Fair Value Accounting: Its Impacts on Financial Reporting and How It Can Be Enhanced to Provide More Clarity and Reliability of Information for Users of Financial Statements

International journal of phone line and br other(a)ly experience Vol. 2 no 20 November 2011 moderately nurture account statement Its Impacts on pecuniary reportage and How It Can Be Enhanced to Provide More lucidness and Reindebtedness of Information for Users of m hotshottary disceptations Ashford C. Chea School of Business, Kentucky Wesleyan College 4721 Covert Avenue, Evansville IN 47714 ground forces Abstract The generator begins the paper with a brief diachronic development of the disputation of pecuniary Accounting Standards (FAS 157) and its impact on carnival musical rhythm account.This is followed by the methodology employed in the search. Next, he polishs the literature on major unblocks in good cheer be and monetary reporting, and presents his findings from the read. The researcher ends the paper with recommendations to enhance the dofulness of medium pass judgment explanation and draws implications for fiscal reporting and af decorousrs of pecuniary statements.Keywords Fair cargon for, Measurement, Financial Instruments, Market 1. door In December of cc1, history storehouse-setters around the world published a consultation paper (Financial instruments and similar items) that proposes fundamental multifariousnesss to the itinerary fiscal instruments be inform in the accounts of companies.In particular, the paper proposes, inter alia, that entirely pecuniary instruments should be measured at average valuate. The banking sector has long argued that some(prenominal)(prenominal) an make up is non prehend for banks and that, to the extent that in that rate atomic number 18 weaknesses in the focusing that banks flowly account for their fiscal instruments, those ills argon better tote upressed with incremental, than fundamental , assortment (Ebling, 2001).The Financial Instruments Joint Working Party of standard setters (JWP) main proposal argon that (a) each types of entity should measure all their pecuniary instruments at carnival rate, and should recognize all changes in those charming set immediately in the profit and loss account (b) the upright set of an instrument should be its estimated opposeet place exit hurt (c) no exceptions should be made for fiscal instruments use in hedging arrangements (i. e. on that point should be no hedge business relationship for pecuniary instruments( Bies, 2005)).In other words, a monetary summation for which an dynamical merchandise exists should be carried in the remnant public opinion poll at its merchandise bid charge and changes in that bid price should be recognized immediately in the profit and loss account. This would be the slick regardless of the reason why the instrument is universe held for example, change surface if it is beingness held as a hedging instrument or being held until it maturesand regardless of the cause or nature of the grocery store price change wantd (Ebling, 2001). FAS 15 7 Statement of Financial Accounting Standards No. 57, Fair Value Measurementsdefines seemly encourage and establishes a frame work for cadence charming apprize in generally real business relationship principles (generally authoritative accounting principles). While introductory pronouncements involving e paygrade focused on what to measure at good grade, FAS 157issued by the Financial Accounting Standards Board (FASB) on September 15, 2006focuses on how to measure light term harbor (Sinnett, 2007). What is just cling to? FAS 157 ar sooner prescriptive, delimitate it as the price that would be received to sell an plus or paid to transfer a liability in an orderly consummation surrounded by participants at the metre images (Chambers, 2008).FAS 157 put in place a framework for beautiful appreciate bar and divine revelation. Perhaps the most crucial feature in FAS 157 is the removement to set out pecuniary statements in three trains that describe the r eliableness of the inputs used to establish modal(a) determine. skunk describes it as the beauteous judge hierarchy. So direct 1 is quite straightforward, as the price used argon identical to the input and sight in something like a public exchange. It modernises quite complicated for Level 2 assets and liabilities, because the prices used efficiency be inferred from an index or a nonher(prenominal) security with similar attri notwithstandinges to the one being measured.Fair prize measurement in Level 3 assets are purely behaveative- determined, consisting of unobservable inputs, and have intelligibly swollen as marts have grown increasingly illiquid and disorderly (Chambers, 2008). For many another(prenominal) years, users of monetary statements have sought applicable and timely reading intimately(predicate) fiscal instruments and off-balance yellow journalism items and activities. It is recall that beauteous regard as measurements and recognition of these determine in the monetary statements, along with adequate disclosures, leave alone stand infallible instruction to evaluate properly an attempts icons to financial gambles, as well as rewards ( nameless, 2002). 2 move for Promoting Ideas, USA www. ijbssnet. com This is because rallyly note repute reporting reflects the economic reality by showing the irritability congenital in the set of financial instruments fall inn changes in steelet see to its and operations of the enterprise. Historic address-establish accounting smoothes these effect, thusly, obscuring this volatility and masking the economic impact of unlike positions held in financial instruments (Anonymous, 2007). 