Fair Value Accounting - Assignment Example

Fair Value Accounting Table of Contents Introduction 3 Understanding Fair Value Accounting 3 Fair value accounting (FVA) and the financial crisis 3 Analytical evidences 4 Empirical analysis 4 Advantages of FVA 5 Disadvantages of FVA 6 Measurement of FVA 6 Improving FVA 7 Conclusion 8 Reference list 9 Introduction Since the beginning of the financial crisis of 2008, there have been many debates and theories to analyse core reasons behind the global meltdown. Subprime crisis, default swaps and rise in debt were identified as major causes. However, several experts are also of the belief that fair value system of accounting has acted as a contributor to the crisis. Due to sudden freeze of the capital markets, many banks and financial institutions were led to devaluating their assets based on the concept of fair valuing. As a result, a number of mortgages, bonds and debts that were performing well were undervalued. This pushed many firms towards insolvency. Many politicians and economists in Europe and the US had suggested removing the concept of fair value system of accounting and favoured historical cost accounting in which assets were generally valued at their original prices (Benston, 2008). Understanding Fair Value Accounting In order to critically analyze whether or not fair value system had any role to play in the financial crisis, it is important to first know about fair value system. The concept had emerged in the late 19th century, when several economists started believing that fairest means of valuing assets would be by valuing them at the rate at which they can be sold in the market. Fair value system of accounting is that system where assets are valued at their market price. Hence, it is a value that a particular asset earns if sold in the market. Nonetheless, due to abusive valuation practices, economists developed more dominant means of accounting such as, historical cost accounting. Yet, Fair value means of accounting remains as an attractive system that is used for reporting purposes (Power, 2010). Fair value accounting (FVA) and the financial crisis The 2008 financial crisis involved extreme volatility of the financial markets. Many financial institutions considered that fair value system had accelerated the financial crisis. Various authorities were also of the belief that fair value system of accounting was a completely destructive tool for the bank capital. The crisis began early in the year 2007, when due to fall in prices of financial instruments; many institutions had to reduce value of the assets existing in their books. As a result, capital ratios were turning out weak. In order to improve the financial position, many firms started to sell their assets in the market. Thus, financial markets started becoming illiquid and this led to an overall liquidity crisis in the market. The inflated level of sales of financial instruments resulted in further fall of their quoted prices (Danbolt and Rees, 2008). However, FVA has received immense support from accounting professionals who claim that the system had nothing to do with the crisis. According to them, FVA is one of the most efficient means of studying the underlying asset position. Even during the financial crisis, FVA provided timely information about the subprime crisis helping investors to monitor their investments accurately. Yet, experts consider that marking assets at their fair value at the time of financial crisis has serious disadvantages (Aboody, Barth and Kasznik, 2004). Analytical evidences Analytical evidences raise concern regarding the use of FVA in institutions and by regulators of the market. For this, two analytical paper models have been selected to study how FVA affects managerial decision making. Allen and Carletti have studied the impact of FVA through industry models of insurance and banking. The results of the study led them to the conclusion that during crisis and times of high liquidity issues in the market; FVA does not show the true financial position of multiple assets as they are under the influence of market meltdown. So, it becomes necessary that this system is ignored. FVA would portray excessive volatility in the assets, which is not the true reflection of asset performance. Also, during financial crisis, the prices do not reflect appropriately discounted values of future cash inflows. Instead, they are shown by the available cash in the market (Allen and Carletti, 2008). Another view regarding the fact that FVA induce volatility in the market can be described on the basis of OTC (over the counter) transaction. In case of OTC transaction of loans, excessive volatility gets induced into transaction prices. It is seen that prices that drive accounting measurements, themselves have an effect on prices of the assets. Additionally, FVA injects artificial risk into the market and effects information regarding security (Plantin, Sapra and Shin, 2008). Empirical analysis The empirical research on the matter of FVA inducing financial crisis have resulted in an understanding that investors view the values of assets to be manipulated. Also, they appear to revise the values of level two assets and level three assets downwards. Nonetheless, under such circumstances, valuations of level one asset were difficult