Fair Value Accounting - Term Paper Example

Fair value model vs mixed attribute theory xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Instructor xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Table of Contents Table of Contents 2 Abstract 3 1.0 Benefits of fair value accounting 4 2.0 Disadvantages of fair value accounting 5 2.1 Testing the heat rather than adding gasoline to fire 5 2.2 Fair Value Accounting is it a messenger or contributor of GFC 6 2.3 Fair value as a contributor of GFC 7 3.0 Fair value model versus mixed attribute model 8 3.1 Fair value model 8 3.2 Mixed attribute model 8 3.3 Why bankers prefer mixed-attribute model 9 4.0 Originate-and-hold model versus originate-and-distribute model 10 4.1 Arguments against mixed-attribute model 12 5.0 Disadvantages using mixed-attribute model for investors 12 6.0 Assets in the case study 13 References 14 Abstract Fair value accounting is necessary measure that is used in the financial institutions. It is an estimate of the price that an asset would sell or the price of an entity. Most financial instruments are reported and measured at fair value. However, fair value accounting has several benefits and limitations in the current market. These benefits and limitations are both to the investors and financial institutions. Critics have argued that the fair value accounting has contributed to the global financial crisis. This mainly is reported to have been the main cause of crisis in 2008. However, findings from different bodies have reported otherwise. There are two main models of fair accounting mixed-attribute model and full fair value model. Most bankers opt for the mixed attribute model. However, the model has formed a burden to the investors. Various authors have contributed to the discussion on the present effects of fair value accounting. Case study analysis: Fair value model vs mixed attribute theory 1.0 Benefits of fair value accounting Fair values do provide vital information about financial liabilities and financial assets as compared to values that are based on received or original price paid. As it reflects the market conditions currently, it gives comparability of the value of any financial instruments which might have been bought at different times. To the investors, fair value accounting benefits include: It permits or requires companies including banks to give reports amounts that are more timely, comparable and accurate than the reports that would have been given under the already existing alternative accounting approaches. This is because it does show the current rates of risk-adjusted discounts and information on future cash flows. This is very significant even during the extreme condition of the markets, it permits or requires the companies to report or give amounts that are always updated on an ongoing and regular basis, it does limit the companies’ ability to easily manipulate their income as losses and gains on liabilities and assets are regularly reported in that period that they occur, not at the time that they are realized after a transaction has been made, losses and gains that have resulted from the estimates of fair value do indicate the economic events that the investors and companies may find it worth to be additional disclosures the fair value accounting over time self-corrects in a timely manner (Plantin et al 2008). The self-correcting quality is vital in the periods of rapidly and high uncertainty and asymmetry of information, for instance credit crunch, there is no need for the companies to reflect or show fire sales values and fair value accounting is an excellent platform for voluntary and mandatory disclosure for the investors to be informed of what to enquire the management (Plantin et al 2008). 2.0 Disadvantages of fair value accounting There are various limitations of fair value accounting especially to the investors. These include: during illiquidity in the market, fair value accounting is a poorly distinct notion involving transaction prices that are hypothetical and cannot be reliably be measured, the fair values are unverified when they are provided by sources which are not from liquid markets. This then allows the companies or banks to engage in some behaviors which include discretionary income management, by recognizing unrealized losses and gains, it creates or provides volatility in the companies’ owners’ net income and equity that also include the financial institutions’ regulatory capital. The net income does not have to correspond to the flow of cash that will finally be realized, it mixes permanent/ normal component of income for instance, interest, with transitory losses and gains, it also increase the volatility on profit and losses accounts, bank sheets, and this affects the regulatory capital that a bank should hold. This would eventually strengthen the procyclicality of the financial markets (Laux & Leuz 2009). Fair value accounting may as a result of volatility; it may create and mitigate perverse incentives in the decisions of bank management which may result to creating much emphasis on the short term. The incentives might be perceived in investments decision and also affects the managers when the accounting results are linked to their compensation. The manager may therefore, benefit from setting goals that will results in short term profits and not strategies on those that have long term effects which includes the risks to be taken (Laux & Leuz 2009). 