Fair Value Accounting - Essay Example

Fair Value Accounting Introduction In the second half of the 20th century, the financial environment had been strived with international market shiftin financial paradigm measurement and standards. Political and economic bodies such as the government, institutions, corporations and interest groups which are related to the financial market have been key players in shaping and formalizing accounting standards adopted today. While a lot of deliberation has been put into consideration for the current international accounting standards, the system is far from perfect. Financial instruments, disclosure systems, and measurement standards are still greatly debated despite their formal application. One such standard that has been much debated is the fair value accounting measure. Fair value accounting has gained popularity in the recent years as the standard for measuring assets and liabilities by firms. Although, fair value accounting has been accepted and adopted by firms across the world, it is still considered to be inefficient in its utility. Perhaps it is because of the discrepancy in the financial systems and conceptual frameworks which have given rise to the chaos that is evident in todays corporate environment. In the following discussion the researcher shall discuss the impact of fair value accounting and disclosures based on current accounting standards, conceptual frameworks and theoretical assumptions with the view to enumerate on its viability, utility and efficiency. Discussion International accounting standards are broadly divided into the United States’ independent regulators’ approach and the European public ownership approach. The European approach had been based on the theoretical framework that since corporations are usually serve their own profit interest, it is up to the government to curb private monopolies and monitor their activities. On the other hand the US independent commissions for monitoring and enforcing regulation had been developed with the view to give the market economic independency on the premise of laissez faire. Ironically, as Gaffikin (2005) points out, both the systems fail to achieve its objective of regulation as a result of market inefficiency and economic regulation consideration. This led to the development of a regulation system based on interest theory - that is serving both the private and public interests (Gaffikin 2005). Today, accounting standards across the world is based on the US Financial Accounting Standard Board and the International Accounting Standard Board. Australia follows similar measurement paradigms as adopted by the FASB and the IASB whereby the transaction and cost based accounting are being replaced by fair value accounting. Fair value accounting according to these standards is defined as "the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arms length transaction." (Australian Accounting Standards Board 2007). This standard requires firms to disclose the value of assets and liabilities based on market’s fair value in an unbiased manner. However, fair value accounting is surrounded by controversies and criticisms as it relies on management decisions, expectations and projections of value; as well as market inefficiency in determining financial instruments and their values (Hitz 2007). Given the current convergence of accounting standards fair value is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." (Hitz 2007). This definition takes into account of the fact that fair value is acquired under idealized market conditions or at least close to ideal market conditions. It also hypothesize that the parties involved are "knowledgeable, independent and economically rational parties." (Hitz, 2007). Moreover, Hitz (2007) also points out that fair value follows a three-tier hierarchy principle. The first tier involves market-based measure of prices, reliability of information and quality of market information on prices. The second tier involves the consideration of prices of comparable items and cash flows. In case these two tiers fail to comply, only then internal estimates and calculations should be taken into account. This is known as mark-to-model technique (Hitz, 2007). These theoretical assumptions, however, are flawed. According to Beaver (2002), application of accounting standards and techniques are based on market efficiency, value relevance, analysts behavior, discretionary behavior and Feltham-Ohlson modeling. Fair value accounting is largely dependent on market efficiency and its information flow. This premise is highly unreliable in its assumptions that the market is unbiased and efficient. Beaver (2002) points out that regulations make the assumption that firms are honest and willing to make accounting data public. While in practice disclosure is mandatory for all, the authenticity of the data and its presentation cannot be vouched for. This is clearly demonstrated in the recent cases of misinformation and disclosure manipulations of corporate America. Fair value accounting therefore cannot be relied upon for "fair" accounting and disclosures as it is based on unreliable information sources. Consequently, one can understand that fair value accounting rely holistically on equivocal market information and disclosure. This unreliability of information is against the premise of fair value accounting theoretical framework which is set on the paradigm of usefulness. According to Hitz (2002), fair value accounting is based on the decision usefulness paradigm. The objective of fair value accounting is to provide alternative measurement inferences to provide information to investors and decision makers to assess future cash flows from shares or securities. For this purpose, fair value accounting relies on the information aggregation hypothesis that market information is unbiased and is generally uniform for all items. While this premise, to some extent, is true when considered in the economic