Tuesday, June 4, 2013

Fair value accounting

Introduction Fair value accounting is a financial reporting method where firms are allowed or required to reports or carry out the measurements of their general financial instruments such as liabilities and the assets in an ongoing basis where the estimates of the prices are used. For instance the price that the firm would receive if the assets were sold or the value the firm would pay if it were to be relieved of its liabilities. Under this method of financial reporting, companies report losses in two instances; when the fair values of the assets of the firm decrease or when the fair values of the liabilities of the firm increase. The vice versa is true when the firm makes profits as the fair values of the assets will increase while the fair values of the liabilities of the firm will reduce. When a firm experiences losses, the equity of the company that is reported will be reduced thus there may also be a reduction in a company’s net income that is reported. The generally accepted accounting principles (GAAP) that has been in use in the US for nearly 5 decades strongly has its roots in fair value accounting. In the recent past, there has been an increase in the number of accounting standards that require the use of fair vale accounting (Kothari and Barone, 2011). The fair value accounting standards also received a major boost in 2006, when the Financial Accounting Standards Board (FASB) issued a new standard which heavily borrowed from the principles of fair value accounting. The new standards, statements of Financial Accounting Standards (FAS), which was aimed at providing a more comprehensive direction towards how firms could estimate their fair values, have increasingly been accepted by more and more firms while an equal number have been skeptical. The skepticism was mostly brought about by the global economic meltdown which rendered fair values to be very difficult to estimate, there were recurrent losses resulting from the effects of the initial losses on the market prices of the stocks and securities of the firms and finally the notion that the reported losses are temporary and in most cases will return to normal. FAS defined fair value as the price that would be paid to transfer a liability or sell an asset at the measurement date in an orderly transaction between different participants in the market (Nissim and Penman, 2008). The paper is a discussion of two main issues regarding fair value accounting; whether IASB’s fair value measurement of assets enhance or detracts from the usefulness of the financial statements; problems facing companies when they measure assets at fair value. Fair value measurement and the financial statements The use of IASB’s requirements and principles of fair value accounting enhance the usefulness of the financial statements in a number of ways. To begin with, fair value accounting same objective even if different method of valuation was used. This is significantly important in the instances where there is a reduced level of volume and activity of the instrument. Fair vale would still remain the price at which the various assets of the firm would be sold or the varied liabilities of the firm exchanges in a transaction which is orderly. This ensures that there is no forced or distress in the liquidation by the various participants in the market under the conditions which reign (Financial Accounting Standards Board, 1991). Secondly, FAS also mandated a variety of disclosures which offer a very good level of classification and categorisation of the different liabilities and the assets of the firm. The categorisation is done in three levels for instance the three levels are also where the various firma are supposed to declare or disclose the fair values of the inputs that are put into the production as well as the product that results from the various inputs of the firm. The firm is therefore required to disclose the assets as well as the liabilities that were measured at fair value at the end of the reporting period. Depending on the level where the assets or the liabilities are on the fair value hierarchy, reconciliations are carried out for the various opening balance for the assets and the liabilities at the opening of the reporting when actually the reporting period ends (FASB, 2007). The FAS principles also require for the disclosure of information regarding the realised as well as the unrealised profits and the losses. This is done through the provisions of the consolidated statement of incomes. It allows for the clear indication of the summaries of the values of assets which are carried in the balance sheet especially associated with the financial statements. The fair value accounting principles also allow for the disclosure of the valuation methods and techniques which were employed by the firm including the different inputs. Above all the above, it also shows the different risks that the investment may be exposed to as well as their different natures. The method of fair value accounting also allows for the disclosure of information regarding the firm’s financial sensitivity towards the varied important observations on the changes to the different (IFRS Student Manual, 2010; FASB, 2007). Fair value accounting principles are very important in helping decision makers in their different duties for instance organisations are able to better make decisions regarding their financial health when they use balance sheets. The balance sheets are very representative of the value of the company better than the historical cost measures which were more or less static and did not reflect the different changes that were taking place in the firm overtime. The fair value also gave the users of the financial statements valuable feedback about the different operations