Fair Value Reporting And The Financial Crisis - Essay Example

Fair Value Reporting And The Financial Crisis This paper analyzes this concept of fair value accounting, highlighting its advantages and disadvantages. This paper is also concerning with apprising the statement that one of the reasons that led to the financial crisis, is the use of fair value accounting by business organizations. It takes a critical look at this concept of fair value accounting, with the intention of finding out whether the statement above is true or false. This paper will also identify other accounting measurements, and it will give the benefits and drawbacks of fair value accounting, in relation to these other measurements. Fair value accounting is unbiased and rational estimate of the market price of a service, an asset, or a product. The concept of fair value accounting takes into consideration factors such as the demand and supply, the distribution, production, and acquisition costs, the various costs of the products close substitutes, the utility produced at any given level of development, etc (Zyla, 2012). These are referred to as the objective factors of fair value accounting. There are also some subjective factors of fair value accounting, and these factors include, the utility which is individually perceived, the risk characteristics, the return on, and cost of capital. It is important to understand that accountants use fair value reporting to depict the market value of a product or a liability, which in most cases; it is difficult to determine their market price. The FAS 157 defines fair value accounting as a value in which an asset can either be sold or bought in a current business transaction that involves willing parties (Zyla, 2012). It is important to understand that fair value accounting is used for assets which have a carrying value that is based on the mark-to-market valuations. It is also important to understand that the fair value of an asset that has an historical cost is not always used. It is important to understand that the financial crisis began with the decline of the housing prices, and with an increase in the default rates. There was uncertainty in the financial market because of lack of accurate information from policy formulators. Availability of information is always crucial for the survival of investment banks, investment funds, and bank holding companies. Özkan and Unsal (2012) observes that lack of information and the illiquidity of the financial market led to serious problems in determining the fair values of the various financial assets and securities. Posner (2009) further denote that the model of investment banks and funds is built on market values. On this basis, the use of fair value reporting is not an option, but a necessity. It is also important to understand that during this period, investors were more concerned with investment funds that had a substantial subprime mortgage exposure. On this basis, there was a nee of high transparency from managers of these funds, to their investors or shareholders. Scholars denote that during the financial crisis, there was a need of high transparency, as investors needed information for purposes of making sound financial decisions. On this basis, Posner (2009) believes that the use of fair value reporting helped to reduce the impact of the financial crisis, as opposed to increasing the impact of the financial crisis. It is also important to understand that the notion that most banks used the concepts of fair value reporting during the financial crisis is incorrect. In fact, Zyla (2012) observes that banking organizations used a variety of protective measures and safeguards that were built from the practices of fair value reporting to protect their investments and business operations during this period of time. For example, scholars denote that a variety of banks, with large trading portfolios and real-estate exposure used the cash-flow based models, for purposes of valuating their mortgages, during the periods of 2007 (Posner, 2009). On this basis, it is very inaccurate to denote that the use of fair value accounting was responsible for increasing the problems associated with the financial crisis. It is important to understand that that financial crisis was characterized by a drop in the housing market, and an increase in the mortgage default rate. On this basis, uncertainty grew over how institutions should value these securities, and the quality and value of assets and other securities held by investment banks (Fiolleau and Hoang, 2010). Examples of these mortgage related securities that are held by investment banks includes the hedge funds. In 2007, when the financial crisis was severe, there was an outflow of these funds, and institutions such as BNP Paribas, and Bears and Stearns disallowed any withdrawals and redemptions of funds. Fiolleau and Hoang (2010) denote that the argument given by these investment banks was that it was impossible to determine the accurate value of these financial assets. This is a concept of fair value reporting, which insists on valuating the value of an asset based on its market price. However, Scholars denote that the use of the concepts of fair value accounting to stop the withdrawals by these investment banks was just an excuse to hold onto the financial assets. This scholar further goes on to denote that the real reason as to why investment banks such as Bears and Stearns refused to allow the withdrawals of financial securities within their possession is based on the notion that these financial securities were financed by short term debts. On this basis, massive withdrawals would lead to a severe financial problem to these institutions and their investors. Milne (2013) observes that in as much as these investment banks used the concepts of fair value reporting in their financial statements, they exaggerated the values of their financial securities. For instance, institution such as the Merill Lynch sold their collaterized debt to a tune of 30.6 billion dollars, inaccurately denoting that it made a loss of 4.4 billion dollars (Milne, 2013). Bears and Sterns also faced an accusation from Barclays Bank of inaccurately depicting the values of their financial securities, making the banking organization to make investments that were not accurate (Bondt, 2010). Scholars denote that the principles of fair value accounting require companies to accurately state the market values of their financial assets. In accurately depicting the values of these financial securities is not a concept supported by the principles of fair value accounting. In fact, scholars denote that the main reason as to why investment banks suffered greatly during this period of financial crisis is poor investment decisions from these banks, high leverage policies, short term debts, and the concerns of investors about the values of their underlying assets. On this basis, Bondt (2010) believe that it is inaccurate to denote that the aggressive write downs brought about by fair value reporting was one of the major causing leading to the acceleration of the financial