Advanced Financial Reporting and Regulation - Essay Example

Fair Value Accounting s Submitted by s: Introduction The part played by fair value accounting, which was declared, as a US accounting standard in 2006, in the mortgage crisis that took place in 2008 remains debatable (Maynard, 2013, p. 81). It obligated that tradable assets, like mortgage securities, be valued based on their present market value instead of their historic cost or future expected values. At the time when the market for this kind of securities became unstable and consequently collapsed, the consequent value loss had a significant financial effect on the institutions that held them regardless of whether they had immediate plans of selling them. Fair value accounting can be also be referred to as Mark-to-Market and may be defined as a the price to be received when selling an asset or the price paid for the transfer of a liability through an orderly transaction taking place between participants in the market at the date of measurement (Zyla, 2013). This delineation is accompanied by a structure that categorizes various forms of assets and liabilities into three levels with measurements that vary accordingly (Jarnagin, 2008, p. 166). Fair value’s hierarchy is: I. The assets or liabilities with observable values in an active market with identical assets or liabilities II. Assets or liabilities with a value that can be quoted from inactive market or founded on internal development mechanisms with input data resulting from observable markets that have the same kind of items III. Financial assets along with liabilities with values that cannot be quoted from an observable market but rather founded on prices or valuation approaches the need inputs which are observable and substantial to the overall fair value measurement. Fair value accounting’s contribution to financial crisis There have been raging international arguments concerning whether fair value accounting, which is an approach that utilizes the market information that is available to approximate the value of assets and liabilities, could have led to or escalated the global financial crisis (Schmidt, 2014, p. 129). Its critics support historical-cost methods as being more dependable since values are founded on real transactions even though this may be dated and superficially irrelevant. The question remains whether a different accounting approach may have stopped the shocking collapse the investment banks and other institutions experienced. It is rare for accounting standards to be considered as a hot bed of debate, but the heated speculation after the global financial crisis concerning whether the fair value accounting approach worsened the meltdown while increasing volatility in the market has gripped the field (Caprio and Arner, 2013, p. 430). Various people including business leaders, economists, professional bodies and politicians have varied opinions in a debate that appears to have long-term ramifications for directors, auditors as well as financial controllers as they continue with their individual corporate tasks. With settling of the dust, it is judicious to consider the characteristics of fair value accounting compared to the historical-cost approach. Fair value compared to historical cost Fair value accounting fundamentally entails the use of available market information in the estimation of the likely sale prices of assets or the costs of settling liabilities. Even though the principles date back to about thirty years ago, it has developed prominence on the last fifteen years at a time when the market started gaining better transparency (Henderson and Peirson, 1975, p, 107; Devi and Hooper, 2011, p. 100). According to this theory, the application of current market information to the valuation of assets and liabilities is the best approach towards providing investors with current information concerning the economic position of companies. In contrast, historical cost accounting is an outmoded approach whereby the assets are valued based on their original cost while excluding any adjustments regarding inflation. Nonetheless, these historical book values consider adjustments like depreciation as well as impairment. These two standards are used broadly while having their opponents and proponents. The people who support fair value state that it provides more timely and relevant market information regardless of the increased use of approximations and judgments, while the critics state it delivers undependable market information that investors may be uncomfortable with. Proponents of historical cost consider it as being more dependable as asset values are founded on actual transactions, though the critics contend that achievement values under this approach are in most cases years old and may be of little relevance to investors. Some of the political and industry observers have been blaming fair value accounting as they search for culprits of the financial crisis (Koyuncugil and Ozgulbas, 2013, p. 92). A recurrent contention from some quarters is that it leads to excessive advantage in the boom markets and the same overblown write-down of assets when the bust is experienced. A picture advanced by the critics is that banks are obligated to sell off distressed securities at low prices