Benefits as well as drawbacks of fair value are discussed the recently years by bank regulators and investors. Some argue that fair value despite the weaknesses is the best method to value financial instruments when accompanied by suitable disclosure as opposed others prefer the traditional and main alternative to fair value, historical cost.
Among the advantages of fair value is that it is a clear concept - the value that a business could get by selling or settling the item now.
Supporters of fair value argue that it is more relevant than historical cost because the fact that it provides up-to-date information, consistent with market whereby increasing transparency and encouraging prompt corrective actions. The historical cost regime relies on past transaction prices and so accounting values are insensitive to more recent price signals. This lack of sensitivity to price signals induces inefficient decisions because the measurement regime does not reflect the most recent fundamental value of the assets (Plantin, Sapra, Shin, 2008).
The fair value accounting allows users of financial statements to obtain a truer and fairer view of the company's real financial situation as only fair value reflects the prevailing economic conditions and the changes in them. By contrast, historical cost accounting shows the conditions that existed when the transaction took place and any possible changes in the price do not appear until the asset is realised.
One further advantage is that fair value offers a consistent and comparable valuation framework due to at the same time valuation and the same principle. The alternative model does not allow comparisons and if so, difficult to be made. For instance two companies with similar financial instruments could disclose different values on their statements according to the moment they bought them.
IASB has defined fair value as a current market exit price. This is tighter definition and more strict. There may be other cases where the kind of measurement is slightly different and ore appropriate like replacement cost or value in use.
It is the value that a business could have obtained selling an asset at thebalance sheet date, but this is a value tha it chose not to sell at. Therefore, in such cases fair value measures what a business would get by selling the asset today, whereby historical cost is based on what the business intends to do withthe asset,namely, to hold on to it and receive the interest and if necessary impair the asset.
When a company's credit rating deteriorates, this falling would lead to a decline in fair value of a company's liabilities and if they were included at fair value this would create a profit at a time when the company's performance or prospectsmay have worsen.
Martin Sullivan, AIG's chief executive, told in the Financial Times press that "mark-to-market" rules forced companies to recognise losses even when they had no intention of selling assets at the current prices (Financial Times 2008).
The historical cost regime relies on past transaction prices, and so accounting values are insensitive to more recent price signals.
assets that are recorded at historical cost, are generally equals the fair value when they are originally purchased. Subsequently, historical costs are adjusted for amortization and impairments, but not for increases in asset values. Impairments have been a part of historical-cost accounting for decades and occur when the fair value of an asset falls below its amortized cost. When asset values decline and impairment is unrestricted, fair-value accounting and historical-cost accounting are conceptually the same. However, in practice, the impairment test differs across assets. Moreover, whether or not the book value of an impaired asset is written down and the loss is recognized in the income statement depends on the asset in question and, in many cases, on whether the impairment is deemed as "other than temporary."
Fair value provides vital information about financial instrument either assets or liabilities in contrast to values based on their historical cost. Fair value provides comparability of the value of financial instruments bought at different times, therefore it reflects the conditions in a current market. Additionally, financial disclosures that use fair value provide investors with insight into predominant market values, further helping to ensure the usefulness of financial reports.
It is not a matter of dispute that investors make decisions based on expectations and, to that extent, fair value is in concert with investors' outlook. However, by reporting fair values alone, investors are deprived from the firm-specific benchmark, which is represented by historical cost or the funds invested in acquiring the asset. Without knowledge of historical cost, the investor would not know whether the fair value (present value of future cash flows) is better or worse the funds given up to acquire the asset. From the investors' standpoint, neither historical cost nor fair value perspective offers the necessary and sufficient information to know the answers to two concerns:
A. Rashad Abdel-khalik 2008
Nevertheless ACCA (Association of Chartered Certifies Accountants) declares openly that fair value still represent the most effective method to reflect the economic realities of market conditions (ACCA, 2009).
The standard is basically applied to all financial instruments that are assigned to the scope of application of IAS 39 except those that are excluded (KPMG, 2006 p.9).
Financial assets are measured as IAS 39 paragraph 45 states.
The setting of regulations and standards for valuating and recognizing financial liabilities, financial assets as well as agreements, dealing with the purchase, sale and holding of non-financial items in financial statements represent the major purpose of IAS 39 (International Accounting Standard Committee, (2000), p. 349).
The first classified assets are measured at fair value and this includes all derivatives and changes flow directly through income statement. Held to maturity investments at amortised cost, loans and receivables too. The latter may not include derivatives nor be quoted on an active market and use the effective interest rate method. Available for sale assets at fair value but the change in fair value goes to equity and is reported in other comprehensive income with gains and losses recycled through the income statement when the asset is sold.