A Fair Value Accounting System as a Critique for Its Applicability in the Market Present Conditions - Assignment Example

Fair Value Accounting and the Financial Crisis Table of Contents Table of Contents 2 Introduction 3 Measurement 3 Advantages and Disadvantages of Fair Value Accounting 5 The Crisis 6 Illiquidity of markets 7 Procyclicality 8 IFRS 13 8 Fair Value Accounting versus Historical Cost Accounting 9 Systematic Risk & Adverse Feedback 9 Fair Value Accounting and Replacement Cost Accounting 10 Fair Value Accounting and Deprival Value 10 Conclusion 11 Reference List 13 Introduction The financial crisis the initiated in USA in 2007 has been qualified as the worst financial crisis that the world has seen since Great Depression of 1930’s. The crisis had marked illiquidity in various financial markets including the market for financial assets which went disorderly. Financial institutions have lost billions when the fair value of certain securities dropped steeply and suddenly (Kotz, 2009). Fair Value measures the price at which one can sell or buy a particular asset in an orderly transaction on a specific measurement date within the participants of the market (Ryan, 2008). The paper is a discussion of the fair value accounting system as a critique for its applicability in the present economic and accounting conditions of the markets. It compares and contrasts the fair value accounting system with other measures like the historical cost accounting, replacement cost accounting and deprival value in the light of its contribution towards the occurrence or even increasing the severity of the recent financial crisis. Measurement As per the definition of fair value accounting as stated in FASB, 2006, the related parties which engage in the transaction process are expected to be willing as well as knowledgeable. It classifies each of the assets and liabilities at three different levels. In the first level, which is the most reliable one, financial instruments have been measured by at market value for representation in the income statement and balance sheet. Fair value is not affected by the company specific factors and measure market based values. The observed market price is the most reliable reflection of fair value systems. Difficulties arise in case there is more than one such value available, the market is considered to be illiquid and there is not specific market item that can be measured. Figure 1: Fair Value Hierarchy (Source: Shamkuts, 2010) In level 2 measurements, financial instruments reflect the price quotes of similarly placed financial instruments in active as well as inactive markets. The characteristics involve fewer transactions, variations of price quotations and little availability of any public information. The inputs that are observable like the yield curves and the interest rates are observed at volatilities, credit risks and default rates. In level 3 measurement system, financial instruments that do not have any directly traded market like innovative derivative products and private placements are based on the mark to model valuation technique (Engelen, et. al., 2008; Bebchuk, Cohen and Spamann, 2009).Such unobservable inputs help in measurements under the fair value system to the extent to which it is there is little observable input available. This allows for little activity in markets at the measurement date in the context of assets and liabilities. (Magnun, 2009). Advantages and Disadvantages of Fair Value Accounting The advantages of fair value accounting include: Precise valuation: the measure allows for real time valuation of assets and liabilities of a company and its reflection on the financial statements. True Income Reflection: the possibility of a company to sell out on assets to manage net income differentials gets highly reduced under fair value accounting helping to measure the true income of the company. The disadvantages associated with fair value accounting include: Reversal of Value: In the scenario where the market is highly volatile, companies who revalue their assets and liabilities under fair value accounting might have serious consequences in the event of reversal of market trends which in turn can have serious valuation impacts of their valued assets and liabilities. Market Sensitivity: In the event of a market slump, devaluation of a particular asset of a company under fair value accounting system might accentuate to sell out pressures further devaluing the security. The Crisis The financial crisis had marked the illiquid and disorderly position of the financial asset markets and certain such other asset liability positions. It is deemed that volatility within the financial markets was responsible and observable within the quasi failure or failure by AIG, Merrill Lynch, Lehman Brothers and Royal Bank of Scotland. The critics of FVA have stated that FVA has been responsible for amplification of the crisis. In 2007, price falls of most financial institutions was responsible for marking down of asset values as reported within the balance sheets. This was further responsible for weakening of the capitalisation ratio. Such financial institutions began sales of securities to increase their liquidity and also improve their financial situations. Such sell-out further amplified the price fall bringing additional devaluations. Financial institutions came to realise that the huge losses could also have been on account of fair value accounting of certain securities Figure 2: Fair Value Measurement of Assets (Source: The Economist, 2008) The crisis has presented two major flaws in the fair value accounting process. 