Importance of Fair Value of Accounting - Example

Fair Value Accounting Contents Introduction 3 Discussion 4 Fair value accounting and the key arguments 4 Level inputs 5 Level 2 inputs 6 Level 3 inputs 6 Importance of fair value of accounting 7 Contribution of fair value of accounting to financial crisis 7 Benefits and drawback of fair value accounting measurement vis-à-vis other measurements 10 Fair Value Measurement and disclosure 13 Conclusion 13 References 15 Introduction The recent financial crisis had raised issue on advantages and disadvantages of fair value in accounting. The dire consequences and unprecedented size of the financial crisis is a major concern of players of financial sectors like policy makers, academics and regulators around the world. The fall of financial institutions like Lehman Brothers, Bear Stearns, Wachovia and Merrill Lynch followed by paralysis of the financial sector with negative consequences on the economy of many countries makes the crisis a unique one. The uniqueness of the crisis made the financial players identify the determinants and the solutions to resolve the issue. One of the major factor which lead to the crisis is the US housing bubble crisis, but now several complex set of reasons are unfolding. One can list set of micro and macro events which leads to the crisis, like current account surpluses in the emerging countries, flourishing housing buying activity, easy availability of loans in developed countries and complex financial instruments like derivatives. Other set of factors like excessive risk taking attitude of the managers, use of excessive leverage, the way the compensation of the managers depends etc. Apart from the above mentioned factors there was another factor which was considered an important determinant of the recent financial crisis, named fair value accounting. With the adoption of IFRS the importance of fair value of accounting grew. IFRS 9 was replaced with IAS 39 and IAS 36. This led to change in accounting regulation to fair value accounting from historical accounting. Discussion In the past there have been many long series of financial crises, but the recent one in 2008 was the first one to which have forced the accounting system to follow fair value approach of accounting on a worldwide scale. Again the onset of crisis matched with the introduction of new accounting framework. This led to the study of fair value of accounting highly topical. This debate of new accounting approach which replaced the old method of historical cost accounting attracted lot of attention and made it a controversial issue. The voluntary or compulsory adoption of IFRS/IAS in 2005, by about 100 countries fuelled the debate since the adoption of IFRS/IAS standards was perceived to depend on fair value measurement as opposed to national standards which was replaced. According to research it was found that there were 7,000 listed companies in Europe alone which adopted IFRS since 2005. Again fair vale accounting was important since it was the aim of the financial regulators to have all the financial assets and liabilities recognized at fair value in their financial statements instead of historical cost (Morris, and Shin, 2008, pp. 231-239). Fair value accounting and the key arguments Listed companies which trade publicly on US stock exchange need to prepare and file quarterly financial statements to the Securities and Exchange Commission. The financial reports are to be prepared following the generally accepted accounting principles (GAAP). The SEC delegates the task of preparing the financial reporting standards to Financial Accounting Standards Board (FASB). The main objective of GAAP is to help facilitate financial transactions in the market. The financial statements provide critical information to all the stakeholders of the company for making their own decision. Thus it is important that the accounting numbers are reliable and relevant. But the degree of relevance depends on the users and there can be conflict between reliability and relevance (Dickinson and Liedtke, 2004, pp. 561-569). According to generally accepted accounting the fair value of a financial instrument is defined as the amount for which a liability could be settled, an asset could be exchanged, between willing and knowledgeable parties in a transaction except in liquidation or forced sale. When the market prices are not available the owner of the liability or asset need to provide the best possible estimation of current market price by using judgements and assumptions about the methods. This way fair value indicates the estimate of the present value of net future cash flows of asset and liability which is discounted indicating both current interest rate and assessment of risk taken by management with those cash flows (Wallison, 2009, p. 21). Fair value has three levels of measurement. Level 1 which is applied when same instrument can be obtained at the current price in a liquid market. Level 2 indicates the current price in a liquid market for a similar instrument which needs to be adjusted for obtaining fair value of the instrument and Level 3 uses valuation model. The term fair value indicates the market value whenever it is available and uses estimated value when the instruments are not traded in the financial market (Véron, 2008, p. 41). Level 1 inputs Level 1 input are quoted prices in markets for identical liabilities and assets which an entity can access at the measurement. The quoted price in an active market provides the most reliable evidence of fair value and is used without any adjustment for measuring fair value whenever available. This input is available for financial assets and liabilities which may be exchanges in multiple active markets. The main focus on Level 1 is determining the principal market for liability and asset, or in absence of any such principal market the most advantageous market for liability and asset. Another