Benefits and Drawback of Fair Value Accounting Measurement - Assignment Example

Benefits and Drawback of Fair Value Accounting Measurement Contents Contents 2 Introduction 3 2. Fair Value Accounting and Financial Crisis 3 2 Defending Evidences: Fair Value Accounting did not cause for Financial Crisis 4 2.2. Supporting Evidences: Fair Value Accounting Ignited the Financial Crisis 6 3. Benefits and Drawbacks of Fair Value Accounting 7 3.1. Benefits of Fair Value Accounting 7 3.2. Drawbacks of Fair Value Accounting 8 4. Conclusion 10 Reference List 11 1. Introduction Fair Value Accounting is the valuation guideline introduced by Financial Accounting Standards Board (FASB) for standardizing the fair value calculations of financial instruments. According to the definition provided by International Accounting Standards Board (IASB), it is a procedure that seeks to capture the changes in the values of assets and liabilities (Langendijk, Swagerman and Verhoog, 2003). Fair value accounting principle was initiated in early 1990s, but the method was amended in 2006 after clarifications of all the bewilderments regarding the standard. The accounting system demands an estimation of fair market value in order to demonstrate the present value of future cash flows (Penman, 2007). Many financial analysts are of the opinion that the fair value accounting has significantly contributed to the reasons behind financial crisis of 2008 (IMF, 2009). In this paper the statement will be critically evaluated to justify such argument. The paper will also analyse the benefits and drawbacks of fair value accounting in comparison with other measurements in order to enhance quality of financial information. 2. Fair Value Accounting and Financial Crisis Many critiques have argued that apart from the reasons such as subprime mortgage, excessive debt and default credit swaps that had mainly caused for financial crisis of 2008, fair value accounting which is also known as mark to market accounting has significantly contributed towards the crisis through producing deceptive data and defective financial statements (Laeven and Huizinga, 2009). However, though there has been much substantiation regarding asset fire sales and downward spirals in financial markets, supporting evidences that may prove the accounting system’s function in igniting the crisis are negligible. Such discussion can be based on the following myths. 2.1. Defending Evidences: Fair Value Accounting did not cause for Financial Crisis 2.1.1. Historical Costs have no Connection to Current Market Value Some critiques have argued in favour of FVA that the assets reported under historical cost in the company’s balance sheet have no relation to their current value. The values of most of such assets are documented at their purchasing price with adjustments for depreciation (for building, plant and machineries etc.) or appreciation (bonds and other fixed maturity investments) of those assets (Bonaci, Matis and Strouhal, 2010). However, such valuation may not be appropriate in current market scenario. For example, value of a company owned building may hold more value in present market than its depreciated book value as calculated under historical cost. Hence, even under historical accounting, importance of fair value has been established to derive the exact market value of the assets on quarterly basis and companies are guided to write the asset off their balance sheet if the value of an asset doesn’t hold good in present market. Following that, in 2008, some of the US banks wrote down approximately $25 billion of goodwill which has become redundant in current market price, reducing their net asset base as well. Hence, it is evident that even under historical accounting system; the banks were forced by the external auditors to present the permanent decrease in the market value, if any to report in the financial disclosure (Laux and Leuz, 2009). 2.1.2. Assets of Financial Institutions Marked to Market Some critiques remarked that most of the bank’s assets were marked to deteriorating market of 2008 whereas a study from SEC has shown that 31% of the bank assets were accounted in fair value and rest were treated in historical costs (Penman, 2007). More specifically, under FVA, all the assets including loans and securities of commercial banks and other financial systems were categorised in three segments: held assets, traded assets and the assets which are available for sale. Among the three categories, the management was able to hold the first two asset segment until maturity, under historical cost, in order to safeguard the net income from affecting directly. The assets available for sale were always marked to market on quarterly basis as the gain or loss incurred by such translation into present values are reported as unrealised gains or losses that does not affect the net income directly. The study of SEC again proved that more than two third of that 31% of banks’ assets that were marked to market were “available for sales” in nature. The total asset affected the net income by fair value adjustment was only 22% which was far away from the majority (Magnan, 2009). 2.1.3. Assets Must Be Valued at Current Market Prices Even If the Market for them is Illiquid Level I rule of FASB indicates that all the financial assets are highly liquid and easy to convert into current market price. However, this does not always hold good as the market prices are not always readily available. In such circumstances, the FASB prescribed that the conversion should be based on observable market price following the rule of Level 2. When such inputs are also difficult to avail because of illiquidity of the market, such as the case of an investment in private equity fund, financial executives are directed to value the assets on the basis of marking to model concept instead of marking to market, based on the assumption of fair market value under Level 3. In 2008, when the debt market became immobile, FASB emphasised on reclassification of trading assets from Level 2 to Level 3 because the market was becoming more illiquid (Menicucci, 2014). However, such regulations were not accepted by the banking authority as applications of such accounting measures led the market value of their toxic assets plunge. As the banking sector demanded more relief, FASB came up with mark to model valuation system that had allowed more securities to be valued by bank models instead of by market indicators. The system also prescribed that only the credit loss section would negatively impact on the bank’s regulatory income portion of the bank’s income. Rest of the parts would go to the special accounts. These accounting rules facilitate the US baking sectors to reduce the level of written down assets during 2009, improving the short term financial condition of those banks. Hence, it is difficult to hold fair value accounting system as the sole responsible for the financial crisis of 2008 (Menicucci, 2014). 