Critical Analysis of Fair Value Accounting - Essay Example

Critical analysis of Fair value accounting Table of Contents Introduction 3 Fair value accounting: Its implication 4 Advantages and Disadvantages of Fair Value Accounting 6 Comparison of fair value accounting with other accounting methods 7 Conclusion 8 Reference List 9 Introduction Fair Value accounting is a method of financial reporting, which requires or permits organizations to measure and report certain assets and liabilities (specifically, financial instruments) on an ongoing basis. The measurement and reporting of these financial instruments have to be done at approximation of prices that the organization would receive if they were to sell financial instruments or pay if they were to be relived of obligations associated with liabilities. The standard set within the fair value accounting approach requires organizations to report losses only when fair value of their assets reduce or liabilities augment. As a result of these losses, reported equity of an organization may get lowered and it may also reduce reported net income (Ryan, 2008). Even though fair value accounting has played a significant role in the United States Generally Accepted Accounting Principles (GAAP) over the last five decades or so, accounting standards that permit or require implementation of fair value accounting have augmented substantially in number and importance over the recent past. The Financial Accounting Standard Board (FASB) in September 2006 stated an important and contentious new standard of accounting referred to as the Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157), which provides a comprehensive guidance to organizations in order to help them estimate fair values. The realistic implication of this standard has been tested by extreme market conditions during the period of credit crisis, especially in the United States (Magnan, 2009). During the period between 2007 and 2009, when the US economy was going through a credit crunch, subprime market as well as market for various other asset and liability positions had been disorderly in many respects and severely illiquid. This prompted world leaders, investors, analysts and various self-interested parties to highlight three primary probable criticisms of fair value accounting. First of all, unrealized losses that are recognized according to rules specified under fair value accounting approach may reverse over time. Secondly, illiquidity in the market may render the task of measure fair values relatively difficult. Therefore, even if the fair value of assets and liabilities are determined, results might be unreliable. Lastly, firms that report unrealized losses according to standards specified under the fair value accounting approach may have unfavourable feedback effects that deteriorate market price of the assets and liabilities as well augment risk of the entire financial system that is termed as systemic risk (Ryan, 2008). This study will involve an in-depth analysis of various dimensions of fair value accounting approach and critical review of the question regarding contribution of fair value accounting towards the financial crisis will be done. Thereafter, keeping the views in mind, advantages and disadvantages of fair value accounting approach will be explained in details and a brief comparison will be drawn with other accounting approaches implemented in the financial industry. Fair value accounting: Its implication As mentioned earlier, the market in the United States had begun experiencing significant instability and illiquidity over the last few years. As a consequence, certain circumstances were created, which made assessment of assets and liabilities through implementation of fair value accounting approach fairly controversial. It is obvious that values of new and innovating, yet complicated, financial instruments such as, derivatives, mortgage backed securities as well as various other customized financial products are subject to market wide volatility and illiquidity. Although majority of the market leaders as well as researchers agree to the fact that a relevant representation of financial statements can be obtained through application of fair value accounting approach and that relevance of outcomes are relatively robust than those obtained by the application of historical cost method; this approach is not perfect (Penman, 2007). The controversies that have been associated with fair value accounting method include the application of this approach in illiquid markets. Another controversy associated with this accounting approach is the question regarding when and how modelling approach should be applied in order to determine fair value of a particular financial instrument. The situation that has been prevailing in the credit market over last few years have led to considerable write-downs as a result of application of fair value accounting method. Most of the charges have been witnessed in cases of banking industry and broker dealers. Organizations that are primarily engaged in credit production through financial instruments such as, credit default swaps on an underlying asset, unlike insurance contracts, have been largely affected because of implementation of fair value accounting approach. According to Ball (2006), even though the default that would drive necessity for credit protection may not have happened, organizations are still required to recognize losses on a specific contract; this is unrealized when fair value of the underlying asset has fallen by a significant margin. In fact, even organizations that have made investments in auction rate securities were impacted severely in terms of