The Trend Toward Fair Value Accounting Case Study Homework Help
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Critics contend that GAAP is seriously flawed. Some in the accounting profession go so far as to pronounce financial statements almost completely irrelevant to the financial analyst community. The fact that the market value of publicly traded firms on the New York Stock Exchange is an average of five times their asset values serves to highlight this deficiency. Many reformers, including FASB chairman Robert Herz, believe that fair value accounting must be part of the answer to making financial statements more relevant and useful.* Advocates of fair value accounting say it would give users of financial statements a far clearer picture of the economic state of a company.
But switching from historical cost to fair value requires enormous effort. Valuing assets in the absence of active markets can be very subjective, making financial statements less reliable. In fact, disputes can arise over the very definition of certain assets and liabilities. The crux of the fair value debate is this: Each side agrees that relevance and reliability are important, but fair value advocates emphasize relevance, while historical cost advocates place greater weight on reliability.
Relevance versus Reliability
The pertinent conceptual guidance for making trade-offs between relevance and reliability is provided by FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information. It provides guidance for making standard-setting decisions aimed at producing information useful to investors and creditors. Concepts Statement No. 2 states:
The qualities that distinguish “better” (more useful) information from “inferior” (less useful) information are primarily the qualities of relevance and reliability … The objective of accounting policy decisions is to produce accounting information that is relevant to the purposes to be served and is reliable.
Critics of fair value generally believe that reliability should be the dominant characteristic of financial statement measures. But the FASB has required greater use of fair value measurements in financial statements because it perceives that information as more relevant to investors and creditors than historical cost information. In that regard, the FASB has not accepted the view that reliability should outweigh relevance for financial statement measures.
Some critics also interpret reliability as having a meaning that differs in at least certain respects from how that term is defined in the FASB’s Conceptual Framework. Some critics equate reliability with precision, and others view it principally in terms of verifiability. However, Concepts Statement No. 2 defines reliability as “the quality of information that assures that information is reasonably free from error or bias and faithfully represents what it purports to represent.” With respect to measures, it states that “[t]he reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has that representational quality.” Thus, the principal components of reliability are representational faithfulness and verifiability.
Although there are reliability concerns associated with fair value measures, particularly when such measures may not be able to be observed in active markets and greater reliance must be placed on estimates of those measures, present-day financial statements are replete with estimates that are viewed as being sufficiently reliable. Indeed, present day measures of many assets and liabilities (and changes in them) are based on estimates, for example, the collectability of receivables, salability of inventories, useful lives of equipment, amounts and timing of future cash flows from investments, or likelihood of loss in tort or environmental litigation.
Even though the precision of calculated measures such as those in depreciation accounting is not open to question since they can be calculated down to the penny, the reliability of those measures is open to question. Precision, therefore, is not a component of reliability under Concepts Statement No. 2. In fact, Concepts Statement No. 2 expressly states that reliability does not imply certainty or precision, and adds that any pretension to those qualities if they do not exist is a negation of reliability.
1. What you think is the fundamental problem with financial statements based upon the historic cost measurement principle used under US GAAP ?
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2. What do you think of the principle’ … accounts must reflect economic reality’ as a core principle of measurement in accounting?
3. How would you measure economic reality?
4. What is reliability in accounting?
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