This article is mainly about an opinion given by Philip Broadley about an article written by Stephen H. Penman regarding the fair value measurement issues. Philip Broadley is a finance director of Prudential plc and also Chairman of the Hundred Group of Finance Directors. He was invited to give opinion from preparer's perspective on Stephen H. Penman's paper, whether fair value helps on the quality of financial reporting. Upon on it, Philip Broadley thinks that preparer take an intense interest in the deliverables that constitute financial reporting rather than just a person who simply responsible to prepare the financial statement. Basically, he agreed with article by Stephen H. Penman. He supported fair value approach as a basis of measurement only if the level 1 criterion is fulfilled.
On top of that, some questions had been raised by him if using fair value basis. First is the achievable of objectives to simplify accounting standards if the market price is not observable, like the issues of comparability and transparency. Second, the extent of deep and liquidity markets for transactions that reported on fair value basis. He used the example of pension accounting and buy out valuation of pension fund for companies. He suggested using UK context in which if pension fund has more than £2bn worth of assets in it, no buy-out valuation of pension fund should be done and disclosed because the degree of certainty is questionable. Third is the appropriateness of discount rate used to value pension liability: the determination of discount rate and whether to independent the fund from the asset mix. Besides that, he also related the bubble notion stated in Stephen's article with the issue of valuation pension fund liabilities for companies in United Kingdom based on a relatively small amount of index linked gilts in issue being traded on. Gilts are risk free bond issued by British government and are an equivalent of US treasury.
He concludes that fair value might provide better information for markets if the problems such as existence of observable market, dept and liquidity of market, one-to-one test can be solved and the utmost things is it can be connected to reality.
2.0 Comparison with article "Financial Reporting Quality: Is fair value a plus or a minus" by Stephen H. Penman
We would like to compare opinion from Philip Broadley with the article wrote by Stephen H. Penman about the plusses and minus of using fair value measurement in financial statement. Stephen H. Penman compared fair value accounting and historical accounting, discussed issues raised from fair value accounting and concludes that although conceptually, fair value works well for the valuation and stewardship purposes but valuation can also be done using historical cost accounting. This statement is supported by the example of coca cola in his appendix. He mentioned that the problems of fair value accounting are difficult to solve in relative to the problems arise with historical cost measurement at the end of his article.
The main difference between the two articles is Stephen took a shareholder's perspective while Broadley took a preparer's perspective. For shareholder perspective, theoretically, the design and the quality of the financial reporting should be judged on how well it serves the shareholders in terms of stewardship and valuation. In the respect of preparer perspective, they consider financial reporting to be able to assist them in making decisions and handle company resources.
In Stephen P. Henman's article, the definition of fair value and historical cost accounting is stated and some issues needed to be considered when using fair value are also being discussed as below.
2.1 What is historical cost accounting?
As for historical cost, assets are presented on the balance sheet at their value at the time of acquisition, which is generally presented on the balance sheet at their value at the time of acquisition and adjusted for depreciation and in some cases with impairment. This acquisition cost is represented by purchase cost. As for liabilities, they are usually carried at the process at which they were incurred. For many years, they assume that historical cost is sufficient. But, because of an era marked by the widespread use of complicated financial instruments and risk management strategies that may render yesterday's prices obsolete, some accounting practitioners think that they need to abandon or modify or replace it with fair value accounting.
2.2 What is fair value accounting?
Fair value accounting is a financial reporting approach in which companies are required or permitted to measure and report on an ongoing basis certain assets and liabilities, which is generally financial instruments, at estimates of the process they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities. Under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. Those losses reduce companies' reported equity and my also reduce companies' reported net income. Fair value states the value of all assets and liabilities on the balance sheet to shareholders to inform the management's stewardship and equity value according to Stephen H.Penman's article. Using fair value accounting, the balance sheet provides the valuation objective, while the income statement conveys about the risk exposure and management performance. There are three notions of fair value: fair value applied in mixed attribute model, fair value as entry value and fair value as exit value. The third notion is most debatable due to its valuation of asset and liabilities with no realization.
