The Advantages and Disadvantages of Fair-Value Accounting - Assignment Example

Fair Value Accounting College TABLE OF CONTENTS 0 Introduction……………………………………………………………………………………3 2.0 Fair Value Accounting...............................................................................................................3 3.0 Critique of Fair Value Accounting.....……………………………………………………...…4 4.0 Arguments in Favour of Fair Value Accounting.…………………………….……………….7 5.0 Conclusion…………………………………………………………………….…………..…10 6.0 References…………………………...……………………………………………………….11 1.0 Introduction The International Accounting Standards Board adopted the IFRS 13, fair value measurement on May, 2011 (Duff & Phelps, 2012). The guidance is provided on the way that fair value measurement should be undertaken but not when it should be adopted. This guidance is the same as US GAAP guidance. IFRS 13 defines fair value and sets out a requirement about fair value measurement disclosures. Fair value accounting is an approach in financial accounting where firms are allowed or required to quantify and report an ongoing basis of the financial instruments at estimates. These are the estimates that they would get if they were to sell the financial instruments in this case assets and liabilities. The companies report profits or losses when the value of their assets increase or their liabilities decreases. The losses decrease the value of the net income and hence the reported equity also reduces. Fair values have played a crucial role in United States for more than half a century. The standards of accounting that allow or otherwise require fair value reporting have increased in a big way over the recent years. In 2006, a controversial and important new standard of accounting was announced by the Financial Accounting Standards Board (FASB) no. 157, which provides a more detailed guidance in assisting firms in the use of fair values. The applicability of this has in recent years been put into test by market conditions which were extreme. 2.0 Fair Value Accounting Fair value was used as early as the late nineteenth century where it was common for organizations to use appraised values in quantifying their capital assets. In other words it was the value that would be realized by their sale in the market. This exit value was also believed by the economists, to be the most appropriate in construction of financial statements. (See, among others, Diewert, 2005). However, the abuse of this accounting standard by managers eventually led to the enactment of more accounting standards that were more formal by the accounting profession. This led to the emergence of historical cost as the dominant standard for reporting the financial instruments; assets and liabilities. Despite this, fair value remained a preferred concept by many theorists in the field (Magnan, 2009, p. 191). For example, Staubus (1961) and Sterling (1970) argue in support of fair values in financial reporting (p 192), which is the realizable value of the financial instrument. The exit value in accounting was used as a default option when accounting for some assets, however, it re-entered the financial statements of businesses in 1993 through SFAS No. 115 (FASB). The SFAS No. 115 (FASB) goes beyond the disclosure requirements of the exit value accounting and mandates the accounting of some securities at fair value, in turn affecting the firm’s final accounting statements. Hierarchy for Fair Value Measurements FAS 157 provides for a hierarchy for fair value measurements inputs, this is according to the reliability starting with from most reliable going down. FAS 157 requires firms to use first level inputs in every instance they are available. These level one inputs are unadjusted prices in markets that are active or similar items. Inputs in level 2 are data that can be observed either directly or indirectly. The inputs in this level is divided into two; the first one is which is generally preferred over the second is the market price that is given in active markets for identical items. These measurements provide values that are adjusted in order to fit with the mark-to-market measurements. These values have a sense of reliability in them depending on the extent of the required value adjustments. The second class other market inputs that are observable such as exchange rates and empirical co relation among others. They produce mark- model measurements that are within the market information. These inputs are only reliable as far as the models used. The inputs in level are however, unobservable as is the case with the second level inputs. These inputs are estimates supplied by the firm like the depreciation of home price. They provide a mark to model inputs that are unregulated by market information. They reflect the assumptions that the participants in this market would use. Because of the decline in price clarity during the financial bust, firms that were using level two inputs in subprime positions were then inevitably forced to adopt level three inputs. FAS 157 do not generally require the firms to use level two inputs instead of level three. Even level two is generally preferred over level three. In times of financial illiquidity, firms using level two should assume that the values are of low quality and hence make the transition to level three instead. If measurement using fair values has even only one level three input, then it would be automatically be considered a level three measurement. Khan (2009) examined into the possibility that exit value accounting contributed to the failure within the banking system. Khan used the sample period between 1988 and 2007 and was inclusive of all U.S. banks. Khan observed