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The report discusses the role of fair value accounting in providing useful and relevant information to users of financial information for making their economic decisions for the allocation of scarce resources. With the help of empirical research, the report finds out that fair value accounting has an important role to play in this regard as it provides users with relevant, timely and comparable information for decision making.
The report also looks into the role of fair value accounting in the creation of global financial crisis of 2007-onwards. According to the research literature reviewed, fair value measurements didn't create the crisis but might have played a role in exacerbating it failed to work when the assets started becoming less and less liquid during the crisis and the business's could not find a way to value these assets. Fair value accounting should not be abolished because it still worked for measuring a vast majority of assets and it provides decision useful information. Moreover, historical cost accounting could not be an alternative to it. Therefore, a fine line would have to be found.
Commonwealth bank of Australia had made considerable use of fair value accounting for the preparation of its 2009 financial reports whereas Woolworths Limited had made limited use of fair value accounting for its financial statements for the same period.
According to International Accounting Standard (IAS) 39 issued by International Accounting Standards Board (IASB), fair value is defined as "the amount for which an asset could be exchanged or liability settled between knowledgeable, willing parties in an arm's length transaction". In United States (US), Financial Accounting Standards Board (FASB) also defines the fair value likewise. Fair value accounting (FVA) refers to the use of fair value to measure assets and liabilities that appear on a firm's balance sheet and income statement. The use of fair value to measure assets and liabilities may impact the income statement of a company.
Fair value is used to measure a wide range of bank and non-bank financial instruments under both International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP). Fair value measurements are also used for increasingly complex and less liquid financial instruments. Both IFRS and US GAAP classify fair value of financial instruments under a three-tier framework: as the observable market price of an instrument (Level 1), or observable market price of a similar item (Level 2), or the result of a financial valuation model (Level 3). See, Statement of Financial Accounting Standards (SFAS) 157 and IAS 39. Currently, IASB is working on a project to converge its views on fair value accounting and measurement with that of FASB. Last year, an Exposure Draft (ED) was issued in this regard. IASB is expected to issue a new standard on FVA in 2010.
Fair value accounting is considered a more useful approach for providing relevant and comparable information to the users of financial statements for making economic decisions to best allocate their scarce resources. However, the technique entails greater degree of manipulation by the management and is, therefore, unreliable. This point has been further elaborated with the help of research literature in PART A on the following pages. PART B takes stock of the recent research literature to evaluate the role of fair value measurements in the creation of global financial crisis (GFC) by critically discussing the limitations of FVA as a measurement tool. Lastly, two Australian companies', namely Commonwealth Bank of Australia (CBA) and Woolworths Limited, most recent financial reports have been reviewed as to ascertain the extent of use of FVA in PART C. The report concludes with conclusions and a list of references.
3 PART A
The purpose of using fair value accounting in financial reporting is to provide relevant information to the users of financial statements for making economic decisions. The choice between adopting fair value versus historical cost approach is made based on the qualitative characteristics of relevance, comparability and reliability of the financial reports prepared under either of these approaches. Reports prepared under fair value accounting are considered to be more relevant and useful for economic decision making of the users of financial reports because they are based on current or observable values of assets and liabilities and give a better idea to the users as to the correct value of a business and its ability to continue as a going concern (Deegan, 2010).
For example, Let's suppose, ABC company had invested $10 million in XYZ company in 2005 the value of which has increased to $15 million by 2010. Would it be more useful for decision makers if this investment is declared at $10 million in ABC's 2010 balance sheet? How about $15 million? Of course, the latter method would provide a more accurate and relevant number for the users of ABC reports because it represents the true and fair value of the investment and is allowed under the current financial reporting regime. This would not have been the case if there was no observable market to estimate the value of the investment. In that case, ABC management would have used an alternative approach to come up with a value of their investment in XYZ which might not necessarily have been a reliable number because of management's tendency towards bias and giving better results to shareholders. Enron's accountants and management extensively made use (or misuse) of fair value accounting for measuring assets and liabilities for which either no quoted prices were available or prices were unobservable as no close approximate asset or liability existed. Hence, management came up with its own valuations which led to the eventual collapse of Enron (Benston, 2006).
