Financial Value Accounting and Its Influence on Recent Financial Crises - Literature review Example

FINANCIAL VALUE ACCOUNTING (FVA) AND ITS INFLUENCE ON RECENT FINANCIAL CRISES Name Course Tutor Date Table of Contents Table of Contents 2 Introduction 3 Historical Context of FVA 3 Definition and Concept of Fair Value Accounting 3 Evaluation of the Statement 4 Implications of the use of FVA 5 Information asymmetry 5 Transparency 5 Quality 6 Contribution of FVA to the Recent Financial Crisis 6 Proponents 7 Critics 8 Advantages and Disadvantages of FVA in relation to others 9 Historical Cost Accounting 9 Advantages of FVA compared to Historical Cost 9 Disadvantages of FVA compared to Historical Cost 11 Deprival Value 12 Advantages of FVA compared to Deprival Value 12 Disadvantages of FVA compared to Deprival Value 12 Conclusion 12 Bibliography 14 Introduction Historical Context of FVA Fair value accounting abbreviated as FVA, is a theory that can be traced back in the history of the financial industry. As far as the 19th and 20th century, most firms had already integrated the concept into their practices valuing their assets through appraised values. For example, some firms practiced the estimation of the net projected value that was to be realized by the assets in the market (Christensen & Nikoleav, 2009; Laux &Leuz, 2009, Laux and Leuz, 2010; Magnan, 2009). The companies would use terms such as current values as well as appraised values, long before standards were developed for fair value measurement. With the 2008 crisis in place a lot of literature has been written both in favor or for or against FVA. The proponents of FVA are in its favor or while critics are against it. Definition and Concept of Fair Value Accounting FVA refers to a fiscal reporting method that permits firms to measure and thus report regularly about liabilities and assets (financial instruments) through estimation of the prices that would be received should the firm be relieved of its liabilities (Magnan, 2008). Laux and Leuz (2009) acknowledge the definition by Financial Accounting Standards (FAS) 157 that financial value is the price that is realized when an asset is sold as well as the price paid to transfer the liability of a firm in the market. To understand this concept, there are interconnected parameters to consider. This include: the regulatory framework, definitions, and evaluation methods. There are accounting standards that govern fair value just like other accounting principles and constructs (Magnan, 2008; Porchazka, 2013). Through the concept, firms are able to report losses whenever their assets decrease as well as when the liabilities increase (Ryan, 2008; Enahoro & Jayeoba, 2013; Porchazka, 2013).Financial value is measured in three basic levels. Level one input encompass the available quoted prices for similar assets in the market (Magnan, 2008). Level two input covers market data such as the prices of similar assets or liabilities in both active and inactive markets among others (Porchazka, 2013). On the other hand, level 3 inputs mainly comprise of unobservable inputs which are used to develop fair value in cases where other evident inputs aforementioned, are not present. It is contrasted to historical or amortized cost accounting that is also applied for the same purposes (Laux and Leuz, 2009). Evaluation of the Statement There has been a controversial debate following the 2008 financial crisis on the merits and shortcomings of FVA. Proponents and critics both have their different viewpoints on the matter. After careful scrutiny of the available literature by both sides, Laux and Leuz (2009) arrive to conclusion that the likelihood that FVA aggravated the brutality of the past financial crisis is very insignificant. Laux & Leuz (2009) further identify and acknowledge the fact that there are limitations in this conclusion. This is because there is a possibility that the role of FVA could have been limited by the relevance of the limited capital requirements and balance sheets of the banks. Based on the prospects of FVA, the concept is very sound for any financial institution. The only bone of contention is the standards that regulate its implementation (Magnan, 2009; Laux &Leuz, 2010). It is also wise to acknowledge that there are weaknesses of FVA that can be strengthened by using some other financial accounting concepts such as historical cost accounting (Penman, 2007). Implications of the use of FVA The implications of the use of FVA can be looked at by considering various topics. This includes quality, transparency, and informational asymmetry. Information asymmetry When FVA is used in firms it mitigates the risk of short-termism that is usually caused by the preparers and investors altogether (Porchazka, 2013). There is harm in failing to report the fair value of liabilities as well as assets, as this heightens the chance of information asymmetry linking the investors with the preparers (Magnan, 2009; Ryan, 2008). For examples some banks have traded gains having the diplomacy that they will report profits and hide the losses of their firm’s portfolio. This as often resulted in suboptimal balance sheet that