depleting financial value, when the value of those auction rate securities started to fall (B. Elliott and J. Elliott, 2013). The prerequisite for applying fair value measurement has been severely criticised due to the fact that it provides erroneous results during unstable market situations, which were experienced during the financial crisis. Such outcomes as a consequence of fair value accounting appear to have long-term effect on several companies. The underlying reason that can be attributed to this fact is that if a company reports losses in such an unstable environment, then it relays a bad signal out in the market; this may ultimately mislead investors (Laux and Leuz, 2009a). Therefore, reporting only recognized gains and losses is a preferable choice. However, if the controversy is taken into consideration, then it is very important to understand that the principle of fair value accounting was developed in order to disclose information that will best serve the interest of investors, policy makers as well as companies in the long run (Landsman, 2007). Leaders, policy makers and academics throughout the world have either proposed for a suspension or reformation of fair value accounting because it is regarded to have been a significant contributor of the 2007-08 financial crisis. Several criticism and escalating political interruptions by the European Commission and the United States Congress have put substantial pressure on the regulatory authorities to modify the accounting standard. Nonetheless, existing evidences provides the researcher with little reason to conclude that fair value contributed to the global financial crisis. Fair value accounting approach plays a minor role in determining the banks’ regulatory capital ratios as well as other parameters from the income statement, except for those banks which have large trading positions. For such banks, investors would have been concerned about being exposed to subprime mortgages and would have made their judgements regardless of the application of fair value accounting approach. In addition, existing standards have numerous safeguards and these standards offer considerable discretion to banks, thereby enabling them to avoid marking to warped market prices of financial instruments. Banks have been witnessed to have used this discretionary power during the crisis period. Moreover, there is also very scant evidence to suggest that asset prices were warped as a result of fire sales or that bank and other financial institutions were forced to engulf excessive write downs during the period of crisis. If it is believed that claims regarding the significant contribution of fair value accounting to the global financial crisis is mostly unfounded, conclusions have to be drawn very cautiously and in a way so that it is not viewed as a supporting comment in favour of extension of the accounting method. Given the scarcity of evidence that fair value accounting was largely responsible for weakening the financial system or causing domino crisis between banks, proposal for relaxing the existing rules of fair value accounting is also very weak (Laux and Leuz, 2009b). From another perspective, it can be said that even if fair value accounting approach were to drive descending spirals and contagion between banks, then negative effect during the period of crisis have to be weighed against positive outcomes of this accounting approach and timely loss identification. When banks are required to write down value of assets as they suffer losses, they have the option of taking prudent measures in order to limit the amount of excessive lending done in the first place. If such is done, then this will ultimately minimize severity of the crisis. According to Allen and Carletti (2008), one of the most important lessons learned from subprime mortgage crisis in the United States is that when regulators relax the rules for financial institutions to confront their losses as and when they occur, the magnitude of loss becomes way larger. For the very same reason, relaxing or suspending the fair value accounting standard during a period of crisis is problematic due to the fact that banks can sensibly anticipate such changes. This reduces their incentives to avoid being exposed to risk. Thus, banks, instead of modifying the accounting standard, should adjust the regulatory requirements. Advantages and Disadvantages of Fair Value Accounting One of the primary advantages of implementing fair value accounting approach is that it enables a company to provide accurate evaluation of their assets and liabilities on an ongoing basis to users of the disclosed financial information. Fair value accounting provides relevant information regarding financial assets and liabilities compared to values based on the historical cost (original cost that is received or paid) of such financial instruments. Given the fact that fair value accounting reveals current market situations, it provides users of the financial information with flexibility to compare the value of financial instruments, which were bought at different times. Alongside that, financial disclosures via implementation of fair value accounting approach offer valuable insight to investors regarding the prevailing market values, thereby enabling them to ensure helpfulness of financial reports. As far as the disadvantages are concerned, fair value accounting is also associated with certain difficulties. The situation of the market, where trading of assets and liabilities are conducted, may fluctuate invariably and may become volatile at times. So, application of fair value accounting allows companies to re-evaluate current value of the assets and