The Case Against Fair Value Accounting - Essay Example

The FASB (Financial Accounting Standards) and IASB (International Accounting Standards Board) are to a great extent utilizing the fair value method of measurement in place of historical cost method. Cynics are, however, still not contented with this move. This is since they still find flaws in the fair value method. The main objections against fair value method are; that fair value is continuously a subjective method and that its use in financial statements of companies is to some extent likely to trigger short-term behavior as regards managers. The first objection says that the method is, thus, not good for financial reporting while the second says that the method will be against the stakeholders and investors’ interest. This study seeks to analyze fair value measurement method in accounting in light of the aforementioned objections. Before embarking on the study’s purpose, it is of essence, though, to define fair value as given by IASB. According to IFRS 13, Fair value is that price that one would receive if he/she disposed an asset or paid to ensure an obligation’s transfer in an orderly kind of transaction between players in a market at the date of measurement. IFRS 13 is there to increase comparability and consistency in measurements that use fair value method and the disclosures that go in tandem through what is referred to as ‘fair value hierarchy’. This hierarchy categorizes the inputs that are usually utilized in the techniques of valuation into three main levels. This hierarchy prioritizes at the top, the unadjusted/quoted prices for identical liabilities or assets and in active markets. The lowest priority is given to unobservable type of inputs. The levels of inputs are explained as under. Level 1 inputs refer to the quoted prices in the active markets for liabilities or assets that are identical that the entity can get at the date of measurement. Level 2 inputs on the other hand are inputs besides those with quoted market prices in level 1 which are observable for the liability or asset, directly or otherwise. Lastly, level 3 inputs refer to those unobservable inputs for the liability or asset in focus. (iasplus.com, 2011) There are arguments against fair value method of measurement especially with regards to its reliability and relevance. Those scholars who are against this method argue that fair value method presents information that is unreliable since it is not usually based upon transactions at arm’s length. Thus, it should not be used when it comes to investors’ making financial decisions. Under its reliability, cynics say that it is not a reliable measurement method. Some of the scholars against this method like Cunningham Colleen, the president of FEI- Financial Executives International, said that the information that is generated by this method cannot be of any relevant use to an investor. According to Cunningham, it is in fact useless to an investor. Income statements are subject to manipulation if this method is applied in measurements. (Shortridge et al, 2006) Fair values are not applicable in cases of firm’s arbitraging of market prices. It is not an appropriate method especially when a firm adds value for stockholders by way of purchasing at input prices of the market and disposing at output prices of the market. In this case, the argument is that the raw materials applied in the process of manufacturing do not gain their value from a variance in their exit prices in the market, but as inputs into processes which add values to the existing market prices by making a product as well as selling the same to consumers. This is because a variance in the value for stockholders is not really connected to a variance in the prices of the market. Thus, as a form of stewardship stockholders should be rewarded by the management through other basis, but not using market values. Also efficient prices are reliant on historical costs and, thus, fair market value measurements cannot serve as substitutes under this kind of scenario. The carrying of investments in a parent company’s subsidiary in fair market value overlaps the subsidiary’s profitability as well as the value of the parent company which forms its basis upon profitability. Fair value also fails under matching concept where liabilities have to be matched with the assets of a business. This is due to the fact that, fair value concentrates on assets and this method uses the fair market valuation on assets only. This leaves behind the corresponding liabilities and thus the matching concept loses its meaning and relevance. In another objection against the use of fair value it is noted that fair valuation brings about bubbles as regards financial statements. The fair market values carry with them caveats. If the condition of one-to-one was followed, fair values would be efficient if they were used in stockholders’ valuation. However, in a price bubble there is the booking into the balance sheet of inefficient prices with some bubble gains shown in the income statement. In a kind of trading where a portfolio is held for a sort-term, then fair value application in valuing investments would be a huge predicament. (Penman, 2007) Critics say that fair market value can distort realities of a market since this gives a lot of discretion to the management team of any given organization and even room for them to abuse it. (Johnson, 2008) According to Abdel-Khalik, the method of fair value definitely has a vital role to play when it comes to reporting in accounting. However, it is not a befitting method when it comes to recognizing income. This is since; there are consequences of not giving equal weights to losses and gains of an entity’s holding to those given to the income that has been earned. Fair value as a method does not accord a similar treatment to these gains and losses. Variances in fair value are likely to be or not to be realized in the long-term or in the immediate future and this makes it to be unreliable to some extent. (Abdel-khalik, 2008) Fair market value as a method of measurement is based upon market prices. According to the article by Plantin, Sapra and Shin, these market prices may give timely signs when it comes to the decision making processes. This is not always the case, though. This is since there can be distorted incentives as well as illiquid markets, which may prove the method inapplicable. There are also other benign impacts that bring about an artificial volatility to the market prices and those may distort real decision making. In a case of fair value, prices of assets variances reflect immediately on the financial intermediaries’ balance sheets and trigger responces from them. Intermediaries relating to banks and banks alike are always responding to variances in the economic environments, however, marking-to-market synchronizes and sharpens these institutional response and this in turn affects the feedback in the market for financial products. In such markets, thus, fair market method may to a very high extent distort the decision making processes of various stakeholders. (Plantin, 