Advanced Financial Reporting and Regulation - Literature review Example

Introduction According to Magnan (2009) although fair value accounting has been adopted universally by standard setters, there continues to be debates among different groups n relation to its usefulness. The recent financial crisis has led to a strong debate on the advantages and disadvantages of fair-value accounting. In particular, many critics have argued that fair-value accounting has significantly contributed to the financial crisis or, at least, exacerbated the problem (See Laux and Leuz 2009a). In order to facilitate a critical appraisal of this statement as well as for an informed discussion of the benefits and drawback of fair-value accounting measurement vis-à-vis other measurements in enhancing the quality of financial information, a proper understanding of fair-value accounting is of extreme importance. Fair-value accounting was introduced over 20 years ago. IFRS 13 defines 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 (IFRS 2012). This IFRS (2012) indicates is a market-based measurement and is therefore not specifically related to the entity concerned. In order to facilitate proper disclosure IFRS 13 requires that an entity should provide information that helps users of financial statements assess both the techniques used to value the assets and liabilities as well as the elements used to develop the measurements. The entity is also required to disclose the effect of fair value measurements on the income statement for the period (IFRS 2012). The origination of fair-value accounting and therefore FAS 157 was due in part to the savings and loan crisis in the United States during the later part of the 1980s and early 1990s (Rubin et al 2009). Critical Appraisal of Statement According to Prochazka (2011) fair value accounting (FVA) has permeated financial reporting over the past 20 years. Entities are required to measure certain assets and liabilities at fair value at the date of reporting. This value is the deprival value or the replacement value of an a similar asset in the same condition. In fact, Ryan (2008) states that fair value is an estimate of the price the seller would receive for the asset or the payment that would be made in order to cancel the loan the loan related to the asset. The debate on its usefulness arose in relation to the financial crisis of 2007 to 2009. The opponents of fair value accounting are those who have seen significant reduction in the value of their assets during the financial melt down from 2007 to 2009. Fair- value or mark-to-market accounting requires valuation of a firm’s assets at fair market price (current value) instead of the price originally paid (historical cost). This has caused a number of businesses to revalue their assets. In times of boom asset values increase while in times of bust their values are reduced (Laux and Leuz 2009b). During the revaluation process a number of entities realised that they were insolvent and were likely to default on loans and thus the reason for the blame in relation to the financial crisis. However, fair value accounting is not the reason for the crisis. What FVA has done is provided the guidance on fair value measurements which show the market valuation for certain assets where historical costing is not permitted. In fact, Casabona and Shoaf (2009) indicates that criticisms about FASBs FVA rules and the possibility of their contribution to the losses incurred during the crisis has been made to the United States Congress. It is the view of critics of FVA including the United States Chamber of Commerce, the American Bankers Association, the American Council of Life Insurers, the Financial Services Roundtable, the real estate and home builders group, and the Council of Federal Home Loan Banks – (all of whom represents firms affected by the financial crisis), that businesses, investors and other entities were not able to value their assets accurately. This became obvious when the markets became more inactive and disorderly. The reasons for the uncertainties were the underestimation of the fair value of certain assets, and loss of confidence by investors, advisors and other market players. The concerns of these groups relate to a correction of what they deem to be unintended consequences of mark-to-market accounting and specifically its role in the determination of fair vale for assets that are not liquid in unstable markets and the need for enhancing transparency by requiring firms to disclose even more information (Casabona and Shoaf 2009). However, the soundness of the standard on fair value accounting has been reaffirmed by the Securities Exchange Commission (SEC) (Casabona and Shoaf 2009; Magnan 2009). In spite of this the SEC made recommendations in relation to its implementation to auditors and preparers (Magnan 2009). Fair value accounting was already incorporated in several financial Accounting Standards (FAS) and so it was the issuance of FAS 157 on fair value accounting in 2006 and its implementation in 2007 coincidentally with the financial crisis which also started in 2007 that led to the blame being levelled at the standard instead of at the inferior investments that were being made at the time. Therefore, even if FAS 157 were suspended there are other standards that make reference to fair value during the measurement of assets and liabilities. The same is true for International Financial Reporting Standards (IFRSs). In fact, Laux and Leuz (2009a) indicate that ‘the concept of fair value predates the issuance of FAS 157’. Koonce (2009) indicates that opponents of FVA contend that it helped to increase the effect of the crisis by forcing entities to write-off billions on their balance sheets when housing prices as well as the value of securities backed by mortgages fell significantly. The financial institutions that were affected by the