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This research focuses on studying about the impact of fair value accounting on the recent financial crisis during 2006 and 2011. After analyzing and assessing different debates over time regarding the pros and cons of fair value the research tried to understand the disparity between the two thoughts and recognize with the help of literature if fair value accounting did indeed affect the recession. By studying eight financial institutions around the world and understanding the implementation of fair value in their financial statements and comparing the shifts in their assets, liabilities, profits and losses the study aimed to derive the effect fair value accounting had on their efficiency and if it caused problems for the institutions well-being. The research showed that the fair value accounting did have a partial effect on the statistics of the financial institutions but this was limited to the seriousness the organization implemented fair value and its geographical location.
Chapter 1: Introduction
Lhaopadchan (2010) asserts that a shift in accounting standards occurred during the last ten years whereby organizations around the world started to value their assets on the bases of fair value rather than historical value. Fair value denotes the reporting of fixed assets on its current market price rather than valuing the asset when it was purchased. Lhaopadchan (2010) further suggests that the implementation of fair value costing has become increasing famous in accounting standards around the world as most firms now wish to maximize their asset value when it is being traded in the liquid market. Barth and Landsman (1995) state that in this era fixed assets aren't the only assets that tend to gain cash inflows for firms but the scope of intangible assets such as goodwill has created great sale price maximization prospects for organizations wishing to trade their assets. This chapter aims to analyze the critiques of historical cost accounting and identify how fair value accounting system was developed to overcome costing problems for organizations.
Application of Fair Value Accounting over Historical Cost Accounting
Critics of fair value accounting argue that it has been one of the major factors that triggered the financial crisis and failed to provide investors with useful information on asset values, especially on assets of financial institutions, to investors which eventually led to the collapse of the housing market and introduction of exotic and complex financial instruments.
On the other hand, its supporters believe that is has been the victim of the recent financial crisis (Jaggi, Winder & Lee, 2010). The main allegations are that fair value leads to excessive write downs in busts. The write downs due to falling prices deplete bank capital and set off a downward spiral, as banks are forced to sell assets at "fire sale" prices, which in turn can lead to contagion as prices from asset fire sales of one bank become relevant for other banks. These arguments are often taken at face value, but evidence on problems created by fair value accounting is rarely provided (Laux and Leuz, 2010).
Background Research: Historical Cost Accounting
Before the advent of fair value accounting system organizations used the historical cost approach for the valuation of their assets for the completion of their financial statements. Elena (2008) discussed the application of historical cost accounting prior to the 1980's and stated that this accounting approach was used to value assets and liabilities whereby the assets were recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition whereas the liabilities were recorded at the amount of proceeds received in exchange for the obligation, or on some circumstance at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business (Elena, 2008).
Oncioi (2012) talked about the disadvantages of using the historical cost account method stating that the method took into account the acquisition value therefore it was impossible to define its relevance as well as any shift in opportunities that related to the current life of the asset. As the asset did not reflect the current economic benefits as well as the time component it was impossible for firms to define the assets existing worth to the organization and any benefits incurred by holding it.
Diana and Ighian (2009) further argued that once an asset entered the company, the value of that asset was taken as the historical cost and then recorded in the accounting books. This accounting method also leads to the undervaluation of the organizations assets as it does not take into account any significant changes in the market prices.
Historical cost accounting was initially questioned at the time of inflation where inaccurate values were reflected of the actual situation. These inaccurate values were the under valuated assets which reflected the overvalued profits. Hence the performance of the company in such cases cannot be assessed accurately with the configured irrelevant information (Cascini & Delfavero, 2011).
Meaning of Fair Value Accounting
Ryan (2008) states that fair value accounting approach is a financial reporting system adopted by organizations around the world in which firms report their existing assets and liabilities on the prevailing established prices in the economy and then recognize the probable price they would receive if they either sold the asset or paid the liability. Furthermore IASB (2006) reports that the the term fair value seemed to be introduced by the accounting standard setters in the U.S followed by its adoption in the U.K and defines fair value accounting as "the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged between knowledgeable and willing parties in an arm's length transaction".
Comparing Historical Cost Accounting and Fair Value Accounting
Emerson et al (2010) provides four reasons for why fair value accounting is better in many ways than historical accounting. Firstly they say that over time, historical values do not designate the correct prices of the asset therefore it becomes extraneous when evaluating an entity's current financial position. Furthermore they argue that in the eyes of an economist fair values reflect true economic substance of the asset and liability. Thirdly the fair value accounting system reports economic income. It delivers a solution faced by accountant when measuring net assets as a change in the fair value of net assets yields income in the balance sheet. Finally, fair value accounting is an impartial measure which remains consistent over time across entities.
Fair value is used as an alternative to historical cost accounting for the same asset or liability but at different times. It is basically established from historical accounting to a fresh start accounting wherein the assets are valued at their replacement cost, with the unrealised gains and losses recorded in the income statement thus proving it to be a better indicator of the future as it would provide a greater impact on the earnings of the firm than providing unreliable information by considering only the cost of the asset. It is treated the same way when the exit value of the asset is calculated, the value being different from its historical or cost price. If historical price is taken into account, the investors would interpret false information on the firm's profitability (Penman, 2007)
Penman (2007) further continues his research by saying that the choice to use either fair value accounting or historical accounting depends on the users of the financial reports. Shareholders of an entity prefer the fair value accounting approach as they would know the true value of the stock but on the other hand bankers would report deposits of customers at a value lesser than the fair value in order to ensure their customers are happy and would sustain with their bank.
