Introduction
Fluctuations in the value of assets or liabilities could cause significant changes to a company’s financial position because of their effects on balance sheets and income statements, which are common indicators of a firm’s financial health. Given the importance of using accurate data for making investment decisions, it is critical to apply reliable measurement techniques to track changes in the value of assets and liabilities (Saastamoinen et al., 2020). Fair value measurement is designed to meet this objective. The International Financial Reporting Standards (IFRS) defines fair value as “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” (IFRS Foundation, 2021, p. 3). In this regard, this statement means that fair value assessment represents the transaction price that would be paid by a buyer if all market conditions are satisfied, including assumptions about risk.
This report explains the potential for the application of fair value measurement in your organization by highlighting its merits and demerits as well as considerations for its adoption. The provisions of International Financial Reporting Standards (IFRS) guide the findings (IFRS Foundation, 2021). In the next section of this brief, I will outline the theoretical basis for the development of the fair value assessment model, as explained by the asset, depreciation, and profitability theories.
Theoretical Foundation
Asset Theory
The asset theory is relevant in assessing the value of a company’s assets or liabilities because of its focus on utility. An asset is a tangible or intangible item that can be consumed or relished over time to create value for the owners (Evans and Kamla, 2018). Assets are often based on their historical costs and are measured consistently over time (Back, 2017). They should also be devoid of misspecifications that may affect the assessment of their value (Ferson, 2019). In cases where accountants have to compute historical costs of an asset, all incidental expenses should be included in the measurement criterion (Back, 2017). Alternatively, maintenance costs may be treated as “ordinary expenses” (Mora et al., 2019). At the same time, the acquisition costs of an asset should be adjusted for changes in price levels from the time of acquisition to the measurement period (Back, 2017). These accounting guidelines demonstrate that the asset theory provides a holistic assessment of value based on the historical, maintenance, or acquisition costs of an asset or liability.
Profitability Theory
Profitability is an important concept of accounting because it outlines the difference between expenses and revenues. The associated theory is relevant in the application of the fair value model because it defines the value that a business generates for its shareholders (Mora et al., 2019). It is relevant in valuing assets and liabilities because it shares an intrinsic relationship with its value (Ujwary-Gil and Nalepka, 2018). Most organizations seek to maximize their profits by taking into account the financial value of an asset as well as its condition at the time of sale (Ujwary-Gil and Nalepka, 2018). A firm’s profitability index could be measured using different metrics, including the Return on Capital (ROC), Return on Investments (ROI), and Return on Equity (ROE).
There is a need to be cautious when using the profitability theory because there is no consensus regarding what profitability entails for different organizations and there is a lack of understanding of the risks associated with evaluating earnings potential (Ujwary-Gil and Nalepka, 2018). Similarly, there is a lack of focus on the time value of money and the economic risks of pursuing different strategic options based on the findings of evaluation processes (Ujwary-Gil and Nalepka, 2018). Therefore, accurate assessments should take into account the timing, uncertainties involved, and the selection of the best alternative to use among a series of options available when making profit-based evaluations.
The Depreciation Theory
The depreciation theory explains the loss in the value of an asset due to its technological obsolesce, aesthetic distress, or functional loss. Given that depreciation often occurs over time, valuation processes that are underpinned by the linked theory account for the historical cost of an asset (IFRS Foundation, 2021; Asish, 2019). According to the International Accounting Standard (IAS) 16, depreciation that negatively affects the value of plant and equipment may affect the financial position of a firm (Deloitte, 2021). Differences in computation may occur across various asset types because each one has its taxation and reporting criterion (Alexander et al., 2018). Differences in laws and accounting standards that are practiced in various jurisdictions may also affect the type of reporting and taxation models adopted (Jia and Zhao, 2020). Therefore, it is important to appreciate the context-specific nature of the depreciation theory when calculating changes in the values of assets and liabilities.
IFRS 13: Application
There are different bases for conducting fair value evaluations with the most common ones being market, cost, and income-based approaches. A market-based model involves a comparison of assets or liabilities of similar nature (Deloitte, 2021). Comparatively, the cost-based approach uses the transaction value of an asset or liability to determine its impact on a business after adjusting for physical deterioration and the potential for technological obsolesce (McDonough et al., 2020). Comparatively, the income approach is based on an evaluation of the impact of an asset or liability based on its future cash flow projections (IFRS Foundation, 2021). The IFRS 14 assumes that the implementation of fair market policies should occur in the principal market of the asset sale and not a secondary one (IFRS Foundation, 2021; Deloitte, 2021). In the absence of the principal market, it is expected that the market offering the “most benefits” would be used for the sale (Deloitte, 2021; Ujwary-Gil and Nalepka, 2018). The same principle is used in assessing non-financial assets because the highest utility of an asset is often used in value computations, as opposed to any other measurement framework (Jansen, 2018). When undertaking the above-mentioned calculations, it is also important to note the measurement criterion used in computing liabilities. Therefore, calculations of fair value assessment should be done by accounting for the non-performance value of an asset.