and this depletes the bank’s capital in the process decreasing the value of the assets, which may lead to a downward spiral that has negative consequences on banks and investors. Even though large losses lead to clear issues for banks as well as other institutions, it should be considered whether reporting the losses as being attributed to fair value accounting leads to more problems. There have been questions on whether the market would have responded in a different manner if the banks were allowed to employ different accounting standards. Even though the accounting principles that were in place were not the main cause of the crisis, arguments have been suggesting that the fair value approach escalated the effects. Since the accounting standards used presently are predominantly founded on fair value than previously, they reflect more current market information by definition. Nonetheless, the adjustment to the fair value approach is still not complete since operations of a trading nature tend to report based on these standards while banks evaluate majority of their assets and liabilities based on historical cost doctrines. Before the financial crisis, it is probable that the companies, which were at fair value, were the most aggressive in the market. Fair value accounting has been seen in some instances as inevitably forward looking and thus banks and institutions have to learn to exist with a lot more volatility. Nonetheless, there is still no standard for a permissible degree of volatility and the main reaction from classic accounting to volatility is usually recommendation for hedging. Even though this has the ability to decrease the degree of volatility, it boils down to the degree of volatility that is acceptable. Among the main areas of analysis after the financial crisis has been the treatment of collateralized debt obligations, which is a financial system grouping loans or assets into categories that may be traded, by the larger banks (Demirgüç-Kunt, Evanoff and Kaufman, 2011, p. 734). The value of numerous CDOs decreased at the time of the financial crisis influenced by sub-prime mortgage catastrophe in the US that entailed banks availing high-risk loans to people who had poor credit histories. The fallout associated with the crisis supports the case for banks to have more flexibility and become less mechanical in how they deal with loan payments. The aspect that aggravated the financial crisis was the rate and magnitude of the fall in values to which banks implemented credit rules leading to liquidation of assets in a hurry therefore pushing the prices down even further (Sitkin, 2013, p. 100). Western banks should learn a lesson from their Japanese counterparts whose operation is in a banking system, which applies the historical cost accounting approach with the Japanese banks being more accommodative to their borrowers during the decline of collateral values (Kwan, 2001, p. 91). These aspects may have assisted the borrowers to weather the storm a little more. Nevertheless, the Japanese market has another angle as since the nineties, banks and the economy have been struggling and some have blamed this struggle on the dependence on historical cost accounting (Adams et al., 1998, p. 89). A culture, which is less permissive than the Japanese system but to some degree more permissive than what existed in the Anglo-Saxon structure, may be suitable in the short-run. A number of detractors of fair value are of the argument that the shock collapse of respected investment banks could have been circumvented under different accounting regimes(Harvey, 2010, p, 73; Centeno and Cohen, 2010, p. 85) . The main issue with institutions like Lehman Brothers was failing as far as liquidity and risk management was concerned, since they took a lot of risk and when the market reacted to it, a crisis occurred. Even though historical-cost accounting could have delayed some market information concerning distressed companies from being delivered, there are still numerous sources of information. Essentially, regulators and creditors as well as investors utilize accounting signals to develop opinions and come up with decisions. In the event that there is more information in the market, there might be intensified improbability since the accounting is not catching up. This makes it unclear whether using the historical cost accounting approach would have had an ability to calm the nerves of the people. Since people understand when a value is old, accounting tries to reflect the fundamental economic situation, although not always with precision as a consequence of measurement issues (Sack Elmaleh, 2005, p. 2). This accounting can be used as a barometer for the diminishing situations and not the cause of the decline. The increasing shift in support for fair value accounting continues to be supported but there are concerns that accountancy as a profession is likely to face challenges under this system (Gross, McCarthy and Shelmon, 2009, p. 145). Often, cost accounting leads to worse situations regarding transparency as well as the legitimacy of the information it avails to users. The arising challenge will be ways of fair valuing accounts associated with limited market activities or in some instances no market activity at all. The