focus is on determining whether the entity can enter into a transaction for the liability or asset at the price in the market. Level 2 inputs Inputs of level 2 are inputs except the quoted prices. In case the liability or asset has a specific term the Level 2 input has to be observable for the entire term of liability or asset. There are many inputs of Level 2. The quoted prices for similar or identical assets or liabilities in the markets which are not active, quoted prices for similar liabilities or assets in the active markets. It also includes inputs which are observable for the liability or asset. Adjustments of Level 2 inputs vary depending on factors of asset or liability. These include location or condition of asset, the extent to which inputs are related to the items which are compared to liability or asset and the level or volume of activity in the markets. Level 3 inputs These include the unobservable inputs for liability or asset. These inputs measures fair value to the degree that pertinent visible inputs are not available and thus allowing for circumstances where there is little market action for the liability or asset. Unobservable inputs reflect reflects the assumption that market participants will use for pricing liability or asset. The assumptions of risks include the risks which are inherent during a particular valuation technique used for measuring fair value and the risk which is inherent in the inputs for the valuation technique. A measurement which does not include an adjustment for risk will not represent a fair value measurement. Importance of fair value of accounting There has been a lot of debate on the introduction of fair value accounting standards. Fair value of accounting proponents argue that it is beneficial to the authorities and investors in using market prices for preparing accounting reports since it reveals more information about the current risk profile of the firm than the historical cost used previously. This is thought to induce greater market discipline and provide the financial statement users information for better capital allocation decision making. Further the market models used by the firms explain the reality to the outsiders better than other book value system. These arguments coincide with the rational expectations agents’ and efficient market hypotheses. These assumptions are considered to have contributed to the financial crisis of accounting regulation (Chea, 2011, pp. 15-18). Contribution of fair value of accounting to financial crisis In the academic literature there are two view points about the role of fair value of accounting during the financial crisis. Some authors believe that fair value of accounting exacerbated the crisis. But in there are scholars who argue that fair value of accoutring had to direct role in the financial crisis. According to De la Dehesa (2009) new accounting rules increased the pace of recent financial crisis. Banks in the short run were permitted to finance their investments using assets as collateral measured at high market values when the economy was booming. This resulted in creation of vicious cycle during the crisis. Banks had to reduce their value of financial assets which were linked to sub-prime loans. Hence the value of assets in their portfolio had to be adjusted to lower levels. Banks argued that such adjustments were not economically justified and their intention was to hold the instruments till maturity. This diminished the value of shareholders equity. But the banks had to maintain mandatory solvency ratios at the required level and hence they were faced with a dilemma (Ristea and Jianu, 2011, pp. 121-127). They were either forced to raise new capital by selling part of their assets under depressed valuation conditions or they had to reduce their lending which will have negative effects on the economy as a whole. Thus under depressed condition the sale of assets made the market value even more contaminated. The vicious circle increases the pro-cyclicality of banking regulation and the additional pro-cyclical effects of fair value accounting leads to depressing consequence of the economy (He, Wong and Young, 2009, p. 17). Studies have shown that introduction of fair value of accounting increases the banks’ leverage. It was found that due to pro-cyclicality fair value of accounting along with high levels of leverage is dangerous when the minimum capital requirements act as crisis amplifiers. During good times, profits measured at fair value increases and it makes the companies increase their leverage. This is harmful during bad times (Akgün, Pehlivanl and Gürünlü, 2011, pp. 168-173). A different point of view is held by the authors who argue that fair value of accounting did not play a significant role towards financial crisis. According to Landsman and Barth (2010) bank regulators and accounting standards have common ground and should have a clear separation of their individual responsibility. According to them it is the responsibility of bank regulators to ensure the stability of the financial system. The main objective of financial reporting is to provide relevant information to present and prospective investors. In contrast to that the objectives of bank regulation is to mitigate the financial risks. Thus there are two separate objectives and hence the information needed from banks should be different (Ijeoma, 2014, pp. 1-8). As far as pro-cyclicality of fair value accounting is concerned many believes that it is unlikely. The hypothesis that asset values of banks are decreasing and hence recognition of impairments needs to be done in the financial statements of banks is not true always. The above hypothesis is applied for bank assets which are measured at fair value or where fair value applies when considering impairment. But the number of banks for which this case applies is limited. According to Leuz and Laux (2010) banks held almost 50 percent of their assets