which take place in the firm. Instances include feedback when there are depreciation and appreciation (McKenzie, 2010). Also, the fair value accounting also allows for the frequent valuation of both the assets and the liabilities of the firm so that the management is able to engage in activities that are bound to ensure that the market discipline of the firm is a high thus eliminating possibilities of risk to the business (FASB, 1991). It can thus be stated that the fair value reporting has greatly contributed to the usefulness of the financial statement as the reports have been used extensively in making investment and trading decisions, measurement as well as the management of the various risks that face the firm. The financial statements derived from the fair value accounting methods have also been used to determine and then devote different amounts of capital for use in carrying out different businesses in the firm (Holmes, Sugden and Gee, 2008; FASB, 2007). The importance of the financial statements that result from the fair value accounting can thus not be underestimated. There have also been issues that have arisen regarding the non-usefulness of the financial statements that are derived from the use of the fair value principles of accounting. The first point of contention has been on the issue of the reliability of the financial statement. Due to the continuous nature of the reporting under fair value, there are possibilities that the firms may engage in the manipulation of the information thus many firms can alter the financial position figures so that the different financial ratios which are reported can be improved (Elliot and Elliot, 2012). This is considered as the height of unreliability especially if the financial statements are used in making important enterprise decisions. The fair value allows the management of the different firms to alter the bottom line of the information which they offer before putting it into the financial reports that are accessed by the different members of the firm. Secondly, there have also been noted inconsistencies regarding the fair values that have been attached to the various assets of the firm which are not tangible. This will lead to scenarios where there can be no objective allocation of the resources between the various ventures that the firm is engaged in. Due to the nature of how fair value principle treats intangible assets, the investors and the general public will be left in an ‘informational grey zone’ as the intangible assets that the firm has can be used up before they know the true nature of the assets. In cases where the valuation of the intangible assets is done successfully, it takes a lot of time while in majority of the cases, it is extremely complex to achieve (Elliot and Elliot 2012; FASB, 2007). The applicability and the usability of the fair value accounting principles are also limited in some cases for instance in cases of investments which are held to maturity as well as contractual receivable and loans. Fair value has a limited capacity is these dealings as its ability to make predictions is limited and thus in most cases it does not present the various cash flows of the future. There are always chances that the values that are not realised will be realised due to various changes (Cotter, 2011). The main point issue here is that when firms hold their different assets to maturity, the applicability of the fair value accounting principles is significantly reduced; no use at all. The use of fair value also is faced with the problem of non-comparability; the financial statements of two identities that are identical may yield different fair values under the accounting principles. A case in point is the level three inputs and how they are treated under the fair value accounting principles (Barlevy, 2007). The application of the level three is not consistent both across the industry as well as within the individual organisation. This brings a situation where there is no consistency especially as firm produce financial statements which are subjective to information that has not been observed. The fair value accounting also worsen the financial reporting situation especially arising from the pressure that it exerts on the prices of the assets of the firm especially when there are decreases of those prices below their economic values. This leads to a cyclical depreciation pressure on the asset prices of the firm. These decreases in the values of the assets of the firm lead to an increased level of panic among the executives of the firm (FASB, 2007). There is a general loss of confidence and thus steps are taken which have an ‘after effect’ on the markets where the firm operates thus leading to an increased level of market volatility. Fair value accounting increases the level of volatility as the financial statement always show some level of change after every reporting period and thus fair values change due to the inflows of the cash brought about by the changes. In conclusion, the general movement away from the use of the historical cost accounting to that where the fair values are used must be recognised as the greatest leap that ever happened to the field of financial reporting. The fair value accounting provides most of the relevant financial statements that the users can rely on to make informed choices and decisions. The performance and value of the firm can be determined from the financial statements which result from the fair value accounting. When the performance of the different firms in the industry are known, the performance of the whole industry can be determine thus it can be stated that it is also important in stating the value of the industry. However, these benefits can only be realised when the different weak points of the fair value system are plugged. The