Measurement in Accounting - Coursework Example

Reading Header: MEASUREMENT IN ACCOUNTING Your institution: Your name: Course name: Course instructor: March 28, 2010 TASK Measurement in accounting is a complex area. Measurement issues generally and in particular the use of fair value measurement, have contributed to the Current Global Financial Crisis”. Discuss. INTRODUCTION Accounting is generally defined as the art of identifying, recording, classifying and summarizing in terms of money, event and transactions which are of financial character and interpreting the results thereof. It is very important to note that only those events and transactions which can be measured in terms of money are recorded in books of accounts. From this accounting principle, any fact or occurrence which cannot be expressed in terms of money is not possible to record in the accounting books. In any country, the measurement unit shall be the base money unit of that country or the most relevant currency. For example, due to hyper inflation levels in Zimbabwe, the local currency has lost it value and this affected the economic viability of the currency. The economists have decided to introduce the US dollar as the currency. The main objective is to make the accounting records relevant since it would not be easy for comparison of records of different entities in and outside the country for unstable currency like that of Zimbabwe. Accounting is not a recent discovery in the world but it dates back more than 7000 years. It was first discovered in the Middle East where farmers used to keep simple records of their livestock and crop produce. Accounting has gone through major developments since then and there has been much debate on which is the best way of reporting accounting information. Accounting Information is very crucial to various stakeholders of the economy and each one of them uses it for different purpose. Among the interested groups of accounting information of an organization include: the management, shareholders, government, creditors, potential investors, and the public. All these groups need this information so that they can be able to make sound decisions on their stake in the reporting entity. Therefore in is very important for the information included in the accounting books be fair and true so as not to mislead. To achieve this, accountants should ensure that they adhere to the accounting principles and any assumption is well articulated and generally acceptable. Though there have been many achievements in accounting profession, measurement issues continue to disturb the minds of experts. It is not clear which is the best method of measurement and under what circumstance. Historical accounting is the earliest method of recording accounting data. But expert argue that this method sometime maybe misleading and can be deceitful on certain circumstances. For example, recording the value of an asset on its original price is going to show untrue value in the balance sheet. Though depreciation may be deducted but in reality the asset may not fetch the same price in the market today. On the other hand, fair value may also not be the best way to record the value of the same asset in the balance sheet. This is because, in economics the price is determined by various factors and these factors are deemed to change from time to time. Therefore the price of the asset today may change tomorrow. CONTRIBUTION OF THE ACCOUNTING MEASUREMENT TO THE GLOBAL FINANCIAL CRISIS A difficult moment has hit again the global economic history. This has been experienced most in large stock markets. These shock waves have led to business failures, bankruptcies, increased unemployment, and long period of economic derail. To address the issue governments are trying to bail out big companies and introducing economic stimulus programmes to avoid breakdown. For example the US government has bailed out two major motor manufacturers and the action seems to bare good fruits. Also there has been an introduction of inexpensive high speed computers, internet, cheap global communication, highly efficient robotic manufacturing and other major innovations which have enhanced productivity and wealth creation. The biggest question that most people have been asking themselves is how did this economic crisis came to be when accountants in large companies prepare detailed financial statements and this statement are analyzed by experts for active decision making. It is argued that if at all accounting is to be relevant it should be predictive. But this seems not to the case even after accounting regulation bodies like International Accounting Standard Board (IASB) releasing revised standards continuously. It is evident that this accounting information reported do not reflect the economic reality. In addition auditors though entrusted to detect any misrepresentation of information in the accounting books either fail to perform sufficient detailed transaction analysis or simply ignored the problems because of the generous fees they are paid for their services. Another heating debate on the causes of global financial crisis is the contribution of the fair value accounting (FVA). First, there has been controversy on what is different and new and different about FVA. Second, it is less clear that these problems apply to FVA as stipulated by the accounting standards. On the third instance is that HCA/ historical cost accounting has low percentage that it would provide the required remedy. As a matter of concern these problems could be larger with HCA than with FVA. Fourth, it is difficult to blame FVA standards themselves when the problem might be with the implementation especially with respect to litigation. Major debate involving the EC, US, accounting and banking regulators among others has been going on the FVA. Critics argue that FVA which is often called mark-to-market accounting (MTM) has contributed to global economic crisis. It has also extended it impacts to the financial institutions in the U.S.A involving other nations of the globe. But proponents of FVA argue that it merely played its role as a messenger. From this point, in this paper we are going to look on how the critics argue on the contribution of FVA to global financial crisis. First, FVA is precyclical