Users and preparers of financial statements look at fair value accounting from different perspectives. Majority of users find fair value disclosures relating to different classes of assets and liabilities useful for decision making purpose. On the contrary, preparers of financial reports take a dim view of the fair value accounting as majority of them believe that fair value accounting doesn't necessarily result in comparable and relevant financial reports ("How useful is fair value accounting?", Journal of Accountancy, 174, No 6, (December 1992).
According to study carried out in New Zealand, current cost accounts (that are based on fair value accounting) were found to be useful for investor decision making because they are not only relevant but are thought to be more reliable than their historical cost counterparts. The study was carried out to test the assertion of New Zealand company directors that current cost accounts were not useful for decision making by investors (Duncan & Moores, 1988). Therefore, fair value accounting plays an important role in providing users of financial reports with relevant, comparable and reliable information to make better economic decisions for allocating their scarce resources.
Moreover, fair value accounting does have its merits from the decision usefulness perspective but its effectiveness depends on the type of assets that are being measured. Empirical research shows that fair value gives better results in terms of decision usefulness if it is measuring financial assets as against the non-financial assets (Hitz, 2007).
Furthermore, evidence from the empirical research suggests that fair value accounting does provide relevant and useful information to investors but the level of usefulness is affected by the measurement error and who made the estimates - management or an independent valuers (Landsman, 2007).
In conclusion, fair value accounting does provide useful and relevant information to the users of financial reports as long as the numbers faithfully represent the true picture of a company's financial affairs.
4 PART B
Fair value measurements have not played any part in the creation of global financial crisis. However, they might have played a part in exacerbating it. But this should definitely not bring an end to the fair value as a measurement tool. GFC was created due to the bad practices of mainly US banking corporations as a result of issuing too many subprime mortgages and selling them on in the form of derivatives. When these derivatives instruments failed to sell in the open market as a result of GFC, the banks and other holders of these instruments had to categories as Level 2 or Level 3 assets as per the guidelines of SFAS 157. As a result of marking to market, companies had to substantially write down these assets below their true values. This further contributed to and amplified the crisis (Pozen, 2009).
As discussed in PART A, the problem does not lay with fair value itself but the preparers of financial reports who misuse it. As Benston (2006) notes; "Of course, over-optimistic, opportunistic, and dishonest managers have misused historical-cost-based accounting to overstate revenue and assets and understate liabilities and expenses. Fair-value numbers derived from company created present value models and other necessarily not readily verified estimates provide such people with additional opportunities to misinform and mislead investors and other users of financial statements. The Enron example provides some evidence that this concern may not be misplaced or overstated".
Fair value provides increasingly relevant information to users of financial reports where historical cost fails in an ever changing world. One of the fundamental criticisms on fair value accounting is the perceived lack of reliability of the numbers produced by using it as a measurement base. But same can be said of historical cost approach, when it comes to impairment of certain assets as the preparers have to determine if the asset's market value has fallen below the historical cost or not. This requirement makes historical cost accounting equally unreliable.
According to Laux and Leuz (2009a), FVA is not responsible for GFC nor should it be looked at as measurement system that values assets but doesn't have its own economic consequences. Under both US GAAP and IFRS, FVA is mainly used for financial assets, although it is not used for all financial assets as some financial assets are measured using historical cost. Two main criticisms that have been levelled against the FVA include the lack of its application to illiquid assets and its procyclicality. The FVA system is said to have contributed to the financial instability in GFC and its procyclicality is said to have resulted in asset bubbles and aggravate the effects of their collapse (Wallison, 2008).
According to Penman (2007), the demand for FVA arises because of perceived deficiency in historical cost accounting and the valuation and performance evaluation of a firm. One should be able to ascertain the value of a business from its book value from an ideal fair value accounting report and earnings have no role to play in this regard. On the contrary, one should be able to value a firm from its earnings under an ideal historical cost accounting report. He tests these assertions and finds that FVA is a plus, leaving aside the implementation issues. Nevertheless, historical cost accounting can fill in the void if an ideal FVA is not attainable. He then goes on to look at the pluses and minuses of all three levels of fair value measurements. He concludes that FVA is a plus at a theoretical level as it answers all the questions regarding firm valuation on which investment decision is mainly based. But if fair value is implemented as exit price, the minuses start creeping in. Fair value accounting works well where one to one relationship exists between exit prices and fair value to shareholders e.g. investment funds where shareholders trade in and out based on the net asset value of the fund. This condition doesn't hold where firm has assets whose value come from a business plan rather than volatility in market prices, even where exit prices are taken from an active market.
