Fair Value Measurements of Financial Instruments by the US Companies - Research Paper Example

? Fair Value Measurements of Financial Instruments by US companies and comparability issues Part I Introduction The financial ments of a companywhich are valued at the fair value of a company have to be classified under the three levels of hierarchy which are: i) the assets and the liabilities which are identical in nature have to be priced in the active markets. ii) The inputs thus provided has to be for the full life term of the financial instruments which are considered above. iii) Any financial instruments not discussed above has to be valued under a similar input valuation techniques based on the given market data. Thus the implementation of the fair value has to be implemented at an applicable hierarchical level (Price Water Coopers, 2009, p.2) Need for study Fair value measurement of financial instruments has become a debatable topic since the emergence of the economic downturn. According to the International Accounting Standards Board (IASB) it has been made a rule to report the financial instruments based on the fair value measurement system. Through the calculation of the financial data at fair value prices the decisions related to the high risky business facing economic problem in the financial market becomes easier. The financial statements of the company computed at a fair value system gives more meaningful information to the investors, suppliers and creditors about the valuation methodologies thus used for the same. Hence it is only justified to have a clear view about the impact of the fair value measures of the financial instrument of the company. Literature review The fair value measurement is implemented both by Goldman Sachs and Citibank with the purpose of getting the actual value during selling of assets or during the transfer of a liability on the date of measurement between the participants of the market. Even while trading of the derivatives of the company measuring in the fair value is of utmost importance to the company. Thus maintaining the rules of the levels of the hierarchy the implementation of the fair value measurement is essential as the correct information related to the accounting of the company’s books of accounts gets projected. Methodology The three methodologies for the calculation of the fair value of the company are market approach, income approach and the cost approach. In market approach the matrix pricing method is used which helps in finding the value of the debt securities in comparison to that of another firm without relying on the data of the quoted prices of specific securities. The time value of money technique is implemented in case of the income approach methodology of fair value measurement. Lastly based on the concept of obsolesce is the implication of cost approach system of fair value. The data related to the calculation of the fair value of a company can be obtained from the annual reports of both Goldman Sachs and Citibank. For the convenience of analysis the period of 2011 has been chosen. The financial ratios are generally implemented to assess the financial health of the company, analysing which the companies fair value measurement can be done. Limitations of study The fair value measurement also has some criticism in its calculation method. Fair value measurement the inherent risk factor of the company tends to gets exaggerated resulting in misleading results in the long run. Hence the recording of the contingent losses which have not yet been realised signals negative outcome to investors, which lead to meeting of negative consequences. The fair value measurement is usually not preferred by many analysts due to lack of reliability as the system of valuation has a tendency of showing an optimistic value irrespective of the present economic situation. Thus the business decisions taken on the basis such fair value measurement may be inaccurate in nature. Company profiles Goldman Sachs The Goldman Sachs Group, Inc. is one of the leading banks which is globally renowned for investment banking and provides a wide range of financial services to diversified client base which includes government, HNWI’s, financial institutions and corporations. The company mainly deals in investment banking, securities, investing and lending, investment management and research. The company believes in the diversity of the ability in its employees for serving its clients throughout the world. The company has ranked sixth in the overall banking sector and ranked first in the investment working sector in 2012. The company also advices various companies on various methods of raising capital helping them to manage risks leading to further growth in future, financing various government operations, making transactions on behalf of clients in the financial market dealing in various securities. Citibank Citigroup Inc. is a diversified holding company which provides various financial services. Citibank is considered the global leader in services related to cash management. In order to meet the changing needs of its customer Citibank is coming up with new technological innovations. It is also one of the leading banks in the field of implementation of the advanced electronic systems of commerce. The company deals in residential mortgages, lending of loans, and various forms of retail banking services. Citibank is one of the company’s to have a very strong liquidity base. The Citibank provides services in the field of securities and banking, corporate and investment banking, private banking, capital advisors and services related to cash transaction of various kinds (“About Citibank”, 2006). Part II Fair value measurement of financial instruments Goldman Sachs The preparation of the financial statement of the company the assumption is made on the basis of the fair value measurement. The fair value measurement is generally made during the accounting process of the goodwill, intangible assets, provision for the losses that arise out of litigation and other regulatory processes of the company. Both the assets and the liabilities of the company are accounted at the fair value for the process of buying and selling of the company made in accordance with the U.S.GAAP. The transaction costs are not included in the fair value measurement of accounting. But the receivable of the company are not accounted at the fair value price instead accounted for at the net amortised value. Many of the firms insurance are accounted under the fair value option of “Market making” of the income of the company. By