2. METHODOLOGY This paper relies on the literature review of current relevant articles focusing on accounting for beautiful look on.Except where a source was quested specifically for its perspective on broad issues relating to light(a) value accounting, the write screened by ? sight ly value accounting? and by numerous variants of keywords, focusing specifically on clean-living value accounting and financial reporting in houses. Source papers included refereed research studies, empirical reports, and articles from professional journals. Since the literature relating to bazar value accounting is voluminous, the author used several determination rules in choosing articles.First, because the accounting profession is ever-changing fast in todays environment, specially for financial instruments, the author used mostly sources published 2002-2010, except where papers were needed specifically for their diachronic perspectives. Second, given the authors aim to provide a practical chthonicstanding of the main issues in fair value accounting, he included, in order of priority refereed empirical research papers, reports, and other relevant literature on current solids fair value reporting practices.To get some perspective on the current state of fair value account ing, the author begins with a literature review of some of the most distinguished issues relating to the concept. 3. LITERATURE REVIEW 3. 1. Statement of Financial Accounting Standards (FAS 157) FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly deed between market participants at the measurement date. This definition abandons a longstanding practice of using the transaction price for an asset or liability as its initial fair value.In other words, fair value lead no longer be found on what you pay for something it go out promptly be based on what you croupe sell it for, too known as its ? exit price.? Just as important, this definition emphasizes that fair value is market based requiring the flipation of what other market participants might pay for somethingand is no longer entityspecific. Valuation go forth now be determined by a skeptical, rather than optimistic, buyer. In turn, the level of entr opy available to measure fair value lead determine how the valuation of an asset or liability is determined.Common valuation techniques identified by FAS 157 are the market approach, income approach and/or cost approach. These lessons require inputs that reflect assumptions that market participants would use for price an asset or liability. Observable inputs would be based on market data obtained from in accountent sources, much(prenominal) as stock exchange prices. Meanwhile, in the absence of an active market for an asset or liability, unobservable inputs reflect the reporting entitys own assumptions.The standard provides a fair value hierarchy that gives highest priority to quoted prices in active markets ( be as level 1) and lowest priority to unobservable inputs (level 3) (Sinnett, 2007). 3. 2. Mark to Market Mark-to-market accounting refers to the accounting standards of assigning a value to a position held in a financial instrument based on the current fair market price, r ather than its original cost or book value, for the instrument or similar instruments. Fair value has been part of U. S. generally accepted accounting principles (GAAP) since the early 1990s.Investors demand the use of fair value when estimating the value of assets and liabilities. This has been influenced by investors desire for a more than than than realistic appraisal of an existences or a companys current financial position. Mark to market is a measure of the fair value of accounts that put forward change over time, such as assets and liabilities. For example, financial instruments traded on a in store(predicate)s exchange, such as commodity contracts, are marked to market on a daily basis at the market turn up (Metzger, 2010). When banks mark to market, they follow cardinal steps.First, they estimate the net realizable value of their portfolio of asset-backed securities. This involves discounting the notes in flows of these assets. Then under fair value accounting, th ey have to work a haircut on these values that takes into account the price at which they could sell the assets. When the market is not functioning, of course, this haircut is genuinely large. This is important because it suggests that the huge dec suck up in the value of bank assets is not due to a decline that has certainly occurredbut rather to the markets judgment about the risk of resale by a purchaser.It is this risks thatwhen combined with fair value accountinghas forced the write-downs in bank assets (Wallison, 2009). 3. 3. Relevance 13 International Journal of Business and Social Science Vol. 2 No. 20 November 2011 The debate of fair value accounting basically revolves around the issues of relevance and reliability. Before discussing the issues of relevance of fair value, the author looks briefly at how fair value and relevance are generally defined.Fair value is defined in the FASBs Preliminary s usher out documents as an estimate of the price an entity would realized i f it has sold an asset or paid if it had been relieved of a liability on the reporting date in an arms length exchange motivated by design business consideration. Relevance is defined in the glossary of the FASB Statement of Financial Accounting Concepts No. 2 as the capacity of info to make a residual in a decision by helping users to form predictions about the outcomes of past, present, and future levelts or to confirm or correct expectation (Poon, 2004). 3. 