crisis or pandemics such as COVID-19, markets would become illiquid. Much of the observable inputs used in valuing assets and firms at fair value under the level I & II will be unobservable. There is no framework in place to obtain and fairly value assets under these circumstances. The accountant's fair value judgment will be similar to level III as much of the management estimates and judgments, including the accountant's own bias, will be incorporated in the fair value (Ayres, Huang and Myring, 2017; Benston, 2008; EPRA, 2016; IFRS -13, 2012). Investors will have no way to verify the actual value of the assets.
   
10. 
    The liabilities such as debts are reported at issuance value minus the financial cost associated with it under the historical method (PWC, 2020; Zack, 2009). While under fair value accounting the debt is reported at the fair value which is closely associated with the market interest rates. If the market interest rates are increased, the current bond or debt will have a lower face value and will be issued at discount in the market to compensate for lower interest rates. The actual value of the loan or debt or bond is lower than the stated value on the balance sheet. Unlike the historical cost method, fair value will create problems when it comes to calculating fundamental ratios.
    

The historical cost accounting is based on “Entry price.” Still, it cannot provide any information regarding the future value of the assets, while fair value accounting is based on “Exit Price,” but it cannot provide previous cash flow of the assets. Fair value accounting still must go a long way to mitigate the problems discussed above. Financial institutions and real estate investment trusts are heavily affected due to high percentages of Financial assets and investment properties under fair value accounting. There are also comparability and benchmarking issues as it is difficult to compare firms under fair value accounting and historical cost accounting within similar industries. Here, full convergence between FASB and IASB is required to mitigate the differences in accounting standards. So fair value accounting is not fair due to inherent complexities in valuation under stress conditions and higher volatilities in earnings and cash flows. Undoubtedly, much better disclosure and robust framework to value assets under stressful full conditions and pandemics might provide much better acceptance among appraisers, investors, and accountants.

5. Statutory Declaration

I herewith formally declare that I have written the submitted thesis independently. I did not use any outside support except for the quoted literature and other sources mentioned in the paper.

I clearly marked and separately listed all of the literature and all of the other sources which I employed when producing this academic work, either literally or in content.

I am aware that the violation of this regulation will lead to the failure of the thesis.

Student’s name Student’s signature

Matriculation number Berlin, date

1^ https://hbr.org/2009/11/is-it-fair-to-blame-fair-value-accounting-for-the-financial-crisis

2^https://www.duffandphelps.com/insights/publications/valuation-insights/valuation-insights-second-quarter-2020/measuring-fair-value-times-significant-uncertainty

3^ https://www.ifrs.org/content/dam/ifrs/supporting-implementation/ifrs-13/education-ifrs-13-eng.pdf