The Main Aspects of International Accounting - Essay Example

Title: International Accounting Table of Contents Table of Contents 2 Introduction 3 The relationship between Fair value accounting and financial stability 3 Challenges associated with accounting standard (IASB) on financial reporting 4 Valuation and risk management processes in adverse market conditions 6 Fair value accounting has resulted to the blurring of traditional frontiers 7 Macroeconomic impact of fair value accounting 7 Transitional approaches to simplify IASB complexity 8 Changes of IAS 39 and IFRS 9 issuance 10 Conclusion 13 References: 14 Introduction International Accounting Standards Board considers fair value as a potential measurement basis in numerous circumstances and has moved ahead with the convergence of accounting standards. The IASB has established long-term goals, one of which is to necessitate all financial instruments to be measured at fair value, and to acknowledge realized and unrealized gains and losses as income within the period in which they take place. In the United States, when interest rates rose and residential prices decreased, subprime loan defaults rose. According to Adrian and Shin (2008) subprime mortgage banks stopped instigating subprime mortgages and field for economic failure. For instance, New Century Financial, the second biggest subprime mortgage originator within 2006, stropped originating subprime mortgages as well as filed for insolvency in 2007. This paper will be analyzing the role of IAS 9 in global financial stability. The relationship between Fair value accounting and financial stability Accounting is at times perceived as a mask leaving the economic essentials unchanged. Actually, in the context of entirely frictionless markets, where assets trade within entirely liquid markets and there are no complications of obstinate enticements, accounting would not be relevant because consistent market prices would be readily available to all. A requirement for applying fair value accounting is that market values are available for assets or liabilities. Nonetheless, for several significant classes of assets or liabilities, the prices at which transactions occur do not correspond efficiently to the ideal of the theoretical frictionless competitive market (Adrian & Shin 2008). A good example is the loans. Loans are not standardized and also do not trade within deep and liquid markets. As an alternative, they are representative of several kinds of assets that trade chiefly through over-the-counter market, whereby prices are established through bilateral bargaining and matching. Loans are also packaged and tranched into debt asset backed securities like collateralized debt obligations. Nevertheless, such transactions occur within OTC markets. Therefore, establishing the “fair value” of a loan or securitized asset is an exercise in establishing the theoretical price that would reign were frictionless market to subsist for such assets. Accordingly, fair value accounting instills tremendous volatility into transactions prices; this means that marking-to-market results into the emergence of an extra, endogenous volatility source that is purely a result of the accounting norm, rather than something that indicates the underlying essentials (Adrian & Shin 2008). Market prices provide appropriate signs that can help in decision making. Nevertheless, when there are indistinct incentives and illiquid markets, there are other less benevolent effects that infuse artificial volatility to prices that deform real decisions. In a world of marking-to-market, asset price changes are signified instantly on the balance sheets of financial intermediaries and elicit reactions from them. Banks as well as other intermediaries have always responded to changes within economic environment, but marking-to-market files and synchronizes their reactions, and this adds force to the response impacts within financial markets (Wahrich 2001). Challenges associated with accounting standard (IASB) on financial reporting On 12th November 2009, the IASB issued a new IFRS for identification and measurement of financial instruments. The intention of IASB is to extend IFRS 9 and to include new standards on the identification and measurement of financial liabilities, the charge-off of financial instrument in addition to the destruction and hedge accounting. IFRS 9 will replace the recognition tactics and measurements procedures within IAS 9. At initial recognition, all financial assets are measured at fair value (Adrian & Shin 2007). There are critical issues of financial instruments. This is applicable to both complex instruments and also more traditional ones that became illiquid, and this makes it extremely difficult to establish market-based prices. As liquidity fast evaporated within the market for several intricate structured products and primary and secondary transactions prices were no longer available, most banks and financial institutions stopped using valuation methods founded on observable prices and started using model-based valuations. The model based valuations require broad use of unobservable inputs (Adrian & Shin 2007). Specifically, the IAS 39 has significant problems, counting the call for more work on accounting affecting securitization and debt-equity instruments. Complexity is one of the most significant problems within financial reporting and also financial reporting instruments are among the most multifaceted things on which to report undoubtedly. Complexity is the state of being hard to understand and apply, and refers chiefly to the difficulty for: Users to understand the economic substance of a transaction or occurrence as well as the general financial position and organizational results. Preparers to appropriately apply commonly accepted accounting principles and communicate the economic substance of a transaction and the general financial position and company’s results. Other element s to audit and regulate the financial reporting of a company. More specifically, IAS 39 standard problems arise from: The numerous means financial instruments are measured Hedge accounting The scope of standards for financial instruments Derecognition of financial instruments Presentation and disclosures Other matters, for example unit of account IAS 39 allows a choice of fair value for a hedge of the foreign currency risk of a firm commitment. For cash flow hedges of non-financial items IAS 39 also allows: Deferred gains and losses to be re-categorized into earning when the non-financial item have an effect on earnings; or Deferred gains and losses to be added to, or subtracted from, appropriately, the carrying amount of the acquired