meant to maximize the short time compensation management (Porchazka, 2013). Due to the richness in information and timeliness fair value accounting reduces information asymmetry faster through time compared to historical cost accounting, reducing the duration of the credit crunch thus the short life term of a crisis (Ryan, 2008). Transparency FVA increases transparency especially for investors. This is so since fair value is estimated founded on market prices obtained from well informed, active and competitive market. The balance sheet in this case provides a lump sum amount of information for the investors and a comparison of the book value against the market price (Laux and Leuz, 2010; Magnan, 2008; Penman, 2007). When the fair value of all the assets of a firm are higher than the market price then the balance sheets are used to make decisions by the investors to buy shares (Porchazka, 2013). Penman (2007) notes that when all the assets and liabilities reported on the balance sheet, price-to-book (P: B) equals one, meaning that the book value reports that equity’s market value. Quality The quality of a balance sheet includes the information on fair value of the assets and liabilities. This offers the investors as well as other shareholders’ key judgments regarding solvency, leverage, the overall risks and asset quality. Laux and Leuz (2010) suggest that the financial crisis reflected the significance of fair value on balance-sheets for financial institutions such as insurance companies and banks. During the crisis the balance sheets were overstated thus delayed impairments (Ryan, 2008). However, should fair value measurements on loan assets been used, it would have reflected the economic actuality in a timely manner compared to the impairments by the amortized costs (Laux and Leuz, 2010). Additionally, high quality fair value of losses and gains are bound to facilitate decisions by the investors (Magnan, 2008). This would largely be based on routine and capital creation of the reporting units in the measurement and reporting epoch (Laux and Leuz, 2010). Contribution of FVA to the Recent Financial Crisis To evaluate the premise that FVA could have or could have not alleviated the financial crisis, it would be wise to look at various view points of both the proponents and the critics of FVA, pursuant to the crisis debate. Magnan (2009) divides the two groups into the regulatory and financial communities, and the academic community based on their viewpoints. However, even superficially, there stand two arguments concerning the matter; those for it and those against it. Some scholars believe that the application of FVA had a hand in exacerbating the financial crisis. On the contrary, others believe that the accounting regime (FVA) never had a direct role in the crisis. Proponents Magnan (2009) points that; FVA has a good support from many financial accounting professionals and regulators. For example, former Superintendent of financial institution of Canada, Nick Le Pan, argued that as FVA is a messenger and should not be evaluated based on the current poor economic outlook (Magnan, 2009). Magnan (2009) further points out that various financial analysis’s communities have supported FVA with open letters to SEC a good example being CFA institute. Porchazka (2011) observes that FVA regulations allowed the financial bodies such as insurance firms as well as banks to finance their investments in the short period using the assets they had as collateral, that were measured at a high market value when the economy was good. As a result, shareholders’ equity was reduced. Laux and Leuz (2009) assert that FVA had varied role in the crisis. They assert that not only was it a messenger, but also had a limited role to play in the crisis. The debate of FVA is compared to that of reliability versus relevance argument. Overall, FVA might be procyclic, highlighting the magnitude of losses and earnings during busts and booms respectively. Laux and Leuz (2009) suggest that the use of FVA should be adapted and that what needs to be done is to draft viable accounting standards. This compared to the capability of historical cost accounting would solve the market inefficiency. From the analysis of the role played by FVA during the crisis through financial exposure of fair values of assets and liabilities, it is evident that FVA had insignificant role to play in the crisis (Laux & Leuz, 2010). Khan (2010) argues that in periods of subprime crises, the cost of fair value oriented accounting regime often creates contagion where prices drastically falls since the market is flooded by assets leading to dumping of assets to evade violating the solvency rules. This increased the risk of failure of the whole financial system (Khan, 2009). Another important argument is that of Ryan (2008). He summarizes the whole debate by saying that FVA is not a contributor to the financial crisis, instead, it provided the investors with information they required concerning the subprime positions. Ryan (2008) however, acknowledge the fact that there is a need for guidance in form of standards on what makes a transaction orderly since the inputs in FVA are