2.1 Testing the heat rather than adding gasoline to fire The current market conditions which are characterized by global financial crisis, are not favoring the financial institutions. The accounting policy should focus on creating policy that first will consider and reduce the causes of financial crisis rather than introduce policies that will increase the current financial crisis as experienced globally. This basically applies to the present times when fair value accounting is being applied in the financial institutions where it might have been determined reliably and it is relevant resulting to added value. However, in case where this value is not experienced, better and more useful ways that measure real financial conditions and value of liabilities and assets should be used. This is as a result of the popular belief that fair value accounting and bank capital rules have aided trigger the present financial crisis (Zack 2009). The argument is that valuations of the long term investments that are based on prices that are obtained from illiquid markets has created an effect whereby the mark to market adjustment did reduce the regulatory capital which forced the bank to sell investments that resulted to depressed prices. This eventually led to instability in the bank and effects in the credits in 2008. 2.2 Fair Value Accounting is it a messenger or contributor of GFC Fair value accounting is a contributor to the global financial crisis. However, its impact is not very extreme as most people are arguing. For instance, the global financial crisis that was experienced in 2008, most critic heaped blame on fair value accounting. This is because most of them implied that the financial institutions had their majority of their assets that were marked in the deteriorating market. However, from the study carried out by SEC only 31% of the bank’s assets accounted for fair value as the rest were for historical cost. This is because under fair value accounting, the management divides all securities and loans into three asset categories: assets that are held, ones that are traded, and those that are ready or available for sale (Zack 2009). Therefore, if the management has the ability and intent to hold securities or loans to maturity, they are then taken to books at historical cost. Many loans and most bonds are held until they mature. If permanently impaired, they are written off. All traded assets are marked quarterly in the market. Any decline in the fair market value of bank assets will reduce the equity on its flows and balance sheets and will be indicated as a loss. In this case, it will be reported as a pretax quarterly loss. The treatment of assets available for sale, it is more complex. The debt securities which fall under this have special treatment and this treatment does not reduce the bank’s regulatory capital or net income. The SEC, in its study found out that almost a third of the 31% of the bank assets that were marked to market were already available for- sale debt securities (Plantin et al 2008). The percentage of those assets that affected the bank’s income that is, marketing to market was only 22% in 2008. This was far from the majority. 2.3 Fair value as a contributor of GFC Fair value accounting is a contributor to the global financial crisis (GFC). The main way through which it contributes to financial crisis, it is involve a link between the bank capital regulation and accounting. It contributes to extreme leverage in periods of boom and results to write-downs that are extreme in bursts. As a result of falls in the markets prices, the write-downs deplete the bank capital and eventually set off a down spiral when the banks are made to sell their assets at fire sale prices which definitely lead to contagious as prices spread from one bank to others. These contagious problems may also rise when the management focuses on the short term, in specific earnings, for instance, bonuses. Therefore, the management can be inclined to sell illiquid assets at a price that is below the essential value to pre-empt the sales that are anticipated by other market participants. In doing this, the bank management avoid to register the asset to a lower price in the market despite creating a contagious effects for other different banks (Gron & Winton 2001). 3.0 Fair value model versus mixed attribute model 3.1 Fair value model The full fair value model is a financial reporting approach where companies measure their financial instruments; assets and liabilities based on their current market value. Prices are estimated according to prevailing conditions and information. According to the FASB’s definition, fair value refers to the sum total for which an asset can be sold or a liability settled in a real transaction involving independent parties. Under the fair value model, companies report their financial positions as reflected in their balance sheets. The fair value model proposes that all financial instruments should be reported in their fair value and variations in such values should be immediately registered in the profit and loss account. Users of this model are able to obtain the fairer and true value of the firm’s financial situation as fair value utilizes prevailing economic conditions. Although fair value has received many criticisms, some banking practitioners argue in its favor explaining that relevance of financial information can only occur when it directly influences the decision of the user (Acharya 2011). 