Advanced Financial Reporting and Regulation - Essay Example

Fair Value Accounting Introduction Recognized as gains and losses in the income ment (Barth and L et al., 1995, pp. 97--107). Critics have claimed that fair-value accounting had a hand in the 2008 financial crisis. They mainly claim that the fair value accounting makes firm to experience advantage in boom periods but during the recession, it makes them experience excessive write-downs. This has resulted to huge debates concerning the advantages and disadvantages of fair value accounting (Laux and Leuz, 2009, pp. 826—834). Fair value allows assets to be valued at amounts that can be traded in the open market. The problem with this approach arises when the market for the asset becomes illiquid. This sets in the use of complex models that the company must come up with through the help of a specialist. These assets are grouped as Level three assets. During the financial crisis, there was a fall in the prices of mortgage and related securities. The result was illiquid markets for them and banks marked down their assets largely. This made banks have a great problem in meeting up their capital requirement. The critics claim that money could have helped solve the crisis that existed at that time. However, banks obtained cash through the sale of assets that further made a downward trend in the prices of assets. This led to an economic downturn and became a cycle. This is the main reason, critics of fair value accounting claim that it had a hand in the financial crisis that occurred. Most critics have distinguished mark- to-market accounting a mechanism through which fair accounting can contribute to the financial crisis. There is a link between bank regulation and fair value accounting when trying to evaluate how fair value accounting can lead to a crisis. Fair value depends on the market prices, which are not consistent and sometimes can deviate due to some reasons. The distorted prices can cause a bank to write down its assets to match the distorted prices. As a result, the regulatory capital of the bank would be depleted and it may force the bank to sell assets at lower prices. If the lower prices in the distressed bank become relevant to other banks, it can result to regulatory capital problems and write-downs even for sound banks (Laux and Leuz, 2009). Laux and Leuz (2009) found out that by the management paying attention to the company’s earnings might create the contagion problems. The management can sell their assets at relatively low prices that result to a contagion effect to the other banks. This makes other banks price their assets at fair values that are reflected by the market. The management of other banks would sell their prices at a price set by the bank selling at lower prices. However, accounting rules do not stipulate for pure mark-to-market accounting. In addition, the crisis revealed that the financial markets were not perfect and the fair value accounting did not give the right opinion of the financial statements. The financial results that the fair value accounting produces contain unrealized gain. The unrealized gain can pose a great danger to any company. Unrealized gain endangers capital gain and the survival of the enterprise. Numerous past crises testify the danger unrealized gains have on the company. Critics have raised concerns that accounting is not attaining its purpose of attaining capital maintenance (Laux and Leuz, 2009, pp. 826—834). Moreover, Benston (2008, pp. 101--114) expresses how the fair value accounting degrades the importance of the profit and loss statement has. Fair value has made the balance sheet the main instrument for periodicity. The profit and loss account should offer balanced information to its users. However, fair value accounting has made it not suitable for use by the users. It has made profit and loss statement to have a new role of offering information on business risks. Critics also argue that fair value gain or losses are random. This is because the prediction on the market values is difficult; they change from time to time basing on future information that is not still available (Boyer, 2007, pp. 779-807). Thus, information that is in the balance sheet does not meet the information needs of the investors. The critics argue that the use estimates of fair values of the assets and liabilities do not make the information on the balance sheet able to address the needs of the investors. Furthermore, the difference between the fair value assets at the beginning of the year and the fair value of assets at the end of the year, cannot account for the depreciation in the financial results of the profit and loss statement. From these arguments, it is not possible using the fair value to estimate the future financial results or the fair value of the net assets. The determination of the fair value has also come under scrutiny. The critics have raised concerns that when valuing illiquid assets there is subjectivity that is involved. This makes the accounting method to be doubted as to whether it offers fair values. In addition, the measurements carried on by managements are prone to market oscillations. For example, when two managers are provided for an illiquid asset to determine its fair value, they will give different values. This illustrates that the fair value accounting is highly subjective and does not guarantee a true and fair insight of the financial information. Consequently, the fair value accounting does not fully follow the principles of accurate balancing. The principles ensure that the financial statements being produced are material and accurate. The principles that have been violated by the fair value accounting include matching, conservatism, objectivity, accuracy, consistency and authenticity principles. Fair value accounting violates the conservatism principle. For example, gain and losses that result from fair value accounting are accepted and acknowledged. Unrealized gains form a basis for paying out huge bonuses that affect the economy. The spending of what was not earned in the real sense is very common among the corporations that have used the fair value accounting. The result can be capital erosion for these corporations. In