Fair-Value Financial Reporting - Essay Example

Fair Value Financial Reporting Introduction This work critically analyses issues of financial reporting. The focus is on the fair value based financial reporting system. This work examines the main features of a financial accounting system and its strengths and weaknesses. There are many limitations to fair value based financial reporting. Some of the important aspects of this area will be examined in this work. This work argues that fair value based financial reporting is not effective in serving the needs of financial users. The following discussion proves this contention. The basic purpose of financial statements is considered differently in the various countries. For instance, in some countries, including the US, investors and their decisions are considered to be of the highest importance. However, in other nations, such as Germany, creditors are regarded as being the most important. With respect to France, the main consideration is the information needs of the French Government. This has produced different definitions regarding the elements of financial statements. The International Financial Reporting Standards (IFRS) aims to get rid of these differences. It adopts standard definitions and procedures to realize this goal[Ahm10]. These procedures and definitions relate to the preparation and submission of financial statements. In this regard, the self-regulation and legitimacy of the profession of accounting imposes conditions. Its accounting standards have to be credible and possess integrity. This has to be with respect to the nature and substance of these standards. Thus, dishonest and unsound business practices are not seen in financial reports. Moreover, this is not the responsibility of the establishers of accounting standards. All the same, there can be no improvement in professional accountability if the following exists. The financial reporting standards should not allow many choices, interpretations and variations. This is especially true with respect to the value of assets. Emphasis upon professional legitimacy and credibility can have the following outcomes. The accounting standards can lessen chances for interfering partiality, incompetent decisions or interpretation views that increase user uncertainties[Raa08]. Fair Value- Based Accounting The International Accounting Standards Board (IASB)’s Framework for the Preparation and Presentation of Financial Statements specifies the aim of financial reporting. It defines it as the delivery of information relating to financial status and performance, and changes in the financial position of an entity that facilitates economic decision making. Such financial statements tend to be suitable for the customary requirements of users, in general. However, they do not provide complete information that could be necessary for taking economic decisions[Mac111]. This is because financial statements mainly show the financial outcomes of previous events. They do not provide non-financial information always. As such, capital markets obtain a favorable environment by good financial reporting. This is because of its influence on the supposed fairness of these markets. It has been noticed that investors tend to invest funds in markets, when there is a higher level of disclosure and a lower level of risk of fraud or misrepresentation. This being with regard to the productive choices of the securities issuing company. Moreover, the resulting marketability of securities is a function of the supposed fairness of capital markets. In capital markets that have an efficient and comprehensive information system, investors have less doubts regarding insufficient or biased information. This is at the time of buying and selling securities[Pal131]. Thus, fair value accounting provides information about the advantages of assets acquired. It also provides information regarding the burdens of liabilities under the economic conditions when these had been incurred. It examines the effect of decisions of the management on entity performance, with respect to retaining assets or the owing of liabilities, and decisions to sell or acquire assets and incur or settle liabilities[Sco10]. Credibility of Fair Value- Based Accounting System Investors find financial statements to be very useful sources of information. Financial information of firms can be easily obtained from the website of listed firms. The present research in auditing and accounting concentrates upon certain factors. This assists in preventing and detecting financial reporting fraud. One measure is increase in the frequency of restatements. Such restatement is a function of major accounting problems. It indicates the unreliability of the previous financial statements. Moreover, it has been noted that earnings-affected restatements are linked to the probability of fraud[Hua12]. In addition, external audit aims to assure investors about corporate reporting. This has several agency issues between external investors and managers. Audit’s credibility is determined by independence of the auditor and the thoroughness of the audit. If the independence of the auditor is doubtful, then the audit could fail to reassure the investors. Agency problems in auditing could be reduced by public oversight. This could facilitate a specific degree of audit quality and thus improve financial reporting credibility. A major issue is that a large proportion of auditing is not visible to outsiders. As investors observe the audit opinion only, they cannot evaluate the influence of public oversight upon external audit. All the same, the oversight regime generates several outcomes that are observable publicly. These