asset. Those choices decrease comparability between entities. Basis adjustments result in adjusting the initial carrying amount off the asset or liability away from its fair value. Valuation and risk management processes in adverse market conditions The ability of risk management and valuation units to cope with adverse market conditions is questionable. The official and the private sector acknowledge that there are key risk management and governance inadequacies. Estimating fair values is difficult owing to the liquidity lack within the market, the intricacy of some financial instruments and the change by some banks to more model-based mechanisms which elevated the utilization of unobservable inputs. All these features strain the ability of business units and control functions tasked with the required authentication and substantiation and this delays valuations productions (Forum 2008). Fair value accounting has resulted to the blurring of traditional frontiers Before fair value accounting was introduced, there was a distinct different between banks’ banking book held at chronological cost. Accounting practices were aligned with banking approaches and mirrored prudential categorization. Consequently, the current state comes up with numerous challenges: Internal management to clearly be aware of and select the right portfolio from the beginning. Financial reporting to offer appropriate rationalizations. Prudential supervisor who chose to “violate the consistency” and establish “prudential filters”, whose goal characterization would otherwise have been routinely affected. Nevertheless, these filters are merely a partial solution to a likely procyclical effect of fair value accounting as they are only applicable to fair value through equity as it would have been too multifarious to implement filters on instrument at fair value through profit and loss (Forum 2008). Macroeconomic impact of fair value accounting One of the greatest problems is to determine is that the general application of practical individual measures does not always result in a practical macroeconomic outline. The application of fair value accounting can have varying impacts. For instance, market price changes have an effect on financial statement very fast and this adds to volatility. To give investors the ability to check, in close to real time, the value of portfolios, the fair value accounting supposes conversely that: Market always competently price assets and single out amongst risks; Investors do not herd and decide basing on all available information In case, this is not the case, fair value does not prevent the development of asset bubbles and can even contribute and exacerbate movements that do not correspond to elementary price dynamic. The financial crisis resulting from the securitization of subprime loans influenced the trends within full fair value accounting for financial instruments that has been endorsed by IASB (Adrian & Shin 2008). Transitional approaches to simplify IASB complexity IFRS 9 necessitates gains and losses on financial liabilities delegated as at fair value through profit or loss (FVTPL) to be separated into the amount of a change within the fair value that is associated with the changes within the credit risk of the liability, which will be offered within other comprehensive income, as well as the remaining amount of change within the fair value as FVTPL. The sum presented within other comprehensive income will not be consequently all of the risks and rewards of rights to another party. Financial liabilities are de-acknowledged when the requirement set up within contract is released, annulled or concluded. All derivatives, together with those associated with unquoted equity investment are measured at FVTPL, except the entity has elected to treat the derivative as an enclosing model according to IAS 39, where the necessities of IAS 39 standard apply. Practically, re-categorizations between FVTPL and amortized cost of fiscal costs are anticipated to be less as they are just allowed when there is a change within the entity’s business form goal for its economic assets. Moreover, re-categorizations are not allowed where the entity has selected equity as FVTOCI or in case the FVTPL alternatives have been enforced (Geneva Association 2004). When compared to the IAS 39 policy, the return of equity ration, with net income within the numerator and average shareholder’s equity within the denominator, will increase within an increasing market and simple within a depressed market when a unit re-categorizes AFS and HFT securities as amortized cost, all other things being equivalent. ROE can also be inferior within an expanding market and higher within a depressed market when an entity delegates HTM as well as LaR securities as FVTPL. The profit margin, which is net income articulated as profits fraction, in most case will be higher in floating markets and minor within depressed market when an entity re-categorizes AFS and HTM securities as FVTPL, all other things being equivalent (Plantin 2008). Additionally, profit margin can be lower within floating markets and higher within depressed markets, when an entity re-categorizes HFT securities as amortized cost. Gearing and leverage rations, under the new conditions can be considerably dissimilar from those computed under IAS 39 and this is dependant on the new categorization chosen for financial liabilities in addition to the market’s state. The precise nature and scope of the IFRS impact on major financial rations will be dependant on numerous elements like when the entity implements it, the categorization and fair values of financial mechanisms before and after implementations. As a result, it is recommendable that the value of the elements of all financial rations used are supposed to be carefully evaluated on a case by case basis, to establish the effect of the new standard on essential analysis (Wahrich 2001). Changes of IAS 39 and IFRS 9 issuance All financial instruments are primarily measured at fair value. The loans are receivables; available-for-sale and held-to-maturity presently within IAS 39, will be eradicated by IFSR 9. Debt instruments that are carried at amortized cost should meet the below tests; Business model test: the goal of the entity’s business form is to hold the financial asset to bring together the contractual cash flows, instead of selling the instrument to take in its fair value changes. Cash flow characteristics test: the contractual terms of the financial asset led to emergence of specified date to cash flows that are exclusively important and interest payments (Dunning 2004). Amortized cost refers to the cost of a security amended for the paying off of