that the system reached a fair value of about 70 percent in 2007. Khan reported three main findings which included proving the extent of banking institution use of exit value accounting increases in poor stock market performance. This was to show failure contagion attributes in the banking industry. Secondly he discovered that the less the market was liquid, the more the contagion effect of failure. The third thing was that the less liquid the banking situation and the extent at which reliance by the banks on exit value accounting complimented each other in worsening the failure contagion condition. However, this excluded banks that were well capitalized for this affected those with weak capital ratios. These findings were consistent with the prediction analysis by other previous researchers like Carletti and Allen (2008a). Fair value accounting in the environment of markets that were not liquid facilitated elevation of distorted figures in the banks balances sheets leading to induced failure contagion. 3.0 Critique of Fair Value Accounting The long history in the use of fair value accounting has brought in its wake a wave of criticisms. The criticism has increased in the wake of the recent financial meltdown. One the criticism levelled against the Fair value accounting is procyclicality which is the exaggeration of the normal cycle of fluctuations in business both in bust and boom environments. This procyclicality is believed to create condition necessary for instability and vulnerability of the system. A number of concerns have been raised against the fair value accounting method that it can encourage procyclicality pressure on the prices of the assets (Laux & Leuz, 2009). In the time of booms, the overstatement of profits quantified in exit value permits businesses or firms to increase their leverage. This is because the tolerance in borrowing is typically connected to the value of the asset. This overstatement limits their abilities in creation of beneficial reserves that would be used in times of financial busts. This means that in times of financial crisis, the exit value accounting puts a retrogressive pressure on pricing which further results in more declines in market prices. In order to make up for the write downs caused by exit value accounting, the financial institutions may attempt and be required to sell in markets that are not liquid even though the original plan was to hold these securities to maturity. These sales become points of reference for other institutions required to rely on exit value accounting to mark their assets in the market (Laux & Leuz, 2009). The low interest of sellers who are not motivated to sell by distress, enter such markets disallowing the prices to recover to or above the core value. The analysis of the model by Centre for Financial Studies (Allen & Carletti, 2006, p. 17), showed that the adoption of mark-to-market accounting in times of financial busts may cause the financial firms to sell their assets which is not necessary originally and in effect, cause the prices of the assets to depend on the market rather than on the potential earning power in the future. This argument however tends to ignore the fact that the measurement of financial tools may lay open the early warning signs of a financial crisis. This may in turn reduce the severity of the crisis and the intensity of the decline in prices of these financial tools (assets). Examining the fair value accounting method empirically of its procyclicality by the International Monetary Fund (Novoa, et al, 2009, p. 39), revealed that exit value accounting could increase the severity of financial tools value cyclical movements. However it puts it to the forefront that the balance sheet volatility is caused primarily by the framework of risk management and protocols followed in decision making by the asset holders rather than the exit value financial accounting itself. This position is also supported by the practitioners’ opinion as explained in the survey by PricewaterhouseCoopers, where more than 300 participants who were board members were polled. 65 per cent of the polled were in agreement that exit value accounting caused volatility in the markets; however, 83 per cent of those polled strongly disagreed with the statement that it was to blame for the bust (Taub, 2009). It should be noted that the worsening of the conditions of credit and ballooning lack of liquidity in the markets in 2008 were not in any way linked with noticeable variability of financial tools quantified at different levels of exit value hierarchy. A slight shift was observed towards Level 1 decrease and Level 3 increase of assets valued using the exit value by the first and third quarter of the year 2008. For liabilities in the same period, the dynamism was less more noticeable as compared to the assets. This was balanced since the liabilities were less in comparison to the assets under the exit value accounting regime. The activities of the companies will be by default be reflected through the report on changes in the financial statements. However, researchers on the subject also pointed at three other sources in which volatility in the final accounts of a firm may be introduced through exit value accounting (Barth, 2004). Foremost, the underlying volatility caused by the economic conditions and is reflected on the value of the assets. Second cause is the error which occurs during estimation leading to volatility because of the fact that the value of the financial tool is estimated, but also due to the assumptions and specifications of the model that may fail to correctly show the truth. Thirdly, is introduction through mixed model volatility, which is