facilitate updated assessments by investors. Moreover, investors can notice changes in corporate reporting, such as the major increase in restatements after SOX had been introduced[Gip15]. Nevertheless, due to its financial status, fair value accounting highlights a precise accounting value for assessing a company. This differs from accounting based upon historical costs. Moreover, it is not necessary to establish the balance sheet at the fair value, so as to fulfil the aim of assessment. The evaluations can be obtained from the profit or loss account by using historical cost. If it is assumed that the essential capital income is known, then, in principle, there is no basis for claiming that fair value accounting is better than historical transactions accounting. As such, settlement is determined by the extent to which the measurement deviates from the ideal[Brî16]. For instance, the economic crisis of Japan has been highlighted by the supporters of fair value accounting. In that crisis, losses of billions of dollars had not been disclosed to the public. These losses had not been made public until it was too late for the public to recover their investments. The Minister of Financial Services of Japan, Yoshimi Watanabe, had condemned the Japanese banks. He had claimed that these banks had worsened the economic difficulties of the nation, as they had not dealt with the losses[Sco10]. Hence, fair value accounting is beneficial, as it orders more frequent valuation. This is of great significance for an entity. This is because the management can take part in activities that maximize market discipline, while avoiding unnecessary risks. In addition, fair value accounting, as per the American Bankers Association, is suitable for assets with the following qualities. These assets should be held for trading purposes. Moreover, it is suitable when the entity’s business is appropriate for assets held for trading purposes. Furthermore, it is suitable when the business model of the entity is managed and founded upon fair value. Some opposition has been expressed, regarding traditional commercial banks; and securities, leases and loans that are retained to maturity. Thus, it has been argued that fair value accounting can be misleading and unsuitable, especially during crises. This has been extended to markets that are not liquid. All the same, banks that concentrate upon customary lending can avoid the effects of such accounting in their income and expenditure statement and balance sheet. This can be done by classifying loans as held-for-investment. Moreover, fair value accounting is not necessary for held-to-maturity securities[Lau10]. As such, between January 2007 and July 2009, US bank regulators had seized bank holding companies that had failed. It was noticed that loans comprised 75% of their balance sheets. The trading assets had no function in this situation. Thus, their balance sheets and trading assets had no function[Lau10]. Therefore, fair value accounting has relevance to assets held with a long-term perspective. Arguments against Credibility of Fair Value Accounting Despite arguments to the contrary, fair value accounting is not perfect. There are several controversies related to fair value measurements. First, application of fair value accounting to markets that are not liquid. Second, how and when modeling is to be used for determining fair value. As such, present credit market conditions have led to huge write-downs through the application of fair value measurements[Pri08]. Most of these charges relate to the broker-dealer and banking industries. As such, the parameters necessary for employing fair value measurements have been criticized. This is because it has produced inaccurate results in the recently noticed abnormal market conditions. These results could damage a company in the long term. In addition, Wallison had strongly criticized fair value accounting. He had claimed that fair value accounting had been the main reason for the reduction in the value of assets and increase in instability among financial institutions. It had also been the cause for the most severe economic crisis in the US after the Great Depression. Furthermore, Wallison had claimed that fair value accounting was highly pro-cycling and that it should be rejected or changed substantially. This would ensure that financial statements would provide information regarding an entity’s stability, instead of its earning capacity. These views had been restated by King, Bloomfield et al., the Chairman of the Federal Reserve Bank and Ben Bernanke[Pro11]. It has even been claimed that fair value accounting could bring about the collapse of the entire banking system. Furthermore, the recent credit crunch had caused the subprime and a few other assets and liability positions severely illiquid and disorderly. This led to several criticisms about fair value accounting. These are: first, fair value accounting identifies unrealized losses that could reverse with time. Second, fair values could become difficult to measure and are therefore unreliable. Third, systemic risk or increase in the overall risk of the financial system could happen, due to the reporting of unrealized losses under fair value accounting by firms. The FAS 157 had been issued in September 2006[Rya08].This standard incorporates has more comprehensive fair value measurement guidance than the previous standards. Moreover, during the recent past, the US markets had been undergoing substantial illiquidity and volatility. This had increased the controversy associated with fair value assessments. The worth of current complex and innovative financial instruments, including derivatives and mortgage-backed