A Discussion on Fair Value Measurement - Term Paper Example

As a result of the current financial crisis, will the IASB totally or partially remove fair value measurement options or requirements from accountingstandards? Introduction Among the accounting standards issued (and will be issued) by the Financial Accounting Standards Board (FASB) for the United States generally accepted accounting principles (US GAAP) and the International Accounting Standards Board (IASB) for the International Financial Reporting Standards (IFRS), nothing has been more scrutinised and criticised than fair value measurement. In fact, the focus on this measurement has been increasing for the past years or so. The IASB, itself, has been working double-time to improve the fair value measurement standards. In 2006, the IASB issued a two-part discussion paper in its invitation to comment on fair value measurement. In introducing the said discussion paper, Sir David Tweedie, the IASB Chairman, emphasised that usage of fair value in financial reporting “is of great interest to preparers, auditors, users and regulators” and that there is a need “to establish a clear international definition of fair value and a consistent framework for measuring it” (Discussion Paper, 2006). The number of comments received by the IASB for this discussion paper reached 136 and came from all sectors that are affected by fair value measurement. Fair value measurement, however, has also been subjected to various criticisms due to its perceived shortcomings. According to PricewaterhouseCoopers or PWC (2009), one of the Big 4 auditing firms in the world, the current financial turmoil being experienced by the global company had shown the shortcomings of fair value measurement. PWC also pointed out that the critics of fair valuation have called for the temporary suspension of fair value measurement as this measurement option “creates earnings volatility and destroys bank capital” during times of illiquidity. This paper aims to analyse fair value measurement in the context of the current financial crisis. In particular, this paper discusses whether the IASB (and other accounting standard-setting bodies) will suspend or remove (wholly or partially) the options or requirements of fair value measurement in light of this financial crisis. A Discussion on Fair Value Measurement What exactly is fair value? According to a white paper issued by PWC in 2008, fair value “refers to a value derived from a market with willing buyers and sellers (or an estimate thereof)”. Based on Financial Accounting Standards (FAS) No. 157, Fair Value Measurements, FASB defined fair value 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” (FAS 157, par. 5). Paragraph 7 of FAS 157 went on to state that fair value measurement assumes that the exchange of asset or liability was done in an “orderly transaction”. The concept of fair value measurement has been around as early as twenty-five years ago when the IASB issued International Accounting Standards (IAS) 25, Accounting for Investments (Deloitte, 2009). However, during the last ten (10) years or so, due to the various financial scandals that rocked the business world, the use of fair value measurement has been increasing. Thus, for the past decade, the IASB has been working diligently to update the standards to reflect the growing usage of fair value. In 2005, IFRS users were required to adopt IAS 39, Financial Instruments: Recognition and Measurement, wherein fair value is the main method of measuring financial instruments. IAS 39 elicited various reactions (both positive and negative) when it first came out, due to the complexity of applying the provisions of this particular standard. As a brief summary, under IAS 39, financial instruments are required to be initially measured at fair value (IAS 39, par. 43). Thereafter, measurement at fair value will depend on the classification of the financial assets or liabilities. Under IAS 39, embedded derivatives, which are separated from the main contracts; are also required to be measured at fair value, with any changes being recognised in the statement of income (or statement of profit or loss) (IAS 39, par. 10). Other than IAS 39, several standards which required the use of fair value measurement (i.e., Share-Based Payments) were also issued in 2005. In subsequent years, the IASB has issued several new IFRS, interpretations and exposure drafts to fine-tune the usage of fair value measurement. However, despite the changes and the issuances made by the IASB, fair value measurement is still far from perfect. The IASB itself recognised this fact. In 2006, the IASB issued its discussion paper on fair value measurement. In paragraph 6 of Part 1 of this paper, IASB identified as the first issue the fact that “guidance on measuring fair value is dispersed throughout IFRSs and is not always consistent”. The IASB recognised that there is a need to establish a “single source of guidance for all fair value measurements required by IFRSs” as this will facilitate the application of IFRSs and “improve the quality of fair value information included in financial reports”. This single guidance will communicate in a clearer manner the “objective of fair value measurements” and will make it easier for the users to apply this concept. Criticisms of Fair Value Measurement As mentioned in the Introduction, the application of fair value measurement has elicited various criticisms in all parts of the globe. These criticisms were mostly based on the perceived shortcomings of this measurement. The current financial crisis being experienced by the global economy has increased these criticisms. Calls for the suspension or even removal of fair value measurement have been increasingly heard. This section of this paper discusses several of these criticisms. According to PWC (2009), fair value measurement has been criticised for “producing misleading reports in the unusual recent market conditions”. Critics, according to the same white paper, have voiced out the view that the unrealized losses recognised due to fair market value fluctuations may mislead investors to thinking that something bad might happen to the entity when this event might not happen at all. Another major criticism on fair value measurement is that it creates volatility in the financial statements of the reporting entity. Companies are required to recognise losses due to fair value fluctuations in either their