Effects of Global Financial Crisis on the Market - Coursework Example

I. Introduction This paper aims to explore how and why financial ments do not necessarily reflect the true and fair value of a company and its activities. The paper starts by exploring the concept of value, then the relative difficulty of establishing a way to set fair value, and its relation to choosing prices as the major determinant of value in the capital markets. Then, the global financial crisis with regard to the bubble that has preceded it is explored, and what has happened. Lastly, the impact of the fair value method of accounting on companies financial statements during the global financial crisis is discussed. II. Body A. Definitions of value Value has been defined in more than one way. In the business world at least, the definition of value ranges from that of finance, to that of marketing. The difference in use according to these definitions are usually the common cause of conflicts with regard to the use of the term. In basic finance, value, or more specifically the value of an asset in economic terms is best defined as the sum of the future benefits, or cash flows to the company which is discounted to the present (Wallace 2008). This is more commonly referred to as the fundamental value (Hanney 2008). On the other hand, built on the argument of benefits that are to be received, value in marketing is usually linked to the asset price that the buyer is willing to pay (OKelly 2008). This is the perceived value. As value is linked to utility, which is linked to perception of future benefits to the receiver of a thing, these two definitions of value, although related in the most basic way, are usually confused when being used (Rossi III, 2009). Perceived value is the concept of true value being reflected in price of a traded commodity (Wallace 2008). This link between value and the price is held by the efficient market theory, where the price includes all the available information in the market and is a good predictor of value (OKelly 2008). Capital markets are considered efficient markets where investors are assumed to be sophisticated, rational individuals who maximise their wealth and utility, and thus only accept prices that reflect the true value of the commodity (Campbell, Owens-Jackson & Robinson 2008). This provides the link between the definition of fundamental value and the perceived value. B. Fair value accounting Accounting regulatory boards have find it hard to define the concept of fair value. According to McCollum, “obtaining information relevant to fair value is one of the biggest challenges organisations and auditors face in the current market (2008, 14).” While regulatory boards such as the Financial Accounting Standards Board and International Accounting Standards Board try to define a concrete definition of the value, the closes that they can get is a specific hypothetical market price under idealised conditions (Hitz 2007, 326). Fair value has been defined by the FASB in SFAS 157 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (Trussel & Rose 2009). The aim of SFAS 157 is to apply common sense and judgement if a certain market is inactive, and using an alternative way to find the fair value of the asset (Wilkie 2009). There are advantages and disadvantages to using fair value in accounting. As according to Penman, “Fair (market) values are a plus when value to the shareholders is determined solely by exposure to market price; that is, shareholder value is one-to-one with market prices (2007, 38). […] Fair (market) values are a minus when the firm arbitrages market prices. That is, fair value is not appropriate when the firm adds value (for shareholders) by buying at (input) market prices and selling at (output) market prices.” In short, the concept behind the fair value is that it captures the economic quality of the investment with the information that is included in the market price; they are also more requested by statement users (Miller & Bahnson 2009). If the shareholder or fundamental value is not one-to-one with market price because of other factors that influence price, therefore when firms record their asset prices using the fair value method, the financial statements do not reflect the true value of the assets. C. The FAS 157 Fair value is considered by many accounting regulatory boards as the most superior reporting method. Under the FAS 157, assets can then be classified into three levels when they are valued. Assets that are highly liquid and easy to value at direct market prices (Pozen 2009) are classified under the Level 1 method. In the absence of market prices, financial executives are allowed to use the Level 2 method where they can use observable market inputs such as trading prices and discounts for securities similar or related to the ones being valued (Pozen 2009). In the absence of all these inputs or because of illiquid markets, assets are valued using the Level 3 method, where financial executives are allowed to use marking to model instead of marking to market using reasonable assumptions (Pozen 2009). Level 3 has been criticised by academics because of subjective requirement behind it. As financial executives can decide on how to price their assets using significant assumptions, this can result in a lot of subjective bias (Boyle 2008), which can result in lower confidence among investors (Finweek 2009). Financial executives are then required to disclose all the basis for their judgement in estimating the fair value of their assets under the Level 3 method (Boyle 2008). D. The markets response to the global financial crisis The concept of fair value being linked into the fundamental value of the assets through the prices hold only in efficient markets (Accounting 2009). The assumptions that investors are rational, wealth-maximising individuals acting on the basis of perfect information with price as the predictor should be met in order to incorporate the concept of fair values (Rossi III 2009). In events such as manias and bubbles, this efficient theory of the market does not hold, thus, the concept of the fair value is lost (Hitz 2007). This has been the case during the start of the sub-prime mortgage crisis. As investors become alerted by the growing problem, chaos and panic have started (Van Deventer 2008). Instead of a rational evaluation of the assets using the concept of fundamental value, investors have gone panicky about what will happen with their investments until the whole capital markets go down and tumbled (Ryan 2008). Perceived value has taken charge; as firms go bankrupt more of the result of capital flights (Ryan 2008), investors perceive their investments to be of little or no value which has been incorporated in the market price (Ryan 2008). Therefore, instead of investors acting as rational individuals, being driven by fear and other emotions, the price instead reflects a distorted perception of an assets value (Rossi III 2009); hence, the market becomes stagnant and illiquid (Hitz 2007). This is when the fair value does not incorporate the true value of a companys activities. E. The effect of global financial crisis on the companies financials through the fair market value accounting When panic has set in because of the global financial market, investors view their investments as something of little or no value. This perception has led them to sell in the capital markets, which has lead to increase in supply (Van Deventer 2008). When scepticism has continued, the demand has fallen so much more (Van Deventer 2008). These increase in supply and decrease in demand have lead to very low asset prices. The worst has not yet ended with this. Even with the efforts for financial markets to recover, some asset markets become stagnant where investors are reluctant to trade, and the markets become illiquid (Hitz 2007). Because of the fair value method of accounting, the assets of companies are reported according to the prices of the market (Practical Accountant 2009). Since there are very little trading activities in some capital markets, the prices do not go upward and remain low (CPA Journal 2009). This has resulted in huge losses that in the companys financial statements (Landy 2009). However, it is to be noted that the fair market value that is being reflected in the companys financial statements are the low price in the market (House 2008), which is a product of the interaction of the supply and demand of the asset in the market—a result of the emotional reaction of investors to the sub-prime mortgage problem (Campbell, Owens-Jackson & Robinson 2008). In this case, the financial statements of the companies fail to reflect its fundamental values, because the value is distorted. III. Conclusion Financial statements do not always capture the fair market value of its assets as well as its liabilities. Because fair value accounting is based on the assumptions that asset prices are the closest to reflect the fair value, prices are subject to factors other than the ones that regulate the efficient capital markets. A companys fundamental value is assumed to be reflected to the assets prices, which is aligned with the investors perceived value of it. However, distortions happen especially in times of mania and bubbles. The bubble that had preceded the global financial crisis made investors to act irrationally, which has resulted in changes in price dynamics, not necessarily a change in fundamentals. The increase in supply and the decrease in demand for assets happen because investors perceive their investments as having very little or no value at all. These have pushed the prices of the assets so low. In these cases, the perceived value is not in line with the fundamental value. 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