2.2. Supporting Evidences: Fair Value Accounting Ignited the Financial Crisis 2.2.1. Pro-cyclical Effect Pro-cyclical effect is considered to be the most important factor for supporting that FVA did contributed to the financial crisis. To be more specific, critiques have sighted that fair value accounting tends to contribute towards excessive leverage when the economy was in boom and it led to write down of assets massively when the economy was suffering from busts. Hence, FVA not only contributed to the financial instability, it also influenced to form asset bubbles that had made the economic downturn more severe (IMF, 2009). 2.2.2. Mark to Market Price System The fair value accounting system tends to mark the asset value in terms of the current market price that requires the financial institutions to adjust their values of the asset base on quarterly basis. Hence, an increase in market based asset price will multiply the accounting numbers and accordingly it would influence the auditors to review the balance sheet more frequently which in turn would strengthen the balance sheet overtime (Schmidt, 2014). However, such practices would lead to increase the asset price and create asset bubbles over time, enhancing volatility of financial system (Allen and Carletti, 2008). 2.2.3. Contagion Effect Finally, during the period of economic busts, the pro-cyclicality effect of FVA had seriously aggravated the severity of financial crisis mainly because of the contagion effect associated with it. Incorporating fair value accounting, the banks were forced to write down their asset base during the bust which had resulted in sale of assets by the banks at a price which was denominated as “fire sale” prices by the critiques (Schmidt, 2014). Consequently, the assets of other financial institutions rather than baking system also experienced a fire sale price of their assets as well. Such effect further created a downward spiral as the market for assets gone down due to absence of potential buyers. Moreover, where bonds and other contractual agreements were evaluated by individuals on the basis of historic accounting principles, credit rating agencies and external auditors evaluated such contracts of banks and other financial institutions, based on FV (Plantin, Sapra and Shin, 2008). 3. Benefits and Drawbacks of Fair Value Accounting Apart from the debate on fair value accounting’s role in financial crisis, the accounting system itself is a debatable subject. Several advantages and drawbacks have been drawn over a period of time to evaluate the efficiency of the system. Some of the critiques claim that investor’s decision making process becomes more relevant through appointing fair value method as compared to the historical costs, other experts are on the opinion that fair value accounting leads to create volatility in the financial statement because it considers market based price while calculating. In the next segment the critical analysis will be done on the advantages and drawbacks of fair value accounting (Menicucci, 2014). 3.1. Benefits of Fair Value Accounting 3.1.1. Realistic Financial Statements It has been experienced that, the financial statements of those companies reflected a more accurate financial result that have incorporated fair value accounting as compared to the companies using some other accounting methods. The main reason behind obtaining such realistic statement is that all the assets and liabilities are reported in their actual value. As this accounting method requires the companies to disclose the present values of cost considerations and sales figures, it provides the companies an opportunity to examine the company’s future cash flows (PwC, 2008). 3.1.2. Investors’ Advantages Fair vale accounting is often applied to the financial assets which are held for a certain period for the purpose of trading in order to get returns from the changes in market price over the period of time. As the accounting system records the present valuation of the assets and liabilities, rather than their historical cost, it provides a transparent picture to the investors and allows them to take a uniform decision regarding their future investment, taking into consideration the current risk profile of the firm and future possibilities for growth and expansion (Bessis, 2011). 3.1.3. True Income The accounting system restricts a company’s aptitude to manipulate the reported net income for tax savings and other purposes. In some cases, the tendency has been noticed that the management deliberately presents the profit or loss incurred from the sale of certain assets in order to increase or reduce the net income to the desired level. Manipulation of net income reduce tax burden of the company as well as it lessens the degree of dividend payment, boosting the company’s net earnings. However, application of fair value accounting leads to document the gain or loss from disposition of any asset or liability over a specified period of time. Hence, an increase in value of asset or a decrease in liability are supplemented to net income in this accounting system in order to arrive at the true valuation of net income (Zack, 2009). 3.1.4. Limitation of Pro-cyclicality It has been observed that there is a correlation between economic quantity and fluctuations, in comparison with other accounting measures. Therefore, the accounting principle reflects the credit quality prevailing in the financial system on a particular period of time and it can act as a signaling system to the banks and other financial institutions to take corrective measure well in advance in terms of building additional reserves and other remedial actions. 