liabilities in current market condition. This distorts value of those assets and liabilities hugely. Even so, when market stabilizes over time, the value changes reverse back to their previous levels, thereby making any reported gains or losses temporary. This suggests that implementation of fair value accounting may often provide misleading information to users (The Bond Market Association, International Swaps & Derivatives Association, Securities Industry Association, 2002). Comparison of fair value accounting with other accounting methods Contrary to the fair value accounting approach, historical cost accounting approach states the requirement that all items of a financial statement needs to be valued at their original cost. Historical cost basically refers to the cost paid or received by the company for a particular item. It is not valued according to the current market price. This means that if a building is purchased by a company, then it will be rerecorded on the balance sheet at its acquisition cost. One of the major advantages of historical cost accounting is that accountants are reluctant to value their assets precisely according to the market condition; this is because in case of an unstable market scenario, valuation of an asset becomes highly unreliable and produces misleading information. The disadvantage of this accounting approach is that by not valuing the assets and liabilities at the current market value, it is ignoring that current market value of the asset may be higher or lower than it actually suggests. Replacement cost accounting is a method that allows for additional depreciation on some part of the difference between replacement cost and original cost of a depreciable asset. The assets and liabilities are valued at their replacement cost. This accounting approach is very similar to fair value approach, but the difference is that fair value of an asset must be replaced at different times in a year to a value at which the asset can be sold by the company in the market place. This method gives a fair representation of the current value of an asset and liability since the values are revised over time in a particular year (Thompson, 2007). According to the deprival value accounting method, value of an asset is equal to the loss that would be incurred by the owner if deprived of the asset. It is based on the principle that owner of a particular asset may use the asset to achieve greater value than the value that can be generated from an instant sale. The rule states that maximum value at which an asset should be recorded is the replacement cost. One of the major disadvantages of deprival value accounting is that this method is relatively complex than other accounting approaches. Its implementation may yield certain values, which might contradict actual market value of the asset (van Zijl and Whittington, 2005). Conclusion Fair value accounting approach, according to researchers, is currently the best possible accounting model available at the disposal of companies in order to value and record their financial items. It is thoroughly based on market estimates and measures. Empirical researchers have stated that implementation of fair value accounting in the current market valuation of certain complex financial instruments may not reveal the long-term reality. Despite that, complex issues of evaluation are open to controversies from both sides. The question regarding appropriateness of fair value accounting model in revealing the long-term reality is a debatable one and has to be assessed vigorously. Even after that, in the contemporary financial system, fair value accounting approach has given a justified reflection of the financial situation of a company (PWC, 2008). Reference List Allen, F. and Carletti, E., 2008. Mark-to-Market Accounting and Liquidity Pricing. Journal of Accounting and Economics, 45(2-3), pp. 358-378. Ball, R., 2006. International Financial Reporting Standards (IFRS): pros and cons for investors. Accounting and Business Research, 36(1), pp. 5-27. Elliott, B. and Elliott, J., 2013. Financial Accounting & Reporting. 16th edition. New Jersey: Pearson. Landsman, W., 2007. Is fair value accounting information relevant and reliable? Evidence from capital market research. Accounting and Business Research, 37(1), pp.19-30. Laux, C. and Leuz, C., 2009a. The crisis of fair-value accounting: Making sense of the recent debate. Accounting, Organizations and Society, 34, pp. 826-834. Laux, C. and Leuz, C., 2009b. Did fair-value accounting contribute to the financial crisis? NBER Working Paper No. 15515. Magnan, M. L., 2009. Fair Value Accounting and the Financial Crisis: Messenger or Contributor? Accounting Perspectives, 8(3), pp. 189-213. Penman, S., 2007. Financial reporting quality: is fair value a plus or minus? Accounting and Business Research, 37(1), pp. 33-44. PWC, 2008. Fair value accounting: Is it an appropriate measure of value for today’s financial instruments? [pdf] PWC Available at: [Accessed 4 April 2014]. Ryan, S. G., 2008. Fair value accounting: Understanding the issues Raised by the credit crunch. [pdf] Council of Institutional Investors Available at: [Accessed 4 April 2014]. The Bond Market Association, International Swaps & Derivatives Association, Securities Industry Association, 2002. Explanation and Benefits of Fair Value Accounting. [pdf] ISDA Available at: [Accessed 4 April 2014]. Thompson, K., 2007. Advantages and Disadvantages of Historical Cost Accounting. [online] Available at: [Accessed 4 April 2014]. van Zijl, T. and Whittington, F., 2005. Deprival Value and Fair Value: A reinterpretation and a reconciliation. Research Archive Working paper No. 16. Read More