1. Problem associated with estimation of fair value in disorderly and illiquid markets 2. Procyclical nature of fair value accounting process that swivels that financial system that brings the financial markets down. According to Laux and Leuz (2009) fair value accounting was not the cause behind the financial crisis in a major manner. It might have been a messenger to it. The FVA debate can be seen as a different version of the reliability versus the relevance argument. The concerns pertaining to marking to market of the assets has also raised significant concerns during the crisis primarily because such assets are ties to different financial contracts as securities and are also under the capital ratio regulation of the banks. In such situations, the accounting standards make sufficient room for alterations and deviations because it is believed that enactment of the FVA might lead to deviation from the standards. Illiquidity of markets Fair value accounting practices uses market prices for valuation and measurement of financial assets without any consideration for the order of markets. Fair value accounting ignores market disorder or even the price of similar level securities within those markets. In the absence of such valuation methods, the companies go with fair value accounting and manipulate their valuations. The recent financial market turmoil has been a victim of such manipulations. (Balckburn, 2008). Procyclicality When financial institutions write down the prices, they sell off assets in order to maintain the regulatory compliance requirements. This again creates a downward pressure on prices. Such cause and effect analysis is clearly presented within reflects the fundamental changes in the fair value accounting process. IFRS 13 Background The prime objective of IFRS 13 was to bring compatibility and consistency in measurements and disclosures pertaining to fair value accounting measure. It was developed with a view to provide for a single framework of IFRS for measurement of fair value accounting systems. The principles under IFRS 13 indicates that fair value accounting must consider 1. The asset or liability that is being measured along with its location, condition and restrictions associated with the sale. 2. The main market where it is possible to undertake an orderly transaction for the proposed sale or purchase 3. In case of a on financial asset, fair value accounting must measure the best use of the asset and its possible status as a standalone or a combination product 4. All kinds of assumptions that is possible to be made during the pricing process of the asset or the liability (Borio, 2008). IFRS uses fair value accounting in measurement of valuation of assets and liabilities on a specified measurement date. It assumes that the transactions take place in the principal market for the assets and liabilities. IFRS 13 considers non financial asset valuation to the highest and best use. Among other, it requires disclosures to be made regarding the recurring or non recurring nature of asset measurement. Fair Value Accounting versus Historical Cost Accounting As per the GAAP accounting principles, assets and liabilities need to be recorded through the historical cost accounting measure where the record of such assets and liabilities is stated at the price on the time of purchase. Under this method, market value of the liability or the asset is presented as the amount at which such an asset or liability can be brought or sold in the prevailing market conditions (Whalen, 2007). On the negative side, market value representation of information is highly unreliable because such measurements are quite at a distance form the actual transaction and provides huge scope for manipulation by company officials. Such information is highly risky for making any investments. In this respect, the following systematic risk associated with fair value accounting over historical accounting has been discussed (Muller and Reidll, 2002). Systematic Risk & Adverse Feedback With unrealised gains and losses, the use of fair value accounting transfers the income and loss recognition aligned in time when compared to the amortised cost method of accounting (Valukas, 2010). When firms make decisions that go suboptimal economically, the investors tend to overreact to unreported losses and incomes and fair value accounting method suffers from effects of adverse feedback. Financial institutions report unrealised losses and sell off assets that are affected with a view to raise additional capital and thereby remove ills form their balance sheets. Such institutions also issues fresh equity and such securities with a view to crowd out direct investment in the assets that have been affected (Barlev and Haddad, 2003). Fair Value Accounting and Replacement Cost Accounting Replacement cost accounting refers to valuation of assets and liabilities at costs that the company is willing to pay for their replacements. Such an accounting method tries to eliminate any distortion that might arise in financial statements owing to true value of the liabilities and assets. When replacement cost if compared to fair value accounting method, they might theoretically appear quite similar. Difference between the both arises in terms of the realised value on sale of an assets and the estimated value of sale of asset (Richard, 2005). Replacement cost method shares the advantage of being a derived value that is justified with future returns. An asset that is valued under replacement cost gets naturally replaced in the event of loss because it is a profit means for the business. On the flip side, it becomes difficult to determine the exact value of replacement of an asset with continuous improvement in the technology aspects. Replacement cost method also tends to be highly subjective than practical. (Davar, 2011). Fair Value Accounting and Deprival Value Of all the other alternatives to the fair value accounting system the deprival value accounting seems to be gaining acceptance because it tends to reflect the economic opportunities for the reporting concern in a consistent manner without any impact from the market conditions. Deprival value considers all the available opportunities for the company and then suggests that opportunity which is most likely to be taken by the company that would be able to provide maximum profit maximisation. The consistent attempt for deprival accounting is to show the degree to which the company shall be better