in leases and loans during 2004-2006 period and those assets were not subject to fair value accounting and thus were not impaired to fair value. According to reports by Shaffer (2010) in 14 largest US commercial banks during financial crisis the decline in tier 1 capital due to loan impairments was 16% and it was based not based on fair value but on incurred loss model. The prudential norms used by bank regulators in many countries in calculating tier 1 capital counteract some fair value losses and gains. Hence temporary changes in fair value do not affect tier 1 capital. The reduction of tier 1 capital due to impairment of held-to-maturity and available for sale assets of the 14 largest US banks during crisis averaged only 2% and this acts as upper bound on tier 1 capital due to recognition of impairment of these assets (Benjamin, Niskkalan and Marathamuthu, 2012, pp. 54-57). Many authors argued that the downward spirals of the banks’ assets are not due to fair value of accounting and that it did not lead to excessive write down of the banks’ asset. According to Laeven and Huizinga (2009) banks exercise discretion while valuing their assets and they believe that it is not possible that banks’ were forced to write down their assets excessively. Benefits and drawback of fair value accounting measurement vis-à-vis other measurements Fair value of accounting makes it difficult to hide the dubious practices of managers from the eyes of the investors. Fair value of accounting and good corporate governance is seen as two sides of the same coin. Hence fair value accounting is a valuable instrument to the outsiders to give them early warning of the possible problems in the institution before the crisis transforms. Another argument in favour of fair value of accounting is the treatment of derivatives. Under historical cost accounting derivative instruments were recorded as per their initial acquisition cost which is close to zero in spite of the fact that exposure is high. The actual exposure of the firm due to these instruments is revealed to the outsiders under the new accounting regime (Laux and Leuz, 2010, pp. 96-105). Fair value of accounting is eliminates profit smoothing manipulation done by financial managers which was possible during historical cost accounting era. Fair value accounting recognizes the gains and losses in the financial statements which were smoothened over the entire life of the instrument under historical cost accounting. Thus fair value accounting ruled out earnings management activity and the accounting reports become more realistic in nature. But there are many criticism of fair value of accounting. They mainly base their arguments on standard setter’s assumptions. When the assets and liabilities of firms in the secondary market are not efficient then use of fair value of accounting would decrease instead of increasing the reliability of financial statements. This happens in case of insurance companies and banks with soft secondary markets. Again complications may arise in case of valuation methods and credit risk models of non-traded and illiquid instruments which are not suitably developed till date. The European Commission in 2001 considers that substantial evidence needs to be collected to support the fact that fair value is better than historical cost for all financial instruments and that fair value can always be determined reliably (Alexandera, Bonacib and Mustatab, 2012, pp. 85-88). Fair value accounting has faced other criticisms like it will bring additional volatility and artificiality into the financial reports and this into financial markets. This artificial volatility arises due to adoption of fair value of accounting without reflecting the underlying fundamentals. Many argue that such induced artificial volatility can destabilize the financial system. Further some financial institution which have adopted fair value of accounting argues that the fair value of accounting does not reflect the way they manage their core business. They criticise that fair value of accounting is more concerned with long term decisions and does not focus on short term decisions. Pension funds and life insurers strongly support the above idea in contrast to hedge funds, dealers and brokers. Pension funds have to change their portfolio frequently and hence they are used to recording their instruments at market value. Life insurers usually hold their investment until maturity and thus they can neglect the short term variability of assets in their portfolios. Regulators are also aware of the opportunity of managers in manipulating the earnings of the shareholders which is implicit in the freedom of making estimates when market prices are not available. Further fair value accounting magnifies economic cycles through its pro-cyclical effects. In case of fair value accounting the non-current asset may be valued as fair value. The fair value is defined the value of asset which would be agreed between a buyer and a seller of that asset. For example, if A is selling his car and B wishes to buy the car, A may initially ask for a high price and B may offer low price. After a period of bargaining a price will be agreed at which the car changes hands and this price is known as the fair value. The main advantage of using fair value for valuing as asset is that it provides relevant and up-to-date information for those individuals who are using financial statements. But the disadvantage is that this information may not be reliable. Hence until an asset is actually sold it is not possible to know the fair value of it. But in deprival method, the fair value, replacement cost, less costs to sell and net realisable value to combine together. Here the deprival value in use is the total future revenue which an asset generates after allowing for the fact that the revenue will be received in future instead of now. Hence future revenue is affected by risk and inflation. The