problem appeared insolvent to bank regulators. This group have therefore concluded that if the financial institutions did not have to write down their assets as required by fair value accounting the crisis would not have materialised. However, Koonce (2009) and others have indicated that fair value accounting was just a messenger of the problems that existed and has inappropriately been blamed for the situation. In fact, Koonce (2009) indicates that FVA was simply the tool that communicated the result of making bad decisions relating to granting and issuing subprime loans and credit default swaps respectively. People who would not under normal circumstances afford mortgage loans to purchase homes were inappropriately given the chance to do so. As soon as interest rates started to increase mortgage holders started to default on their loans. As the value of houses started to decline due to the increased supply caused by the housing bubble, the high level of demand no longer existed. The value of the houses was less than the mortgage and therefore, some mortgage holders thought it was unwise to hold on to their homes. Some had no choice and so they defaulted on their loans. In addition to mark-to-market accounting, Jickling (2010) identified other factors as being responsible for the crisis. They include: imprudent mortgage lending due to the availability of funds to grant loans, low interest rates and a vibrant house market. When prices began to decline significantly and mortgage holders started to default the financial system experienced a shock (Jickling 2010). A somewhat similar account of the crisis as provided by Poole (2010) who indicates that with low interest rates in 2003 and the memory of the dot-com stock crash, the search started for investments that yielded high returns. The perfect vehicle appeared to be collateralized debt obligations (CDOs) which were structured in three tranches in accordance with their risk characteristics – the senior tranche being rated triple A (AAA) by rating agencies. In the later half of 2000s the standards for granting subprime mortgages fell and mortgages were made to households with insufficient income and assets to service these debts (Poole 2010). There was no proper documentation in some instances in relation to the income and assets of the mortgage holders. Additionally, some of the borrowers were investors who anticipated quick returns from resale of properties (Poole 2010). The hunger displayed by investors for high yield products meant that investment banks could package subprime mortgages in the form of CDOs with ease and sell them to investors. As the market became depressed these investments were affected significantly. As the prices of houses fell to reflect the demand and supply conditions in the market and the adjustable rate mortgages taken out during the period 2003 to 2004 began to increase mortgagees started to default (Poole 2010). Magnan (2009) indicates that both theoretical and empirical evidence suggests that far value accounting played a role in the crisis. In fact Magnan (2009) made four observations: FVA has several ways of determining market and their validity is dependent on the existence of an efficient market; FVA places emphasis on shareholders; FVA implementation poses a challenge to concepts such as verifiability, reliability and conservatism; FVA emphasizes the disparity between what is happening in the economy and the financial statements However, the various accounts that seek to explain the reason for the financial crisis provides clear evidence that the housing bubble and the issue of subprime mortgages as CDOs led to the financial crisis. Fair value accounting was the tool that helped authorities to realise that there was a crisis. In fact, Casabona and Shoaf (2009) point out that those proponents of fair-value accounting argue that it facilitate users’ awareness of the economic realities in an ever changing environment. Casabona and Shoaf (2009) also point out that even some opponents of fair-value accounting have recognised that it was not the cause for the crisis. However, their contention is that when it is applied in an unstable and declining economy there is a domino effect that facilitates an accelerated decline which leads to problems in determining market value in an unstable market. Benefits and Drawbacks of fair value accounting measurement vs. other measurements The most popular alternative to fair value accounting is historical accounting (Laux and Leuz 2009a). The use of FVA makes it possible for users to determine the economic reality in an ever changing environment while historical costs accounting tend to hide declining values. As long as there is an active market there is little room for the value of assets to be manipulated and so the estimate of the fair value is deemed reliable in times of boom when the value of assets increase and there is an active market for the asset. The drawback to this valuation is that when level 2 or level 3 inputs are required – comparable assets are used to value a specific asset or the discretion of management is required. This can lead to misleading valuations. Fair value provides information that is more relevant to investors when making decisions related to the allocation of capital (Hermann et al 2006). However, constructing fair values that are reliable can at times be expensive due to problems associated with their verification (Watts 2006). The other benefits of fair value accounting compared to historical accounting include: a) Its reflection current market conditions (PWC 2008) ; b) Its transparency (PWC 2008) Although fair value is by no means perfect, it is arguably the best method of reflecting the conditions that exist in the market at a particular point in time. However, it needs to be supported with adequate disclosure information. Additionally, once an active market