Fair value assessments should also be implemented by following specific rules. For example, considerations for selecting the valuation method are dependent on the availability of sufficient data (Schmal et al., 2021). At the same time, it is common practice to maximize observable inputs, while minimizing the unobservable ones. IFRS 13 requires all parties to disclose relevant information about the valuation (Deloitte, 2021). For example, analytical techniques used to measure assets and liabilities should be disclosed when using information borrowed from validated financial documents, such as balance sheets or income statements (Ujwary-Gil and Nalepka, 2018; Schmal et al., 2021). Fair value assessments that involve unobservable inputs should also disclose all relevant data that may influence the profit or loss of a company (Deloitte, 2021). In this regard, the intention to hold on to assets or to settle claims should be excluded from fair value assessments (Deloitte, 2021). Instead, market forces should be used as the primary criterion for making assessment decisions, as opposed to entity-specific factors.
Benefits and Limitations of Assessment
Benefits
Given that fair value measurements rely on updated market information and time-specific data for analysis, it emerges as a reliable source of timely information for businesses. This attribute makes it possible to take corrective actions in a timely fashion. The benefit is aligned with the accuracy of data it provides because there is synchrony in the movement of prices and valuation techniques adopted in fair value measurement (Ntim et al., 2017). Current movements in price will allow your company to know its position, relative to its valuation processes.
Compared to other techniques, the fair value measurement also provides rich data relating to a company’s financial performance, relative to other forms of accounting. For example, it provides more information about an asset or liability, such as its historical cost and market value, compared to other techniques (Chen et al., 2020). In this regard, it enhances the power of financial data when making corporate decisions (Kallio et al., 2021). Therefore, fair value measurement is a reliable source of updated market information and time-specific data. The information obtained from fair value measurement is also thorough, in the sense that it requires all participants to disclose relevant information about valuation, including the methodologies used and any risks or assumptions made in the process (Lehner et al., 2019). In this regard, there is increased transparency of accountancy standards in the firm and more importantly in the accounting practices adopted.
Limitations
Some researchers hold differing views regarding the merits of fair value assessment outlined above. For example, Drake et al. (2019) argue that fair value adopts a generalized understanding of asset value computation, while a customized model could be developed to meet the same goal. Therefore, they highlight the need to exercise caution when applying the fair value assessment model because they believe it does not outline measurement or disclosure requirements needed in making transactions (Reinstein et al., 2020). At the same time, disclosure requirements for fair value reporting are also rarely accommodated in daily assessments, especially those that relate to the development of retirement and benefits plans.
It is also important to exercise caution when implementing the fair value assessment model because of the risk of value reversal and market effects that may emerge when reporting financial data. The risk of value reversal could occur when there are fluctuating market conditions where assets or liabilities are traded, thereby making conditions volatile for sale (Drake et al., 2019). These unfavorable conditions could create large swings in the value of assets or liabilities, thereby negatively affecting the valuation process.
Fair value accounting should also not be applied in uncertain times because conditions are rife for developing misleading reports, especially when large swings in value are published as accurate prices of assets or liabilities. IAS 36 defines the rules for reporting assets that have significant changes in value (Deloitte, 2021). Given that such losses in value are non-recurring, most businesses tend to write them off because the loss in value may significantly erode an asset’s worth (Deloitte, 2021). Overall, it is important to understand how the risks and benefits of fair value reporting influence financial reporting practices.
Conclusion
In this brief, I have explored the potential for the application of fair value measurement in your organization by highlighting its merits and demerits as well as considerations for its adoption. Given the importance of using accurate data for making investment decisions, the justification for this analysis is founded on the need to apply reliable measurement techniques to track changes in the value of assets and liabilities. Indeed, the insights highlighted in this paper show that fair value assessment is increasingly being adopted as the preferred mode of value assessment for assets and liabilities.
Fair value assessment emerges as a reliable measure for use in your company because its merits are centered on its ability to provide a true measure of income, timely data, and an accurate valuation of the worth of assets and liabilities. Implementing fair value assessment guidelines in your organization should be done by following the guidelines of the IFRS and IAS – whichever is appropriately suited to your taxing and accounting laws. At the same time, it is important to be cautious about the risk of value reversal, which could occur when there are fluctuating market conditions. Overall, fair value measurement is a reliable metric for tracking changes to a company’s assets or liabilities.
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