Question

Fair Value Measurements

As you examined in this week's Discussion, fair value measurements can influence financial reporting. For an accountant, it can also be considered a moving target, especially when values of certain assets, such as financial instruments, are based on a changing market. The pressures associated with reporting according to fair value measurements also pose ethical dilemmas. As you prepare for this Application, consider how ethics impacts accounting practice and how final assenting and dissenting opinions of rule making boards impact fair value measurements.

Write a 2- to 4-page paper analyzing the impact of fair value measurements on accounting practices. Research the development of fair value accounting rules and guidelines. Consider issues surrounding fair value accounting. Explain the impact of rules and guidelines surrounding fair value measurements on a particular industry (use the industry that you choose for your Discussion question) and how they might influence how a company manages its assets. Finally, analyze the pressures managers and auditors face to report favorably on a company's assets and the ethics at work in their role.

Answer 1

The revaluation model is an alternative to the cost model for the periodic valuation and reporting of long-lived assets.

IFRS permit the use of either the revaluation model or the cost model, but the revaluation model is not allowed under US GAAP. Revaluation changes the carrying amounts of classes of long-lived assets to fair value (the fair value must be measured reliably). Under the cost model, carrying amounts are historical costs less accumulated depreciation or amortisation. Under the revaluation model, carrying amounts are the fair values at the date of revaluation less any subsequent accumulated depreciation or amortisation.

Under the revaluation model, whether an asset revaluation affects earnings depends on whether the revaluation initially increases or decreases an asset class’ carrying amount. If a revaluation initially decreases the carrying amount of the asset class, the decrease is recognised in profit or loss. Later, if the carrying amount of the asset class increases, the increase is recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset class previously recognised in profit or loss. Any increase in excess of the reversal amount will not be recognised in the income statement but will be recorded directly to equity in a revaluation surplus account. An upward revaluation is treated the same as the amount in excess of the reversal amount. I Any subsequent decrease in the asset’s value first decreases the revaluation surplus and then goes to income. When an asset is retired or disposed of, any related amount of revaluation surplus included in equity is transferred directly to retained earnings.

An increase in the carrying amount of depreciable long-lived assets increases total assets and shareholders’ equity, so asset revaluations that increase the carrying amount of an asset can be used to reduce reported leverage.

Assets revaluations that decrease the carrying amount of the assets reduce net income. In the year of the revaluation, profitability measures such as return on assets and return on equity decline. However, because total assets and shareholders’ equity are also lower, the company may appear more profitable in future years. Additionally, reversals of downward revaluations also go through income, thus increasing earnings. Managers can then opportunistically time the reversals to manage earnings and increase income.

Asset revaluations that increase the carrying amount of an asset initially increase depreciation expense, total assets, and shareholders’ equity. Therefore, profitability measures, such as return on assets and return on equity, would decline. Although upward asset revaluations also generally decrease income (through higher depreciation expense), the increase in the value of the long-lived asset is presumably based on increases in the operating capacity of the asset, which will likely be evidenced in increased future revenues.

Also, the revaluation amounts must be appraised by an independent external appraiser or management. Appraisals of the fair value of long-lived assets involve considerable judgment and discretion.

The presentation of transactions in the financial statements should be made in a fair and transparent manner. When revaluation model is adopted, the managers should ensure that there is no manipulation of accounting and the transactions are reported fairly. The intent behind adopting the revaluation model should not be to manipulate earnings.

The auditor must give an honest and fair opinion on the revaluation measures adopted by the company and about the correctness of disclosures made as a part of financial statements.

In companies where the performances are directly linked with remuneration policies, the managers may be motivated to employ measurement bases to manipulate earnings. Similarly, the dependence of auditor on particular client fee or other factors creating conflict of interest act as a threat to independence of auditor to give an unbiased opinion. Promoting an ethical culture in the organisation and an ethical framework which helps in decision making of individuals will help in overcoming these situational influences.