term, it is not really a reliable framework for reportage and information usage. Without quality and reliability in information, the utility of fair value diminishes. This is especially true in the case of financial instruments which rely on market information holistically such as fair value hedges, cash flow and net investment funds (Australian Accounting Standards Board 2007). These instruments rely on active market quoted prices for determining value for assessment and transactions. In Australia, if a financial instrument cannot be measured according to active market prices, then it would be measured using a valuation technique agreed by both knowledgeable parties. The valuation technique has not been specified by the Standard Board, but it has been noted that the technique should be commonly used by general financial entities. This technique should use maximum market inputs and rely least on entity specific inputs (Australian Accounting Standards Board 2007). What this does is further ensures the unreliability of information, especially if the market is inefficient. On the other hand, if the market is operating in idealized conditions, and it is efficient, then the chosen fair value accounting standard proves to be highly reliable for carrying out market transactions by entities which are already strived with distrust, uncertainties and risks. For example Beaver (2002) points out that market inefficiency is a common phenomenon, and reliability on market factors and information is naive. This is because portfolio strategies involve risks. Consequently, analysts and market leaders rely on market-to-book value ratios to model earnings forecasts. For these reasons, it is better to rely on a proxy fundamental valuation standard then to use overpriced or under priced stocks and attempt to value it at book value. With regard to the third tier information, fair value accounting may have to rely on internal inputs if the first two tiers are not available. This third tier is highly unreliable in terms of accounting information verification. Corporate history indicates general distrust among the government, corporations and the stakeholders. For these reasons independent institutions such as the IASB have been created to monitor and control individual firms, and curb them from irregularities. Despite these measures, financial crises and malpractices in reporting system continue to prevail. It is therefore safe to assume that corporations do not necessarily act in the interest of stakeholders. Instead, they often vie for opportunities to monopolize, disguise, and hinder information flow to misrepresent, and indirectly benefit from these activities. Profit skimming, free riders and information asymmetries according to Gaffikin (2005) are common in the corporate scenario. Regulations exist to curb these externalities from infringing on the stakeholders. Moral hazards exist in both formal and informal industries. Consequently, to rely on internal sources for fair value accounting purposes can be construed as ineffectual and inaccurate. While it may serve the purpose for one party in case of transaction (such as the seller) but it may not be useful for the other party (or parties) involved (such as the buyer). This is clearly evident in the rule for hedge instruments and cash flows transactions where revaluation for income is carried out at fair value but historical cost ceiling are also mandated to curtail abnormal returns (Hitz 2007) when carrying out fair value accounting. In such instances, regulations are mandatory for sustaining market efficiency, and to ensure all entities gain fairly from transactions. Fair value accounting regulations came into existence to address this type of chaotic and volatile financial environment of today. Fair value accounting is still at its rudimentary stages. With issues of reliability, disclosure methods, valuation techniques and so on plaguing fair value accounting standards, the practice is far from perfect. Since fair value is a disclosure regulation, it is not interventionist based (Gaffikin 2005). As a result, it largely relies on trends in accounting standards set by professional bodies or agencies. In Australia, where accounting standards follow international trends have to go through similar pitfalls of new regulations before it can perfect its implementation. Conclusion Regardless of these negative impacts, fair value has a significant impact on the measurement, information and decision usefulness accounting regulation. It is a transition standard which is slowly gaining respect and independence. Accounting problems and issues associated with corporate social responsibility in accounting disclosures will have to be modeled on an intermediary model of command and control, and self-regulation before fair value accounting standards can acquire its truest efficiency. Once perfected over its many flaws, eventually fair value accounting would have achieved its desired objective of providing a platform for financial accounting practice that is based on current information rather than on old or future financial information. This eliminates the critical issues of distrust, misinformation and risks involved in financial decision making activities. Lastly, fair value accounting may be developed to attain credibility through stricter regulations which can be achieved by independence of regulatory institutions. References Australian Accounting Standards Board (2007) Financial Instruments: Recognition and Measurement. Compiled Accounting Standard AASB 139. Beaver, W. H. (2002) Perspectives on Recent Capital Market Research. The Accounting Review, Vol. 77, No. 2, pp. 453-474. Gaffikin, M.J.R. (2005) Regulation as Accounting Theory. Working Papers Series, School of Accounting & Finance, University of Wollongong, Australia. Hitz, J. (2007) The Decision Usefulness of Fair Value Accounting - A Theoretical Perspective. European Accounting Review. 16:2 pp. 323 — 362 Read More