3.2. Drawbacks of Fair Value Accounting 3.2.1. Volatility The fair value accounting inherently involves volatility in the system. Especially if the market is volatile, the values of assets and liabilities tend to change frequently. Such frequent changes in balance sheet tend to bring volatility in the earnings and overall profitability of the firm. In general, losses are written off against the company’s earnings. Hence, for a public limited company, it becomes difficult for the investors to identify exact value of the company when such frequent adjustment takes place. Apart from that, such frequency of adjustments creates difficulties for external auditors to keep a track of the financial occurrences of the company (PwC, 2008). 3.2.2. Inability to Value the Assets In case of business with complementary or specialized assets, application of FVA finds it difficult to value such assets in open market. When market information is limited, the accountants are liable to make a professional judgment on valuing such items, taking into consideration all the technical aspects of those attributes. However, possibilities are huge that the fair value as suggested by professional deviate from the actual market price; thus creating a discrepancy in accounting results (Persaud, 2008). 3.2.3. Reduced Book Value The book value indicates the total assets owned by the company. Historically, the book value of a company changes only when the company tends to purchase new assets or disposes old, redundant assets. However, fair value accounting tends to change the book value of a company based on some arbitrary issues. Such accounting system requires the firm to adjust the value of asset base over a short period of time, whenever the price level changes (PwC, 2008). 3.2.4. Less Reliable Some of the financial experts find the system less reliable as compared to historical cost on the ground that in FVA, accountants typically concentrate on market while valuing an asset or investment. Hence, in this process of valuation, the professionals must take into account different present values of such assets and investment in different regions and currency regimes. As the accountants tend to avoid such complexities, fair valuation often leads to present less reliable financial statement. 3.2.5. Price Adjustment Complexities Because of the pro-cyclical nature, price bubble can be infused into financial statements, particularly when the economy is in boom. In such financial condition, price movements are amplified, weakening the quality of financial reports (Zack, 2009). 3.2.6. Asset Liability Mismatch Finally, it becomes difficult to strike a balance between asset and liability in fair value accounting. For instance, in commercial banking system it is possible to measure the loan portfolio in terms of fair value but translating deposits into fair value for accounting purpose is an unrealistic phenomenon. Such discrepancies create asset-liability mismatches which in turn deteriorate the quality of financial information. 4. Conclusion After analysing the role of fair value accounting on financial crisis of 2008 it has been observed that fair value accounting system had caused for pro-cyclical effect in financial system which in turn created asset bubble in the system when the economy was experiencing busts and ignited the source of financial crisis. However, it is also clear that imperfect application of fair value system, illiquidity of the market as well as defective marked to market procedure have created contagion effect which in turn intensified the financial crisis. There, it can be inferred that fair value accounting cannot be hold sole responsible for the crisis, the prevailing condition of the market, asset base and aggressive risk taking behavior of the banking systems combined with FVA system accelerated the path for such severe crisis in 2008. Considering advantages and drawbacks of FVA, it can be concluded that the accounting system is more appropriate for the asset classes held for trading. Considering the overall acceptance of this accounting system, more conscious measurements should be taken in order to obtain quality financial reports. Reference List Allen, F. and Carletti, E. 2008., Mark-to-market accounting and liquidity pricing. Journal of Accounting and Economics, 45(2), pp. 358-378. Bessis, J., 2011. Risk Management in Banking. New York: John Wiley & Sons. Bonaci, C. G., Matis, D. and Strouhal, J., 2010. Crisis of Fair Value Measurement? Some Defense of the Best of All Bad Measurement Bases. Wseas Transactions on Business and Economics, 2(7), pp.114-120. IMF, 2009. Fair Value Accounting and Procyclicality. [pdf] Available at: [Accessed 19 February 2015]. Laeven, L. and Huizinga, H., 2009. Accounting Discretion of Banks During a Financial Crisis. Washington DC: International Monetary Fund. Langendijk, H., Swagerman, D. and Verhoog, W., 2003. Is Fair Value Fair: Financial Reporting from an International Perspective. New York: John Wiley & Sons. Laux, C. and Leuz, C., 2009. Did Fair-Value Accounting Contribute To The Financial Crisis? National Bureau of Economic Research, 1(1), pp. 19-29. Magnan, M., 2009. Fair Value Accounting and the Financial Crisis: Messenger of Contributor? Ontario: CIRANO. Menicucci, E., 2014. Fair Value Accounting: Key Issues Arising from the Financial Crisis. Basingstoke: Palgrave Macmillan. Penman, S.H., 2007. Financial reporting quality: is fair value a plus or a minus? Accounting and Business Research, 37(1), pp. 33-44. Persaud, A. D., 2008. Regulation, valuation and systemic liquidity. Financial Stability Review, 12(1), pp. 75-82. Plantin, G., Sapra, H. and Shin, H.S. 2008. Fair value accounting and financial stability. Financial Stability Review, 2(12), pp. 85-94. PwC, 2008. Fair value accounting: Is it an appropriate measure of value for today’s financial instruments? [PDf] Available at: [Accessed 19 February 2015]. Schmidt, A., 2014. Fair Value Accounting and the Financial Market Crisis: To What Extent is Fair Valuation Responsible for the Financial Crisis? London: epubli. Zack, G. M., 2009. Fair Value Accounting Fraud: New Global Risks and Detection Techniques. New York: John Wiley & Sons. Read More