securities, is conditioned by the volatility and illiquidity of the market[Pri08]. As such, several empirical studies have shown insignificant, positive and negative differential effects on financial reports’ quality, because of IFRS and US GAAP. Thus, Barth et al. had noted that US firms had better accounting quality than IAS firms. However, Leuz had shown that this difference was negligible. Moreover, Psaros and Trotman had observed results that favored accounting standards that were more principle-based. This difference in results arises from the indirect measures of empirical analyses. These concentrate upon specific features of financial reporting information that can affect financial reporting quality[van091]. All the same, none of these measurement procedures promote comprehensive evaluation of financial reporting quality. Thus, accounting discretion has always been controversial. This has been independent of whether it functions as a conveyor of earnings management or private accounting information. As such, this controversy related to fair value accounting. During the final stages of the global financial crisis of 2008, the FASB issued FSP 157-3. The aim was to control the pro-cyclical effect of fair value accounting. This pro-cyclical effect had intensified the downward trend in the economy. The FSP 157-3 permitted reporting entities to make significant adjustments to market inputs of fair value measurement. This was to be based on assumptions obtained from the private information held by the reporting entities. This modification to reporting had been confirmed by the IASB. However, it has been felt necessary to investigate the influence of the additional discretion granted by FAP 157-3 upon the information content of fair value reporting[Che121]. In addition, it has been asserted by Penman that the implementation of fair value accounting, even if it is assumed to be of benefit, does not achieve success. In addition, the entire process of valuation becomes unreliable when the correlation between exit prices and fair values to shareholders fails. Penman further claimed that fair values are meaningless, when a firm holds net assets whose worth is based upon the carrying out of a business plan, instead of market price fluctuations. Moreover, Dichev and Tang had declared that the employment of fair value measurements reduced value of information provided by earnings. This was because alterations in fair value could not be predicted and that their inclusion made it more difficult to separate the recurring component of earnings. Furthermore, Bezold had suggested that fair value had no utility value, vis-à-vis prediction of future earnings[Mar161]. However, fair value accounting was held to be unsuitable for a market that had to be liquidated forcibly. A major criticism levelled against fair value accounting is that it introduces contagion and volatility to the market. Thus, Forbes had declared that mark-to-market accounting had appeared as a major threat for the economy. In addition, it was the main cause for the financial disaster of 2007-2009[Fah11]. Furthermore, Arya and Reinstein had concluded that fair value accounting had worsened the recent financial crisis. This had happened as it had forced the write-down of good assets, on account of diminished market prices. Conclusion The intention of fair value based reporting system was to assist the financial users in their decisions. There are advantages and weaknesses in this system. For instance, the fair value accounting method identifies the losses in a timely manner. This forces entities to adopt appropriate measures early. In addition, it makes it difficult to hide potential problems that could worsen the crises. However, this benefit is offset by many disadvantages. For instance, fair value accounting brings in instability in financial statements when prompt action is not required. Moreover, full fair value accounting can produce unsuitable outcomes during times of crisis. Moreover, it has been argued that fair value measurements produce inaccurate results, when market conditions are unusual. It has also been claimed that these results cause substantial damage to companies, in the long run. The opponents of fair value accounting have declared that whenever, a company is compelled to record losses, investors are presented with information that could be misleading. Therefore, these critics assert that it would be desirable to record just the actual gains and losses. Nevertheless, internal control of accounting in organisations, enables financial monitoring. In addition, the financial reporting framework enables communication of financial and accounting information. This is regarding decision making processes. Moreover, this framework promotes consistent and reliable information. When internal control is not satisfactory the reporting tends to be misleading or incorrect. Having the same accounting processes across the world provides several benefits. These are: completeness, consistency, comparability, reliability, relevance, transparency, and verifiability. These outcomes effect a change in the quality of accounting information reports. This improvement promotes the confidence of investors. Moreover, it empowers investors and other users of accounting information. In addition, it assists acquirers to estimate the true worth of target companies. As such there are many controversies connected with the role of the fair value-based accounting system. From the above discussion, it can be assumed that fair value-based financial reporting is not of benefit to financial statement users, under all circumstances. 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