the adoption of the fair value measurement the financial results of the company related to the operations of the cash flow did not get affected. The financial instruments or the securities of the company which are ready to be sold are at a fair value of $ 4.86 billion (2011) and $ 3.67 billion (2010) are held in the insurance subsidiaries of the company. The implementation of all the level of fair value measurement is undertaken in the Goldman Sachs. The statement displayed above we can interpret that at the ending of December an increase of the financial assets have taken place which is due to the increase in the equity investment, purchases and the net transfers that have taken place from the level 2 in order to offset the sales effect partially. But the quoted market price has been multiplied with the fair value of the quantity at level 1. Contrary to the above situation the valuation at level 3 the option for the best estimate for the fair value is applied, i.e. the cash instruments being valued initially at the transaction price. The valuation of the inputs and the related assumptions are based on the realised value of the sales of the company for the valuation of the financial assets at level 3. At level 3 the cash instruments are frequently hedged with the cash instruments of level 1 and 2. Consequently the losses occurred in level 3 are offset with the gains of level 1 and 2 and vice-versa of the company. The calculation of the NAV value is also done at the fair value of the company. Computation of the derivatives of the company is usually done at level 1 and 2 of the company. Roll forward of the company is also calculated at the level three of the fair value of the company. The primary reason for the opting for the fair value of measurement is due to the fact that the reflection of the current economic occurrence can be projected on a timely basis, the volatility of the earnings of the company can be assessed and most importantly the cost benefit consideration of the company related to the various financial instruments can be taken care of (Goldman Sachs, 2011, pp.125-140). Citibank The assets held by the company at the fair value are $ 5.5 billion as on 31st December, 2011 comprising of securities. But in the fair value hierarchy of the company the majority of the exposure are seen in level 3. Against the loans that were held by the company compounded to $21.2 billion fair value of the collateral securities comprising of a variation margin of $1.1 billion which were mostly in cash. The liquidity position of the company is made through the liquidity adjustments which are applied to items in either level 2 or 3 of the fair value hierarchy. In Citibank’s consolidated balance sheet all the assets and the liabilities are valued at the fair value. The reason for the use of the fair value options are reduction in the operational burden of verifying the beneficial interest under the guidance of the ASU. Secondly, avoiding complications related to the operation of the derivatives of the company and lastly, incorporating of better economic hedging strategies without the inclusion of the volatility in the earnings of the company. A significant transfer from level 1 and 2 of the fair value of the company is implemented by the ASU disclosures of the company. Further disclosures related to the gross purchase and sale of the company along with the activities related to issuance is carried out in the level 3 of the fair value measurement hierarchy required for the respective fiscal years of 2010 and 2011. The nature and risk of the investments of the company are further classified in level 2 and three for the classification of the respective investments. For the measurement of the identical liabilities of the company application of the level 1 fair value measurements is made. Both the qualitative and the quantitative nature of the fair value related to particular instruments of the company are carried out through level 3 of the fair vale measurement. The guidance in relation to the calculation and the adjustments of the portfolio of the company and the scope for expansion is valued under all the levels of the company under the fair value measurement system (Figure: 1) (Citibank, 2011, pp.160-190). Figure 1: Fair value disclosure Part III Conclusion The fair values are based on certain assumptions depending on the participants of the market by the use of assets and liability pricing. So the fair value measurement is based on level 1 according to which quoted prices of the identical assets and liabilities in the current market, level 2 according to which the condition of level 1 follows along with quoted p[rice of similar assets and liabilities present in the market that are not active, inputs related to the interest rates, volatilities and yield curve and finally inputs derived directly from the market, level 3 according to which inputs that are unobserved, reflecting the company’s own assumption in coordination with the market assumptions and should be based on the best information available according to the circumstances. Based on the study executed on the given project it can be said that the adaption of the fair value of the company for the valuation of the liability as the transfer pricing and the effects related to the reduction in the risk factor of the company were mixed. The notion of transfer pricing was initially not accepted but the fair value of the respective assets of the company led to the typical thought process of the liability valuation of the company. Both the company has implemented the 3 levels of fair value measurement hierarchy at various stages of different financial instrument calculation in order to offset the negative effect of losses incurred by the company. Based on the fair value system of accounting if the process of “mark-to-market” can be implemented the present valuations of the different financial statements of various companies can be upgraded accordingly as a result of which the company will have an updated accounts depending on the present market conditions. References Goldman Sachs, (2011). Annual Report. Retrieved from: http://www.goldmansachs.com/investor-relations/financials/current/annual-reports/2011-annual-report-files/GS_AR11_AllPages.pdf Citibank, (2011). Annual Report. Retrieved from: http://www.citigroup.com/citi/investor/quarterly/2012/ar11c_en.pdf Price Water Coopers, (2009). Fair’s Fair. Retrieved from: http://download.pwc.com/ie/pubs/fair_value_ifrs7.pdf Faircom, (2006). About Citibank. Retrieved from: http://faircom.com/pdf/ss_citibank.pdf Read More