i.e., it expands swings in the financial system in it application through the business cycle. It may cause downward spiral in the financial markets. It is argued that during boom in the economy FVA and asset write ups will allow banks to expand their leverage levels. This in turn makes the financial system more vulnerable and crisis more severe. In the contrary, HCA prohibits asset write ups in booms and creates secret reserves which are drawn in times of crisis. This argument ignores that FVA provides early warning signals for upcoming crisis and hence may render banks to take right measures early enough. Consequently FVA may in reality reduce the severity of a crisis. The reason behind banks choosing to hold hidden reserves under HCA which has lower leverage is normally driven by the book equity rather than the market value of the equity. This is due to the regulatory capital requirement. HCA and fixed regulatory capital ratio based on book value result in dynamic regulation where banks have lower leverage ratios when measured in market values during boom when fair value exceed historical costs during recessions. A bank can also increase its leverage during boom time under HCA by disposing assets and retaining a small claim on it. This was the case when banks securitized their loans. From this argument it is very logic and appropriate to conclude that it is more advisable to change the banking regulation than the accounting system. The second argument on FVA is that it triggers corruption in the financial markets. The fundamental idea on this is that banks may trade their assets at a price below the true value and the price from these sales is relevant to other institutions that are obliged by FVA to trade their assets to market. This argument needs support of some direct and indirect ties to the accounting system. These ties will trigger the sale of the assets. Accounting based regulatory capital requirements for banks can lead to corruption. Management with shot term goals can create similar effects by focusing only on short term accounting earnings because they are concerned on current market prices which result to indirect ties. Similarly rating agencies create indirect ties when they use of accounting information and issuing ratings used in debt contracts and capital requirements. FVA in its pure state and under nay situation can create corruptive effects. To respond to these FVA effects there are a number of ways to accountants address the problems. One solution is to use HCA. Valuing assets at their historical cost shield banks from market price changes and from prices that are instituted by other banks and from potential harmful spill-over effects. HCA may create incentive for the banks to employ inefficient asset sales to get early earnings. This problem should not be underestimated in practice. The capacity of banks to engage in “gains trading” i.e. selling financial instruments selectively with unrealized gains and holding on to those with losses was a major motivation to introducing FVA for these instruments. In addition securitization of loans which were accounted for at the repaid cost and contemporary held to maturity could be affected by banks’ desire to realize accounting profits early. Before this crisis the trading of securitized loans was liquid enough and gave banks a chance to earn substantial gains from loan origination. Even if there are problems with FVA it is not clear that HCA will solve these problems. To deal with contagion in the accounting system, it is better to deviate from market prices. GAAP and IFRS allow these deviations in certain situation. The standards clearly states that market prices from forced sales should not be applied. This is meant to protect against damaging spillover from the troubled banks. The standards also allow the application of valuation models to obtain the fair value when markets are inactive. This mitigates contagion impacts in a financial crisis.\ CONCLUSION FVA is not responsible for Global Financial Crisis. FVA is not a measurement in accounting that reports assets value without economic consequence on its own. From the above debate many of the arguments need further scrutiny and it is clear that the controversy results from confusion on the purpose and what is new about FVA. In a study conducted by SEC mandated by Economic Stabilization Act of 2008 argue that FVA did not lead to bank failures since the fraction of assets reported at fair prices was insignificant in most cases. And where it was larger the share prices shown even higher losses than what banks reported. REFERENCES Drever M. & McGowan, S. 2007, ‘Contemporary Issues in Accounting’, John Wiley & Sons Australia. Forster, J. 2010, ‘The Global Financial Crisis’, John Wiley & Sons Australia. Reading list: 1.Laux, C & Leuz, C 2009, 'The crisis of fair-value accounting: Making sense of the recent debate', Accounting, Organisations & Society, vol. 34, no. 6-7, pp. 826- 834. 2. Liu, J & Taylor, D 2008, 'Legitimacy and corporate governance determinants of executives' remuneration disclosures', Corporate Governance, vol. 8, no. 1, pp. 59-72. 3. Deegan, C & Blomquist, C 2006, 'Stakeholder influence on corporate reporting: An exploration of the interaction between WWF-Australia and the Australian minerals industry', Accounting, Organisations & Society, vol. 31, no. 4-5, pp. 343-372. Stevens, D & Thevaranjan, A 2009, 'A moral solution to the moral hazard problem', Accounting, Organizations & Society, Vol. In Press, Corrected Proof. 5. Guthrie, J Cuganesan, S & Ward, L 2008, 'Industry specific social and environmental reporting: The Australian Food and Beverage Industry', Accounting Forum, vol. 32, no. 1, pp. 1-15. 6. Kuruppu, S & Milne, M 2010, 'Dolphin deaths, organisational legitimacy and potential employees' reactions to assured environmental disclosures', Accounting Forum, In Press, Corrected Proof. 7. MacKenzie, D 2009, 'Making things the same: Gases, emission rights and the politics of carbon markets', Accounting, Organisations & Society, vol. 34, no. 3-4, pp. 440-455. 8. Biondi, Y & Suzuki, T 2007, 'Socio-economic impacts of international accounting standards: an introduction', Socio-Economic Review: Special Issue: The Socio Economics of Accounting, vol. 5, no. 4, pp. 585-602. Read More