revealed because of the fact that the financial tools (assets and liabilities) are quantified at exit value where as others are quantified using the historical cost, other at current value. As a result of this, the financial statements do not fully show the effect of economic events. The ballooning of volatility on the information presented in these statements may decrease the relevance of these statements and the investors’ reliability on such. This unreliability may affect the ability of the investors use their understanding of the present and past events through confirming or correcting expectations. The use of estimated values for input in exit value accounting may in a way affect the reliability because they cannot correctly be verifiable. As such the use of this exit values accounting may kill the ability of the investors to weigh the market by assessing the risk (economic) of the firms operations. The increase of volatility is seen in situations of swiftly changing conditions economic in nature as was the case in the year 2008, where a number of formerly liquid markets were absorbed into inactive markets. The exit value measurements using Level 3 inputs is a major concern when it comes to objectivity and accuracy, the ballooning volatility of the financial markets is mainly linked with exit value measurements at Level 1 and 2 as they transfer the instability to the active markets. It should also be observed that the historical cost is also can be associated with volatility in the financial statements. This historical cost is sometimes viewed as an alternative to the exit value regime. This happens when profits and losses that are linked to increase in asset values that are unrecognizable are used in a single accounting period. This volatility is commonly referred to as the delayed recognition of events, economic in nature (Barth, 2004). 4.0 Arguments in Favour of Fair Value Accounting Fair value accounting supporters more often use three arguments in favour in of the fair value accounting method. The importance of the use of limitations associated with the historical cost accounting, which is recognized as an alternative to fair value accounting method, increased importance of the information presented to the investors using the exit value accounting and lastly, the decreased likelihood on the management of earnings. Under the historical cost method which is considered as an alternative to fair value accounting, company’s asset is recorded at cost. That is to mean the value is recorded after adjustments like depreciation or at market price where the assets are considerably impaired. The support for this method is mostly justified by its simplicity in use and low costs in relation to its administration. However, several other advantages are pointed among them is its conforming nature to the “matching concept” which states that the costs related with the resources should however be matched with the revenues reported in the income statements. This permits more evaluation of profitability as it compares the earned revenues with costs. The use of actual value as opposed to an estimated one and reduced likelihood of quantifying error are other advantages of historical cost accounting method. The list of its shortcomings however, is longer. One of the main of its shortcomings is that it does not show the true value of assets and liabilities and the alignment of the instrument market value is only done at certain situations when the firm demonstrates permanent alteration of the financial instruments. The other disadvantage is that, the method does not take into account the changes in the currency purchasing powers. In periods of rising prices, the method overstates earnings. Thus, the historical cost accounting becomes useless in economies undergoing high rates of inflation. The method also includes estimates in form of judgments touching on the life of assets and liabilities. Also the method uses the assumption that the firm will remain in existence in the foreseeable future whereas the firms may collapse. Another disadvantage is that historical accounting is too simplistic for the transactions that are complex in nature (Jensen, 2009). The existence of fundamental trade-offs to more recent price signals and insensitivity of the method was as a result of both the advantages and disadvantages associated with exit value accounting and historical cost accounting. This was as a result of lack of proper basis for investor decision making caused by lack of sufficient information on the balance sheet values and the distortion of current financial information provided by exit value accounting method for non-liquid assets. This shows that, the fair value accounting is less in-efficient in comparison to the historical cost method. Specifically, modern research analyzed the economic effects of both accounting regimes and came to a conclusion that in some cases of sufficiently short lived, liquid junior assets, fair value was better for it exhibited less inefficiencies in comparison to historical cost accounting (Platin, et al, 2007, p. 26-27). For long duration assets that are traded in non-liquid markets, the historical cost accounting may be preferable over fair value accounting. However, this domination diminishes when impairment measurement is used and the exit value again takes the lead depending on the nature of asset impairment (p. 27). The core aim of reporting in financial circles is to portray the economic position of the firm and to properly mirror the real financial fluctuation of the business. This automatically increases the relevance of the information contained in the statements and in turn improves the decision making