Assessed to the municipality of Tower Hamlet’s decision

Assessed Coursework BUSM107

 

The use of fair value accounting has become increasing
popular in financial reporting as an alternative to historical cost accounting.
This report will discuss how, dependent on the situation and type of asset,
either of these methods could be the most applicable. A range of research has
looked into the appropriateness of fair value and historical cost accounting
with regard to different forms of assets to give a variety of arguments for and
against each. Some would argue that the use of both in conjunction with one
another could be a beneficial way of taking advantage of each method (Penman,
2007: 35), but alternatively other perspectives could argue that this would
eliminate the more prominent benefits of using fair value or historical cost
accounting on their own. The following, will examine three scenarios for the
company ‘Combo applications’, and suggest the most suitable accounting
treatment for each scenario, and their implications on the balance sheet and
income statement.

 

Scenario 1

 

On the 1st of February 2017 Combo applications
bought a building for £500,000 but in August 2017 the announcement of a
landfill to be created adjusted to the building resulted in impairment of the
building. Subsequent to this, the building was revalued to £200,000. The IAS 36
for the impairment of assets, and the fair value, will be used as the relevant
accounting treatment for this scenario. For this accounting standard, the asset
that has been impaired is the building bought by Combo application. The
indication of impairment is defined by the external source that the market
value has declined. Upon revaluation by the agent, the recoverable amount of
the building was found to be £200,000. This has been based on the reliable
source that is the independent estate agent, this source can be deemed reliable
as the agent is unbiased towards Combo applications. The
decrease in value of the building should be disclosed in both the income
statement and the balance sheet. The impairment loss, due to the municipality
of Tower Hamlet’s decision to build the landfill, should be disclosed as a
loss, which comes under the expenses, in the income statement, and as a
decrease in the equity and assets in the balance sheet.

Although it has been suggested that historical costing can
be beneficial for many accounting applications, it has also been said that
“historical costs do not reflect the current fundamental value of an asset”
thus proving to be less useful than fair value (Laux and Leuz, 2009: 828).
Building on this, it has been argued that the use of fair value is most suitable
in financial reporting as it “increases transparency by providing more timely
information” which is most useful to allow a manger to understand the current
financial state of a company (McDonough and Shakespeare, 2015:96). Reliability
is also a critical factor of any form of financial reporting, and has been
defined by “three primary characteristics” which are “predictive value,
feedback value, and timeliness”, that are all represented with far more
strength by fair value in comparison to historical costing (Herrmann,
Saudagaran and Thomas, 2006: 49). The use of revaluations of a property and
fair value reporting are also incredibly useful in the predictive forecasting
“of future earnings” and are therefore a much more beneficial method of
explaining “current returns and prices” over the use of historical costing –
proving to offer a more incremental “predictive value” to financial reporting
(Herrmann, Saudagaran and Thomas, 2006: 49).  Considering this, it is important to emphasise
the “feedback value” that comes from the use of fair value over historical
costing, as fair value allows one to strengthen their understanding of the
financial situation of a company by confirming or correcting “prior
expectations formed by users based on current economic conditions and the most
recent revaluation” thus providing important information when assessing the
situation of a company such as Combo applications after the impairment of
assets (Herrmann, Saudagaran and Thomas, 2006: 50). The most prominent issue when
opting for fair value instead of historical costing in financial reporting is
the “reliability of the valuations”, as emphasised in a paper about “the use of
fair valuation at Enron”, but as the revaluation has been made through an
independent estate agent in this scenario, the reliability can be deemed as credible
(Gwilliam and Jackson, 2008: 244).

 

Scenario 2

 

On the 25th of September, Combo applications
bought shares of Petroleum for £2,000,000, but a fall in oil prices resulted in
a plummet in the value of the shares to a new value of £780,000 on the London
Stock Exchange. The IAS 39 for financial instruments: recognition and
measurement, and the fair value will be used as the relevant accounting
treatment for this scenario. The financial assets in this scenario will be
classified at fair value through profit or loss designated as held for trading.
As stated in the IAS 39, after the initial recognition measurement, any future
measurements should be taken at fair value.1 The IAS 28 will not be used for this scenario, as it is assumed that Combo
applications are not associates, therefore IAS 28 for investments in associates
is not applicable. The decrease in fair value, as a result of the fall in oil
prices, should be shown in both the income statement and in the balance sheet.
In the balance sheet, it should be disclosed as a decrease in the value of
financial assets, and in the income statement it should be shown as a loss from
the change in value of a financial asset, which comes under expenses.

