Question

SFAS No. 159 (see FASB 825) allows companies to value financial liabilities at fair value. If not elected, financial liabilities will continue to be accounted for under the historical cost model. In at least three paragraphs, support one of the positions presented below. You should use references to reference material, as necessary.

Position #1:  Present arguments in favor of measuring liabilities at fair value.

Position #2:  Present arguments against measuring liabilities at fair value.

Answer 1

Arguments in favor of measuring liabilities at fair value:

1. Reflects current information : There is no denying that fair value accounting reflects current information regarding the value of liabilities on the balance sheet. Historical cost information can be outdated, giving rise to what may be termed hidden liabilities.
2. Consistent measurement criteria : Another advantage that the standard setters stress is that fair value accounting provides the only conceptually consistent measurement criteria for liabilities. At present, financial accounting follows a mish-mash of approaches that is termed the mixed attribute model.
3. Comparability : Because of consistency in the manner in which liabilities are measured, it is argued that fair value accounting will improve comparability, that is, the ability to compare financial statements of different firms.
4. No conservative bias : Fair value accounting is expected to eliminate the conservative bias that currently exists in accounting. Eliminating conservatism is expected to improve reliability because of neutrality, that is, reporting information without any bias.

Arguments against measuring liabilities at fair value :

1. Lower objectivity : The major criticism against measuring liabilities at fair value accounting is that it is less reliable because it often lacks objectivity. This issue is crucially linked to the type of inputs that are used. While nobody can question the objectivity of Level 1 inputs, the same cannot be said about Level 3 inputs. Because Level 3 inputs are unobservable and based on assumptions made by managers, many fear that the extensive use of Level 3 inputs especially for operating assets and liabilities—will lower the reliability of financial statement information.
2. Susceptibility to manipulation : Closely linked to lower objectivity is the concern that fair value accounting would considerably increase the ability of managers to manipulate financial statements. Again, this issue is closely linked to the use of Level 3 inputs—it is more difficult to manipulate fair values when Level 1 or Level 2 inputs are used. Because Level 3 inputs are less objective, a crucial issue that will determine the reliability of fair value accounting is the extent to which Level 3 inputs will need to be used.
3. Lack of conservatism : There are many academics and practitioners who prefer conservative accounting. The two main advantages of conservatism are that (1) it naturally offsets the optimistic bias on the part of management to report higher income or higher net assets, and (2) it is important for credit analysis and debt contracting because creditors prefer financial statements that highlight downside risk. These supporters of conservative accounting are alarmed that adopting the fair value model which purports to be unbiased will cause financial statements to be prepared aggressively, therefore reducing its usefulness to creditors, who are one of the most important set of users of financial information.

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