Fair Value Accounting Comparing to Other Measurements - Essay Example

Fair Value Accounting Better Than Other Measurements of Introduction: This paper seeks to critically appraise the statement that the recent financial crisis has led to a strong debate about advantages and disadvantages of fair value-accounting (FVA), particularly on the argument by critics that fair-value accounting has significantly contributed to the financial crisis or, at least, aggravated its severity. In addition, the paper will discuss the benefits and drawback of fair value accounting measurement compared with other measurements (historical cost, replacement cost, and deprival value) in enhancing the quality of financial information. 1.1 The recent financial crisis The credit crunch in 2008 and 2009 saw the fall of big financial institutions including Lehman brothers, AIG, Bear Stearns, and the others. The US government and other governments in Europe tried to provide bail-out funds to save companies because of the economic consequences of the problem but the crisis was unstoppable (Ryan, 2008). In an effort to prevent the occurrence of similar problem in the future, the issue on the influence or effect of the use fair value accounting in the preparation of financial statements becomes a subject of investigation and debate. Fair value is close related to market price as SFAS 157 defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. (FASB, 2006). 2. The benefits and drawbacks of fair value-accounting vs. other measurements First, compared with other measurements, FVA permits or requires companies to report in the financial statements more accurate, timely and comparable information on amounts, regardless of the condition in the economy (Ryan, 2009). This means that fair value is more relevant than historical cost when it comes to understanding the assets and liabilities of business organizations. It is believed that fair value does reflect the underlying fundamentals most specifically the risk of the asset. In other words the quality of information is enhanced in giving relevancy more importance than reliability for decision makers (Scott, 2010, citing Plantin, Sapra & Song Shin, 2008). The use of fair value in the financial statements would come closer to valuation conducted by investors or finance people for decision making purposes (Brigham and Houston, 2002). Second, the reported amounts under FVA would more updated on a regular and on-going basis (Ryan, 2009) allowing decision makers to know that the company would still an on-going concern. On the premise that accounting information are meant to inform the decision makers, then the purpose of accounting is best accomplished with fair value accounting considering that these investors, regulators, and management may act more responsively if they have information that could influence them into action. In other words, decision making are made in the context of seeing the consequence of decisions and fair value is actually more future oriented (Scott, 2010, citing Levitt Jr., & Turner, 2008) Fair value accounting is believed to allow more responsibility from management to maximize market discipline considering the requirement for frequent valuation process because fair value needs to be updated periodically. It therefore requires accountants to understand the business and the economy that in an economy that makes use of the law of supply and demand, the survivors could only include those who are vigilant to know of how changes are made as result of every changing conditions of business. Frequent valuation is believed then to be proactive in avoiding unnecessary risk for decision makers so that management could adjust accordingly (Scott, 2010; citing Boyer, 2007). Management are meant to be drivers of organization in the same that humans could be drivers of running vehicles. In both cases, both drivers are required to be awake. The use of fair value accounting would help reveal the condition of the organization (Kieso, et al , 2007) or vehicle in the case of a vehicle to respond accordingly and adjust. When the driver falls into sleep, accident is not too far. Having only cost accounting could cause management to sleep and may lead to not satisfying the value that other decisions makers would want to have. Third, the chance of manipulation of net income or the so called creative accounting due gains and losses on assets and liabilities would be minimized if not eliminated because bottom line profits could be computed as the time of occurrence not at the time of realization of the result of transaction (Ryan, 2009). , Fair value account requires more transparency compared with historical accounting. Said lack of transparency is equivalent to lack of candidness which may consist in hiding losses with the intention of possibly misleading if not defrauding decision makers. But with the requirements of disclosing the basis for evaluation using fair value and the related accounting standard as issued by the Financial Accounting and Standards Board (FASB) in the case of the US or International Financial Reporting Standards Board (IASB) in case of those in Europe. Increased transparency with fair value accounting is actually adding credibility