any payment or discount. For instance, in case a debt instrument with a 100 par value is bought at 105, it will be at first recognized at 104 but the disparity between 105 and 100 (par value) is amortized over the asset’s life to enable the instrument to progressively move from 105 to 100. All other debt instruments should be measured at fair value through profit or loss. This is where the instrument is recorded at fair value within the balance sheet with modifications within fair value acknowledged within the profit or loss. A debt instrument that fulfills the two amortized cost tests can be voted as a fair value through profit or loss if by doing this does away with or considerably decreases an accounting disparity; for instance where the financial asset is examined at amortized cost and its matching financial liability since all equity investments within the standard scope are measured at fair value through profit or loss. Nevertheless, in case an equity investment is not held for trading, an entity can make irreversible resolve at preliminary recognition to examine it’s at fair value through other comprehensive income (FVOCI) with only divided income acknowledged within profit and loss. The FVTOCI alternative is simply available for equity instruments. The IAS 39 ‘cost exception’ for unquoted equities will be abolished by IFRS 9 (Geneva Association 2004). IFRS 9 did not change the fundamental accounting model for financial liabilities under IAS 39. Two measurement classifications are still in existence: FVTPL and amortized cost. Financial liabilities held for trading are measured at FVTPL and other financial liabilities are measured at amortized cost except if the fair value alternative is applied. Financial liabilities with one or more implanted derivative are catered for as FVTPL (Michael 2004). The IASB objectives The main objective of IASN in regard to convergence is to bring out union of national accounting standards as well as International Accounting Standards and International Financial Reporting Standards to high quality solutions. The dictates of national standards guides the financial reporting. The accounting community acknowledges the importance of official standards to guarantee the dependability and relevance of financial information (Schafer 2007). There are many benefits that come with the implementation of international standards. All security regulators are supposed to work jointly and diligently to establish sound international regulatory frameworks that will improve the vitality of capital markets. Capital markets are likely to benefit a lot from uniform standards. At present, companies wanting to issue stock through capital markets within various countries should follow the different rules of every country. This results into major hindrances to entry since meeting the varied financial reporting requirement results to significant increased costs (Financial stability Forum 2008). Uniform accounting standards will result into reduced cost of capital since internationally accepted standards will increase the base of global financial support devoid of additional reporting costs. This will get rid of cost as a hindrance to entry and persuade investors to follow access to foreign markets; which will cause increased competence within cross-border capital flows (Schafer 2007). Furthermore, uniform accounting standards will do away with duplication of effort preparing accounting standards. Global standards facilitate a concentration of accounting professionals committed to establishing standards to meet information users’ requirements; accounting standards with a global approach rather than a narrow national focus. International accounting standards could also result to greater agreement between accounting and financial measures (Samuel 2006). One element central to the benefits of utilizing global standards is synchronization. Standard setting officers as well as accounting researchers emphasize the significance of differentiating “standardization” of the rules from harmonization. Harmonization entails a reconciliation of different opinions. This is a more practical and conciliatory approach since harmonization is a matter of improved information communication within a form that can be interpreted and understood globally. An intrinsic benefit of harmonization is that it doesn’t force the removal of national standards, which could be met with xenophobic resistance. Harmonization by using global standards will improve the comparability of financial statements across borders; therefore providing an improved quality of information for investors as well as creditors. Nevertheless, some developing national are not ready to embrace harmonization since they perceive that accounting standards will be dominated by accounting standards from developed nations (Samuel 2006). Conclusion In conclusion, Financial Stability Forum (FSH) proposes that the standards setters consider improving the accounting model to enable careful examination of financial instruments of credit liaisons regarding the use of fair value accounting. There are two opposing opinions regarding the link between fair value accounting and the financial crisis. One is that fair value accounting plays a big role within the financial crisis. It is allied to be a major contributor in triggering a liquidity death spiral and hence leading to the financial crisis. The other opinion is that fair value accounting does not have an effect on the financial crisis. Irrespective of the accounting system, fair value is just allied to capital regulations as well as private contracts (Financial stability Forum 2008). References: Adrian, T., & Shin, H., 2007, Liquidity and leverage, working paper, Princeton University, Princeton. Adrian, T., & Shin, H., 2008, liquidity and financial contagion, financial Stability Review, Vol.11/1. Dunning, J., 2004, Multinational Enterprise and the Global Economy, Wesley, Addison. Financial stability Forum, 2008, Enhancing market and institutional resilience, Financial Stability Report. Geneva Association, 2004, Impact of a fair value financial reporting system on insurance companies, Geneva papers on Risk and insurance: issues and practice, Vol. 29/540-581. Michael, I., 2004, Accounting and financial stability, Financial Stability Review, Bank of England, June 118-128. Plantin, G., 2008, Marketing-to-market: panacea or Pandora’s Box, Journal of Accounting Research, Vol. 3/1. Samuel, K., 2006, Comparative International Accounting, Prentice Hall, New York. Schafer, D., 2007, Advanced Accounting, McGraw-Hill Irwin, London. Wahrich, M., 2001, The Evolution of International Accounting Systems, Peter Lang, Frankfurt. Read More