Fair Value Accounting - Essay Example

According to AASB number 102 fair value is defined as “the amount at which an asset could be exchanged, or aliability settled, between knowledgeable, willing parties in an arm’s length transaction.” Fair value accounting has raised several concerns with respect to calculations of property trusts, infrastructure and also in relation to instruments of finance and sponsored benefit funds that have been defined. The belief by ASIC is that there is inadequate utilisation of information about markets and the disclosure of methods as well as assumptions when computing the fair value. (Parshall, 2009) This study is set out to discuss fair value accounting and more specifically determine its role in the credit crisis that rocked the world in 2008. It will try to justify the statement that, “Fair value accounting only works in efficient, active and liquid markets. In order to produce information which is relevant and reliable, fair value focuses on market prices.” Due to the financial crisis, fair-value approach for accounting has triggered major debates globally. Among the debaters are the European Commission, USA Congress as well as accounting and banking regulators in the globe. Cynics have it that the financial crisis impacting the whole world in the recent past has been mostly caused by the effects of fair-value accounting. The study is going to determine whether fair value accounting is only applicable in active, efficient and liquid markets. Various arguments will be considered while trying to draw the befitting approach to the issue. The Standards of accounting reports, IFRS and US GAAP, aid in deriving from market prices in various circumstances. However, it is not very clear whether these standards are the origin of the predicaments. The allowing of the managements of organisations to be flexible when it comes to dealing with future value accounting problems leads to the manipulation during such times as those of financial crisis. From the perspective thus the market conditions may impact on fair value accounting. However, according to Laux and Leuz, future value accounting is an approach to the measurement of liabilities and assets in a given company’s balance sheet. FAS’s number 157 definition is that fair value accounting is “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.” Under IFRS fair value has been defined as the sum at which a certain asset and liability could be exchanged or settled respectively. (Laux and Leuz, p2) McSweeney also reinforces the idea that fair value accounting had a fueling contribution to the recent financial crisis. This is since as part of accounting it reflected a continuous growth which aided in speculation. This is due to the balance sheet asset valuations that are upward spiraling. The notion of the fact that financial markets usually have an effective way of pricing assets led to more speculative buying in the times when prices were rising and thus made a contribution to the rise in bubbles of speculation. Besides this, it made a discouragement on the central banks regarding intervening in the bubbles of asset price. He goes further to say that the claim about fair value accounting granting “a faithful representation of reality” is not right. This emanates from the idea that the valuations of assets basically rely upon expectations of a future that is rather hypothetical. Thus, the claim would only hold if the market was perfectly able to forecast with power. Apparently, no person has the power of forecasting with accuracy. The speed of fair value accounting was high in the valuation of assets leading to overvaluation. It caused high speculative expectations and that were too-rosy, triggering the financial crisis. These would be unmistakably referred to as the “accelerator effect” of the fair value accounting. (McSweeney, 2009 pp837-844) As the economist magazine stipulated, the rules of fair value accounting are highly associated with the credit crunch. This is the mark-to-market type of accounting which calls for the banks to value their assets as per the estimated price they would be sold at that particular moment. The Institute of International Finance sent a memorandum that was confidential to the Financial Accounting Standards Board and the International Accounting Standards Board, saying that it was quite obvious that the markets had failed as well as that various companies should be permitted to do away with the fair value accounting on assets which had caused undue valuation. They argued that other kinds of accounting assets’ and liabilities’ valuations like historical cost accounting would be more reliable. Even though this did not look credible at that particular moment, many people today have confirmed to their being right. (economist.com, 2009) The IASB argues that the main objective of fair value accounting approach is that price, in the market, at which any given orderly transaction would be carried out on the date of measurement. Thus, the transaction should not be a liquidation that has been forced or a distress disposal. Determination of an assets fair value in a market that is rather inactive relies upon the circumstances and facts, which may call for a significant judgment regarding whether a specific transaction has been forced one. Therefore, any transaction that has been concluded to be a forced one does not apply in fair value accounting. During a time when there is no relevant data existing in an observable market, managers of a given organisation may determine the fair values to be applied in that organisation. This is usually based on the assumptions from inside the organisation, by the management, concerning future cash flows as well as reasonably risk-adjusted rates of discounts. (iasb.org, 2008) IASB 7 is usually applied to supersede AASB 130 which is about the financial statements of banks disclosures as well as similar financial institutions. It requires that it be utilised when fair value accounting cannot be measured in a reliable manner, disclosure of how and whether a business entity wants to sell an instrument. This is especially applied under hedging instruments and the hedged items of hedges of fair value. (Charteredaccountants.com.au, 2009) According to Bruner and Carr, even though mark-to-market approach of accounting increased the level of transparency, it amplified the level of liquidity risk especially among various institutions. The credit securities market froze and it became a hard task to determine the value of securities. During this panic, fair value accounting only increased the exposure to opacity. The placement of the US residential securities that were mortgage-backed spread to the rest of the globe. It came to rest in banks of countries like Germany, Switzerland, France, and Australia. Then, it became a difficult task to determine whose risk was higher than the other. (Bruner and Carr, 2009 p181) In Australia, it is believed that even if it did not cause the credit crisis, mark-to-market accounting served in exacerbating the crisis. Thus, any rectifications of the accounting standards are not likely to play any role in easing the credit situation. During the normal times, fair value accounting functions well. However, when there is a financial crisis, the values of some securities and loans at market price including the ones with little risk upon the payments o interest they can fall since there are very few transactions in a market that is illiquid. (Stummer, 2008) International Accounting Standards Board (IASB) did not go without fighting back on the issue of fair value accounting contributing to the financial crisis. The chairman of the board, Tweedie, said that the volatility that has been witnessed in the market place is not necessarily of accounting methods’ making. This is since volatility is not an invention but rather the change in the value of liabilities and assets of a business is due to the exposure of all businesses to economic volatility. He argues that accounting has a responsibility of describing the market but not triggering volatility. Instead, as some people believe, fair value accounting facilitates disclosure and transparency which helps in disclosing the true economic value of an asset or liability. Also, fair value stipulations ensure transparency and at the same time contribute to the understanding on the part of the investor of the risk of financial institutions. (Iasb.org, 2008) Thus, one can make a conclusion that fair value approach of accounting can only thrive in market conditions that are efficient, active and liquid. Through this it can produce information that is reliable as well as relevant since its main focus is on market prices. As from the arguments regarding its impact on the recent financial crisis it can be seen to be involved first hand since financial markets are always full of speculation. As pointed earlier one can see that it was not the main cause of the crisis, rather it served as an exacerbating factor to the whole issue. I would go by the first statement in the question. This is due to the fact that as pointed out in the AASB and other arguments fair value accounting only works in a market that is active, efficient, and liquid. Therefore, in other markets that do not involve in transactions due to instability it is not possible to apply this accounting valuation approach. Read More