According to FASB Standard 157, Fair Value Measurements, to determine market price, three levels of inputs are identified by differentiate the level of subjectivity. The input for Level 1 is quoted prices for identical asset and liability which is observable in active market. Philip Broadley supported the use of fair value of the criterion of Level 1 is fulfilled. Both level 2 and level 3 for fair value measurement use estimates of hypothetical market prices. Level 2 inputs are inputs other than Level 1 quoted prices that are observable, directly or indirectly; examples include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs such as observed interest rates, credit risks, volatilities, and default rates, and inputs corroborated by observable market data by correlation or other means. (Penman, S. H.,2006) The input for level 3 are unobservable that reflect company's assumption that market participants would use when price asset and liability.
2.3 Issues that need to be considered when using fair value accounting
2.3.1 Bubbles to income statement
Fair values bring price bubbles into financial statement. This is because the loss of information on history cost will cause the price to be inefficient. In a price bubble, the prices stated in the balance sheet are inefficient, as the bubble is flowing throughout the income statement. This leads to a large problem in long term portfolio, rather than in short term. The reason is, the price bubble easily give us the appearance of adequate reserves in the future, however, when the price reaches a certain point and collapses violently, it will cause serious loss.
2.3.2 Estimation Problem
The estimation based on own assumption is questionable because this method is subjective and might be manipulated for own interest.
Below are the issues of using estimated fair values.
1. Estimation is required may be limited, as there are many restriction.
2. Is discipline in estimation of market price being emphasized in level 3?
3. When there is error occur in fair value estimation, this will cause the balance sheet and income statement to suffer error.
4. History cost involves estimates and estimated fair values are no different.
5. Historical cost estimates true up against the actual transactional record quickly.
6. It is doubted to carry out a superior analysis on fair value accounting. A question arises here, how would the estimation mistake be noticed?
7. The tolerance for estimated fair value is limited, as estimation prices required realization before distribution.
2.3.3 One-to-one condition
Fair value is beneficial if there is a one-to-one condition occurs between the shareholder value and the market price. For example, an investment in a marketable bond that is fluctuate freely with the change of market price without the interference of the firm and the shareholders' welfare is tied to the market price is said to be fulfill the one-to-one condition. Thus, fair value is a plus in this situation. In other word, fair value is appropriate when value comes from assets and obligation and value added or lost is from the fluctuation of these assets and obligation in the market prices.
However, fair value is inappropriate when firm arbitrages market price. In other words, firms gain profits by exploiting price differences of similar financial instruments on different markets. In this situation, the one-to-one condition is not fulfilled.
2.3.4 Matching Problem
Although fair value accounting is said to be a mean to avoid "myriad of rules" in the matching concept of business model, there are some difficulties in implementing the matching concept of fair value accounting. Fair valuing an asset and not fair valuing a liability may lead to a mismatching that result in recognition of gain and doesn't match losses (or vice versa). It will then produces "excess volatility" in earning and mislead the reader of the income statement in making economic decision. Financial statement doesn't capture the value of asset and liabilities accurately. For example, in a borrowings case, when value of assets declines, if the decrease in asset value does not recognized but the decrease in liability value is recorded as gain, then this will results in overstated of earnings. The asset and liability are not matched.
3.0 Conclusion
To the extent of the importance of providing relevant, reliable, comparable, and understandable information to the user, accounting practitioners have raised an issue as to whether to value assets and liabilities in fair value or historical cost. The relevancy and reliability of using either fair value or historical cost in measuring assets and liabilities is still in question. The issue of relevance and reliability of fair value accounting also rose in FASB report which is issued on 28 February 2005, whereby the board has required greater use of fair value measurement due to its relevancy to investors and creditors compared to historical cost information, reflects better present financial performance, and better help in evaluating their past performance and future prospects. The issues of reliability in fair value measurement is argued with arguments that financial statements nowadays are full with estimate which is regarded as sufficiently reliable and most measurements used in financial reporting are based on estimates, which can only be verified indirectly and less faithfully represent what it purports to represent.
In a nutshell, it is important for us to ensure that the financial reporting to be reliable, comparable, and transparent to increase the usefulness and understandability for all the users. Future discussions and researches need to be done in ensuring the public confidence in financial reporting.