3.2 Mixed attribute model Mixed attribute model on the other hand combines historical cost calculations and fair value approaches of financial reporting. In this model, some financial instruments are valued according to historical costs, some at the lower of cost and market price while some at the fair value. This approach was developed to deal with notable confusion emerging from inclusion of fair value standards into current financial reports. It allows its users to choose the measurement attribute they deem fit for a particular desired position. For instance, a firm may treat a security as available for sale, as one of trading or held to maturity. Over the years, the mixed-attribute model has prompted many accounting-motivated transaction structures. Valuation of assets and liabilities reflects a combination of historical data, current information and expected future outcomes. Historical value refers to the cost of acquiring assets or the nominal amount initially incurred by a liability. On the other hand, current value reflects updated value of the historical costs with fair value information of the financial instruments as portrayed in the balance sheet (Acharya and Richardson 2009). 3.3 Why bankers prefer mixed-attribute model Many bankers prefer mixed-attribute model to fair value model for several reasons. To begin with, in the mixed model valuation criteria, the market cost of the instrument does not depend on its characteristic but instead on its time scale in the organization; that is whether the company intends to trade it off or hold it for long term use. Therefore, as a result of application of mixed model, instruments can be valued differently and affect the profit and loss statement as well as the balance sheet in different ways. Another factor that makes mixed-attribute model the preferred approach by bankers is the fact that it provides a degree of accounting arbitrage. This means that the bank can trade off its financial instruments in different markets and in the most negotiable prices in order to maximize profits. According to Acharya and Richardson (2009), financial statements must be able to give the company’s financial situation and provide a comparison with those of competitors in order to determine its real financial performance. This then implies that situations, events and commodities similar to each other must be treated the same way. Although the mixed model uses different valuation methods for identical instruments, results offered are quite consistent and perfectly comparable. On the contrary, fair value model has a significant degree of subjectivity during preparation of financial reports making it difficult for comparison. Mixed-attribute model can be applied to all kinds of financial instruments unlike in fair value where it’s impossible to estimate values of certain instruments especially those that lack active markets such as deposits acquired and loans granted. Relevance and reliability of information is a fundamental aspect in the preparation of financial statements. Mixed-attribution model is a perfect mix of reliable and relevant information which can be easily translated to give details about timing, risks and future cash flows. Information is regarded relevant if it can affect the decision of the user based on the financial reports whereas reliability is the aspect of trust and faithfulness represented by the financial statements. Verifiability is a good example of reliability. Mixed model is a mixture of three basic components which are historical data, current information and future prospects. Such information is quite reliable since it gathers all information required in valuation of the instruments and it’s relevant since it affects the decisions of the users. 4.0 Originate-and-hold model versus originate-and-distribute model The originate-and-hold (OAH) model refers to a lending approach where the lender, mostly a banking institution, retains its loans assets in the balance sheet and actively engages in credit analysis. The ownership of the loan therefore, belongs to the bank which also bears the risk of loan defaults. The bank therefore, has a major obligation in monitoring the borrower and evaluating his responsibility in repaying the loan. This also applies to mortgages whereby the lender has the right to all incentives at the time of origination and retains the mortgage risk. The OAH is quite limiting since it does not allow mortgage liquidation and funding to supply of deposits issued by banks. In addition, holding of loans and fixed-rate mortgages exposes the banks to the interest rate risk like the one experienced by the U.S savings and loans industry a few years ago. This approach of ensuring that loans are held till maturity enables the originators to adequately underwrite and carefully calculate all the risks that may be involved as opposed to the new model where risks are no longer core in distribution of the loans. The originate-and-distribute (OAT) model is an approach of lending where the banks give out loans, earn the fees thereof and later distribute them to investors. This model has prevailed greatly due increasing demand for secondary markets which has in turn accelerated the growth of Collateralized Loan Obligations (CLO) and Collateralized Debt Obligations (CDO). There are clear implications of the OAT bank credit model to all the parties involved who include the originating bank, the borrowing firm, the investors and the regulators. The basic reasons why banks have moved from OAH model to the OAD model are; for risk management reasons, for