It has been argued that historical cost accounting should
not be considered as an alternative for fair value accounting for “liquid
assets (e.g., stocks) in banks’ trading books” and that it is “surprising” that
one would assume that “the liquidity of an asset should play no role” in
financial reporting, as such factors are critical in the ongoing determination
of “margin or collateral requirements” (Laux and Leuz, 2009: 828). In addition
to this, it is important to “maximize the use of observable inputs” in
financial reporting to improve reliability and usefulness, therefore “quoted
prices in active markets”, such as the London Stock Exchange, should be used as
“fair value when available” for transparency and profitableness from such
reports for the most promising use by managers (Laux and Leuz, 2009: 827). Although,
it must also be taken into account that fair value accounting can “introduce
volatility in normal times” and “give rise to contagion effects in times of
crisis”, thus various external factors, such as the overall economic conditions
of the company, should be considered when deciding between the use of fair
value accounting and historical costing (Laux and Leuz, 2009: 832). In contrast,
the use of fair value in regard to stock shares is one of the most advantageous
and reliable uses of fair value accounting. It has been documented that there
is a “statistically significant association between stock prices and fair
values of investment” over historical costing, thus justifying the “incremental
explanatory power” that fair value has over the use of historical costs
(Carroll, Linsmeier and Petroni, 2016: 5). Similarly, research has shown that
there is a “statistically significant association between stock returns and
fair value estimates of securities gains and losses” in financial reporting,
hence signifying the importance and potency in the use of fair value accounting
in conjunction with shares in an active market to ensure the most beneficial
outcomes from such reports (Carroll, Linsmeier and Petroni, 2016: 5). This
scenario is particularly well suited to the use of fair value accounting as it
is based on a level 1 asset and level 1 “fair value measurements are derived
from observable valuation inputs on quoted prices in active markets”,
consequently this method of financial reporting is far more reliable than that
of historical cost accounting (McDonough and Shakespeare, 2015: 97). This
offsets one of the most prominent worries in the use of fair value over
historical accounting, guaranteeing that “the estimates represent the
underlying economic transactions they are intended to represent”, thus proving
fair value accounting to be the most appropriate and reliable method to use for
financial reporting in this scenario (McDonough and Shakespeare, 2015: 99).

 

Scenario 3

 

Combo application bought raw materials, with a value of
£120,000 on the 1st of October 2017, that were kept in their warehouse,
but due to a flood on the 2nd of October 2017 80% of the raw
materials were destroyed. This 80% has a scrap value of £20,000, and new
material had to be bought with a replacement cost of £130,000. The IAS 2 for
inventories, and historical cost accounting will be used as the relevant accounting
treatment for this scenario. The historical cost and
value of the asset in this scenario is £120,000. The £130,000 paid for the
replacement of the destroyed material is shown as an expense in the income
statement, but will not be shown in the balance sheet.

Although it has become increasingly common for financial
reports to use fair value accounting over historical cost accounting, the
latter can still be the more applicable option in certain situations. It has
been suggested that with respect to inventory, the use of historical cost accounting
can be sufficient, as long as the projections of “future revenues” can be
accurately made by a manager (Baldenius and Reichelstein, 2005: 1039). In
addition to this, if such forecasts cannot be made accurately, and “market
conditions are uncertain”, then the “lower-of cost-or-market rule” can be used,
such that in scenario 3, this would result in the historical cost accounting
method being used over that of the fair value Baldenius and Reichelstein, 2005:
1039). The use of fair value has an ongoing issue of reliability of valuation, hence
resulting in valuations that are “costly to determine and verify”, as a pose to
historical costing which only relies on the amount that was initially paid for
the assets, making it a much better option for financial reporting in this
scenario (Benston, 2008: 103). Looking at the use of historical cost accounting
in contrast to fair value accounting from a managers point of view, it can be
said that unlike fair value, historical cost accounting “does not report the
(present) value of expected outcomes” with regard to the business plan, but
instead it conveys the advances that have been made in “executing the plan”,
while allowing the recognition of “value added (earnings)”, which can be a much
more advantageous approach to financial reporting for a manager to be able to
gauge the position of a business and where improvements may be needed with
regards to strategy (Penman, 2007: 36-37). Hence, conveying how this method of
financial reporting can bring much more knowledge and, in consequence,
advantage for the future of a business. One disadvantage of using fair value
rather than historical value accounting in this scenario is that without a
potential purchaser for the assets the “exit values would be zero or even
negative” if the assets would have to be disposed of, therefore “a substantial
expense” would have to be reported if fair value were to be used over the historical
accounting value (Benston, 2008: 103-104). Lastly the issue of how products are
priced relates to the consideration of which accounting method should be used,
historical or fair value. It is argued that the “raw material used in
manufacturing” gets its added value from the production of a product using the
raw material, which is then sold to customers, not from “changes in its exit
market”, therefore the use of fair value accounting (which focuses on the exit
market) in this scenario would be inappropriate in comparison to that of
historical costing, which the pricing depends on (Penman, 2007: 39-40).

 

In conclusion, the relevant accounting treatment for
scenario 1 would be to use IAS 36 with fair value accounting, for scenario 2
would be to use IAS 39 and fair value accounting, and for scenario 3 would be
to use IAS 2 and historical cost accounting. This conclusion was based on the
most applicable international accounting standard for each scenario, in
conjunction with the most suitable accounting method between fair value or
historical cost accounting to develop the most useful report for a manager. The
latter was decided upon using past research on various scenarios and their use
of each accounting method, taking into account the pros and cons of each to
reach a final decision of the most suitable accounting method for the scenario
at hand.