exists it is difficult for subjective information to seep in. However, when similar assets are used in the valuation an element of subjectivity is brought to bear. This is even more problematic when there is no active market and manager’s discretion is used. This may open the door for manipulation but adequate disclosure information will facilitate a determination of the level of objectivity that was used in making the decision on the fair value estimate. Transparency in valuation is important as the value of assets should be comparable to those currently on the market - whether used or new. It is therefore important that a more transparent method be utilised in the process of obtaining information on market value of certain assets. Fair-value satisfies this requirement as provision of the appropriate disclosure information facilitates a better understanding of the process involved in obtaining both relevant and current market values There are a number of drawbacks associated with the implementation of fair-value accounting. They include: a) Its reliability in illiquid markets (PWC 2008); b) Uncertainty introduced by volatile markets (PWC 2008) When there are no market prices available for these assets, models have to be used to determine fair-value. This introduces a level of subjectivity as managers discretion may lead to manipulation of the financial statements. The criticisms related to illiquidity are focused on products such as CDOs which came about as a result of securitisation of mortgage loans (Veron 2008). CDOs are at the centre of the financial crisis. Market volatility may result in uncertainty in determining prices. This simply means that the earnings reported may not be as predictable as under normal conditions. This is representative of the financial crisis of 2007- 2009 and this is the reason for the controversy in the use of fair value accounting for financial instruments (See PWC 2008). However, some critics believe that losses will reverse as the market regains normality since market volatility is not something that remains over the long-term (Ryan 2008). Conclusion The need to use fair value accounting has been laden with criticisms as it has been blamed for incorrect results in the very unusual conditions of 2007-2009. The critics indicate that recording losses in that kind of environment sends signals that may be misleading to investors (PWC 2008). Therefore, the preference is for recording only gains and losses that have been realised (PWC 2008). However, the objective is to provide information that will allow investors, businesses and policy makers to make well informed decisions (PWC 2008). Providing any other information as required by critics of fair-value accounting would be misleading as it may cause investors to act inappropriately. This is the reason for the implementation of fair value accounting as part of the standards to be utilised in the preparation of financial reports. Despite these drawbacks fair value is considered to be more appropriate and very useful in assessing current values. Historical costing is based on original cost and cannot be viewed as a replacement for fair-value accounting, and therefore, cannot be considered as a reasonable substitute. The call to curtail its use in uncertain and unstable market conditions is a call to manipulate the financial statements. What is required is adequate disclosure that can help investors make the right decisions. This should include information on the likely long term value of the asset and an estimation of the time it will take for the market to return to normal. The benefits of FVA far exceed the costs of implementing it. Additionally, it provides useful information for investors who depend on the financial report to inform their decisions. The fact that the disclosure is required is another plus as it explains how fair values were arrived at. References Hermann, D., Saudagaran, S.M and Thomas, W.B. (2006). The quality of fair value measures for property, plant and equipment. Accounting Forum, 30(1), p. 43 - 59 IFRS. (2012). Technical Summary: IFRS 13 Far Value Measurement. [Online]Available at: http://www.ifrs.org/IFRSs/Documents/IFRS13en.pdf [accessed 10th April 2014] Jickling, M. (2009). Causes of the financial crisis (R40173). Washington, DC: Congressional Research Service. Koonce, L. (2008). Chaos Theory. Texas, Fall/Winter 2008, McCombs School of Business Magazine Laux, C and Leuz, C. (2009a). Did Fair-Value Accounting Contribute to the Financial Crisis? [Online] Available at: http://www.nber.org/papers/w15515.pdf?new_window=1 [Accessed 11th April 2014] Laux, C and Leuz, C. (2009b). The Crisis of Fair Value Accounting: Making Sense of the Recent Debate. Accounting, Organizations and Society, 34(6-7), p. 826 -834 Magnan, M.L. (2009). Fair Value Accounting and the Financial Crisis: Messenger or Contributor. Accounting Perspectives, 8(3), p. 189-213 Poole, W. (2010). Causes and Consequences of the Financial Crisis of 2007 – 2009. Harvard Journal of Law and Public Policy, 33(2). p. 421 – 440. Prochazka, D. (2011). The Role of Fair Value Measurement in the Recent Financial Crunch. Economics, Management, and Financial Markets, 6(1), p. 989 - 1001 PWC (2008). Point of View - Fair value accounting: Is it an appropriate measure of value for today’s financial instruments? [Online] Available at: http://www.pwc.com/en_US/us/point-of-view/assets/pwc_pointofview_fairvalue.pdf [Accessed 10th April 2014] Ryan, S.G. (2008). Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch. Stern School of Business, New York University, NY: Council of Institutional Investors, White Paper Rubin, L., Shi, Xi and Toskova, N. (2009). Fair Value Accounting: Trouble-maker or Life-saver? The Financial Reporter, 76, p. 3 -7 Veron, N. (2008) Fair value accounting is the wrong scapegoat for this crisis. European Accounting Review, 5, p. 63 - 69 Read More