based on the transaction and the date of measurement (Laux &Leuz, 2010; Magnan, 2009; Penman, 2007). The sum total of using Fair Value Accounting is increased flexibility; this does not in any way catapults the crisis (Laux & Leuz, 2010). Magnan (2009) further argues in favor of fair value accounting stating that there lacks proper evidence on its role in the crises and that it is relevant for the fiscal statements dependents such as investors and other users. Additionally, it assures improved quality features of accounting intelligence of information compared to historical cost accounting (Magnan 2009; Laux and Leuz, 2010). Critics Khan (2010) further points out that FVA is pro-cyclic, concurring with Laux and Luez (2009), noting that it should be abandoned or modified to ensure that financial reporting accentuates the stability of an entity more willingly than earnings power. The extent to which a financial institution such as bank uses FVA heightens the chance to pull off deprived stock in market presentation. This leads to contagion effect (Khan, 2009). Additionally, when the market is illiquid, there is a greater effect of contagion this is brought in by FVA thus catapulting crises (Magnan, 2009; Penman, 2007). The failure of the contagion effect might also be brought about by a banks overreliance on FVA and accompanying illiquid conditions (Khan, 2009). In this way the use of fair value accounting elevates the chance of a crisis (Magnan, 2009). FVA amplifies the flexibility in the prices of assets relative to the fundamental values. That is when the prices decrease, the incentive sells, and the converse is true (Laux and Leuz, 2009; Magnan, 2008). This creates a kind of artificial volatility that can lead to some firms being affected strongly. The sources of volatility are recognized to be underlying economic volatility, results from mixed measurement accounting models, and measurement from error in estimates in FVA changes. Advantages and Disadvantages of FVA in relation to others There are other methods of fiscal reporting. Historical cost Accounting (HCA) is the major alternative of FVA, others include deprival value accounting (Porchazka, 2013; Laux and Leuz, 2009). Historical Cost Accounting Advantages of FVA compared to Historical Cost FVA is a way of measuring the financial instruments (assets and liabilities) that appear in the firm’s financial position (Magnan, 2008; Laux &Leuz, 2009; Porchazka, 2013). This in a way increases transparency, gives support to the investors in understanding the risk margins, encourages prompt and corrective actions compared to amortized and historical cost accounting that do not encourage the value of financial instruments in the current market conditions (Laux &Leuz, 2009). FVA also bar firms from managing their incomes through trading gains since loses and gains are documented any time they occur and not when they are realized (Penman, 2007; Porchazka, 2013). In case the market exhibits bubble prices, the fair value becomes more exact, comparable and timely in different firms compared to historical cost and amortized cost accounting (Ryan, 2008; Porchazka, 2013). This is because FVA records and reflects the current information on the current risk-adjusted discount rates and future cash flows. On the other hand, amortized and historical cost accounting is bound to differ drastically to be very long term positions. Historical costs may be meaningless relative to the current exit or market values with reference to financial assets and liabilities (Laux & Leuz, 2009). In this case there will be misleading earnings management opportunity for the firms (Enahoro &Jayeoba, 2013). In this case FVA is very useful for the firms. Penman (2007) asserts that as time passes the historical prices are rendered irrelevant in assessing the current financial position of an entity. The prices recorded in FVA provide the latest information of the value of the assets compared to historical costs that are founded on a balance-sheet that lacks value but instead earnings satisfactory to value the firm (Laux and Leuz, 2009; Porchazka, 2013). Compared to the rules in amortized cost accounting or HCA, FVA reports the economic income thus an explanation to the accountant’s dilemma or predicament of measuring income (Laux and Leuz, 2009). FVA recognizes losses and gains prior to the real time, this aids firms in realizing losses and gains that are bound to be accrued compared to historical cost accounting (Ryan, 2008). Ryan (2008) further notes that FVA is very rich in information and has associated voluntary and obligatory disclosures thus reducing uncertainty. Additionally, it reduces information asymmetry faster through time compared to HCA and other methods, in this way it reduces credit crunch (Porchazka, 2013; Penman 2007). Disadvantages of FVA compared to Historical Cost On the contrary, HCA allows the trade of gains especially for financial bodies (Ryan, 2008; Penman, 2007). Gains and losses that are unrealized have the risk of being overstated in FVA. In this case the two are reversed if there is existence of bubble prices (Porchazka, 2013). When firms use this information to make