ability of investors and regulators. Fair value is seen to be better in this for it permits for the statements to be easily comparable. For instance, under exit value accounting, the assets acquired by two different firms are comparable where as in historical cost accounting approach; the values of these assets would likely be in different balance sheet records of these two institutions. The amount that a firm should pay to replace a certain asset is the deprival value. Recently, the accounting standards have put fair value in place of deprival value as a favorable measure (Zijl and Whittington, 2005). The reason behind the replacement is that the loss suffered of the asset should not be more than its cost of replacement (Baxter, 2003). The advantage of replacement cost is that it puts into consideration the institution’s circumstances and whether it is going to replace the asset or otherwise. The argument behind incompetence of deprival value is that it puts its reliance on the incompleteness level of the financial market (Horton and Macve, 2000). The measurement of fair value is done by use of replacement costs that assets are valued again in dependence of their current market costs. The gains and losses that have not been realized are recognized in the income statement. The replacement cost is not path dependent. 5.0 Conclusion Belkaoui (2004) stated that an accounting statement should be in such a way that it gives relevant information for decision making. If both historical and fair value accounting methods can be used to give reliable information to the market, the both of them should be adopted by firms in their financial statements. So, those involved in preparation of financial statements should be encouraged to improve the quality of these documents by even incorporation of footnotes and summaries among others. The alternatives in accounting would increase the reliability through better quality but concern over cost should be taken into account and comparison should be done. 7.0 Reference List Allen, F. and Carletti, E. (2006). Mark-to-Market Accounting and Liquidity Pricing, Centre for Financial Studies, Working Paper No. 2006/17 Allen, F., and E. Carletti. (2008a). Mark-to-market accounting and liquidity pricing. Journal of Accounting and Economics 45: 358 – 78. Allen, F., and E. Carletti. (2008b). Should financial institutions mark-to-market? Financial Stability Review 12 (October): 1 – 6. Barth, E.M. (2004). Fair Values and Financial Statement Volatility, International Accounting Standards Board. Available at http://www.iasb.org/NR/rdonlyres/721AD4A0-42BB-4A09-9A91-140D27D65B84/0/FairValuesandFinancialStatementVolatility.pdf, accessed September 3, 2009. Baxter, W., (2003). Asset and Liability Values. Accountancy, (April, 2003), pp.7-135. Belkaoui, A.R., (2004). Accounting Theory. London, Thomson Learning 2004, Fifth Edition, pp. 330-353. Diewert, W. E. 2005. Issues in the measurement of capital services, depreciation, asset price changes, and interest rates. In Measuring Capital in the New Economy, eds. C. Corrado, J. Haltiwanger, and D. Sichel, 479 – 542. Chicago: University of Chicago Press. Financial Accounting Standards Board (FASB). (1993). Statement of Financial Accounting Standards No. 115: Accounting for certain investments in debt and equity securities. Norwalk, CT: FASB. Financial Accounting Standards Board (FASB). (1995). Statement of Financial Accounting Standards No. 123: Accounting for stock-based compensation. Norwalk, CT: FASB. Financial Accounting Standards Board (FASB). (2001). Statement of Financial Accounting Standards No. 142: Goodwill and other intangible assets. Norwalk, CT: FASB. Financial Accounting Standards Board (FASB). (2006a). Statement of Financial Accounting Standards No. 157: Fair value measurements. Norwalk, CT: FASB. Financial Accounting Standards Board (FASB). (2006b). Financial Accounting Standards No. 159: The fair value option for financial assets and financial liabilities. Norwalk, CT: FASB. Horton, J. and Macve, R., (2000). ‘Fair Value’ for Financial instruments: How Erasing Theory is Leading to Unworkable Global Accounting Standards for Performance Reporting. Australian Accounting Review, Vol. 11, No. 2, pp. 26-39. Jensen, R.E. Fair Value Accounting in the USA. Available at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/21-Jensen-chap21.pdf, accessed September 3, 2009 Khan, U. 2009. Does fair value accounting contribute to systemic risk in the banking industry? Working paper, University of Washington. Laux, C. and Leuz, C. (2009). The Crisis of Fair Value Accounting: Making Sense of the Recent Debate, The University of Chicago, Booth School of Business, Working Paper No. 33 Laux, C., and C. Leuz. (2009). The crisis of fair value accounting: Making sense of the recent debate. Accounting, Organizations and Society 34 (6 – 7): 826 – 31. Magnan, M., and D. Cormier. (2005). From accounting to “forecounting”. Accounting Perspectives 4 (2): 243 – 57. Novoa, A. et al (2009). Procyclicality and Fair Value Accounting, International Monetary Fund, Working Paper No. WP/09/39. Platin, G. et al (2007). Marking-to-Market: Panacea or Pandora’s Box? 2007 Journal of Accounting Research Conference, p. 26-27 Staubus, G. J. (1961). A theory of accounting to investors. Berkeley: University of California Press. Taub, S. (2009). Survey: Boards are Often Blind to Major Risks, CFO Magazine. Available at http://www.cfo.com/articlecfm/12454618?f=search, accessed August 5, 2009 Zijl, T.V. and Whittington, G., (2005). Deprival Value and Fair Value: A Reinterpretation and a Reconciliation. Center For Accounting, Governance and Taxation Research, Working Paper No. 16, pp. 1-25. Read More