Fair Value Accounting, Financial Economics and the Transformation of Reliability - Essay Example

A Critical review of “Fair value accounting, financial economics and the transformation of reliability Introduction” by Michael Power In the journal article, Power addresses the question and the reasons for the use of fair values or practices during accounting before the year 2007 despite there being several misgivings about the fair practices (Power 2010, p. 197). He argues that there are four reasons that led credence to the need to have the fair practices in accounting which include cultural authority involved in financial economics and the fact that accounting problems that require derivatives provide platforms and catalysts that require that fair values are provided for accounting purposes and financial instruments. Moreover, the changing of the traditional balance sheet by conceptual frameworks from a legal to an economic institution required that both assets and liabilities are economically viable, which could only be guaranteed by fair practices in accounting. Finally, fair value became integral in the development and transformation of professional and regulatory identity for those that are involved in the setting of standards. Power therefore stresses that for fair values in accounting to be successful, there is need to understand such parameters such as measurement, reliability, financial economics, accounting policy and the different financial instruments. Power addresses the reasons as to why there was need to change into fair practices in accounting and its significance arguing that it did not just come up because of forensic analysis of the developments in the financial market. The reason for the transformation to fair practices is due to the contest between fundamentally different accounting concepts in terms of reliability majorly based on market-based and marketing simulation that competes with the traditional transaction-based model. He draws summaries on fair value and the distinctive notion of accounting and therefore reliability as articulated before the financial crisis of 2007 emerged. Power further deals with the rise of financial economics as a challenge and an important cultural resource for financial accounting stating that the preconditions for fair value can only be achieved through open-minded delivery of decision significance for accounting that must take into consideration the market dynamics. To him, the problem in accounting practice for derivatives many a times pose a great challenge on the credibility of accounting, but may at times work in catalysing the appreciation of the importance of fair value and reliability as required of accounting. Power also states that the de-legalization of the traditional balance sheet by continual theoretical background developments fashioned a call for accounting numbers /reports that are meaningful in the balance sheet. The effect of this has created an opportunity to promote fair value and the doing away with the concept of realisation in accounting. He finally draws on the relevance and importance of political economy of the international accounting policy that he gives as the reason for adoption of fair value as an accounting standard in the global financial market. Fair value and the reshaping of reliability Fair value can described as the outlay that would be received by a person or an entity when he trades an asset or reassign a liability in a business deal deemed as orderly between participants in the marketplace at the date the transaction is carried out (Power 2010, p. 198). Therefore, proponents of fair value appeal that those involved in accounting tell things ‘as they are’ and improve transparency motivated with the need to potentially minimize the freedom to manipulate the accounting numbers (Leuz, Pfaff & Hopwood 2004, p. 42). Reliability on the other hand is one of the fundamental qualitative characteristics of accounting information founded based on a consensus whose strength is empirical as opposed to conceptual facts (Power 2010, p. 200). As a benchmark, accounting reliability focuses on the liquid but orderly markets where assets can be exchanged easily while at the same time liabilities are transferred with ease. However, accounting reliability witnessed in accounting report is dynamic and may change as bodies of valuation knowledge become acceptable as a basis for transaction (Ernst & Young 2008, p.168). From the foregoing argument, fair value can be understood as a transformation in the expertise base of accounting while reliability is basically for relevance purposes with an implicit need for external valuation expertise. It is also important to note that fair values are not real market values but are estimates of the market prices that would or could be obtained as at that time and depend on critical assumptions about markets deemed as orderly. The rise of fair value in accounting can therefore be attributed by the need provided by the conceptions of ‘good accounting’ from within the accounting community that seeks to align the profession to the dynamics of the market (Bank for International Settlements, European Central Bank, & World Bank 2011, p. 105). Financial accounting is also described as composed of many disciplines that incorporate the cultural authority of financial economics that encompasses both fair value and reliability in accounting practice. Therefore the relationship between accounting and economics in terms of value are found in the determination of accounting for derivatives as well as the financial instruments used in financial accounting (Power 2010, p. 203) Conclusion The financial crisis experienced in the years starting 2007 raised the stakes in the debate about fair value and due to the requirements of the FASB and IASB on fair value in accounting; banks have been forced to either adopt them albeit with flexibility conditions. The proponents of fair values in accounting practice insist that it must be adopted irrespective of the market conditions. However, its opponents have expressed concern at the often witnessed political intervention in what should otherwise be an independent policy and regulatory process. Also, it is noted that accounting reliability is just a matter of the sufficiency of social consensus on the shift from the legally documented transactions to a financial reality of both the assets and liabilities as measured with expected cash flows (Power 2010, p. 209). Finally, it is imperative for scholars and practitioners in the accounting field to note that the adoption of financial economics into the practice of accounting through the fair values practice is impure, partial and pragmatic in that it is not absolute but highly selective. Reference List Power, M. 2010. Fair value accounting, financial economics and the transformation of reliability. Accounting and Business Research, Vol. 40. No. 3. pp. 197-210 Leuz, C., Pfaff, D., & Hopwood, A. G. 2004. The economics and politics of accounting: international perspectives on research, trends, policy, and practice. Oxford: Oxford University Press. Top of Form Bank for International Settlements, European Central Bank, & World Bank. 2011. Portfolio and risk management for central banks and sovereign wealth funds JEL classification: E58, F33, G11 Bottom of Form ERNST & YOUNG, 2008. International GAAP 2008 generally accepted accounting practice under international financial reporting standards. Hoboken, NJ: John Wiley. Read More