equity or their income statements, despite the fact that these losses are still unrealised and may not be realised at all when the companies finally dispose their financial instruments. This perceived volatility has led various personalities (even politicians and former regulators) to charge fair value accounting as the reason behind the current global economic crisis. The banks, in particular, have pointed out that fair value measurement have forced them to recognise huge (unrealised) losses. These banks say that “illiquid markets for certain securities have led to fire sale prices that do not represent appropriate valuations and they have lobbied to be allowed to value certain troubled securities based on their own estimates” (Mavin, 2009). Still another criticism (related to volatility) is that fair value measurement is all right for those financial instruments with a ready market as there are available market prices. However, “when there is no market, or a market disappears as it did in the credit crunch, companies must use complex mathematical models to come up with values that can be just as confusing to investors” (Chasan, 2008). Lastly, fair value measurement has also been criticised for “the inconsistency of fair-value rules” (All’s Fair, 2008), which, in turn, leads to inconsistency in valuation of financial assets and liabilities, not only among companies but within a company as well. In Support of Fair Value Measurement Not everyone in the accounting world criticises fair value measurement or views it as something that is not good for financial reporting. In the April 22, 2009 article of James Hamilton, Mr. Hamilton reported that the Basel Committee for Banking Supervision recognised the “significance of fair value measurements for regulatory capital adequacy and internal risk management” of the banking institution. In this regard, and in support of fair value measurement, the Basel Committee has issued “guidance to financial institutions and their regulators designed to strengthen their valuation processes for financial instruments”. In February 5, 2009, an article in CFO.com reported that the US Securities and Exchange Commission (SEC) did not accept the offer of the US Congress to stop mark-to-market rules (which is one of the controversial items in fair value marketing). The US SEC reason is that “investors find mark-to-market accounting gives them the best view into the current value of their companies’ assets” (Johnson, 2009). Still another supporting argument to fair value measurement is that it produces “balance sheets that are more representative of a company’s value” (Shortridge, Schroeder and Wagoner, 2006). Finally, in response to the criticism that fair value measurement creates volatility in times of financial crisis, supporters have pointed out that this is exactly the role of fair value measurement. In particular, application of fair value measurement in these troubled times increases the ‘transparency of the impact of market forces on financial performance, which investors prefer – deferring bad news does not create investor confidence” (Power, 2008). Will IASB Remove Fair Value Measurement Options? Now we go back to the initial question this paper aims to answer. In the face of the ongoing financial crisis and with mounting calls to suspend or even remove the fair value measurement option, will IASB give in to these calls and the pressure? Not highly likely. In March 2008, Sir David Tweedie was quoted by CFO.com that fair value measurement is “here to stay” (Johnson, 2008). As a matter of fact, the same article cited Sir Tweedie as predicting that “fair value will be applied to all financial instruments some day – long after he has left IASB”. However, it should be noted that in the face of the financial crisis in 2008, the IASB mellowed its stance on fair value measurement. In 2008, the IASB rushed “out a rule allowing financial institutions to reclassify some loans as a way of avoiding marking those assets to market” (Leone, 2008). This basically enabled the banks to avoid measuring their financial assets at fair value and being hit by unrealised losses due to the ongoing market crunch. However, Sir Tweedie (in the same article) pointed out that there were reasons for making this change and such reasons were valid. Sir Tweedie also pointed out that this change was a one-time revision and will not happen again. To prove this, the IASB “pulled together all its recent guidance” on fair value measurement “into one document” (Leone, October 2008) and issued such a document in October 2008. This guidance did not change anything nor did it deviate from the previous standards. Rather, the guidance reiterated “all the principles in IAS 39…and then addresses thorny practice issues” (Leone, October 2008). With this issuance, it is worthy to note that the IASB has not budged from its stance to continue improvements in fair value measurement and to eventually see a single dominant standard that will provide not only fair value measurement guidance but also answer the issues attached to this measurement option. Conclusion In summary, fair value measurement has greatly evolved from the time it was first introduced to the present time. This evolution has been spearheaded by IASB in its desire to ensure that entities will present a more realistic financial report. This evolution, however, has not prevented critics to voice out their concerns on fair value measurement. With the current financial crisis, these criticisms have become louder and more frequent. Calls have been made from the temporary suspension of fair value measurement to outright scrapping of this option. However, the IASB has not budged from its stance that fair value measurement is the right accounting, even in these troubled times. The IASB may have softened its stance in 2008 through the change it made in IAS 39; however, this softening is not permanent and is a one-off thing. With the consolidated guidance it issued in October 2008, the IASB has shown that it remains steadfast in its commitment to require companies to fully-apply fair value measurement in their financial assets and liabilities. Bibliographies 1. “A Proposal to Improve Fair Value Accounting”. Point of View. PricewaterhouseCoopers website. 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The CPA Journal. Available at http://www.nysscpa.org/cpajournal/2006/406/essentials/p37.htm. (Accessed April 28, 2009). Read More