Enhancing the Quality of Financial Information - Essay Example

A Critical Appraisal of Fair Value Accounting in the backdrop of Recent Financial Crisis Introduction In the history of accounting practices, fair value accounting has gained such a momentum that was not anticipated initially. However, presently, fair value accounting is thoroughly being scrutinized keeping in view the recent global financial crisis. Competing arguments, for and against this accounting practice are on their way to mature. It is therefore important to understand potential role of fair value accounting in initiation and aggravating of the crisis. A critical appraisal is henceforth being made so that its implication could be ascertained. The measurement of liabilities and assets at their fair value is a concept old to financial managers. The notations like appraised values or current values were frequently used in 1920s. A US Security Exchange Commission Report (2008) has provided details of the genesis of fair value accounting standard. This notion was common long before formal definition of the accounting standards. Johnson (2009) opines that this term has gained support after 2002 in order to standardize financial measurements, understanding and across board validity. It will be relevant if elementary concepts for the understanding of fair value are considered in this introduction. These concepts also include the regulatory framework that governs fair value and will be discussed subsequently. For most of the cases, fair value measurement is governed by set of standards. Before the development of International Financial Reporting Standards or IFRS, many countries used country specific accounting standards. These standards are now known as Generally Accepted Accounting Principles or GAAP, which in effect, are the country specific directives for the financial statements preparation. IFRS is now replacing GAAP in many countries (Lefebvre, Elena, 2009). In 2000s International Accounting Standards Board started to shift a number of accounting rules that included the implementation of fair value accounting. In Financial instruments IAS-39 Recognition and Measurements, Impairment of Assets IAS-36, Financial Instruments IAS-32 Disclosure and Presentation etc. the practice of fair value has been applied. The concept of fair value is self-explanatory; it represents the re-valuation of assets and liabilities to general market price. The concept applies to those assets which are financial in nature. However, three more groups of assets are property/ equipment, intangible assets and investment. These assets are also considered for valuation in fair value measurement when desired. Thus financial reporting, in fair value accounting, aims at provision of financial statements which are relevant and reliable. The users are actually the capital holders which are known to be the investors, lenders, suppliers, regulators, bargaining units and the management representative. They can be considered as key stake holders in a business. The statements are primary source of information for them Gains and losses are directly related to these values presented in them. The financial statements are categorized according to their use into four main classes. First are assets and liabilities that are held for maturity, second are the loans/ receivables, and next to them are the assets that are available for sale. Last category is of those which are held for trading purpose. Each class has separate impact on financial statements. The last basic concept is valuation techniques that are employed for fair value accounting. According to IASB, active markets might not exist all the times for identification of their price. And even in some cases a set of liabilities and assets may not be put forward for price appraisal due to the market conditions. Therefore a standard has been developed that is in the form of hierarchy which helps in valuation. There are three levels in this hierarchy. For the sake of simplicity two end levels are discussed. At the highest level (L1) tangible assets like capital, properties etc. are placed. The lowest (L3) priority is given to intangible assets that are in effect less transparent. For the sake of market activity the transactions of assets are carried out with sufficient volume and frequency. IASB recommends three approaches for valuation which include, cost (replacement cost), income (cash flows or income/ expenses) and market (includes comparable liabilities and assets) approach (IASB, 2009). The use of fair value accounting has brought along a good deal of criticism, especially in wake of speculations during present economic melt-down. Currently, two main arguments are thought to be at the basis of this criticism. One is the proclivity that increases the procyclicality, and second is its contribution towards increased information-volatility. Conceptually, procyclicality is said to be the increase of fluctuation in otherwise normal cyclical business. This contributes to instability of the system. Main concern in this instability of financial system is the fair value accounting has a potential that can cause pro-cyclical strains on assets and liabilities values (Laux, Lauz, 2009). Overstatements of the profits that is usually done in booms has a special function that allows institutions to increase leverage and contain the incentives in order to make reserves (to be used during down times). Conversely, in busts, fair value accounting potentially forces down pressure on prices in markets that are already enfeebled. This bust causes additional decline in the otherwise normal market prices. This in turn pushes the financial institution to sell their securities. Otherwise real intent would have to possess these investments till maturity. This forced sale, therefore, becomes tangible inputs for others who rely on fair value accounting in order to put on their assets and liabilities in to the market. Analysis conducted by Centre for Financial Studies has explicitly shown that this accounting regime, during the crisis, might cause liquidity of financial institutions. Subsequently, the asset price becomes dependent on liquidity rather on power of the assets to earn (Carlette, 2009). This argument against fair value accounting ignores an important aspect that fair value accounting reveals warning for the crisis that might occur and thus has a potential that can reduce the dire crisis and declining of prices. An investigation which was conducted by International Monetary fund is