Fair Value Accounting, Financial Economics, and the Transformation or Reliability - Literature review Example

The author of the article “Fair value accounting, financial economics, and the transformation or reliability” draws from several summaries and analyses to discuss the debate about fair value. The discussion focuses on how the notion of accounting and reliability emerged and was articulated before the financial crisis. Further, the paper examines the rise of financial economics as a challenge to and as a cultural resource for financial accounting. Power then discusses how accounting for derivatives challenged the credibility of accounting while acting as a catalyst for the significance of fair value as well as for reliability. The author further notes that the de-legalization of the balance sheet created a demand for accounting numbers in the balance sheet.

Analysis
The author argued that four main conditions led to the significance of fair value accounting before the financial crisis. One of them was the cultural authority of financial economics. Power (2010) argues that financial accounting has increasingly drawn on the cultural authority of financial economics – an authority that is not in question. Power (2010) argued that the pro-cyclicality of fair values was demonstrated by the financial crisis. This is consistent with the arguments by Allat (2001:22) that fair value accounting leads to more restrictive lending policies and more demanding loan covenants. Chea (2011:15) agrees with the sentiments of Power (2010) that reliability is being reconstructed by shifting the focus from transactions to economic valuation methods hence giving the methods a firmer institutional footing. A study by Mikes (2013:3) demonstrated that even though risk controllers draw on the authority of financial economics, such credentials do not automatically lead to credibility in the organization.

The second argument for the significance of fair values in accounting as articulated by Power (2010) was the problems related to accounting for derivatives. The author argued that derivatives posed a challenge to the existing accounting logic of appropriateness. Their historical cost was irrelevant to their value over time. Another problem was the financial classification. Derivatives accounting therefore embedded the principle of fair value accounting as the mirror of the market. While acknowledging market-to-market reporting for derivatives, Chea (2011) agreed with the use of fair values for derivatives reporting. Metzger (2010) noted that the use of fair value accounting for derivatives reporting enhances accountability, transparency, consistency, inter-period equity, and risk management. Further, Zhou (2011:36) found evidence that the recognition of the fair-value-based hedging performance measure under SFAS 133 improves the value and risk relevance of accounting earnings. The studies by Barth et al. (1996), Eccher et al. (1996), and Nelson (1996) examined the value relevance of fair value information including derivatives and found that fair values of investment securities have explanatory power beyond the book value.

Power (2010) also cited that the third reason for the significance of fair value accounting was the transformation of the balance sheet by conceptual framework projects from a legal to an economic institution. The author argued that this created demand for asset and liability numbers to be economically meaningful. This demand could be satisfied by fair value. According to a study by Nissim and Penman (2007:71), “expanding fair value accounting is not likely to significantly improve the information in bank financial statements and, in some cases, may introduce distortions that reduce accounting quality”. This argument is therefore against the application of fair value to measure assets and liabilities in the balance sheet.

Power (2010) further argues that fair value accounting became significant to the development of a professional, regulatory identity for standard-setters. The author argued that while standard-setting bodies are less sensitive to specific private interests, they are more sensitive to other transnational bodies and specific nations who wish to exercise veto rights. Cortese and Irvine (2010) referred to this situation as a “black-box” where powerful extractive industries, entities, and coalitions covertly the IASB as regards the implementation of IFRS 6 to secure their own ends thereby ensuring that the status quo was maintained. These standards are usually scrutinized by some countries before adoption as noted by Palea (2013) in the case of IFRS 13 and IFRS 9 by the European Commission.

While the author provides the reasons for the significance of fair value accounting even before the financial crisis, it does not discuss the role of specific individuals in the fair value debate hence lacking a more complete analysis of the role and power of key actors in fair value application in accounting. Read More