weak points that should be dealt with include; the possibility for manipulation of the financial statements, non-comparability as well as the volatilities that may result from the use of the fair value method of accounting. Practical problems which face firms using fair value accounting principles The first problem is the reversal of unrealised profits and losses which may result from two different scenarios. The market prices attached by the fair value may not correspond to the future flows of cash which were likely to be received by the firm or those that the firm will use to pay for their liabilities with. This is because under the fair value accounting, the distribution of the flows of cash in the industry is skewed. Also, the market prices may be bubble thus very different from the fundamental values. There may be instances where there is a low likelihood of the assets of the firm bringing any significant flows of cash into the firm. When there are severe losses in the future, the fair values of the assets of the firm will significantly reduce. Bubble prices in the market inflated by an increase of liquidity in the market or an over optimism about the prospects of the market while the depressed bubble is caused by little liquidity as well as market pessimism (FASB, 2007). The main problems for the firms is the FAS hierarchy of fair value inputs as well as the ability of the firms to know when the bubble exist and also when they will definitely burst. The various firms in the industry will have different views about the bubble and thus their reactions would be inconsistent and discretionary (Barlevy, 2007). This level of non consistency is the real problem that the firms face as they are not able to have any reasonably high degree consistency application. Secondly, firms which have adopted fair value principles also face problems regarding evidence especially in instances when the firm is required to prove that the market is illiquid. This mostly occurs when the level two assets of the firm are driven by the forced sales of the firm. In such an instance, firms are allowed to use level 3 asset fair values; which is only possible when the firm can be able to produce convincing evidence that in reality the markets prices as well as all the market information that is available to people are a result of the illiquidity that exist in the market (FASB, 2007). The firms in most cases are not able to convince the SEC regarding the existence of the illiquidity and thus in most cases are forced to use level 2 asset fair values which in most cases will yield very huge amounts of unrealised losses. The main point of antithesis here is the measure that is used to determine that what the firm has provided meets the threshold of ‘sufficient evidence’ to convince the SEC that illiquidity exists in the market where the firm operates in (American Institute of Certified Public Accountants, 2001). There has also been the issue of unrealised feedback effects as well as systematic risks. This problem is faced by firms who use fair value accounting principles especially if they overstated their unrealised profits and losses especially when the higher prices of the firm persist longer than they were predicted to take. The firms have in some instances made decisions which were suboptimal while investors have also in certain instances reacted overly to the reports concerning unrealised gains and losses which are reported by the financial statements of the firm. This leads to adverse feedback effects as these positions would not be taken by either the firm or the investors if the other methods of accounting were used for instance cost accounting. The decisions of the firms for instance the writing down of the assets of the firm have in many instances led to a further reduction in the market value of the various assets of the firm (Elliot and Elliot, 2012). There have also been instances where the firm may sell the assets whose prices have fallen to raise the capital as well as remove the tainted asset from the balance sheet of the organisation. Finally, the use of fair value accounting standards has also brought a problem to the banking and financial institutions who traditionally relied on book value measures. FAS requires banks to value their liabilities and assets so that they can reflect the current market prices and thus by extension the risk premium associated with the bank. When the assets are recorded at fair value and there are realised or unrealised losses, the result would be a decrease in equity as well as the capital position of the firm. The fair value capital can signal falsely the insolvency of the firms (Nissim and Penman, 2008). The fair value accounting will also bring problem especially those related to capitals of the firm as it does not differentiate between loans that are held for sale and investment. In conclusion, FASB could develop clear indicators of market illiquidity so that the firms which are faced by the illiquidity, low trading depths and large bid ask spreads problems especially in their asset prices can be able to objectively provide the evidence following the measurement of the variables which are provided. The requirement for the firms to support their level three valuation is important for ensuring discipline and thus the only way this discipline will be ensured is through giving variables which will measure in absolute or relative terms. Bibliography American Institute of Certified Public Accountants 2001, Accounting by Certain Entities (Including Entities with Trade Receivables) that Lend or Finance the Activities of Others, Statement of Position 01-6. New York, NY: AICPA Barlevy, G. 2007, "Economic Theory and Asset Bubbles", Economic Perspectives, Third Quarter, 44-59. 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