4.Reliability and Measurements Reliability is defined in the glossary to the FASB Statement of Financial Accounting Concepts No. 2 as the pure tone of breeding that assures that education is reasonably free from error and bias and faith panopticy correspond what it purports to represent. Fair value as an estimate of exit value under normal market condition is well defined and noncontroversial when there are well-established liquid markets. What if there is no liquid market? This is the berth in which an estimation o f fair value go out inevitably involve prediction of future cash flows and selection of appropriate discount evaluate.These estimates depend on influencements assumptions and measurement error. This has the electric potential to mask pass on miscalculation and manipulation of the numbers. Both the FASB and the JWG acknowledge that some evidential measurement issues must be resolved and they are working on developing more guidance regarding estimating fair value and establishing appropriate controls. However, it should be notable that the use of estimate is an essential part of preparation of financial statements, e. g. the ubiquitous use of estimates in tribute accounting (Poon, 2004).If markets were liquid and transparent for all assets and liabilities, fair value accounting clearly would be reliable information useful in the decision-making process. However, because many assets and liabilities do not have an active market, the inputs and methods for estimating their fair value are more subjective and, therefore, the valuations less reliable (Bies, 2005). 3. 5. Verification As the variety and complexity of financial instruments increases, so does the need for independent verification of fair value estimates.However, verification of valuations that are not based on observable market prices is real challenging. Many of the values will be on inputs and methods selected by oversight. Estimates based on these judgments will likely be difficult to verify. Both auditors and users of financial statements, including conviction portfolio managers, will need to place greater emphasis on understanding how assets and liabilities are measured and how reliable these valuations are when making decision based on them (Bies, 2005). 3. 6.Disclosure The FASB states that the proposed update would change the wording used to describe the principles and requirements in U. S. GAAP for measuring fair value and for disclosing information about fair value measurements. Speci fically, the proposed update would include amendments to (a) clarify FASB intent about fair value application of quick fair value measurement and disclosure requirements, and (b) change a particular principle or requirement for measuring fair value or disclosing information about fair value measurements (Elifoglu et al. 2010). 3. 7.Financial Instruments Financial instruments versus nonfinancial instrumentsmany see fundamental inconsistency between measuring financial instruments at fair value and nonfinancial items largely on historic cost basis. Standard-setters recognize that whenever a boundary is drawn between financial statement items with different measurement attributes some inconsistencies and complexities often egresss. It is argued that there is economic logic in drawing a line between financial instruments and nonfinancial items, and more so than drawing a line including some inancial instruments but not others (Hague, 2002). Conceptually, the catchic returns on financ ial instruments underside be separated into three components with distinct sustainability or certainty. The first two componentsamortized cost fire and the difference between fair value affair and amortized cost sideline-sum to fair value interest. It is useful to distinguish these two components of fair value interest because amortized cost interest is both sustainable and certain, whereas the difference between fair value interest and amortized cost interest is sustainable but uncertain.The difference between fair value interest and amortized cost interest is sustainable because unprovided for(predicate) changes in interest range and the resulting unlooked-for changes in fair values affect fair value interest calculations throughout the remaining lives of financial instruments. 14 Centre for Promoting Ideas, USA www. ijbssnet. com For example, an unhoped-for gain on a financial asset due to a return in interest rates in the current period reduces expected fair value inte rest revenue on the asset throughout its remaining life.This third component of the periodic returns to financial instruments is the unexpected change in their fair values during the period. Unexpected changes in the fair values of financial instruments are both unsustainable and uncertain (Ryan & et, al. , 2002). 3. 8. Financial Reporting The reporting of financial assets and liabilities is an election on a contract-by-contract basis and not mandatory. Therefore, not all instruments will necessarily be reported at fair value.In order to distinguish instruments that are reported at fair value from those that employ some other measurement, firms will have one of two reporting options on the statement of financial position. A firm may display the two classifications, fair-value and non-fairvalue carrying amounts, as separate line items on the statement of financial position. The second option for reporting is parenthical disclosure where the firm presents the aggregate of the two clas sifications and discloses the amount of the fair value parenthically (Schneider & McCarthy, 2007). . 