capital relief and to take advantage of the borrower’s negative information. Gambacorta and Marques-Ibanez (2011) points out that banks also sell out their loans in order to free up capital and use the returns in more profitable activities. Activities of fee-based loan origination are subsequently increased by use of this model which creates a competitive advantage of the banks against non banking financial institutions. In turn, positive impact of return on equity and return on assets is quite tremendous. With regard to risk management, OAD is frequently used by banks as a risk diversification mechanism. Another advantage if using OAD is that the balance sheet of the bank can be easily liquidated through sale of loans. This enables asset liability management and enhances the bank’s ability to respond to harsh economic environments. The model is generally considered as a socially desirable. 4.1 Arguments against mixed-attribute model One of Hertz’s arguments is that Loans are a financial instrument and should be covered by any rule that affects those instruments. The other point is that loans are not always held to maturity. According to the mixed attribute model all financial instruments are included in the financial statement which should actually not be the case as some of them like loans can only be recognized after settlement. His third argument is that loans are increasingly parcelled out through securitizations, which gives them a short-term feel. Hertz therefore, states that originate and hold model of treating loans has been subsequently replaced by the modern originate and distribute model where loans are not held in the accounts of the lender but are distributed to investors. 5.0 Disadvantages using mixed-attribute model for investors There are several burdens that investors have to bear as a result of the mixed-attribute model. To begin with, the problem of comparability among companies becomes a problem for investors when looking for the best company to invest in. The mixed-attribute model is based on many factors including historical, current information and future expectations which vary from company to company. Another challenge faced by investors is the dynamism in the complexity of financial instruments. It is quite evident that financial instruments are evolving at a very fats rate which is ultimately making it very difficult to know how to deal with them in the financial statements. Some of these instruments do not exactly fit in any of the approaches used in the mixed-attribute model. The issue of arbitrage of accounting is quite troubling to investors. Mixed-attribute model can allow banks and other financial institutions to structure their trading strategies depending on the market they are targeting. It has been proven that some of them do actually change the method of financial instrument measurement and make inadequate changes to economics. Another problem of mixed-attribute model is the difficulty in assessing if the value attached to marketable security is temporary or a permanent impairment. In addition, the mixed-attribute model poorly describes the risks involved in financial instruments of financial institutions and is not adequate in determining their net value (Gambacorta and Marques-Ibanez 2011). 6.0 Assets in the case study The assets that constitute the subject matter of the case are loans and receivables. According to the Australian Accounting Standards, a financial asset is regarded as a loan or receivable if it is a non-derivative, has determinable or fixed payments and it has no quotation in an active market. Loans and receivables are measured at the cost of amortization immediately they are recognized. Adjustments accrued from the carrying amount of the assets go directly to the profit and loss account. To measure the amortized cost of loans and receivables, the effective interest method is used with deduction of any impairments being done in the profit and loss account. Interest income is also calculated using the effective interest rates. However, this only applies for long term loans and not short term receivables. Disclosure requirements for loans and receivables are contained in the IFRS 7 which requires that these assets be valued at the fair value in the profit and loss account (Ryan 2008). References Acharya, V, 2011. Guaranteed to fail: Fannie Mae, Freddie Mac, and the debacle of mortgage finance. Princeton: Princeton University Press. Acharya, V. and Richardson, M, 2009, Restoring financial stability : how to repair a failed system. Hoboken, N. J.: John Wiley and Sons. Bies, S, 2004, Fair value accounting. International Association of Credit Portfolio Managers general meeting paper, November 18 2004. Gambacorta, L. and Marques-Ibanez, D., 2011, The bank lending channel: lessons from the crisis. Economic Policy, volume 26, issue 66: p.135–182. Gron, A., & A. Winton, 2001, Risk Overhang and Market Behavior. The Journal ofBusiness 74: 591-612. Laux, C., Leuz, C., 2009, The crisis of fair-value accounting: Making sense of the recent debate. Journal Accounting, Organizations and Society. Plantin, G., Sapra, H., Shin, H, 2008, Marking-to-Market: Panacea or Pandora's Box? Journal of Accounting Research 46, 435-460. Ryan, S, 2008, Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch. Financial Markets, Institutions and instruments, volume 18, issue no. 2,p. 163-164. Zack, G, 2009, Fair Value Accounting Fraud: New Global Risks and Detection Techniques, New York: Wiley Sons and Inc. Read More