and should improve accuracy of the financial statements and therefore it enhances usefulness of the information for decision makers. Hence, changes producing gains and losses if the fair value estimated are important and relevant information to users which are required to be disclosed under FVA (Ryan, 2009). Lastly, the worlds major standard setters the FASB and IASB are almost in agreement on the use of fair value accounting. There appears only a slight difference but a harmonization of two standards leading to the adoption and use of accounting for many companies in the world is expected to materialize (Scott, 2010, citing Tweddie, 2009) As proof of advantage of FVA, the past has spoken on the consequences of the use of historical accounting based on the experience of Japan. Japans history of economic crisis provides evidence on the limitations of the use of historical accounting, when billions of dollars were not made known candidly to decision makers until these investors were too late to recover their investments. The Japanese banks, which actually used historical cost accounting model, still fell during the crisis (Scott, 2010 citing Policy Brief, 2009). The use of historical accounting by banks actually was found to have exacerbated the problems of their economy when they avoid facing up to the losses which should have been made known if the fair value accounting and its disclosure requirements were made in place. Given the fact that the Japan banking system was considered strongest and most sophisticated in the world, the failure of cost accounting model should not be allowed any further. On the hand, there are arguments against the use of fair value accountings are as follows: First, it has been claimed that fair value accounting can cause pro-cyclical downward pressure in asset prices, which could cause price of assets to fall below the true economic value. This claim is being used by those who believe that the use of fair value contributed to the crisis. The counterargument for this of course it the fair value accounting is just the messenger that revealed the real problem and it was not the cause. When the doctors tell a visiting patient that the latter has cancer, the doctor is not the cause of the disease, he was the one just telling the truth. The same is true is with fair value accounting, it is just a messenger or one who tells the message to decision makers. Secondly, requiring banks to record that what they will never actually incur will cause excessive volatility. Thus accounting is blamed for such behaviour of investors to respond the information. The connection is hard to appreciate given if decision makers are properly guided they should know that fair value are just information for them to process. To cause them to over react is not the fault of the requirement to reveal in the financial statements the true or underlying fundamentals of the balance sheet accounts, particularly the assets and liabilities. (Scott, 2010 citing Boyer, 2007). Third, fair value is being attacked on the premise that it works only on an efficient market. However, this argument is presuming that information chooses the applicability. The fact that a person has cancer will not change that fact. Lastly, fair value accounting is also being blamed as the cause of banks to violate regulatory capital requirements that would cause them to impede lending as they would just have to sell of their assets to maintain adequate capital (Scott, 2010 citing Boyer, 2007). 3. No convincing proof that fair-value contributed to the financial crisis or, at least, aggravated its severity There is no convincing proof about the claim by many critics that fair-value accounting has significantly contributed to the financial crisis or, at least, aggravated its severity as supported by the following: Firstly, the past does not support the claim that fair value caused the crisis. It was the loss of confidence in banks and banks failure to respond to the changes even with the use of historical accounting that caused the crisis (Scott, 2010). It can be further asserted that the crisis was so pervasive because the use of fair value defined under SFAS 157 and made effective in 2007 did helped find the truth. Had not the standards setters and SEC required the use of FVA, the effect could have been worse. FVA was in effect an aid in the diagnosis of the economic values generated by the firms. Because of the requirement to report and adjust books to fair values, there is no more way to hide and postpone the agony. It is just like a patient who was found to have cancer using a modern technology equipment to discover the same. Under historical cost accounting there was simply more freedom for companies to ignore fair value or market prices. Secondly, the US Securities and Exchange Commission (SEC) concluded in a study that fair value did not cause bank failures on the basis of the requirement of section 133 of the Emergency Economic stabilization act of 2008 (Scott, 2010, citing SEC, 2008). The SEC is the most objective institution allowed by law to declare the lack of evidence to blame fair value as contributory to the crisis. The result of its study must be respected. Even Magman (2009) who claimed