Fair Value And Valuation Analysis

Considerable controversy exists about the changing views on accounting measurement. Traditionally historical cost has always been used in the measurement of value but more recently standard-setters have been pushing the use of various fair value concepts to measure value. Critics of the fair value argue that the fair value concepts have made accounting information less fit for purpose but I would argue that the use of fair value concepts in measurement, while not without limitations, is a worthy opponent to historical cost.

The choice and use of measurement impacts how well we fulfil the key objectives of financial reporting particularly the objective of decision usefulness. (Rankin, Stanton, McGowan, Ferlauto & Tilling, 2012) Measurement

(Rankin, Stanton, McGowan, Ferlauto & Tilling, 2012) The techniques chosen is a matter for professional judgement but much of the assumptions and judgements come from management. This in turn leads to the question, can management be objective when selecting valuation techniques? Managers have an information advantage over gatekeepers (auditors etc.) and manipulate results so they are advantageous to them which are misleading or do not necessarily reflect the most faithful economic representation of the item being valued. (Laux & Leuz, 2009) This results in fair value becoming less neutral. In response to this criticism we need to look at the alternative, historical cost. Historical Cost is unlikely to be a remedy as it has also has its own sets of problems. The neutrality of historical cost comes under scrutiny because historical cost accounting provides incentives to engage in ‘gains trading’ or to securitize and sell assets. (Laux & Leuz, 2009) This reduces the reliability of historical cost to faithfully represent the entity’s economic situation and performance. Historical cost can also be argued to be subjective as it includes a substantial number of estimates such as judgements regarding economic life of the asset, allocation of indirect and joint costs, bad debt reserves etc. (Lefebvre, Siminova & Scarlat,

Historical cost has the advantage of being simple to compute and on a surface level seems easy to understand. (Rankin, Stanton, McGowan, Ferlauto & Tilling, 2012) However to address a complex transaction with historical cost is too simplistic. An example of this would be when a firm has an interest rate swap which obliges it to pay large sums even though the historical cost of the swap as zero. (Lefebvre, Siminova & Scarlat, 2009) The limitations of historical cost are not always well understood and that can reduce the understanding ability of financial information users. Fair value is generally viewed as more understandable to general users of financial information – particularly to those who not financially literate. To them it makes sense to have updated, current values rather than a value of something that has happened in the past, because as most people are aware, the value of something changes over time. (Rankin, Stanton, McGowan, Ferlauto & Tilling,