this relation, critics have termed fair value accounting, a method that incites consumption, inflates prices and creates a false economic picture of economic growth. The objectivity principle is often violated when using fair value accounting. The economy reality does not allow for active markets for numerous assets and liabilities. This is an assumption the fair value accounting makes. However, this has resulted to lower reliability of the information when the large share of properties and obligations are assessed. This is because of the different techniques employed by the management and the wide range of statistical models. In addition, it reduces the number of items to be assessed by it and the number of countries where it can be applied. Any accounting method should be consistent with the accuracy principle. The financial statements should be accurate, since the statements that are made are material. However, the fair value accounting method has failed to achieve accuracy. Critics point out that the derivate financial instruments reflect this. The participants of derivatives enter into contracts that will end in a specific future date. In reporting derivatives, fair value accounting recognizes the derivatives in the balance sheet, even before the contract start producing real economic effects. Moreover, the consistency principle advocates for comparing the information on the balance sheet over the different accounting period. However, fair value accounting does not comply with the consistency principle that presumes some assets or liabilities not to change. Fair value accounting makes the financial statements not to be comparable over the accounting period. This is caused by reclassification done to the assets and liabilities and consequent change in evaluation. Due to the violation of the accuracy and consistency principle critics claim that fair value accounting also violates the authenticity principle. This principle requires truthfulness when composing the financial statements. By violating the accuracy principle, it leads to false and erroneous financial statements with unjustifiably high amounts. Critics have raised several arguments that link fair value accounting to the economic crisis that occurred. From the arguments above, fair value, accounting aggravated the severity of the financial crisis that was experienced in the year 2008. This has increased the need for reformation of the fair value accounting (Benston, 2008, pp. 101--114). 2. In order for the financial statements to be quality, they must be relevant, reliable, comparable and understandable. All this aspects must be present in the financial statements to be considered as containing quality information. Financial statements that offer quality information ensure that the investors and other users of the financial information make informed decision. Relevant information of the financial statements helps the user in the process of decision-making. It should help the user evaluate the past, present and future events. Fair value accounting provides information that reflects the firm’s current value. Its balance sheet contains assets and liabilities that have been valued at the existing market prices. Fair value produces information that is relevant and understandable by the users about the costs of assets and liabilities (Karaca, 2009). In contrast, historical cost accounting takes account of only the conditions that existed at the time the transaction took place. Historical cost accounting is insensitive to changes in the market. It is not efficient in economies exhibiting hyperinflation. Therefore, fair value incorporates current information about the current market conditions into its financial statements. Fair value method provides information that can be used for prediction when compared with the historical method, which has outdated cost. Moreover, fair value accounting provides investors with relevant information that help them in decision-making (EisnerAmper, 2014). In contrast, fair value accounting has drawbacks that prevent its financial statements from being relevant. In practice, it is difficult to evaluate correctly the future fair value of the assets based on the statement of financial position, and future financial results based on the income statement. In addition, fair value accounting does not offer the user relevant information due to short-term market oscillations, speculation about movement of prices and other market conditions. In practice, there exist unstable market conditions, which make the information irrelevant and not suitable for investors to use it in decision-making. Information in the financial information should be reliable. In order for information to be reliable, the conservatism principle should be applied. Conservatism principle advocates for proper valuation of the properties, revenue, liabilities and expenses. It strives to ensure that the information is reliable by making sure the assets, revenues are not exaggerated, and the liabilities and expenses are not reduced. In order to achieve this other principles are applied to ensure that the conservatism principle is achieved. The lowest principle ensures that assets are not exaggerated. Moreover, the realization principle ensures the revenue is not exaggerated. In addition, the highest value principle ensures the liabilities are not reduced. Ultimately, the imparity principle ensures that the expenses are not reduced. Fair value accounting has violated the lowest value principle and the highest value principle. The assets are valued at their fair values based on the market prices at that day of balancing the statements. The previous value has no effect on the value determined whether lower or higher. Liabilities are valued based on the prior period. The disregard of the lowest and highest principle by the fair value accounting results to the recognition of the unrealized gains in the financial statements. Because fair value accounting conflict with the conservatism principle, the information it produces is deemed unreliable. Deprival value is an alternative to fair value because it is an accounting concept that is used to measure or value the appropriate measurement basis for an asset. They