off by owing the particular asset or how much the company shall loose in the event of loss of the asset (Montgomerie and Williams, 2009; Zijl and Whittington, 2005). In relation to fair value accounting measure, deprival value accounting might sound theoretically sounder and it is in fact a better representation of liability within the balance sheet and presentation of income statement in issues regarding revenue recognition. The deprival accounting system is weak in accounting for price changes and it becomes difficult to represent such prices within the accounting statements (HM Treasury, 2009). Conclusion Fair value accounting is deemed to be a more accurate and timely measure for accounting that facilitates comparison across nations as well as companies. FV is a true reflection of the future cash flows and presents the risk adjusted rate of discount. Additionally, fair value accounting allows firms to be strict with their fund management by recognising the losses as well as gains as and when they occur and not only once they get realised. As per the advocates of fair value accounting measure, voluntary and mandatory disclosures bring forth the best possible platform for investors and provide them with sufficient support to question the management (Warwick Commission Report, 2009). On the flip side, limitations of fair value accounting do not function reliably in illiquid markets. It makes hypothecations regarding transaction prices. Another limitation regarding fair value accounting brings up the case of source of accounting which is different from liquid markets. They become non verifiable and allow scope for the managers to make discretions regarding the incomes. Through the recognition of losses and gains, fair value accounting brings in a lot of volatility in the owners’ equity of firms where the net income might not be corresponding to the current cash flows. Critics of the accounting system also accuse fair value accounting to be the cause behind the subprime crisis and the financial meltdown. It is said to be responsible for the vicious circle of fall in prices and also for the increase in risk within the financial systems. In a summary of benefits and drawbacks associated with the friar value accounting system, it is likely that measurements within fair value system remain and continue to be the best method available in the field of financial reporting. In difficult times, fair value accounting serves to be the best method available to keep the investors updated with information while in times that are characterised by strong economic conditions, the fair value accounting system can offer to be the best way for companies to represent their earnings and its impact on company growth, profitability and creation of value. Despites all this, it is realised that the system needs to be improved to introduce more transparency, reliability and accountability. Reference List Balckburn, R., 2008. The Subprime Crisis. New Left Review, 50, pp. 63- 106. Barlev, B., and Haddad, J., 2003. Fair Value Accounting and Managements of Firm. Critical Perspectives on Accounting, 14, pp. 383-415. Bebchuk, L. A. Cohen, A. and Spamann, H., 2009. The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008. Working draft. November. Borio, C., 2008. The financial turmoil of 2007–?: a preliminary assessment and some policy considerations. BIS Working Papers, 251, March. Davar, E. 2011. Flaws of Modern Economic Theory: The Origins of the Contemporary Financial - Economic Crisis. Modern Economy, 2, pp. 25-30. Engelen, E., Erturk, I., Froud, J., Leaver, A. and Williams, K., 2008. Financial Innovation: Frame, Conjuncture and Bricolage. CRESC Working Paper Series, 59, November. HM Treasury, 2009. Reforming Financial Markets. Paper Presented to Parliament by The Chancellor of the Exchequer by Command of Her Majesty. 7667. July. Kotz, D. M., 2009. The Financial and Economic Crisis of 2008: A Systemic Crisis of Neoliberal Capitalism. Review of Radical Political Economics, 41(3), pp. 305-317. Laux, C., and Leuz, C. 2009. The crisis of fair value accounting: making sense of the recent debate. Accounting, Organizations and Society, 34, pp. 826-834. Magnun, M. L., 2009. Fair Value Accounting and the Financial Crisis: Messenger or Contributor? CAAA/ACPC, 8(3), pp. 189-213. Montgomerie, J. and Williams, K., 2009. Financialised Capitalism: After the Crisis and Beyond Neoliberalism. Competition & Change, 13(2), pp. 99-107. Muller, K. A. and Reidll, E. J., 2002. External Monitoring of Property Appraisal Estimates and Information Asymmetry. Journal of Accounting Research, 40 (3):865-881. Richard, J., 2005. The concept of fair value in French and German accounting regulations from 1673 to 1914 and its consequences for the interpretation of the stages of development of capitalist accounting. Critical Perspectives on Accounting, 16, pp. 825-850. Ryan, S. G., 2008. Fair value accounting: Understanding the issues raised by the credit crunch. [pdf] Council of Institutional Investors. Available at: [Accessed 3 April 2014]. Shamkuts, V., 2010. Fair Value Accounting. [pdf] University of Iceland. Available at: < http://skemman.is/stream/get/1946/4234/12284/1/Thesis_fixed.pdf> [Accessed 3 April 2014]. The Economist, 2008. All’s Fair: The crisis and Fair Value Accounting. [online] Available at: < http://www.economist.com/node/12274096> [Accessed 3 April 2014]. Valukas, A. V., 2010. Lehman Brothers holdings inc. United States bankruptcy court Southern district of New York, Chapter 11 Case No. 08‐13555 Warwick Commission Report, 2009. The Warwick Commission on International Financial Reform: In Praise of Unlevel Playing Fields. The report of the Second Warwick Commission, November. Whalen, C. A., 2007. The U.S. credit crunch of 2007: A Minsky moment. The Levy Economics Institute of Bard College: Public Policy Brief, 92. Zijl, T. V. and Whittington, G., 2005. Deprival Value and Fair Value: A Reinterpretation and a Reconciliation. Centre for Accounting, Governance and Taxation Research Working Paper Series, 16. Read More