Fair Value Hunter Buie ACTG 6110 Fall 2015

Relevance vs. Reliability Relevance Relevant information can make a difference by improving decision makers’ capacities to predict or by providing feedback on earlier expectations. Reliability quality that can be demonstrated by securing a high degree of consensus among independent measures using the same measurement methods

Effect of Fair Value On Users Fair value accounting generates more relevant information for the user but due to estimation uncertainty leads to less reliable information. However, this begs the question of…. Is increased relevant information meaningless without having reliability attached to it? “Though a longstanding debate continues, the FASB has concluded that improvements in relevance generated by the use of fair value is often worth the trade off of reliability of information.” (Fornaro 2007)

Financial Statement Effect Bal ance Sheet Fair value valuation of assets and liabilities are attached to the market as opposed to acquisition price. For that reason, creates volatility on the balance sheet because values are constantly changing. Economic downturn of Because fair value is attached to the market, the economic downturn resulted in many companies having to record their assets at lower values than what they were worth. This in turn forced many companies to sell their assets in order to maintain debt agreements.

Financial Statement Effect Income Statement Fair Value Accounting has a direct impact on the net income of a company One example can be seen in the Other Than Temporary Impairment (OTTI) account. Write down any asset and recognize loss if there is impairment. An impairment is only “Other Than Temporary”.

Effect on Management Fair value accounting requires increased subjectivity for management. This increased subjectivity can lead to bias and manipulation throughout the financial statement by management. Fair Value Hierarchy Level I Level II Level III Other Than Temporary Impairment (OTTI) account

Fair Value Hierarchy (Level III) Level three inputs require the most subjectivity in fair value accounting. Based on unobservable inputs that are gathered outside the reporting entity. Useful when generated legitimately but in some circumstances can lead to management bias. Ex. Management getting an estimation of land from three outside sources at $500k, $700k, $950k.

“OTTI” Management team can decide to take large OTTI charge in a single quarter. This action implies that the entity’s asset value is underestimated. Thus, in such situation, the entity will benefit from higher earnings in subsequent periods, cash flows are stronger than what the values carried on the balance sheet would suggest. To investors who consider returns on equity, the financial statements of such a company will look promising because the equity is low (as manipulated) compared to its return

Future Research Cost/Benefit analysis of preparing a balance sheet with two columns First column valuing assets at historical cost Second column valuing assets at fair value This would allow for users to have information that is both relevant and reliable appear on the financial statements in order to make decisions.

Questions??