that FVA may have contributed cannot defeat the definitive conclusion by SEC. Thirdly, in an economy governed by the law of supply and demand the decision makers are determined to know the fair value or market price of things that they transact with. The use of fair value just allows things to be known sooner than later. Thus it caused not the crisis. While Magman (2009) claimed about the significant contribution of the fair value accounting for the 2008-2009 crisis, the above findings and conclusions were more than enough to disprove the claim. Moreover Magman (2009) is not definitive in his commentary or conclusion on whether FVA has contributed to the crisis. In his analysis of the analytical and empirical evidence available, he was just saying that FVA may have played a role in the in the financial crisis. He admite3d at the time of writing that crisis is still unfolding and thus there is very limited empirical evidence on validity of the claim. 4. Conclusion This paper finds reason and basis about the strong debate about advantages and disadvantages of fair value-accounting in the light of association the concept with recent financial crisis. On the premise that the US is the biggest of the world economy, any problems in its economy generated by the financial crisis will send the rest of the world into problems as well. Indeed the bail-out by the US government was not able to prevent the collapse of Lehman Brother and other big financial institution of the US since the defect was really a deep one. Since the decisions are made based on information, anything that caused the decision makers to make their decision will definitely be subject of inquiry. There seriousness of issues attracts more attention when fair value accounting was in fact blamed for the crisis. However, to say that it contributed may indeed be a very serious matter that must be address. Nobody wanted to have a repeat of the crisis as the effect was world-wide but blaming fair value accounting without scientific proof could be very dangerous considering that its use would more prevalent by its adaption/continuation by the FASB and IASB to strengthen financial reporting regulation of companies. The claim that of many that fair-value accounting has significantly contributed to the financial crisis or, at least, aggravated its severity, cannot be taken hook, line and sinker without clear or convincing evidence on the same. To accept the claim without the benefit of analysis would be to be trapped to what is called a blame game situation. In the nature of things, to say that one thing contributed to the crisis, is implying that without which there could have been no such magnitude of the crisis. In other words, it was arguing that had standard setter maintained the historical accounting method of accounting without including fair values in the financial statements, the crisis could not have been as bad. But the experience of Japan which used historical accounting speaks well for the drawback of historical accounting alone. It was assuming a priori that the situation could have been better. The claimant however failed submits proof on what could have been situation. Perhaps the simple way to understand it is to ask the question on whether FVA is useful in making decision or it has misled people in acting not rationally with situations or. Given the evidence presented there is reason to believe about the lack of convincing proof that decision makers were misled. The claim that fair value just acted as a messenger of the crisis is more evident. There is reason therefore to continue the use of FVA not only in the United States but in the whole world as the economy continuous with globalization. Reference: Boyer,R. (2007). Assessing the Impact of Fair Value Upon Financial Crisis, 5 Socio-Econ. REv. 779, 792 . Brigham, E. and Houston, J. (2002). Fundamentals of Financial Management, London: Thomson South-Western Financial Accounting Standards Board (FASB). 2006. Statement of Financial Accounting Standards No. 157: Fair value measurements. Norwalk, CT: FASB. Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Levitt Jr., A & Turner, L. (2008). How to Restore Trust in Wall Street, WALL ST. Journal Magman (2009). Fair Value Accounting and the Financial Crisis: Messenger or Contributor?. Accounting Perspectives / Perspectives compatibles. Vol. 8 No. 3 - PC vol. 8, no 3. pages 189 - 213 Plantin, Sapra & Song Shin (2008), Marking-to-Market: Panaceaor Pandoras Box?, 46 Journal of Accounting Research . Policy Brief (2009). Inst. Chartered Accountants in Eng. And Wales, Fair Value Accounting and the Financial Crisis 2 Ryan, S. (2008). Understanding the Issues raised by the credit crunch. Council of Institutional Investors Scott (2010).Fair Value Accounting: Friend or Foe? . Retrieved 20 April 2014 from SEC (2008), Report and Recommendations Pursuant To Section 133 Of The Emergency Economic Stabilization Act Of 2008: Study On Mark-To-Market Accounting 35-36 Retrieved 20 April 2014 from http://www.sec.gov/news/studies/2O08/marktomarketl23008.pdf Tweddie (2009). International Accounting Standards Board, Statement to the Economic and Monetary Affairs Committee. 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