Q1
Yes, the use of level 3 inputs actually provides useful information for
users of financial reports. Major accounting standards such as the United
States Generally Accepted Accounting Principles (GAAP) and International
Financial Reporting Standards (IFRS) provide their guidance on how to estimate
fair values of financial assets and liabilities(Hoti,2011,pp.256-257). Both
standards emphasize the values established in arms-length transactions as their
definitions of fair value to the effect that fair value is mostly an exit
position. For the U.S GAAP, the latest guidance on fair value measurement is
contained in Financial Accounting Standard No. 157: Fair Value Measurement (FAS
157) while IFRS 13 provides the same for IFRS. Common to both standards is the
hierarchy on the levels of inputs that reporting entities should use in
determining fair values. Level 3 ranks at the lowest end of that hierarchy.
Both FAS 157 and IFRS 13 guidelines provide that level 3 inputs should
only be used as a last recourse when levels 1 and 1 are inapplicable (Hoti,
2011, pp.256). By definition, level 3 inputs rely on valuation models in which
the reporting entity’s own assumptions are substituted for what market
participants would have reasonably assigned to the asset or liability. Critics
argue that the level of subjectivity and biases involved in making these
assumptions. These criticisms notwithstanding, it is not enough to just wish
away the usefulness of the information to users of financial reports simply
because their generation involved a higher level of judgment.
For one, much of financial reporting involves making judgment even in
situations where information is available (Hoti, 2011, p.260). For instance,
reporting entities use the historical cost approach in recording the value of
purchased fixed assets. Most often, the amount of depreciation applied on those
assets involve a judgment on the part of preparers of financial reports. Provision
on doubtful debts is also another aspect of financial reporting where judgment
is very important in determining the figures to report. In essence, subjective judgment does not of
itself render the figures generated from that process useless in the eyes of
users of financial reports.
In addition, the concern that the use of level 3 inputs may affect the
usefulness of fair value measurements in financial reports is mitigated by
disclosure requirements in most guidelines on fair values (Hoti, 2011, p.261). Through
these requirements, reporting entities are under an obligation to disclose
qualitative information on how they obtain fair values. For example, FAS 140
relating to Accounting for Transfer and Servicing of Financial Assets and
Extinguishment of Liabilities insist on such disclosures. Users of such
financial reports, who are investors in most cases, are thus able to assess the
reliability and relevance of the provided information and choose to accept or
reject them following that assessment.
Lastly, users of financial reports are better off having some attempt at
estimating fair values than to have none at all(Hoti,2011,p262). The
alternative would be to presence incomplete financial reports where reporting
entities would simply indicate their inability to place a value on some of
their assets and liabilities. Such a scenario would be an appropriate breeding
ground for a waning confidence in financial reports. Besides, level 3 inputs
are used in very significant proportions of total assets and liabilities of
most firms as to make their use harmful to the financial reports as a whole.
Reference
Hoti, A.H., 2011.Credit Crisis with Focus on
Level Three Valuations and 157: Analysis and Recommendations
for Change. International Journal of
Accounting and Financial Reporting,
1(1), 255-263.
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