Fair Value Accounting - Coursework Example

FAIR VALUE ACCOUNTING . By     Location FAIR VALUE ACCOUNTING Introduction Fair value accounting is a measurement of a firm’s assets and liabilities by consideration of current market prices of the items. Thus the balance sheet prepared using the fair value technique represent the actual income a firm will get at that point if it were to trade its assets and liability at current market price; also known as market-to-market accounting. The method of accounting is preferred by management as it gives the actual realizable value of the firm in the current market. While the firm may retain its current assets and liabilities over a period, the fair value of these assets and liabilities change over the period due to changes in market prices of the assets and liabilities. Thus, firms using fair value accounting keep appraising and decreasing value of its assets and liabilities depending with the current market prices. The changes in value of assets can be used by management to virtually increase profitability of the firm if the value of assets increases. The opposite is also true; if the market value of assets decrease, the firms profitability virtually decrease. Many critics have argued for and against the contribution of fair value in financial crisis. Indeed fair value accounting had a role to play in the financial crisis as discussed below. Fair value has significantly contributed to financial crisis There is a general believe that a combination of fair value accounting technique and bank capital regulations contributed to the recent 2008 financial crisis (Menicucci 2014, p.100). During the year 2008 financial crisis, the credit market was seized up leading to significant decrease in value of assets held by financial institutions. Many banks and other financial institutions opted for fair valuing of the financial assets of these institutions further worsening the situation. The valuation of long term investment was worse affected by changes in the market value of assets. Given that the long term investment were measured as per their value in the illiquid market, the use of fair value accounting reduced the regulatory capital forcing financial institutions to sell off products. The use of fair value in valuing the various assets and products of the banks brought about volatility of the market prices as well as created pro-cyclical process. Pro-cyclical process is the link between credential requirements for equity capital and fair value accounting. Financial institutions are required to maintain a certain level of regulatory capital. To maintain this regulatory capital, financial assets are sold in the market to raise the required capital. The effect of sale of more financial assets is the fall in value of the assets resulting in the need to sell more assets to meet the capital regulatory requirement. Thus, the end result of the extreme negative credit effects of market to market valuation was a financial crisis. Fair value mainly depends on trading activities to determine market value of assets and liabilities. Prior to the 2008 financial crisis, the major contributors of the profits and losses from fair value was the trade in assets and liabilities at fair value and the available for sale assets ( Schmidt 2014, p.155). Significant increase in the available for sale assets decreases the market value of the assets due to excess supply over demand while excess demand is also a sign of inefficiency in the market caused by various market conditions. 2006 can be classified as a normal financial year as there were no significant changes in the financial market activities. Derivatives were the first sign of financial crisis visible in 2007. Derivatives increased exposure to financial crisis for investors and firms in the derivatives market. Fair value effects caused by financial crisis were evident in the large increase in the derivatives market. During the 2008 financial crisis, the trading assets and available for sale assets decreased and derivative assets and liabilities increased. Using the fair value accounting, firms had resultant losses in the 2008 financial report thus fair value contributed immensely to the financial crisis. Further, use of fair value accounting exposes a firm’s assets to volatility of market prices. Initially, managers used fair value accounting to increase the firm’s profitability as the market prices for assets was rising steadily. The method poses a risk to the financial institution as well as the entire market. In boom periods, fair value accounting leads to excessive leverage while during burst the firms experience excessive write down. The excessive write down push firms to trade their assets at fire price further aggravating the situation (Koyuncugil and Ozgulbas 2013, p. 94). One institution trading at fire price affects other financial institutions. Fire price is the dislocated price from the fundamentals due to forced transactions (fire sales). Financial institutions whose capital requirement is credit sensitive, the capital requirement increases with decrease in asset credit. Changes in the fair value of assets has two major effects on a firm; the capital held by the firm is reduced significantly due to losses associated with decrease in the fair value of the firm’s assets. Secondly, decrease in regulatory capital charge of the asset increases with decrease in asset credit for firms whose capital requirements are sensitive to credit (Merrill, Nadauld, Stulz and Sherlund 2012, p.4). During financial crisis similar to one that occurred in 2008, the use of fair value is highly compromised. Due to extremely volatile market conditions at such time, actual market value of the assets and liabilities are distorted. As such an alternative to generate market value is applied. The alternative used is the use of models to determine fair value of financial assets and other financial instruments. The use of models is the last options after the failure of measuring actual market value fails and the use of reference to similar securities also fail. In this context, use of models is usually referred to as level 3 values. The use of models is neither a smooth practice as it comes with many challenges. The perspective of the management towards the use of models will determine the value of the financial instruments. Assumptions and judgments are made by management as to what the market is expected to be. In this context, misleading assumptions and judgments can be made further aggravating the financial crisis. Due to absence of proper guidelines to be followed by management when making the assumptions and human error in making judgment, the financial crisis may be made worse by the assumptions and decisions by management. However, critics argue that fair value accounting standard by itself does not contribute to financial crisis. Rather, the interaction between the fair value and definition of capital requirement is what leads to financial crisis (Lehner p.118). Though the capital requirement for banks and other financial institutions are periodically revised by stakeholders, fair value accounting effects on the regulatory capital requirement are not taken into consideration. Given that investors prefer fair value accounting, the accounting method is thus used by most financial institutions to value assets and liabilities. Investor preference for fair value accounting is caused by the perception that fair value accounting gives the actual market value of an investment thus investors are able to effectively value assets before undertaking any investment decision. Use of fair value accounting with regulations that do not take into consideration of the accounting method to be