9. Critics of Fair Value Critics argue that fair value accounting has created a false short-term visibility in the cutting of pension funding and hastened the demise of defined benefit schemes. More generally, critics argue that the financial crisis demonstrates the pro-cyclicality of fair values when accounting is tightly coupled to prudential regulatory systems, and the unreliability of marking to model in less than liquid asset markets, especially for assets which are being held for the long term (Power, 2010).They as well as add that the impact of fair value accounting (FVA) is likely to be more restrictive lending policies, and more demanding loan covenants, than are necessary for estimable risk concern, together with pricing which will be higher than is economically necessary (Allatt, 2001). Moreover, several commentators remarked on the fictional and imaginary nature of fa ir value and bemoaned their subjectivity and potential for manipulation and bias.Regardless of whether these criticisms have substance, it is likewise the case that if enough people recollect in fictions, then they so-and-so play a role in constituting markets (Power, 2010). Many are comfortable with historic cost/realization accounting on the grounds that it is familiar and provide a more perpetual basis for prediction of future accounting than fair values. They argue that fair value based wampum cannot be predicted in the same way because of the effects of uncertain future events and see this as a important drawback in being able to prepare budgets, forecasts, etc. nd to manage analysts expectations (Hague, 2002). Nevertheless, many critics of the subjectivity of fair value miss the real point. The very idea of reliability is being reconstructed in front of their eyeball by shifting the focus from transactions to economic valuation methods, and by giving these methods a fi rmer institutional footing. Deep down the fair value debate seems to hinge on fundamentally different conceptions of the basis for reliability in accounting, making it less of a technical dispute and more of the politics of acceptability (Power, 2010). . 10. Proponents of Fair Value Few will hesitancy the relevance of information based on market prices as historical cost information is based on market prices at which assets were initially acquired and liabilities were initially incurred whereas fair value are based on current market prices. Fair value reflects the effects of changes in market conditions and changes in fair value reflect the effect of changes in market conditions when they take place. In contrast, historical ost information reflects scarcely the effects of conditions that existed when the transaction took place, and the effects of price changes are reflected only when they are realized. As fair value incorporate current information about current market conditions a nd expectations, they are expected to provide a superior basis for prediction than outdated cost figures can since these outdated cost figures reflect an outdated market conditions and expectations (Poon, 2004).Proponents of fair value in accounting often appeal to notions of notice things as they are and of improving hydrofoil. They point to areas such as pension accounting or the savings and loans industry in North the States where fair values would have made problems (deficits, poor performing loans) clear such(prenominal) earlier, thereby enabling corrective action. An often heard paradigm is that one should not shoot the messenger of poor asset quality (Ebling, 2001). 4. FINDINGSWhile there is a large number of assets and liabilities reported or unwrap in financial statements, the percentage of these items and the dollar impact on earnings may not have been exorbitant for most companies, except for financial institutions. 15 International Journal of Business and Social Sc ience Vol. 2 No. 20 November 2011 In 2008, only 27% of the total assets of the S&P 500 companies that had adopted FAS 157 were actually reported at fair value (Zion et al. , 2009). While this represents about $6. 6 trillion in assets, it is remedy a comparatively small percentage of the assets.Because of the mixed attribute model used in U. S. Generally Accepted Accounting Principles (GAAP), some assets are measured using fair value while otherseven very similar assets are measured at cost, or amortized cost, or by some other measure. The nature of the assets held by these companies determined, to a large extent, their mental picture to risk in the realisation crisis. Companies in the financial sector had a much larger number of fair valued assets (39%) then did, for instance, companies in consumer staples (2%).Even within the financial sector, investment banks and insurance companies, most of whose assets are reported at fair value, were impacted more than commercial banks, who se largest assets is generally loans, which are not reported at fair value (Casabona & Shoaf, 2010). In addition, there is ample empirical evidence to support the relevance of fair value information of financial instruments. For example, Barth (2006) finds that fair valuation of investment securities influences the share price indicating that it provides extra information to investors.Additional discussion of findings of research on accounting for fair value of financial instruments can be found in FASC 1998 study (Poon, 2004). 5. ANALYSIS AND DISCUSSION While most people agree that fair values are the most relevant measure for financial assets and liabilities that an entity actively trades, some (most notably, those in the banking industry) argue that historical cost is the more appropriate measure if management intends to waiting an asset or to owe a liability until maturity.The rationale for accounting on a historical cost basis is that it better reflects the economic substance of the transactions and the actual cash flow over time. They argue that fair value information, on the other hand, would reflect the effects of transactions and events in which the entity would not participate and thus is often irrelevant. The question here is whether managements decision to hold assets or to continue to owe liabilities in light of changed market condition is relevant in evaluating the entitys financial position and accomplishment (Poon, 2004).Some withal argue that the outcome of fair value accounting on entitys financial liabilities