also of the same view that fair value accounting exacerbated cyclic movement in assets and liability values. It was also observed that volatility was caused due to the framework for risk management. Researchers have opined that there are ways in which fair value accounting might cause volatility in financial statements. It is pertinent to mention that the activities performed by companies are reflected in changes which are reported in financial statements for a given period. First potential source is the volatility that is inherent due to change in economic conditions (conspicuous in the values). Second source is in the estimation error volatility which is due to the fact that the values are estimated not observed. Increase in information volatility as give in financial statements caused reliability of information to decrease (Barth, 2004). This has a negative effect on the ability of the investor to correctly expect and understand from the past. Thus fair value accounting might reduce the assessing power of the investor. 2. A comparative Analysis of Accounting Measurements Fair value accounting is defended mainly because of three advantages. First is the limitation that was associated with historical cost method. Second is the information that is given to investors and third is the less likelihood of revenue management. Keeping in view these limitations in historical cost accounting method, these aspects are discussed below. Main alternative to fair value accounting is historical cost accounting. With this methodology, assets and liabilities are recorded in financial statements of the company with its history cost, which caters fewer adjustments in case of impairment of the asset. This methodology was exercised for a long term because of its simplicity in administration. Other plus point in this method was its conformity to concept of matching. The measurement error and real-time transaction, against the hypothetical transaction, were the two other aspects that favored the historical cost accounting regime (Jensen, 2009). Similarly, as opposed to fair value accounting, historical cost model has a long list of shortcoming. Main shortcomings are pertinent to be mentioned here. (Laux, Leuz, 2009) The HCA model does not show real value of the financial instruments and accounting value of assets/ liabilities as per the market prices. Some other aspects that favored fair value accounting to take over are: Historical Cost accounting method does not take into consideration the changes that occur due to fluctuation in purchasing power of a currency. Thus it can be ascertained that historical Cost method becomes useless in those economies which show hyperinflation trend. The estimates that are put forward in this method are less objective and the estimates that are valuated are subjective. They affect judgments regarding economic life, debt reserves, joint costs and liabilities that come under the head of warranty. Historical cost accounting method makes a basic assumption that the institution will remain-the-same beyond future that is foreseeable. However there are many companies that lie in ambiguous area (exit values and on-going concern). Complex transactions cannot be carried out with this method, as for instance, a firm might intend to swap interest rates. This complexity is not catered with Historic cost accounting methodology. These arguments can be summarized as fundamental trade-offs that lie between insensitive historical cost accounting and disfiguration of information given by fair value accounting for assets. Also that fair value accounting is less inefficient as compared to historical cost accounting. From general principles it is known that for a liquid or sufficiently junior asset, fair value accounting proved to be more efficient. Similarly, for those assets that had a long duration or which exhibited downside risk, historical cost regime showed dominance. This advantage is markedly enfeebled when impairment measurement is employed. Here fair value accounting again gets superior. 3. Fair Value Accounting & the Global Financial Crisis Critical evaluation of the debate that is sprawled over years can be understood by pointing out following concerns (Ryan, 2009): In fair value accounting the first important point is discussed under ‘unrealized profits’. The assets and liabilities are revaluated on balance date as per their current fair value which could lead to unpredictable gains. Once the profit is distributed among the owners it can lead towards capital erosion. Further the risk of inappropriate distribution of unrealized gains is under question especially when bubble price situation occurs. Second point is the reliability of measurement. The reliability comes under severe criticism when fair value measurement is made hypothetical in inactive or illiquid conditions of market. Also that relevance is questioned and doubts are prevalent about the information in income-statement. This happens whenever mixed basis are used to measure the elements of balance sheet. Suboptimal behavior is also a point of concern in fair value accounting. Fair value accounting leads to premature speculations of gains as compared to the old historical cost model. As a case study it is relevant to mention an event from 2008 financial crisis. During the second half of 2008, the crisis started to deepen. Most of the banks raised concerns about fair value accounting for their liquid assets. Due to fair value accounting the observed prices were intentionally shown as low which created the problem. From the perspective of investors, the accountants are not much concerned as banks seem to be. Fair value accounting is a method that provides authentic disclosures and gives reliable, comparable and timely information better than any other alternate approach. (Ryan, 2009) It is noteworthy that European banks are more than biased to criticize fair value accounting than the US banks. All standards face trade-offs and fair value accounting is of course not an exception. Here the tradeoff resides between reliability and relevance, and is seen at the heart of the debate. Thus the concerns can be summarized as Fair value accounting causes volatility during normal times Fair value accounting can cause domino effect especially during crisis. To treat these genuine points, regulations are required to be put in place. The capital should be counter cyclic. It cannot be the solution to revert back to older system which is not able to cater the needs of complex markets 4. Potentials