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Accounting for Financial Instruments for Securities and Investment Companies and Banking Institutions - Term Paper Example

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This term paper "Accounting for Financial Instruments for Securities and Investment Companies and Banking Institutions" discusses fair value measurement that provides a solid framework on which policy guidelines for valuation and accounting for fair value goes on for various companies…
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Accounting for Financial Instruments for Securities and Investment Companies and Banking Institutions
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?Sur 08 March 8, Accounting for Financial Instruments for Securities and Investment Companies and Banking s The accounting policySFAS 157 (ASC 820-20) Fair Value Measurement has an effect that cuts across a number of industries. The impact of the Fair value Measurement accounting policy on the different industries will extend far into the future although its application of the accounting policy across many industries varies considerably. In particular, the use of the SFAS 157 accounting policy differs in its application for the banking industry and investment companies. Recent bouts of credit crises have ended in lasting implications in which financial instruments have stringent regulations. International accounting standards demand that certain procedures get disclosure in the accounting and valuation of financial instruments and securities. The standards are highly specific on fair value measurements for different classes of financial instruments. The objective of this report is to debate the differences in accounting for financial instruments and securities in investment companies and banking corporations with regard to SFAS 175 (ASC 820-20). Introduction Advancements in economic perspectives are responsible for the unprecedented increase in the use of financial instruments. Therefore, accounting regulations bodies have had to come up with policy guidelines to keep pace with these changes. Policy changes in regulation of financial instruments will continue to affect the industry for many years to come. An intriguing and somewhat challenging issue pertaining to the use of financial instruments and securities is the difference in their usage across a range of industries. SFAS 157, on fair value measurements, seeks to fill this important role and resolve any obstructing issues. This paper discusses how the financial reporting standard varies for the investment and the banking industries. SFAS 157 (ASC 820-10) Fair Value Measurements The fair value measurement standard, which came into force in 2006, seeks to provide a unified framework that offers greater consistency in application of fair value measurement guidelines (J.P. Morgan, 2).SFAS 157, Fair Value Measurement, defines fair value, outlines a framework for its measurement through levels, and expands disclosures relating to fair value. The accounting statement provides a major pronouncement to the measurement of fair value for financial instruments, and its effects spread to several corporate entities. The broad mandate of the SFAS 157 is to increase disclosure requirements for fair value measurements. IFRS standards require that the measure on securities be at fair value. Previously, accounting regulations on measurement of value for financial instruments were scattered and inconsistent, and the Fair Value Measurements guidelines’ intention was to lay a foundation for all fair value measurements, disambiguate the term ‘fair value’, and enhance disclosures falling under the fair value categorization (Deloitte, 7). To some extent, the disclosure of the financial instrument values and particularly securities differs with the industry type, notably for the banking and the investment industry. Terms on Fair Value Measurement In SFAS 157, fair value is the price at which an asset is saleable or transferrable between participants in the market at the date the measurement takes place (J.P. Morgan, 3). Inputs can either be observable and unobservable, where the observable inputs are indicative of the market conditions and the unobservable inputs indicate the company’s perspective on the price of an asset. An active market is one where daily price is obtainable and the fair value is easy to obtain without reliance on forecasting models or other forms of adjustments. Accounting for Financial Instruments and Securities Financial instruments are negotiable cash instruments with a certain financial worth. Financial instruments give an entity the right to receive or the commitment to provide cash or another financial instrument to the other contracting party. Financial securities, otherwise known as securities, are forms of financial instruments. Financial securities include bonds, debentures, and banknotes for primary securities (wiseGEEK, 1). Secondary securities include common stocks, preferred stocks, and other types of stocks. The purpose of issuance of securities is to raise money or capital. Investors interested in generating money through interest on securities supply the targeted funding. Some of the securities bear considerable risk implications for the investors, and therefore, government and industry regulations are in place to ensure investors and all stakeholders involved get some form of protection on their funds. Other forms of securities include derivatives like forwards, futures, options, and swaps. Banks and investment companies alike issue securities. Impact of SFAS 157 (ASC 820-10) ‘Fair Value Measurement’ on securities and investment companies and banks with regard to accounting, valuation, and disclosure The fair value measurement seeks to put in place techniques to help give a more concise report though a prioritization of inputs. Inputs refer to the presumptions upon which pricing of assets occurs. Further, the inputs are classifiable as observable, which depends on external market data, and unobservable inputs, which develop internally within the industry. Banking institutions make use of what the SFAS regulation would regard as unobserved input. Banks tend to rely heavily on internal systems of measurement to determine the value of various financial instruments. Widespread use of block discounts by banking institutions has had major overhaul from the new accounting dispensation. Similarities for Banking and Investment Companies