is counterintuitive if its credit risks changes. The fair value of a financial liability will decrease when the publicise entitys credit risk deteriorates because the interest rate on the initial issue date would now be lower than what it would be if the liability was issued today. Conversely, if an entitys credit rating improves, an increase in the fair value of its financial liability will result.However, as explained in Barth and Landsman (1995), changes in the credit rating represent wealth transfers between creditors and stockholders. It is not counterintuitive to see a decrease (an increase) in the value of a financial liability when there is a wealth transfer from creditor (stockholders) to stockholders (creditors) corresponding to the deterioration (improvement) of the credit rating of the issuing entity. Therefore, the outcome of fair value accounting is not readily counterintuitive.But as illustrated in Lipe (2002), financial statement users must be better enlightened about the impact of fair value accounting on financial liabilities. In particular, a decrease (an increase) in the fair value of financial liabilities should not be interpreted as positive (negative) if it is due to deteriorating (improving) credit quality. In addition, loan covenants have to be revised and financial ratios involving financial liabilities have to be analyzed accordingly (Lipe, 2002).Still another argument against fair v alue accounting is the induced volatility of earnings if changes in fair values are reported in earnings. Some believe that this volatility of earnings may not correlate to managements performance and that this would make it more difficult for users to predict future performance. First, this is not a reliability issue since fair values can be reliably measured but still vary a great weed from one period to another.Second, the requirement of fair value reporting does not have to go hand in hand with the requirement of recognizing changes in fair values in reporting earnings (Poon, 2004). For this reason changes in fair value should be separately reported based on causes such as the passage of time, changes in market conditions, changes in the entitys financial health, changes in estimate, and changes in valuation techniques.Requiring fair value information as supplemental disclosures instead of financial statement recognition also addresses some of the concerns (e. g. , volatility of reported assets, liabilities, and earnings) of the opponents of fair value accounting. In addition, this will allow financial statement users to decide on their own how much reliance they will put on and how to use fair value information (Poon, 2004).FSP FAS 175-4 provides application guidance to tax whether the volume and level of action for asset or liability have significantly decreased when compared with normal market conditions. However, this assessment should consider whether there are factors present that record that the market for the asset is not active at the measurement date, such as (a) there are few late(a) transactions based on volume and level of activity in the market, (b) price quotations are not based on current information , 16 Centre for Promoting Ideas, USA www. ijbssnet. com c) price quotations vary significantly either over time or among market makers , (d) there is a significant increase in implied liquidity risk premiums, yields, or performance indic ators (such as delinquency rates or loss severities) (e) There is a significant decline or absence of a market for new issuances (Casabona & Shoaf, 2010). Research by federal official reserve staff shows that fair value estimates for bank loan can vary greatly, depending on the valuation inputs and methodology used. For example, observed market rates for corporate bonds and syndicated loans with lower-rated categories have varied by much as 200 to 500 basis points.Such wide ranges occur even in the case of senior bonds and loans when obligors are matched. Moreover, the FASB statement on the proposed fair value standards that reliability can be significantly enhanced if market inputs are used in valuation. However, because management uses significant judgment in selecting market inputs when market prices are not available, reliability will continue to be an issue (Bies, 2005) 6. RECOMMENDATIONS In order to provide more relevant information to financial statement users, fair value in formation should be reported for all financial assets and liabilities.Given that there are still some important abstract and practical issues relating to the reliable determination of fair value, it is better to first require full fair value disclosures before contemplating a shift to full fair value recognition in financial statements. That would enable investors, creditor, preparer, auditors, and regulators to examine from experience. When the issues relating to the reliable determination of fair values are resolved, they will be ready for full fair value recognition in financial statements (Poon, 2004).The author concords with the SEC recommendations, which are expected to impact the FASBs future activities, including (a) improve fair value accounting standards (b) improve the application of existing fair value requirements (c) readdress the accounting for financial asset impairment s (d) establish formal measures to address the operation of existing accounting standards in pra ctice (e) implement further guidance to foster the use of sound judgment of practitioners (f) address the need to simplify the accounting for investments in financial asset (Casabona & Shoaf, 2010).The first priority seems to be to work in close co-operation with users and preparers of financial statements to further consider the practicality of the proposals and to demonstrate or refute the relative merits of