also matches the lower of unused cost and recoverable amount and recoverable quantity is higher on the net peddling price and value in use. Under FAS 115, fair value hedge derivatives and fair value hedged items under FAS 133. These ones are used to crash fair value on balance sheet with unrealized advances and losses in net income for every period. Quality financial statements should be comparable over a series of the accounting period. In order for one to compare the accounting statements, they should comply with the principle of formal and material consistency. The usage of fair value accounting in evaluating real estate investments, short-term and long-term liabilities, plant and equipment and non-material investments does not provide the comparability of financial and rentability position thought time and between entities. The fair values fluctuate from time to time due to changes in market oscillations. Market oscillations make the prices of the assets and liabilities change frequently. Thus, the statements of financial position over the different accounting period are incomparable. On the other hand, historical statements are easily comparable since it does not take into account the fluctuations that take place in the market. Moreover, the financial statements should be easily understandable. Understandability is also a crucial factor in determining the quality of the financial statements. The fair value accounting produces information that can easily be comprehended by even stakeholders who have little knowledge of accounting (Karaca, 2009). Financial statements should portray accurate information to the investors to enable them make right decisions. Fair value accounting statements portray the underlying economic fluctuations that exist. This improves the relevancy of information contained in the financial statements. The investors are offered a better insight of information that is current and relevant that enables them make an informed decision (Hitz, 2007, pp. 323--362). On the other hand, historical cost’s information is out of date and does not offer the investor quality information. In addition, historical cost accounting includes more estimates that are subjective which make the statements produced not accurate. They have subjective estimates such as warranty liabilities, life of an asset and bad debt reserves. Financial statements necessitates the replacement cost because most it is the exact way to regulate the replacement cost of an asset or any other constructing professional to produce comprehensive estimate (Goh et al. 2009). The estimates only include the structural property that is supplementary to the system; they include systems, fixtures, and finished items will also be included as well; for example, land cost is included in home’s market assessment, which should not comprise of insurance purchased. Replacement method has a beneficial factor on the fair value because in an event of any financial loss, replacement cost coverage, helps the family to return to their home and normal quality of life with minimum financial interruption. The Fair value has benefits to the corporation. In fact, it is considered better than the traditional method in providing quality information. With the globalization of markets, seemingly the investors have become interested in the fair values of the assets and liabilities. Though the various drawbacks illustrated herein, fair value accounting is mostly adopted due to its capability of reflecting the current economic conditions. However, many recommendations have been developed to better the fair value accounting system (Chea, 2011, pp. 12--19). The recommendations are due to the criticism that has been raised concerning the fair value accounting. Critics claim that fair value accounting plays a role in increasing the severity of a financial crisis. If the concerns solved fair value would offer the users quality information. References Barlev, B. and Haddad, J. R. 2003. Fair value accounting and the management of the firm. Critical Perspectives on Accounting, 14 (4), pp. 383--415. Barth, M. E., L and Sman, W. R. 1995. Fundamental issues related to using fair value accounting for financial reporting. Accounting Horizons, 9 pp. 97--107. Benston, G. J. 2008. The shortcomings of fair-value accounting described in SFAS 157. Journal of Accounting and Public Policy, 27 (2), pp. 101--114. Boyer, R. 2007. Assessing the impact of fair value upon financial crises. 5 (4), pp. 779-807. Available from: doi: 10.1093/ser/mwm018. Cga-canada.org. 2014. Fair Value Accounting. [online] Available at: http://www.cga-canada.org/en-ca/AboutCGACanada/CGAMagazine/2005/Sep-Oct/Pages/ca_2005_09-10_ft2.aspx [Accessed: 8 Apr 2014]. Goh, W. B., J. Ng, and K. O. Yong. 2009. Market pricing of banks’ fair value assets reported under SFAS 157 during the 2008 economic crisis. Working paper, Massachusetts Institute of Technology and Singapore Management University. Chea, A. 2011. Fair value accounting: its impacts on financial reporting and how it can be enhanced to provide more clarity and reliability of information for users of financial statements. International journal of business and social science, 2 (20), pp. 12--19. Cornett, M. M., Rezaee, Z. and Tehranian, H. 1996. An investigation of capital market reactions to pronouncements on fair value accounting. Journal of Accounting and Economics, 22 (1), pp. 119--154. EisnerAmper. 2014. Fair Value Accounting. [online] Available at: http://www.eisneramper.com/review/s09-4-fair-value-accounting.aspx [Accessed: 8 Apr 2014]. Hitz, J. 2007. The decision usefulness of fair value accounting--a theoretical perspective. European Accounting Review, 16 (2), pp. 323--362. Karaca, Z. 2009. An Analysis of Advantages and Disadvantages of Using Fair Value Measurement in Accounting Practices. Available at SSRN 1529419. 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. 826--834. Laux, C. and Leuz, C. 2009. Did fair-value accounting contribute to the financial crisis?. Yinghong, L. 2009. A Challenge to the Fair Value——Due to the Worries of the Financial Turmoil and the Reducing Reliability of Accounting Information. Journal of Guangdong Polytechnic Normal University, 5 p. 018. . Read More