to pin down as different companies reported different trends. Some showed an upward trend, while others tracked it downward. Hence, due to such immense volatility that FVA system induces into the market during liquidity crisis, it is challenging to establish correct values. Investors consider that withdrawing from the market would be more rational, rather than facing high uncertainty and volatility (Cudahy and Henderson, 2005). Furthermore, negative effects of FVA on the banking system are seen as quite high. During times of crisis, banks end up achieving poor stock market performance. The greater the liquidity problem, higher is the performance failure of banks. However, well-capitalized banks are less likely to be affected on the basis of FVA during such times (Barth, Beaver and Landsman., 2001). From the above discussion, it is quite clear that FVA method leads to a wrong way of judging assets during financial crisis. This was the main reason why many held FVA to be a contributor to the financial crisis. If investors had discarded FVA method and took investment decisions based on the historical cost method during the crisis, then market situation would not have hit such lows. Even though the historical costing method would not have helped much to solve the liquidity crisis, yet it would have at least prevented stocks from being valued so low (Holthausen and Watts, 2001). Advantages of FVA A primary advantage of fair value accounting is that it provides accurate information about the assets and liabilities to users of financial reports. If prices of particular assets are expected to rise in the near future, then they are marked up in the financial statements so as to reflect gains of the firm on selling the asset. Similarly, the system effectively shows how much a firm would have to pay in respect of a liability on the basis of current market prices. The prices of assets and liabilities are marked down when markets show a falling trend of prices. In general, this system proves to be effective in knowing the current market trends and their impact on financial records of the company (Magnan and Cormier, 2005). Investors can get a true picture about the assets and net income of a firm. FVA limits a company’s ability to manipulate the net income from sale of asset. A firm may at times arrange for sale of assets in such a manner that they can report incomes or losses at their desired time. This, however, is avoided under FVA. In the FVA system, any increase or decrease in the value of assets and liabilities and accordingly any gain or loss arising thereof is reported in the period in which they occur. An increase in the value of assets and fall in the value of liabilities add to the net income of the firm. On the contrary, a fall in the value of assets and an increase in the value of liabilities lead to loss of net income (Laux and Leuz, 2009). FVA takes into consideration all possible future cash inflows, when inflows of cash are skewed. Similarly, it takes into account new and timely information regarding future cash inflows. Disadvantages of FVA Fair value accounting can pose significant challenges for a firm at times when markets face high liquidity and volatility problems. FVA system under such market conditions may further enhance the problem of volatility. So, when a firm operates in a highly volatile market and follows the FVA system, this creates huge swings in values of the firm’s assets and liabilities. Later as market conditions stabilize, assets and liabilities values are revised and are again brought to their previous levels. This would mean that the values of assets and liabilities at the time of market volatility were misleading. This would result in immense losses for investors as they would not be able to gain correct and adequate information about the market situation and get driven by existing rates. Several firms may reflect insolvency ratios and a total fall of their financial positions during such a meltdown. Nevertheless, later when market situations stabilize, firms get back to their solvent position. Hence, FVA affects stability of firms and makes them extremely vulnerable to market ups and downs. Even those instruments, that are otherwise performing well, get affected by market volatility (Milburn, 2008). Additionally, FVA leads to further lowering of the market situation by devaluing assets at lower prices. The low prices lead to rise of sales on a rapid level, which in turn aggravates liquidity problems. Therefore, because of such reasons, many firms prefer to not adopt the FVA system (Cotter and Zimmer, 2003). It is also observed that during the period of financial crisis, the market is subject to bubble prices. Bubble prices arise out of short-term observations of the investors. They may arise from both rational and irrational perspectives. They are influenced by high illiquidity and market pessimism (Martin, Rich and Wilks, 2006). Measurement of FVA Under fair value system of valuation, assets and liabilities can be valued on the basis of three levels of measurements. In level one, assets are valued based on their existing market prices that are quoted for similar assets, which are active in the market. There are no adjustments made to the market prices that are taken in this manner (Ahmed, Kilic and Lobo, 