main objective of deprival value is to find out the value added to the business because of owning the asset. In deprival value of accounting the valuation is done in relation to the entity which currently controls the asset. Hence in case an entity is unable to use the asset or access a particular market then there will not be opportunities for assessment of deprival value. But within the opportunities which are available, the deprival value of an asset is to maximise the value. There are two stages in assessment of deprival value. The first step is to select the relevant opportunities and second is choosing between the opportunities. In this method of accounting, there are three courses of action in relation to an asset which is held by an entity. First is disposing the asset, or using it in business and replacing it by acquisition in the market. Hence there are three types of values like disposal proceeds, present value of future benefits and replacement cost. In this method, during assessment of replacement cost, all the necessary costs of acquiring the asset including the installation and transportation costs are included. Fair Value Measurement and disclosure FASB introduced ASC 820 which is the process of measuring or evacuating fair value of asset and disclosures of the same to provide guidance and to provide additional information on issues relating to measurement of fair value. Fair value measurement does not create any new accounting, but rather provides preparers of financial statements additional information on how FASB proposes fair value is measured when it is needed in reporting of financial information. But there are certain exceptions related to share-based payment transactions. According to IFRS 13 during fair value measurement the following must be taken care of Presence of asset or liability which is to be measured including its location, condition and any restrictions on sale The principal market where transaction would take place for the asset and liability In case of any non-financial asset, the best and highest use of the asset and whether the asset can be used with other assets or is to be used on a stand-alone basis The assumption that during pricing of asset or liability market participants would be used Extensive disclosures are required as per IFRS 13 to help the users of the financial statements asses the inputs and valuation techniques used to measure fair values. It is also needed for fair value measurements which are regularly updated. Conclusion Recent financial crisis had caught the attention of policy makers, academics and regulators around the world due to the negative consequences. Fair value accounting is often viewed by many as an important link in the mix of financial crisis determinants. This financial crisis coincided with the new fair value approach adopted worldwide and thus it heightened the scale of interest. But there was much debate on fair value accounting even before the introduction of financial crisis. Many argue that during preparation of accounting reports the use of market prices is helpful to authorities and investors since it provides relevant information to the stakeholders. But critics argue that the induced artificial volatility, valuation of illiquid financial instruments and pro- cyclicality puts fair value of accounting on negative foot. Additional efforts are necessary to understand the role of fair value of accounting during the financial crisis. It is difficult to separate the responsibility of accounting regulation in the financial crisis. It is still unclear how the crisis would have unfolded under historical cost and the academic community still has finds feasible research alternatives. References Akgün, M., Pehlivanl, D. and Gürünlü, M. 2011. “A Process Design for Auditing Fair Value”, International Journal of Economics and Finance, Vol. 3(3), pp. 168-173. Alexandera, D., Bonacib, C.G. and Mustatab, R.V. 2012. “Fair Value Measurement in Financial Reporting”, Procedia Economics and Finance. Vol. 3(1), pp. 85-88. Benjamin,S.J., Niskkalan, A. and Marathamuthu, M.S. 2012. “Fair Value Accounting and the Global Financial Crisis: The Malaysian Experience”, Journal on Management Accountants. Vol. 10(1), pp. 54-57. Chea, A.C. 2011. “Fair Value Accounting: Its Impacts on Financial Reporting and How It Can Be Enhanced to Provide More Clarity and Reliability of Information for Users of Financial Statements”, International Journal of Business and Social Science, Vol. 2(20), pp. 15-18. Dickinson, G. and Liedtke, P.M. 2004. “Impact of a Fair Value Financial Reporting System on Insurance Companies: A Survey”, The Geneva Papers on Risk and Insurance. Issues and Practice. Vol. 29(3), pp. 561-569. He, X., Wong, T.J. and Young, D. 2009. Challenges for Implementation of Fair Value Accounting in Emerging Markets: Evidence from IFRS Adoption in China. Available at: https://tippie.uiowa.edu/accounting/mcgladrey/pdf/wong_tj.pdf. [Accessed on: 05 April. 2014]. Ijeoma, N. B. 2014. “The Contribution of Fair Value Accounting on Corporate Financial Reporting in Nigeria”, American Journal of Business, Economics and Management, Vol. 2(1), pp. 1-8. Laux, C. and Leuz, C. 2010. “Did Fair-Value Accounting Contribute to the Financial Crisis?, Journal of Economic Perspectives. Vol. 24(1), pp. 96-105. Morris, S. and Shin, H.S. 2008. “Financial Regulation in a System Context Comments and Discussion”, Brookings Papers on Economic Activity, Vol. 4(1), pp. 231-239. Ristea, M. and Jianu, I. 2011. “Fair value – from the Romanian reality perspective”, International Journal of Accounting and Information Management, Vol. 19(2), pp. 121-127. Véron, N. 2008. Fair Value Accounting Is The Wrong Scapegoat For This Crisis. Available at: http://aei.pitt.edu/8378/1/PC200803.pdf. [Accessed on: 05 April. 2014]. Wallison, P.J. 2009. Available at: http://www.oecd.org/governance/budgeting/42416969.pdf. [Accessed on: 05 April. 2014]. Read More