Template for Bachelor thesis in International Business
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Fair Value Accounting US GAAP VS IFRS
IntroductionThe financial markets, investors, academics, analysts and appraisers rely heavily on financial statements to make economic decision to invest in certain assets classes. The financial statements are created by following set rules and regulation under certain accounting system which provides reliability and acceptance among wide audiences and users. The pre-set accounting rules aims to provide better, correct, and timely information to the investors, appraisers, and analysts to measure and compare the entity's or asset’s performance to make better investment and economic decisions (Brousseau et al., 2014). The economic decisions include whether to suggest or recommend these securities to the investors, invest in the underlying securities, or assess the firm's credit potential to extend trade or lend money. Analysts, appraisers, and investors use these financial statements to evaluate the firm's past performance and create a forecast of the firm's earnings and cash flow potential to value the asset. The asset’s higher potential of less volatile cash flows leads to higher pricing in the financial markets (McInnis, Yu and Yust, 2018). Low volatility in the fundamentals of the firm helps financial markets in two ways, 1) to track the historical performance of the firm and management, and 2) to forecast future performance in combination with the firms business strategy. Similarly, earnings with high volatility create a problem for investors to develop sizeable future earnings estimates, affecting the asset prices - however, the impact is much less than the cash flow volatility (Schildbach, 2011). Income statement (P&LS), balance sheet and cash flow statement all three occupies a pivotal position, but under the concerned topic income statement and balance sheet is of prime concern as much of the non-cash charges are reversed on the cash flow statement (Zack, 2009). The historical cost accounting system which is mandatory under US GAAP but also allowed under IFRS is said to be less efficient, informatory and reliable due to the huge gap between its book value and market value (Ayres, Huang and Myring, 2017). This flaw is supposed to be corrected by the Fair value accounting concept which can return the market value of the assets and liabilities through financial statements to the concerned parties – which was not possible using the historical cost accounting system. The historical cost accounting is based on the initial price paid for the assets or incurrence in case of liability acquired (Jaijairam, 2012). Under the historical cost system, the long-lived assets (non-financial) are reported at their historical purchase costs and subsequently carried at amortized cost. The fair value accounting concept is not new to US GAAP and IFRS accounting procedures (Menicucci and Paolucci, 2016). It uses revaluation of the assets and liabilities over regular and defined periods, which profoundly impacts the three financial statements (Chen and Gavious, 2016). The fair value accounting usually is applied to the assets and liabilities, but primarily it also subjects particular non - financial assets such as intangible assets like goodwill, investment properties, and property, plant and equipment are subjected to fair value measurements in some instances (Herring, 2013; Jaijairam, 2012) One crucial reason for the broad acceptance of fair value accounting is its ability to provide the fair value of the assets and liabilities based on mark-to-model or mark-to-market model (Palea, 2013; Schildbach, 2011). The mark to model approach offers the "exit price" to the investors, appraisers, and accountants based on the level of the hierarchy of valuation. Doing so assumes to bridge the gap between the accounting value and market value and provides current market price to the investors and appraisers, which might help reduce volatility or uncertainty regarding the market price (Damodaran, 2010). The balance sheet occupies a pivotal position under fair value accounting where assets and liabilities are marked to market on the balance sheet – and the impact of revaluation or fair value write-ups or write-downs impacts the P&L statements' bottom line in one way or the other (Ayres, Huang and Myring, 2017). The unrealized gains and losses from fair value change in the assets combined with impairments and revaluation charges create a significant impact on the income statement. Financial institutions such as commercial banks, insurance companies and real estate investment trusts have a much higher exposure to fundamentals volatility (Chorafas, 2006). The non-financial firms having businesses in multiple international markets and excessively involved in trading financial instruments can also witness higher volatility of fundamentals compared to their peers with less involvement in the aforementioned segments (Zhang and Zhang, 2020). But the fair value accounting is not without its counterarguments due to certain limitations and adjustments on the financial statements (Chen and Gavious, 2016; Palea, 2013). The first Fair value accounting criticism started with the credit crunch of 2008, where Fair value accounting was held responsible for its more prominent role in the credit crunch due to its procyclicality during the economic cycle 1. Many critics have also argued that fair value accounting creates downward pressure on the Asset's prices. In the scenario of a pandemic or economic downturn, the Fair Value prices of assets and liabilities might not justify their underlying value. It also creates a problem - in certain intangibles such as goodwill, where buying an asset at fair value prices lower than it is carrying value might implicate negative goodwill, which is not correct. Critics like (Damodaran, 2010; Schildbach, 2011) believe that fair value accounting causes too much fluctuation in earnings and cash flow, making it difficult to estimate future figures. Fair value accounting might also create problems as it focuses on relative valuation (Multiples used from the market transaction) to value assets instead of using the valuation methods based on cash flows and intrinsic valuation (Schildbach, 2011). Thus, there are still many flaws in using fair value accounting, just like using only historical cost accounting provides only initial valuation but provides no information regarding the future value of the assets (Jaijairam, 2012). Therefore, this research paper will concisely discuss wide acceptance and the benefits offered by fair value accounting when compared to the historical cost method and current problems that originated due to its implementation. In the end, a brief discussion will be presented underlining future challenges for fair value accounting. Download 383.21 Kb. Share with your friends:
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