suboptimal economical decisions or even investors rush due to the unreported gains and losses, FVA would result into an adverse feedback effect (Christensen & Nikoleav, 2009). In HCA, each asset is recorded on the firms’ fiscal statements at cost including its historical cost, depreciation or the market price when the asset is permanently impaired (Porchazka, 2013). Contrary to FVA, historical cost accounting does not yield adverse feedbacks if used instead (Christensen & Nikoleav, 2009). For example, Ryan (2008) notes that the sub-prime’s and other assets’ write downs, have resulted in reduced market values of those assets and thus also cushioning systemic risks. The mechanism of income, for instance, interest is mixed with transient gains and losses in FVA (Christensen & Nikoleav, 2009). On the contrary, HCA does not recognize the gains and losses as permanent but dependent on whether or not the firms have snowballing unrealized losses and gains bound to be revealed by the firm (Magnan, 2009). Additionally, FVA also catapults volatility in investors’ equity and the net-income that must not match the cash flows to be realized (Laux & Leuz, 2010; Porchazka, 2013). This is likely to yield systemic risk. Fair values do not depend on the liquid markets other than sources earlier mentioned in the introduction (Ryan, 2008). The sources are unverifiable allowing discretionary accounting behaviors and income management (Porchazka, 2013). Deprival Value Advantages of FVA compared to Deprival Value FVA replaces deprival value which measures the additional value resulting from asset ownership (Ryan, 2008). Deprival value in itself is very good compared to replacement cost and current value accounting (Porchazka, 2013). However, it is not the best way of enhancing financial information being that it has difficulties in evaluating assets, the difficulties which rely on the imperfection or complete market (Christensen & Nikoleav, 2009). Deprival value is a bit complicated and it usually gives rise to values that vary significantly from value of the market. Comparing assets’ value that are owned by varying entities can be challenging if deprival value is utilized as it reflects reporting entity position. This then fully proves that FVA is efficient in enhancing financial information compared to deprival value (Ryan, 2008). Disadvantages of FVA compared to Deprival Value Deprival value, usually rests of comparing a current entry value with recoverable amount. It attempts to measure the economic opportunities that face the entity. It also reflects the loss to the entity when hypothetically deprived of that asset and if calculated as the lower recoverable/replacement cost (Ryan, 2008). Conclusion The public, professional and scholarly domains have been debating on whether or not fair value had a hand in aggravating the recent 2008 financial crisis. As have been seen both proponents and critics within the aforementioned domains have their valid reasons as to why they stand their ground. However, due to the more advantages that FVA has within itself. It would be wise to stand firm with the proponents. What needs to be changed for FVA to be perfect is tweaking the standards of accounting so that all the weaknesses of the measurement using fair are mitigated. There are implications when using FVA including information asymmetry, control, quality and transparency. Overall, FVA beneficiaries are usually the stakeholders and investors in firms. Bibliography Chea, C. A 2012, FVA: Its impacts on Financial Reporting and How it can be Enhanced to Provide More Clarity and Reliability of Information for Users of Financial Statements, International Journal of Business and social science, Vol. 2, No. 20, p. 12-19. Christensen, H.B & Nikoleav, V 2009, Who uses fair-value accounting for non-financial assets following IFRS adoption? EAA 2009 Annual Conference Paper, FR.PSD.29, Tampere. Enahoro, J. A & Jayeoba, J 2013, Value Measurement and Disclosures in Fair Value Accounting. Asian Economic and Financial Review, Vol. 3, No. 9, p. 1170-1179. Khan, U 2009, Does FVA contribute to systemic risk in the banking industry? Working paper, University of Washington. Laux, C & Leuz, C 2009, The Crisis of Fair-Value Accounting: Making Sense of the Recent Debate. Accounting, Organizations and Society, Vol. 34, No. 6-7, p. 826-834. Laux, C., Leuz, C. 2010, “Did Fair-Value Accounting Contribute to the Financial Crisis?” National Bureau of Economic Research: Working Paper No. 15515, [on-line], http://www.nber.org/papers/w15515.pdf. Magnan, M. 2009, “FVA and the Financial Crisis: Messenger or Contributor?”CIRANO: Scientific Series, Montreal. Penman, S. 2006, Financial Reporting Quality: Is Fair Value a Plus or a Minus? Accounting and Business Research Special Issue: International accounting Policy Forum, p. 33-44. Porchazka, D. 2011, The role of fair value measurement in the recent financial crunch, Prague Economic Papers, Vol. 1, p. 71-88. Ryan, S.G 2008, “FVA: Understanding the issues raised by the credit crunch,” Available at http://www.cii.org/UserFiles/file/resource%20center/correspondence/2008/CII%20Fair% 20Value%20Paper%20(final)%20%20071108.pdf Read More