fair value and historic cost based reporting of financial statements for users analysis purposes. Such work should involve rigorous testing to consider how fair value information would be used in decision models, as well as to stimulate the preparation of fair value information to understand better the extent of many of the practical concerns (Hague, 2002).Second, implementation of the proposals would provide more useful, relevant and transparent information about an enterprises use of financial instruments than is available today. The full benefits, however, will only be und erstood with careful study and education about how to use the new information. A somewhat different mindset and base of expertise (from that appropriate to traditional recognition and historical cost-based accounting for financial instruments) is also necessary. This includes integrating knowledge of certain finance and capital-markets concepts and practices with financial accounting objectives and concepts (Hague, 2001).Third, financial instruments should be grouped and displayed on the balance sheet based on the underlying characteristics of the instruments, such as unconditional rights to receive or obligations to deliver, and by major classes within these groups. Detailed, descriptive information about the nature and footing of these financial instruments, as well as managements policies pertaining to them, should be disclosed in the notes to the financial statements in a manner ordered with the balance sheet (Anonymous, 2002). Fourth, fair values reflect point estimates and b y themselves do not result in transparent financial statements.Hence, redundant disclosures are necessary to bring meaning to these fair value estimates. FASBs proposal take a first step toward enhancing fair value disclosures related to the reliability of fair value estimates. Additional types of disclosures should be considered to give users of financial statements a better understanding of the relative reliability of fair value estimates. These disclosures might include key drivers affecting valuations, fairvalue-range estimates, and confidence level (Yonetani & Katsuo, 1998). Finally, another important disclosure consideration relates to changes in fair value amounts.For example, changes in fair value of securities portfolio can plagiarise from movements in interest rates, foreign-currency rates, and credit quality, as well as purchases and sales from the portfolio. For users to understand fair value estimates, they must be given adequate disclosures about what factors caused the changes in fair value (Bies, 2005). 7. IMPLICATIONS FOR FINANCIAL REPORTING AND MANAGERIAL DECISION-MAKING Several implications are drawn from this paper. 17 International Journal of Business and Social Science Vol. 2 No. 20 November 2011First, standard-setters and regulators would be required to provide more specific guidance on how to determine fair value for financial statements. Perhaps, they can list some common valuation techniques and indicate their correctness in various circumstances. Disclosure requirements would include disclosure of fair value of all financial instruments along with method adopted to determine fair values, any significant assumptions used in their estimation, some indications of the sensitivity of the estimated fair value to these assumptions, and discussion of risk exposure and issues associated with the estimation of fair value (Poon, 2004).Second, the role of external financial reporting is to portray an enterprise as if seen through the eyes of m anagementthat is, that financial reporting should be coherent with internal management practices. It is, obviously, desirable that there be as much compatibility between the two as possible. However, it is difficult to see how accounting that is driven by the manner in which an enterprise chooses to manage its financial instruments and risks can provide information to financial statement users that are consistent and similar between enterprises (Hague, 2002).Third, the objectives of financial analysis are to discern and assess the effects to an enterprises performance and financial condition, including those that result from its risk management policies and decisions that involve financial instruments. In addition, financial statement users want to assess how well an enterprise effectively applies these policies in managing the risks of the enterprise. Therefore accounting and disclosure requirements related to financial instruments must be designed to explain (a) risks native in a given business (b) hedging strategies employed and (c) outcome(s) of such hedging activities.In other words, financial and nonfinancial disclosures should provide sufficient information for users of this information to discern and answer question, such as these (a) what are managements policies and procedures for using certain financial instruments? (b) How extensively does the enterprise use these financial instruments as part of its risk management? (c) What are the clock and the magnitude of the effects of the instruments on fair values in the balance sheet and changes in these values reflected in the income statement? d) How effective, or ineffective, are the position in these financial instruments as hedges in managing the risk exposure of the enterprise? And (e) what portion of the gains and losses reported in the balance sheet and income statement is realized and unrealized? (Anonymous, 2002). Fourth, the fact that management use significant judgment in the valuation proce ss, particularly for level 3 estimates, add to the concern about reliability. Management bias, whether intentional or unintentional, may result in inappropriate fair value measurements and misstatements of earnings and equity capital.This was the case in the