accounting is meant to make available the best approximations of fair value when the information available is limited but this does not imply that this information is accurate as it is the best estimate that is available at the time (Graham, 2010, p. 371). In the cases where there is a wide array of potentially acceptable market prices for a specific asset, the adage “disclosure is your friend” should be adopted, as the capacity to disclose that array of possible results is in most cases important at that particular time. Additionally, this is where disclosure is required in order to fill the gaps resulting from limited information about the market. Standards of accounting will keep evolving and improving, particularly as a result of the financial crisis (Rajasekaran and Lalitha, 2011, p. 31). The markets have been going through unprecedented times and this has necessitated that fair value accounting react to these occurrences in the best way they can. Even though some companies are not comfortable with the way they are supposed to mark their assets, it is a reflection of the position where the market has been. Nonetheless, more advantages could be realized in fair value practices can be refined. For instance, the processes through which the value of assets is measured is among the areas which are open for review and even though indicators like the present value of assets and discounted cash flows are favored, other people in the accounting field emphasize on the ratio and price of the comparable asset. It remains clear that the financial crisis acted as a wakeup call for international markets and certainly, this histrionic occurrence will result in some already overdue changes (Birdsall and Fukuyama, 2011, p. 20). The International Accounting Standards Board which is an accounting body that sets standards based in London, has already started establishing a common principle for counterbalancing assets and liabilities which provide more valuable information on the future of an entities net cash flows. Hedge accounting regulations have been made simpler in order to make sure of closer alignment between accounting and company risk management approaches, while adjustments to the deficiency of financial assets are also unresolved. Accounting standards have demonstrated the areas where accounting may be value-added and they have made the necessary changes. However, it should be noted that debate will continue to exist concerning the accurate market value of assets based on fair value practices, with the distortion of the value being of the same value as the distortion in the market. Notwithstanding any changes in the regulation, the agreement among numerous observers seems to be that fair value accounting was not the genesis of the bank failures in 2008 (Davies, 2010, p. 115). The fair value accounting approach does not seem to be the origin of the failure, which was faced by banks and other institutions. Instead, it can be said that fair value hastened the crisis as it revealed itself in counterparties that reduced and in some case eliminated credit as well as other risk exposures they had. Conclusion Fair value plays a small part in the income statements and regulatory capital ratios of banks with the exception of a few banks that have larger trading positions. In the case of these banks, the investors could have been skeptical about these being exposed to subprime mortgages and instead made their own judgment even without relying on the fair value disclosures. Banks typically have safeguards and discretionary powers, which enable them to circumvent any distortions in market prices, and at the same time, they do not advocate for additional extensions of fair value accounting, as they do not consider the practice as perfect. More research is needed to develop more understanding of the impact of fair value accounting in booms and busts to provide guidelines to reform regulations. One of the best aspects of a capitalist society is that while it may be considered that governments assisted the financial markets through bailing them out, the effect of the financial crisis has resulted in companies and financial institutions histrionically reassessing the areas of risk management that needed to be re-evaluated. The perception of the proponents of fair value accounting is supported by an adequate body of practical evidence demonstrating that the fair value is the only measurement approach that can continually and meaningfully provide information on financial statements concerning the risk exposures of customers. Bibliography Adams, C., Mathieson, D., Schinasi, G. and Chadha, B. 1998, International capital markets, International Monetary Fund, Washington, DC. Birdsall, N. and Fukuyama, F. 2011, New ideas on development after the financial crisis, Johns Hopkins University Press, Baltimore. Caprio, G. and Arner, D. 2013, Handbook of key global financial markets, institutions, and infrastructure, Academic Press, London. Centeno, M. and Cohen, J. 2010, Global capitalism, Polity, Cambridge. Davies, H. 2010, The financial crisis, Polity Press, Cambridge, UK. Demirgüç-Kunt, A., Evanoff, D. and Kaufman, G. 2011, The international financial crisis, World Scientific Pub. Co, Singapore. 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