Contemporary Issues in Accounting and Finance in FASB - Coursework Example

Introduction The recent corporate frauds and failure of financial s at mass level indicated towards serious flaws into the way accountingwas used. According to many, the mark-to market accounting was primarily the most important reasons for the current financial crisis as it allowed many financial institutions to hide or rather under-estimate the risks that they have undertaken. Though mark- to market process or so called fair value accounting was considered as necessary to capture the risk however, it seems to have worked like a double sword wherein a potentially small problem was turned into a bigger one because asset values were down due to market freeze despite the fact that most of the firms managing such assets were performing well. (Pozen, 2009) What contributed towards the development of fair value accounting and under what conditions it was advocated is one of the most important debates in the current accounting and finance literature. The theoretical contributions that have been made in recent past for the development of fair value accounting largely viewed this issue from a different perspective. The fair value accounting advocates therefore focused on the development of a comprehensive accounting framework which can cater to the needs for properly recording those assets and liabilities whose values change with the changes in the market fundamentals or for any other reasons. This paper will therefore provide a comprehensive review and critical analysis of the role, if any, played by the accounting and finance theory in the development and implementation of fair value accounting by FASB. What is fair value accounting? Before discussing the role that theory has played in the development and implementation of fair value accounting, It is important that a comprehensive understanding of the term fair accounting is developed and why it was advocated to be implemented. According to generally accepted accounting practices, fair value of the asset is the current value at which an asset can be sold in the market between two parties under an arms length transaction. Generally, accounting practices or standards advocated the use of historical cost in recording the assets and liabilities in the balance sheet however, as the financial products became more complex and financial innovation took place, the real value of the assets does not necessarily reflected the cost only. Complex derivative transactions with no down side risk protection can cause their value to decline significantly hence they may not represent the correct assessment of the value of the assets. (Ryan, 2008) As such there emerged a need for having a revised and updated framework for the fair value accounting which can actually provide true picture of the overall assets and liabilities of a firm so that investors can take well informed and rational decision. Generally, the current market price is considered as the best proxy for the value of the assets. As such FASB revised its standards to consider fair value accounting as a most relevant measure of assessing the true value of the financial instruments and their correct reporting in the financial statements. It is also significant to note that the fair value accounting may not provide relatively correct measures of the value of the firm’s assets when markets are generally illiquid. In such situations, the mark to market process may not provide accurate or correct description of the asset values and may mislead the investors. This is what happened during the current credit crunch as generally asset values fell and firms have to report lower asset values on their balance sheets. FASB and Fair Value Accounting During 2006, FASB issued a comprehensive accounting standard with the name of Statement of Financial Accounting Standards 157 – Fair Value measurements. This was probably one of the most comprehensive steps so far to integrate new set of rules for measuring the value of financial instruments and assets. It is effective for all financial statements prepared after November 15, 2007 and as such the revised framework is in place last few years. This standard however, also permits that the firms can use different valuation methods to assess the fair value of their assets where it cannot generally be assessed with the help of market prices. However, the valuation models and their capability to estimate the correct fair values of the assets can be debatable given the traditional weaknesses of such models. What is also however, important to note that the implementation of fair value accounting standards allowed firms to report a great deal of information necessary for investors to make wise decisions. Under the standard, firms are also required to periodically report their gains and losses incurred during the currency and a such investors get a comprehensive view of the overall profitability or loss situation of a firm. However, the necessary force behind the implementation of the fair value accounting standards by FASB included many important players and a comprehensive body of research which advocated the implementation of the fair value accounting standards. Securities and Exchange Commission was one of the most instrumental bodies which actively perused the implementation of the standards. In its report published in 2005, SEC’s chief accountant provided a comprehensive understanding of the potential benefits that can be achieved with the introduction of fair value accounting. Firstly, the implementation of the fair value accounting standards may help to discourage the use of creative accounting under mixed attribute accounting models. Mixed attribute accounting models used historical cost as well as fair value concepts to record he transactions. However, the motive behind using such techniques was always to take profit due to the accounting loopholes. As such the implementation of the fair value accounting therefore will attempt to discourage the use of such creative accounting to use mix attribute models to book quick accounting gains which may actually be losses. It was also believed that the implementation of the fair value accounting will reduce the complexity of financial reporting that may arise due to using the mixed attribute model of accounting. Public Interest One of the most important aspects of the regulatory change is the public interest which compels regulatory agencies to make changes that are in-line with the public interests. This sort of approach therefore is based on the utilitarian approach wherein regulatory actions are taken in such a manner that they can create greatest good for the greatest number of people regardless of the actual consequences of the actions. As such the overall regulatory response to such public interest was the culmination of regulatory standards which set forth to protect the public interest. (McLeay & Riccaboni, 2001) Advocates of this theoretical approach therefore focus on the development of