crisis. In fact Larkin and DiTommaso (2013) observe that after the crisis, evidence emergence of the distortion of the values of assets that were held by investment banks, and banking organizations. For instance, scholars give an example of a report by the Bank of England in 2008, when the ABX indices gave an overstatement of losses by over 20% (Larkin and DiTommaso, 2013). This was relative to losses that were estimated, based on the projected delinquency rates and an increase in the expectations of credit losses. It is important to understand that an ABX index helps in providing the price benchmark of financial assets that are backed by loans aimed at supporting mortgages. Scholars denote that the inaccuracies of this loss provided by ABX indices is depicted when the indices continued to fall, even after the crisis had been contained, and the economy of England improved. On this basis, it is inaccurate to blame the concept of fair value reporting as the cause of accelerating the development of financial crisis. Catty (2010) believes that the use of fair value reporting was essential in communicating the financial conditions of banking organizations, and different financial institutions. This includes communicating the negative effects of bad investment decisions such as the issuance of subprime loans, and the swapping of credit defaults. On this basis, scholars denote that blaming fair value reporting to the emergence of the financial crisis is uncalled for, and it can be equated to blaming a messenger for bringing bad news to his or her superiors. This scholar further goes on to denote that an alternative to fear value reporting is the historical cost reporting. In the perspective of Tsamenyi (2009), the use of historical costs in reporting the values of financial assets is aimed at avoiding the reality of the values of these assets, and it is therefore a misleading practice to the shareholders of a business organization. Mook (2013) further observes that it is very important for the fair value information to be available to the providers of capital, and any other user of the financial statements of the company. Investors should insist on having this information during periods of market inconsistencies, which is also characterized by crunches in the liquidity of a financial market. Langendijk, Swagerman and Verhoog (2003) therefore denote that the use of fair value reporting helps investors to have knowledge on the values of their investments, and this will make them to help in recapitalizing institutions which face financial difficulties. This is because they will act on a point of knowledge, based on the information that emanates from the financial records built upon the principles of fair value reporting. It is important to understand that an alternative to fair value reporting is the historical cost reporting (Sobel, 2012). Historical cost accounting, values of assets and financial securities are recorded at their historical costs. That is, when the assets under consideration were bought, or purchased. It is important to understand that under this concept; the values of these assets are always adjusted, based on their impairments, and amortizations. However, when the values of these assets are increased, these values are not always shown in the financial records. On this basis, fair value accounting is advantageous, because it is able to depict the accurate market value of an asset (Larkin and DiTommaso, 2013). This makes an investor to have knowledge on the accurate value of his investments, as opposed to the historical cost reporting where an investor does not have any knowledge on the accurate value of his assets/ investments (Schneide and Kuhner, 2013). It is therefore important to denote that there is little room for managers to manipulate their accounting and financial records when they use the principles and concepts contained in fair value accounting. On the other hand, historical cost reporting provides little room for the manipulation of accounting records, when the original purchase prices or amortization costs are used. However, banking institutions might sale and repurchase highly liquid assets, for purposes of making gains. This is because the historical cost does not recognize the gains made by an asset. On this basis, investors and government financial institutions advocate for the use of fair value reporting by organizations. Fair value reporting also has some disadvantages. One of the disadvantages is that it is difficult to record the value of stocks that normally experience frequent market changes. For instance, in a volatile and highly liquid market, it’s is always difficult to provide the true market value of an asset, based on the frequent changes experienced by assets that trade in such kind of a market. This is one of the reasons that Bearns and Sears gave, when it restricted investors from withdrawing the financial securities under their possessions. Mard and Hitchner (2010) observe that the use of fair value reporting is responsible for reducing the book value of assets that are owned by the business organization. On a historical note, the book value of a company changes when the institution purchases a new asset, or it disposes off the asset under consideration. However, scholars denote that fair value reporting is responsible for changing the book value of a company’s assets for arbitrary issues (Tomasic, 2011). For example, scholars denote that if an asset of a company drops in value, the accountants of the institution will have to make the adjustments; similarly, if the value of the asset goes back to its original position, the accountants will also be forced to make the adjustments. On this basis, fair value reporting is just a waste of time, as it concerns itself with arbitrary issues (Tomasic, 2011). In conclusion, fair value reporting did not contribute in worsening the 2007 financial crisis. This is because the principles of fair value reporting denote that the value of the assets must be reported at their market value. On this basis, Fair Value Reporting juts provided an insight on the value of assets that investors had, and pin pointed the bad investment decisions that financial institutions made. On this basis, even if these institutions used the historical model of reporting, chances are high that the financial crisis would have occurred. It is therefore important to conclude that the main reasons for the occurrence and worsening of the financial crisis are, poor investment decision by financial institutions, short term debts, anxiety amongst investors, etc. On this basis, it is therefore wise for organizations to continue using the principles of financial reporting, and this is because it will provide accurate information to investors on the value of their assets and investments. Bibliography: Bondt, W. D. (2010). The Crisis Of 2008 And Financial Reform. 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Accounting in emerging economies. Bingley, UK: Emerald. Zyla, M. L. (2012). Fair Value Measurement Practical Guidance and Implementation. (2nd ed.). New York: Wiley. Read More