The banking industry has been and is a very vocal opponent of the push of standard setters towards fair value accounting. The industry argues that banking is a long term business and a short term measure such as fair value fails to take the realities of banking industry into account. Another concern that the industry has is they it would become necessary to use inherently subjective valuation methods to measures a fairly large section of a bank's books which will substantially affect the reliability of the information (Chisnall, 2001 and Ebling, 2001). It should be noted that banks raised these concerns well before the start of GFC in 2007.
The use of FVA as a measurement tool results in management applying its discretion to the detriment of the users of financial reports. This is not only true of financial assets but non financial assets are also affected by it. Watts & Ramanna (2007) concluded that increasing degree of non impairment of goodwill is associated with the non verifiable fair value based discretion. Similarly, empirical research has found problems with fair value based measures especially where no corresponding market prices are available and the fair value is based on a level 2 or level 3 measure (Benston, 2008). Furthermore, research has found a connection between failure of a firm and the use of various fair value based measures. Enron used market to model measures to value its real estate transactions and energy contracts (Benston, 2006).
In conclusion, the use of fair value based measurements is problematic when there is no active market for the element that is being measured as it gives greater discretion to management for manipulating the numbers. Moreover, fair value as a measurement tool is not suitable to certain industries like banking and under certain economic conditions like GFC. Let us hope IASB and FASB come up with better and improved standard on fair value as a result of their joint project that is currently underway.
5 PART C
In the following sections, 2009 annual reports of CBA and Woolworths have been reviewed to identify and discuss the extent to which FVA was used.
5.1 Commonwealth Bank of Australia
CBA is the largest bank of Australia. The bank's financial statements have been prepared using the historical cost with some exceptions. For instance, the bank has used fair value measurements for the following assets and liabilities: derivative financial instruments, assets and liabilities at fair value through income statement, available-for-sale investments, insurance policy liabilities, domestic bills discounted which are included in loans, bills discounted and other receivables, investment property which backs liabilities paying a return linked to the fair value or returns from assets including the investment property, owner-occupied property, defined benefit plan assets and liabilities, employee share-based remuneration liabilities, and recognised assets and liabilities attributable to the hedged risk in a hedging relationship that qualifies for hedge accounting treatment (2009 Annual Report pp. 96).
CBA has made extensive use of fair value accounting for preparation of its financial statements because it operates in the banking and financial industry and most of its assets and liabilities are financial and financial instruments for which it has to apply AASB 139 Financial Instruments: Recognition and Measurement. Interestingly, the company is using fair value accounting for its investment and own occupied property instead of the historical cost approach.
5.2 Woolworths Limited
Woolworths limited operates Australia's largest network of supermarkets and is one of the biggest employers in the private sector. The company is mainly involved in retail food business but has also launched a financial services brand Everyday Money in 2008 (http://www.woolworthslimited.com.au/phoenix.zhtml?c=144044&p=our-history).
Woolworths's 2009 financial statements have been prepared on the basis of historical cost except following assets and liabilities have been measured using fair value: derivative financial instruments, financial instruments held for trading and financial instruments as classified as available-for-sale (2009 Annual Report pp. 77). As we can see, the use of fair value is limited to financial assets and instruments in case of Woolworths. The company is using historical cost accounting for majority of its assets and liabilities except mainly the derivative financial instrument. This is consistent with the retail industry that has to measure stock/inventory, its largest asset, at lower of cost and net realisable value.
Fair value accounting plays an important role in providing useful and relevant information to the users of financial statements for making economic decisions to allocate their scarce resources. Empirical research shows that fair value is considered a better, more relevant and comparable measure but not necessarily a reliable measure especially where fair value has been determined by the internal valuers instead of the external appraisers.
The role of fair value in creating the GFC is debateable although it can be said that it did play its part in amplifying the crisis. While fair value measurement does have its limitations i.e. lack of reliability especially in case of less or illiquid assets (e.g. Level 2 and Level 3 assets) and under financial turmoil, but there is no point in scraping fair value accounting without a better alternative. The current alternative, historical cost accounting, has its own demerits.
CBA has made substantial use of fair value accounting to measure assets and liabilities in its 2009 as against Woolworths that is using fair value accounting mainly for derivative financial instruments.