2006). In level two, observable market inputs that are market driven or are corroborated by the market are taken into perspective to value the assets. Such deriving market interest rates yield rates, volatilities and so on. In other words, in this level, direct or indirect data from the market are used as inputs for valuing the assets. There are two broad subclasses for this type of input. In the first type, the quoted market prices for similar assets that are active or inactive in the market are taken into consideration. The second subclass consists of observable market inputs such as, yield curves, exchange rates, correlation values and other such aspects. The yield valuation in this category is disciplined by market information (Watts, 2003). In level three, the inputs for valuation are unobservable. These yield valuations are not market regulated such as, forecasts of depreciation, leading to loss on mortgages. These inputs are majorly those, which a participant in the market would consider. These inputs are largely firm supplied. Due to lack of price transparency during credit crisis, subprime positions were valued based on the level three type valuations, which were earlier done on the basis of level two (Gron and Winton, 2001). In general, firms prefer using level two inputs than level three. However, the accounting standards do not necessarily imply that firm must use level two inputs. Rather, firms must consider those inputs that a market participant would have to use in order to price assets or liabilities. Usually when market position is stable, firms can use the level one system. When there is liquidity problems in the market, firms may use the level three method of fair valuation as using level two method under unfavourable market situations may end up generating extremely low values of assets (Ryan, 2008). Improving FVA From the overall study of FVA, it can be said that it has had considerable effects upon markets during the crisis of 2008. Even so, the fault lies in way in which the concept was used. Generally, the concept of fair value accounting is apt, if used under right circumstances. When implemented poorly, even historical cost based accounting can yield negative results. Hence, financial performance can only be improved by enhancing the existing financial regulations (Hopwood, 2009). There should be greater control mechanism upon the FVA and historical cost accounting practices followed by firms. This involves strengthening the audit mechanisms and regulatory processes associated with accounting. Conclusion Regulators have overlooked the weaknesses of FVA and also other methods of accounting, which has been one of the prime reasons for a weakened financial condition. FVA is regarded as a broader trend that moves away from accounting and incorporates estimating future cash flows into the business. This greatly undermines the traditional concepts of accounting (Arnold, 2009). Even though FVA is a highly informative method, yet its usefulness to financial regulators has been questioned. Therefore, it can be rightly said that regardless of the system of accounting that is followed, it should be well-implemented in order to reveal the proper financial condition of the firm. Reference list Aboody, D., Barth, M. E. and Kasznik, R., 2004. 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Cotter, J. and Zimmer, I., 2003. Disclosure versus recognition: The case of asset revaluations. Asia-Pacific Journal of Accounting and Economics, 10(1), pp. 81-99. Cudahy, R. D. and Henderson, W. D., 2005. From Insull to Enron: Corporate (re)regulation after the rise and fall of two energy icons. Energy Law Journal, 26(1), 35–110. Danbolt, J. and Rees, W., 2008. An experiment in fair value accounting: UK investment vehicles. European Accounting Review, 17(2), pp. 271–303. Gron, A. and Winton, A., 2001. Risk Overhang and Market Behavior. The Journal of Business, 74(1), pp. 591-612. Holthausen, R. W. and Watts, R. L., 2001. The relevance of the value-relevance literature for financial accounting standard setting. Journal of Accounting and Economics, 31(1), pp. 3–75. Hopwood, A.G., 2009. The economic crisis and accounting: Implications for the research community. Accounting, Organizations and Society, 34(1), pp. 797-802. Laux, C. and Leuz, C., 2009. The crisis of fair value accounting: Making sense of the recent debate. Accounting, Organizations and Society, 34(6), pp. 31-826. Magnan, M. and Cormier, D., 2005. From accounting to “forecounting”. Accounting Perspectives, 4(2), pp. 243–57. Martin, R. D., Rich, J. S. and Wilks, T. J., 2006. Auditing fair value measurements: A synthesis of relevant research. Accounting Horizons, 20(3), pp. 287–303. Milburn, J. A., 2008. The relationship between fair value, market value, and efficient markets. Accounting Perspectives, 7 (4), pp. 293–316. Plantin, G., Sapra, H. and Shin, H. S., 2008. Marking-to-market: Panacea or Pandora’s box? Journal of Accounting Research, 46(2), pp. 46-435. Power, M., 2010. Fair value accounting, financial economics and the transformation of reliability. Accounting and Business Research, 40(3), pp. 197-210. Ryan, S. G., 2008. Accounting in and for the subprime crisis. The Accounting Review, 83(6), pp. 38-1605. Watts, R., 2003. 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