coherent regulatory frameworks which can actually provide a comprehensive protection to all the stakeholders. As such the protection of the stakeholders including general public and government serves as the stakeholders. Viewed in this perspective, the development of accounting standards by the regulatory agencies such as FASB is also a step towards achieving greatest good for the greatest number of people. The fair value accounting process tend to provide better understanding of the financial reporting process and provide accurate description of the value of the assets and liabilities of the firm. As such investors can make more informed decisions in the wake of such information. However, as discussed in the initial paragraphs that the implementation of fair value accounting also resulted into the inflation of the current financial crisis as asset values were forced to be reported at lower levels despite the fact that problem was general in nature and almost every firm faced the same situation. Institutional and Contextual perspective This approach towards the accounting theory development focused on the social and political issues of the regulations. Accounting theory that developed under this head focused on how the accounting regulations can be used to set broader contextual framework for the financial reporting. As such the emphasis on the fair value accounting was also a result of this approach wherein focus was on the institutionalization of an approach that can provide comprehensive protection to all the stakeholders. (Hoque, 2006) Agency theory was one such theoretical attempt by the finance which attempted to narrow the gap between the interests of the shareholders and that of the managers. Agency theory basically highlighted that the managers take actions which are potentially in their own benefits rather than benefiting the shareholders or adding value to the firm. Accordingly, managers, within the context of financial instruments, may take positions which can only ensure the increase in their own benefits through higher compensation rather than generating the returns for the shareholders. Fair value accounting therefore provides a necessary tool and method to the shareholders to assess and evaluate the real worth of the assets of the firm. Agency theory also further provides theoretical justification for the implementation of the fair value accounting principles as the same will further narrow down the conflict of interest between the shareholders and the managers besides offering a broader role to the shareholders and other stakeholders to properly evaluate the performance of the managers and accordingly set the compensation for them. There is also an element of risk into the agency theory also as it has its roots in the economic literature. Since fair value accounting requires the accounting of risky positions undertaken by the traders and managers therefore its impact on the development of accounting standards for the implementation of fair value accounting can also be considered as an effective response to this theoretical progress in the field of finance. Financial Bubbles Literature on the financial bubbles can also be considered as one of the most important theoretical contributions towards the development of standards for fair value accounting. Financial markets are considered as inherently volatile working in cycles wherein the highly inflated values of the assets can be experienced during the period of high activity whereas when this activity go on to decline the asset values also decline. The pro-cyclical nature of the financial markets therefore creates strong possibility that the values will be inflated as well as deflated thus creating a misleading picture. (Forbes, 2009) The theoretical focus on this type of accounting issues focused on diversified range of problems including mergers and acquisitions as well as the use of creative accounting. What is also important to note that the research in this direction also focused on the potential regulatory powers of the various agencies including FASB to implement the accounting standards. Coupled with this, the overall role of audit and the auditing standards was also questioned regarding their ability to actually assess the correct position of the firm’s assets, liabilities as well as earnings. Positive Accounting This research framework can also be considered as an important contribution towards the development of the relevant accounting standards. This stream of research focus on the social side of the financial disclosures and advocate the use of financial reporting in such a manner that it allow to fulfill the corporate social responsibility aims and objectives. This stream of research therefore explains as to why the firms make social disclosures however, the major weakness of this research is the fact that its dependent on the empirical data and actually deals with what social disclosures should be and why companies make such disclosures. (Milne, 2001) Viewing from this perspective, it is critical to note that the positive accounting also advocates for the establishment of fair value accounting frameworks as it focus on why and how the firms can make social disclosures. As such fair value accounting also requires the firms to make correct disclosures of the values of the assets and their liabilities. Conclusion There is enough body of evidence which indicates that there were important theoretical contributions both in the field of finance as well as accounting that advocated the development and implementation of a comprehensive framework which can help assess the investors a true nature and value of the assets of the company. The recent failures of the financial institutions as well as the other institutions simply proved that there was a great need for the implementation of the fair value accounting principles and their impact on the firms’ financial position. Bibliography 1. Forbes, W. (2009). Behavioural Finance. Chichester: Wiley . 2. Hoque, Z. (2006). Methodological issues in accounting research: theories, methods and issues. New York: Spiramus Press Ltd. 3. McLeay, S., & Riccaboni, A. (2001). Contemporary issues in accounting regulation. New York: Springer. 4. Milne, M. J. (2001). POSITIVE ACCOUNTING THEORY, POLITICAL COSTS AND SOCIAL DISCLOSURE ANALYSES: A CRITICAL LOOK. Retrieved June 11, 2010, from http://www.commerce.adelaide.edu.au: http://www.commerce.adelaide.edu.au/research/aaaj/apira_2001/papers/Milne36.pdf 5. Pozen, R. C. (2009, November). Is It Fair to Blame Fair Value Accounting for the Financial Crisis? Retrieved June 10, 2010, from Harvard Business Review: http://hbr.org/2009/11/is-it-fair-to-blame-fair-value-accounting-for-the-financial-crisis/ar/1 6. Ryan, S. G. (2008, July). FAIR VALUE ACCOUNTING: UNDERSTANDING THE ISSUES RAISED BY THE CREDIT CRUNCH. Retrieved June 11, 2010, from uic.edu: http://www.uic.edu/classes/actg/actg593/Readings/Fair-Value/Fair%20value%20accounting%20-%20Understanding%20the%20issues%20Ryan.pdf Read More