used leads to financial crisis caused by gross devaluation of assets and liabilities. Benefits and drawbacks of fair value accounting measurements vis-à-vis other accounting measurements with respect to enhancing the quality of financial information The major alternative accounting measurement used by firms is the historical cost accounting. Historical cost accounting is based on past history of the assets and the buying price of assets to determine the value of assets and liabilities. The accounting principles use different approaches in analyzing financial reports and presentation of the balance sheet. The end result of the varying financial accounting methods gives different profitability levels of the firms for the same financial year. Depending with the method applied, the profits are either presented as actual, undervalued or overvalued. Fair value accounting has weak and strong points against other financial accounting method as discussed below. To start with, fair value accounting gives up to date information that is relevant to the firm and investors. Given that historical cost accounting uses past information to value assets and liabilities, fair value accounting is more reliable as a source of the most current information. With the changing trends in the market, there is need to value assets and liabilities at their current economic market conditions for sound investment decisions to be made. The use of fair value thus avoids misconception from the use of past data to value currently held assets. Actual economic realities reflected by the fair value accounting helps in making corrective measures to bring the company’s accounts back to the desired direction. For historical cost accounting, the current market value of the assets is not considered but rather the historical value of the asset. Historical cost is a miss-guide especially for investors wishing to invest in financial instruments as they may get an impression of a higher value for the asset than the actual market value of the asset. The misrepresentation of assets value in historical cost accounting can lead to losses to investors for investing in over-valued assets. However, fair value accounting, unlike historical cost accounting may be manipulated in favor of the management desires (Wahlen 2014, p.13). In cases where values are based on models, managers can manipulate the value to get their desired outcome thus not giving a true picture of the actual worth of the firm. Historical cost analysis is not subjected to any prejudice since the historical value of the asset is considered and relevant adjustments made. Historical value is neither subject to changes in market conditions (Warren, Reeve and Duchac, 2011 p.712). Fair value accounting leads to volatility of financial statements caused by volatile financial market. Financial markets are prone to changes affecting the value of assets and liabilities some of which are undue influence on the financial statement f firms. An example is change in value of assets caused by decrease in market liquidity. The actual value of the assets should not change much in this case but due to fair value accounting, the financial statement is greatly affected by the market changes. The application of fair value is also very costly compared with historical cost accounting. The adjustment of the value of all assets and liabilities needs to be done periodically and at a higher cost than adjusting for historical cost. Fair value is able to detect losses early in advance thus gives room for changes in the positive direction. For historical cost accounting, the historical costs have to be followed with supporting documents thus losses cannot be detected in advance and prevented. When it comes to measurement of relevance, fair value analysis is more relevant than historical cost to investors. Fair value gives the actual market conditions which can guide actions while historical cost uses past data and cannot predict the future. In terms of reliability, fair value may not be that reliable as compared to historical cost accounting. While fair value accounting can be based on unfair market conditions and be subjected t manipulation by the top management, historical cost accounting is never altered. Historical cost accounting is evidence based from actual recorded transaction amount. The consistency of fair value accounting in valuation is another added advantage over historical cost analysis. Fair value analysis only uses one technique in accounting for items in the financial statement. On the other hand, historical cost analysis uses past data to value past transactions while using fair value to measure current transactions. Thus historical cost accounting lacks consistency in measuring the items in the financial statements. The approach to revenue recognition of the two methods also gives fair value higher score than historical cost analysis. Measurement of revenue earned or lost at any time is possible especially when there is a slight change in the market conditions. In the case of historical cost analysis, revenue recognition only occurs after certain pre-determined conditions for revenue recognition are met. Revenue recognition can thus be undertaken after a specified period of time which may cause delays in decision making. Fair value accounting is also more superior in reporting of financial status of the firm than historical cost analysis. The use of the balance sheet as the primary source of information to investors and management gives fair value higher performance. In fair value accounting, income account is only for purposes of informing stock holders of changes in the value of the firms’ assets and liabilities. The added advantage comes in due to the traditional role of the balance sheet of showing the financial position of the firm. Historical cost analysis however uses the income statement as the primary tool for communicating financial information. The income statement is meant to show the firm’s earnings for the given financial period but not inform of the financial position of the firm (Warne 2008, P.54). One major drawback of fair value accounting is the lack of predictability capacity. The accounting is only based on market value changes and market trends thus accounting is done according to the current market conditions. Thus, the future market conditions cannot be estimated. Historical cost analysis on the other hand uses recorded transactions for accounting purposes. The presence of recorded transaction by itself is a good ground for trends to be generated. The trend generated can be used to predict the future trend thus historical cost analysis can help managers predict and prepare in advance for future changes. Bibliography Koyuncugil, AS & Ozgulbas, N, 2013, Technology and financial crisis economical and analytical views. Hershey, PA, Business Science Reference. Lehner O, 2015, proceedings in finance and risk perspectives ’12. Cambridge Publishing house. Menicucci, E, 2014, Fair value accounting: key issues arising from the financial crisis. Basingstoke: Palgrave Macmillan. Merrill C, Nadauld T, Stulz R and Sherlund S, 2012, Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities? National Bureau of Economic Research; Working Paper 18270. Schmidt, A, 2014, Fair Value Accounting and the Financial Market Crisis To What Extent is Fair Valuation Responsible for the Financial Crisis? Berlin, epubli GmbH. Wahlen J, Jones J, Pagach D, 2015, Intermediate Accounting: Reporting and Analysis. Cengage Learning. Warne R, 2014, The Effects of Fair-market Valuations on the Judgments of Commercial Lenders and Nonprofessional Investors. ProQuest. Warren C, Reev J, and Duchac J, 2011, Accounting.Cengage Learning. Read More