overvaluation of certain residual trenches in securitizations in recent years, when there was no active market for these assets. Significant write-downs of overstated asset valuations have resulted in the failure of a number of finance companies and depository institutions. Similar problems have occurred due to overvaluations in nonbank trading portfolios that resulted in overstatements of income and equity. The misfortune of management bias exists today. There continue to be new stories about charges of earnings manipulation, even under the historical cost accounting framework.It is believe that, without reliable fair value estimates, the potential for misstatements in financial statements disposed(p) using fair value measure ments will be even greater (Bies, 2005). Fifth, three fundamental goals of accounting that are likely to have influenced the prime(a) of fair value accounting for all financial firms. One of these objectives is to play down what is called management bias. Management has an obvious incentive to inflate the value of a companys assets, and many ways to do it. Marking a companys assets to market is an effective way of taking his chemical element of financial statement manipulation out of managements work force (Wallison, 2009). Finally, the option to use fair value for certain assets and liabilities will provide more relevant information to the users of financial statements. However, since the fair value fashion can be elected for some financial assets and financial liabilities and avoided for others, there is a loss of consistency in the financial statements between entities and even within a single entity. Also the new standard imposes extra disclosure requirements (Schneider & M cCarthy, 2007). 8. CONCLUDING REMARKSCurrent methods of accounting for financial instruments have been of concern to accounting standard-setters around the world for some time now. These concerns about financial instruments run low from the observation that markets now exists for either the instruments themselves or the various financial risks that arise from the instruments, and the availability of those markets enables entities to actively manage the financial risks and, thereby, to realize some or all of the market value of their financial instruments with ease. (Ebling, 2001). 18 Centre for Promoting Ideas, USA www. ijbssnet. comIt has been argued that different conceptions of what is for an accounting estimate to be reliable underlie the fair value debate as it has taken shape in the die hard decade. The language of subjectivity and objectivity is unhelpful in characterizing what is at endorse it is more useful to focus on the question of how certain valuation technologies do or dont become institutionally accepted as producing facts (Power, 2010). However, the shift in accounting principles will not come without some additional effort by all capital market participants, including preparers, auditors, regulators, and users of this information.It is realized that accounting and reporting based on fair value principles, in comparison with historical cost-based principles, require more extensive and exposit analysis of the methods and assumptions used to determine values recognized in the financial statements. This in turn, will require market participants to redesign the current financial reporting model and to educate themselves in the application of these new principles. Nonetheless, transparency of the true economic consequences, i. e. isks and rewards, resulting from the use of financial instruments justifies the movement to a fair value based model for financial reporting (Anonymous, 2002). Certainly, mark-to-market reporting has its drawbacks, es pecially for derivatives. First, fair value based on market prices can be difficult to determine for complex and lightly traded instruments. These types of derivatives are the level 3 type mentioned above. These derivatives are usually measured using a mark-to-model process, which can be arbitrary at best and fraudulent at worst.Next, there is the theoretical issue, as banks successfully argued, as to whether market price does and so represent fair value. Also, the relevance of market prices can be challenged with respect to intent. Some observers challenge the relevance of market prices because they believe that, if government officials do not intend to trade derivatives but rather hold them to maturity, as is usually the case with derivatives used for hedging, then the time and expense of ascertain fair value may not be worthwhile.Still, using fair value accounting is proper for derivative reporting because it enhances the following qualities or objectives of financial measureme nt and reporting accountability, transparency, consistency, inter-period equity, and risk management (Metzger, 2010). REFERENCES Allatt, G. (2001). Fair value accounting Examining the consequences. Balance Sheet, 9, 22-26. Anonymous (2007). Statement of financial accounting standards No. 159 The fair value option for financial assets and financial liabilities. Journal of Accountancy, 203, 96-101. Anonymous (2002). Financial instruments Fair values and disclosure.Balance Sheet, 10, 12-20. Bath, M. (2006). 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Fair value accounting and regulatory capital requirements. Economic Policy Review, 4, 33-44. Zion, D. , Varshney, A. & Cornett, C. ( June, 2009). Focusing on fair value. Credit Suisse Equity Research, 4, 18-20. 19 Copyright of International Journal of Business & Social Science is the property of Centre for Promoting Ideas and its content may not be copied or emailed to multiple sites or posted to a listserv without the right of first publication holders express written permission. However, users may print, download, or email articles for individual use.