Please read the below case study and complete the questions within 1500 words.

Please
submit your assignment online on or before 11pm Sunday, 26 May 2019. The penalty for
late submission is a reduction of 10% of the available mark each day.

The trend toward fair value accounting

By J Russell Madray, CPA

The Debate

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 “the 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, saleability 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.

* Robert H. Herz’s remarks to the Financial Executives International Current Financial Reporting
Issues Conference, New York Hilton Hotel, November 4, 2002.

Source: Excerpts from ‘The trend toward fair value accounting’, Journal of Financial Service
Professionals, May 2001, pp. 16-113.
 Questions:

1. What you think is the fundamental problem with financial statements based upon the
historic cost measurement principle used under US GAAP?
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?
5. How will the use of fair values affect the role of auditors and the audit function? Do you
think it will affect the training of accounting students? How so?