J.P. Morgan has a significant securities and investment arm, which deals with corporate bonds and government bonds just like Citigroup. For this group of financial instruments, which fall under level 2 of the SFAS 157 regulation, the corporate can sufficiently establish the fair value measurement for the securities through the active market prices of the same (Wikinvest, 1). Bonds trade freely in the market and the fair market price is easy to establish. Generally, for both the securities and investment companies and banking companies, the AFAS 157 has increased the reliance on observable data to determine the fair value of their financial instruments. Differences in accounting and valuation of financial instruments for securities and investment industry and banking industry The fair value regulation has put in place a hierarchy for the classification of various financial instruments. There are three levels: level 1, level 2 and level 3. The differences in accounting for financial instrument, therefore, lie in the level in which each establishment primarily trades in. The level of placement of a financial asset affects its valuation regulations, and the level of disclosure the input requires. For instance, level one assets do not allow adjustments such as block discounts. At this level the entity is at liberty to formulate its own pricing mechanism for a financial instrument where the active market price for the commodity is unavailable for the specific product even though it is also available for identical financial products. Level one financial instruments include exchange related equities and exchange related derivatives. For the level two instruments, there is need for evidence of a two-way flow in the instruments within the market, purchases, and sales. This level of assets has readily available observable inputs from the active market for the valuation in fair value measurement. Level 2 financial instruments include privately placed bonds, OTC rate swaps, forwards, government bonds, corporate bonds, CDOs (Collateralized debt obligations), and high-yield debt securities among others. Level three instruments have a higher unobservable element in gauging their fair value, and the transactions involving this class of financial instruments are not two-way. Level three financial instruments include long-dated commodity swaps with directly observable market data for establishment of fair value, shares of private companies, limited partnerships, and mortgage servicing rights (J.P. Morgan, 5). For instance, in the valuation of derivative positions, Citi now factors the default risk into the valuation, and eliminates the use of servicing adjustment (Wikinvest, 1). The regulation on block discount was of particular impact to Citigroup, as the practice of using block discount was in wide usage in the company before the regulation came into place. The banking establishment also relies more on observable input for valuation of derivatives in comparison to the past (Wikinvest, 1). J.P. Morgan on the other hand uses the Black-Scholes pricing model when establishing the fair valuation for derivatives. The company also makes use of models, which have a wide usage in the industry. However, for its less developed markets, J.P. Morgan gives the derivatives a level 3 hierarchy according to the AFAS 157 hierarchy (J.P. Morgan, 3). Normally, derivatives belong to level two, but for the underdeveloped markets, their pricing depends highly on unobserved inputs, unlike in active developed markets where observable data is available to make fair value judgment on the price of the financial instrument. Most of the financial instruments traded by J.P. Morgan are treated as level two assets, and are valued at the market price, which is usually the bid price. The valuation technique for each class of financial instrument contained in each disclosure and your understanding how they are applied Both Citi and J.P. Morgan have adopted the fair value measurement policy. Their valuation of financial instruments is in levels. Each of the companies seeks to capitalize on the use of observable input to disclose the fair value of the financial instruments. J.P. Morgan uses the technique of active market valuation for most of its securities. Active market price is an observable input according to the SFAS policies, and J.P. Morgan takes this to be equal to the bid price for the securities (J.P. Morgan, 3). Citi, makes use of observable input, but still incorporates elements of unobserved input to establish the final fair value, particularly for the default risk element. In addition, the bank has done away with the use of block discounts and portfolio servicing adjustments. Conclusion Fair value measurement provides solid framework on which policy guidelines for valuation and accounting for fair value goes on for various companies. Some elements of the policy guidelines are similar for both the banking and the securities and investment companies, while some vary considerably. The variations are highly attributable to the nature of the financial instruments each of the two entities primarily trades. For level one financial instrument, disclosure and determination of fair value varies, as does for the other two levels. The study reveals the various ways in which industries have to change their initial accounting and disclosures strategy to be more compliant to the AFAS 157 accounting policy. The general drift is towards the use of observable or active market pricing for financial instruments in both investment and securities and banking industry. Differences still abound in the application of the fair value measurement guideline, although the AFAS 157 regulation is an accounting regulatory framework, which causes more differences in the way industries apply fair value measurement, and the impact the policy will have on the industries in future. Works Cited Deloitte. Technical Brief for Investment Companies. Deloitte. 2011. Pp. 1-7. Web March 6, 2012 < http://www.deloitte.com/assets/Dcom-CaymanIslands/Site%20SMF/EN/ Services/ Audit/Techbriefforinvcompanies_vol1.pdf> J.P. Morgan. Response to FASB ASC Topic 820, Fair Value Measurement and Disclosures. J.P. Morgan. 2012. Web March 6, 2012 Wikinvest. Citigroup. Fair Value Measurement. Wikinvest. 2009. Web March 6, 2012 wiseGEEK. What is a financial security? wiseGEEK. 2012. Web March 6, 2012 < http://www.wisegeek.com/what-is-a-financial-security.htm> Read More
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