2008) Fundamentally, the activities of any typical company are usually summarized in the reported financial statements. The fair value method of measurement is increasingly a method being applied in financial statements globally. Researchers, though, have criticized this measurement method of reflecting transactions in financial statements. A major reason why these researchers have criticized this method is that fair value may bring about volatility into these financial statements. One of the ways it causes this volatility is that there is an inherent kind of volatility that is usually triggered by the variance in the underlying conditions in the economy and it is showed by the variance in the value in question. Another way is the mistake usually brought about by the estimation of values’ volatility caused by the estimation and also due to the assumptions and specifications that may reflect reality incorrectly. There is also the volatility that is caused by fair value method through mixed-method volatility, where some of the obligations and assets may be measured using fair value while others apply historical cost or current value. The result of all this is economic events that are unrecognized in these financial statements and in case they are recognized using the fair value method, then, this is not done with congruency. (Lefebvre, et al, 2009) Criticism has risen in the recent times, especially since the setting in of the global credit crisis. The reason behind this is that most of the cynics believe that the financial crisis was escalated by the application of fair value method of accounting. Most of the criticism emanates from the view that fair value is a method based on the variance arising between the market value of specific securities in the already distressed markets and that value which is obtained by holding these securities up to the point they become mature. (Carmichael and Graham, 2011 p452) The application of fair value method proved especially inappropriate during the period of the credit crisis. The reasons why this method was mostly criticized by the cynics are mentioned under as per the book by Acharya and Richardson. Firstly is the unrealized losses and gains reserve. These reserves may be made with more than 50% probability since the existing market price positions might be bubble kind of prices which deviate from fundamental values. These deviations are believed to be caused by market illiquidity, either wholly or partly. These prevailing market prices may also not match the expected cash flows in the future. Bubble prices may distort the fair value method since sometimes there might be excess liquidity or optimism in the market causing a lot of inflation. In other cases the market may be depressed due to market participants’ pessimism as well as illiquidity in comparison to primary values. These bubble prices may lead to rational decisions in the short-term by investors who are in efficient markets. But in markets where there is inefficiency, investor irrationality is likely to occur. Thus, fair market value has proven inapplicable in the recent financial crisis where the markets had become so inefficient. The method of fair value is supposed to show the future cash flows in the financial statements based upon the currently existing information concerning positions and the information should also be adjusted with regards to the risks that are in the market. Fair value method is usually revised in accordance with the prospects in future cash flows, but by relatively very small amounts. In future, changes that might occur might involve huge amounts of cash flows and these cash flows might reflect skewed forms of distribution. Thus, fair value method where cash flows are likely to be very volatile in future is not a very advisable method to apply. (Acharya and Richardson, p223, 224) According to an article by Reuters, some of investors are raising queries on the fair value method of accounting saying that assets’ values have evaporated. Thus, as per their views application of fair value method of accounting in measuring the value of assets is not fair enough. The method of fair value in measurement of assets has been applied in the US since it shows a lot of transparency. However, due to the noted flaws especially in the recent times of the credit crisis, questions have been raised about the method. (Chasan, 2008) In conclusion, therefore, even if the two major organizations (the FASB (Financial Accounting Standards) and IASB (International Accounting Standards Board) have been moving towards the usage of fair value as a method of measurement of the liabilities and assets in the financial statements, the cynics are not wholly convinced. This is as seen in the study. In fact, the making of decisions by investors is highly compromised when it comes to the scenarios where fair value method is applied and the market prices existing are very volatile. Fair market value is not wholly applicable to all assets in the balance sheet. Therefore, historical cost still has some relevance despite the advice by the two organizations of accounting to adopt fair value method wholly. Reference list: Abdel-khalik, Rashad. (2008). The case against fair value accounting. Retrieved 29 October 2011 http://docs.google.com/viewer?a=v&q=cache:L1BmJsooEaAJ:www.sec.gov/comments/4 -573/4573- 229.pdf+arguments+against+fair+value+accounting&hl=en&gl=ke&pid=bl&srcid=ADG EESiAi90sOfHaxMWSNfbT_8vjIXdpRfdP9sNrokqyfkoiUyX8ySooU7j_2DOT9IyrOFd 9dndq6ojFTd1BrORhCEl8_Q5NkDB11cl_ASkOnag0NV6KpOR7Ssgu69PyLgqURyYh 9V_V&sig=AHIEtbTvROYm4JlCigsnUN0yQdYVr4hsKQ Acharya, Viral V. and Richardson, Matthew. (2009). Restoring financial stability: how to repair a failed system. Edition illustrated. John Wiley and Sons. pp223,224. Carmichael, D. R. and Graham, Lynford. (2011). Accountants' Handbook. Edition 11. John Wiley and Sons. p452. Chasan, Emily. (2008). Is Fair Value Accounting Really Fair? Retrieved 29 October 2011 http://www.reuters.com/article/2008/02/26/us-column-lifting-idUSN1546484120080226 Penman, Stephen H. (2007). Financial reporting quality: is fair value a plus or a minus? Retrieved 29 October 2011 http://www.jpsdir.com/Forum/uploads/12611/Financial_reporting_quality_fair_value.pdf Plantin, Guillaume et al. (2008). Fair value accounting and financial stability. Retrieved 29 October 2011 http://faculty.chicagobooth.edu/haresh.sapra/docs_OP/Fair%20Value%20Accounting%2 0and%20Financial%20Stability.pdf iasplus.com. (2011). IFRS 13 Fair Value Measurement. Retrieved 29 October 2011 http://www.iasplus.com/standard/ifrs13.htm Johnson, Sarah. (2008). The Fair-Value Blame Game: Fallout from the credit crisis has put mark-to-market accounting to the test. Retrieved 29 October 2011 http://www.cfo.com/article.cfm/10902771 Lefebvre, Rock, et al. (2009). Fair Value Accounting: The Road to Be Most Travelled. Retrieved 29 October 2011 http://www.cga-canada.org/en- ca/ResearchReports/ca_rep_2009-12_fair_value_accounting.pdf Shortridge, Rebecca Toppe et al. (2006). Fair-Value Accounting. Retrieved 29 October 2011 http://www.nysscpa.org/cpajournal/2006/406/essentials/p37.htm Read More