of Fair Value Accounting- Is the model Perfect? The reliability and relevance of fair value accounting is, however, currently under question. Due to illiquid and volatile situation of market weakness of this model is under intense scrutiny. Probable solution is to increase focus on regulation rather than reverting back to alternatives (historical cost accounting as discussed). Present S&P chairman, D. Sharma has pointed out that financial statements should tell economic condition of a company. According to Mr. Sharma, reporting should be modeled to have this fundamental principle (Sharma, 2008). Moreover Fair Value Accounting is not a solution for everything (IMF, 2008). As another objection, it is also argued that procyclicality is the inherent tendency of the model which causes forced sale of assets. Some (Kokenge, 2014) are of the view that efforts are needed for better assessment and measurement techniques than those which are currently being used in fair value accounting. When liquid markets are absent the clients tend to move to alternate ways in order to determine the fair value. The market players have models, whereas others have to start from the beginning. This is the gap that needs to be filled. In addition to these changes, greater transparency in fair value accounting is also required. There is a need for refinements that should be considered. These include; 1. Market-based-information should be entity-specific instead. Thus whenever observations lack/ influenced by fluctuations and disruption, the specialized regime should be used in order to evade subjectivity. 2. There should be a benchmark instead of unrealistic general application of fair value hierarchy for measurement approaches. (CPA Journal, 2008) 5. Conclusion- Enhancing the quality of financial information Fair Value Accounting regime is in evolutionary phase, which, due to its superiority has permeated across globe. Due to complex financial instruments that are currently in use, investors back this model instead of previous historical cost accounting system. As speculated, the regulatory environment will become more complex with the evaporation of economic borders. Although fair value accounting cannot be exonerated from shortcomings, yet it has clear advantages over the alternatives as discussed above. As criticized above there is a need that transparency should be promoted. Enhancing clarity and robustness for disclosure will also help in the success of this model. Assumptions-based-valuations remain problematic for putting accurate information for the investors. Simplification of accounting standards and achieving less subjective approach for measurements will also tame such crisis situations. It will not only help investors, analysts, and regulators but will also help preparers and the public completely understand its potentials and loopholes (Vinals, 2008). If companies disclose, valuation approaches, volatility, underlying risks, assumptions, adjustments & sensitivities for the users, situations that were faced during 2008 would be confronted much affectively. Flexibility in the use of standards under a regulatory regime can avert certain disadvantages. The financial regulation has a close relationship with accounting standards and this feature is a key for the supervision of banking industry (Zhou and Ding, 2009). Fair value accounting provides an opportunity to be cautious about the market- regulatory regime in China provides a good example. A certain degree of regulations that put restriction should be implemented so that adverse effects based on speculative measurements could be avoided. (Zhou and Ding, 2009) Works Cited Allen, F., & Carletti, E. (2008). Mark-to-market accounting and liquidity pricing. Journal of accounting and economics, 45(2), 358-378. Barth (2004). International Accounting Standards Board, Fair Values and Financial Statement Volatility, September 3, 2009. Available at: CPA Journal (2008). Fair Value Accounting Works Well, but Is Not Perfect. Retrieved from http://www.nysscpa.org/cpajournal/2008/708/perspectives/p9.htm http://www.iasb.org/NR/rdonlyres/721AD4A0-42BB-4A09-9A91-140D27D65B84/0/FairValuesandFinancialStatementVolatility.pdf IASB (2009). Basis for Conclusions on Exposure Draft Fair Value Measurement. Retrieved from http://www.ifrs.org/Current-Projects/IASB-Projects/Fair-Value-Measurement/ED/Documents/EDFairValueMeasurementBC_website.pdf IMF (2008). IMF Global Financial Stability Report -- Containing Systemic Risks and Restoring Financial Soundness -- April 2008 -- Contents. Retrieved from http://www.imf.org/external/Pubs/FT/GFSR/2008/01/index.htm Jensen, R. E. (2009). Fair value accounting in the USA. Retrieved from http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/21-Jensen-chap21.pdf Johnson, S. (2009). Simplified Reporting: Forgotten in the Crisis? | CFO. Retrieved from http://www.cfo.com/article.cfm/14209682/1/c_2984368?f=search Kokenge, C (2014), PWC, Fair value assessments, http://www.pwc.com/us/en/audit-assurance-services/accounting-advisory/fair-value-assessments.jhtml Laux, C., & Leuz, C. (2009). Did fair-value accounting contribute to the financial crisis? (No. w15515). National Bureau of Economic Research. Laux, C., & Leuz, C. (2009). Center for Financial Studies : WP 2009-09 The Crisis of Fair Value Accounting: Making Sense of the Recent Debate. Retrieved from https://www.ifk-cfs.de/index.php?id=1583 Lefebvre, R., Simonova, E., & Scarlat, M. (2009). Fair Value Accounting: The Road to Be Most Travelled (No. 091205). Certified General Accountants Association of Canada. Ryan, S. G. (2008). Fair value accounting: Understanding the issues raised by the credit crunch. White Paper prepared for the Council of Institutional Investors. Sharma (2008). The CPA Journal, Fair Value Accounting Works Well, but Is Not Perfect (http://www.nysscpa.org/printversions/cpaj/2008/708/p9.htm) US Securities and Exchange Commission. (2008). Report and recommendations pursuant to section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-market accounting. Office Of The Chief Accountant, Division of Corporation Finance (http://www. sec. gov/news/studies/2008/marktomarket123008. pdf). Vinals, J. (2008). Improving fair value accounting. Financial Stability Review, 12, 121-130. Zhou, Ding (2009) Jul. 2009, Vol.5, No.7 (Serial No.50) Journal of Modern Accounting and Auditing, ISSN 1548-6583 The defects of fair value under global financial crisis School of Accounting, Zhongnan University of Economics and Law, Wuhan 430073, China Read More