According to Trussel and Rose (2009), fair value accounting is to be used for claims that are short term, liquid and junior while historical cost for claims that are long term, illiquid and senior. Nowadays it is seen that fair values are reported as footnotes on the financial report in order to provide a true statement which provides relevant and reliable information to the users, however, one cannot only focus on the way the investors would like to see their company's financial report. Companies need to follow some sort of uniformity in preparing financial reports that would be compatible and would practice the existing standards set by the FASB & the IASB.
Differences in the Concepts of Fair Value Accounting According to IASB and FASB Regulations - U.S Perspective
IFRS differs from the U.S. GAAP with regard to the concepts of fair value accounting. While the IFRS reflects the exchange between a willing buyer and seller in its definition, the U.S. GAAP confides its definition to the exit value approach, thus taking into consideration just the selling price of the asset. While the IFRS takes into account impairment charges, revaluations of assets and liabilities and write ups; this degree of flexibility is not found in the U.S. GAAP (Graziano & Heffes, 2008).
Graziano and Heffes (2008) further asserts that companies following IFRS use fair values to measure assets/liabilities on their initial recognition at the balance sheet date and to record impairments. The IFRS requires companies to use fair value accounting to measure derivatives, equity investments; defined benefit plan assets, other financial assets held for trading, some biological assets and the list goes on. Under IFRS, loans and advances are measured at amortized cost model and not using fair value as impairment charges are difficult to estimate.
Fair value accounting model is said to bring about high profits to the company if the economy is thriving and vice versa. During the economic downturn capital is destroyed which results in excessive write downs which in turn leads to asset sales that leads to more falling prices. This is one of the reasons for which the U.S GAAP wanted to converge with the IASB because of the IAS 39 which excluded certain financial instruments from fair value accounting. Some of the accounting standards are amended due to political pressure in order to meet the economic objective of the country/state (Olsen and Weilrich, 2010).
While companies await the financial standards to converge with IFRS, Holthausen (2009) argues that even if the standards become uniform throughout the world, yet the reports would not be comparable because of the different market conditions and economic factors prevailing in different economies.
1.2 Research Objectives
The research objective for this study is to understand the "Impact of Fair Value Accounting after the Financial Crisis of 2007". The basic aim behind this research is to firstly identify previous literature that defines the scope of fair value accounting and any arguments prevalent about its implementation and adaptation. Apart from that the research will aim to analyse financial statements of eight financial institutions in order to see what has changed after the financial crisis based on the fair value accounting approach. The whole study will revolve around how the credit crunch affected firms around the world and the impact of fair value accounting methods on their financial assessments.
1.3. Motivation of the Research
Prior to the advent of the global financial crisis, it was commonly agreed that fair value accounting would become the method to measure financial assets (Fiechter, 2011). Critics of fair value accounting argue that it has been one of the major factors that triggered the financial crisis and failed to provide investors with useful information on asset values, especially on assets of financial institutions, to investors which eventually led to the collapse of the housing market and introduction of exotic and complex financial instruments. On the other hand, its supporters believe that is has been the victim of the recent financial crisis (Jaggi et. al, 2010).
The main allegations are that fair value leads to excessive write downs in busts. The write downs due to falling prices deplete bank capital and set off a downward spiral, as banks are forced to sell assets at "fire sale" prices, which in turn can lead to contagion as prices from asset fire sales of one bank become relevant for other banks. These arguments are often taken at face value, but evidence on problems created by fair value accounting is rarely provided (Laux and Leuz, 2010).
In this research, a review on the various debates with regard to fair value accounting on the financial crisis have been analysed so as to identify the role of fair value accounting on the financial crisis. The fair value approach is believed to be more relevant than historical cost accounting and to improve the entities financial reporting (Allen and Carleti, 2008).
Significance of the Research
This research is likely to benefit researchers who would want to enhance their knowledge on the impact of fair value accounting over the years. The findings that were discovered in this study was firstly, the approach to fair value accounting differed with the accounting standards adopted by different countries. Secondly, the changes with regard to fair value accounting after the financial crisis was adopted by most of the countries in a similar manner and it is also seen that companies are now awaiting the convergence of the IASB and the FASB in order to follow similar approach in reporting financials of the company.
Structure of the Research
The second chapter provides a review on the debates with regard to fair value accounting and its impact on the financial crisis has also been analysed in order to get a general overview of the research topic. The third chapter focuses on the research methodology wherein the approach followed in conducting the analysis has been put forth. The fourth chapter discusses the analysis on the eight banks that have been researched upon on the basis of fair value accounting, before and after the financial crisis. Lastly, the thesis will contain a conclusion that discusses changes that can be implemented to the fair value accounting approach in order to provide a better reporting system.
Chapter 2: Literature Review
This chapter delivers a comprehensive study on the impact of fair value accounting in the course of the financial crisis. The purpose of this chapter is to analyse literature that shows the impact fair value accounting had on the financial crisis and further more discuss the use of fair value accounting in financial reporting. The standards that have fashioned the base of fair value accounting and the changes executed by the standard setters have also been deliberated in order to see how fair value accounting has advanced over the years.
The first section in this chapter concentrates on the evolution of fair value accounting and its progression over the years. The second section then argues against and for fair value accounting. Following this section, an appraisal of fair value accounting on the latest financial crisis is provided so as to comprehend the concerns with fair value accounting that directed to the crisis and an analysis of the alterations that have been executed after the financial crisis is also undertaken. After this, the next section discusses the problems regarding IAS39 have been assessed and the modifications that were made after the financial crisis have correspondingly been indicated. With the institution of IFRS 9 in 2009, the amendment IAS39 has brought about has similarly been conferred so as to evaluate the improvements of this standard after the crisis.
The accounting for financial assets and liabilities is a complex issue that has been evolving towards the use of fair value. Both FASB and IASB provide the option of using fair value accounting in reporting financial assets and liabilities and certain other items. This move is not without any controversy. Many have estimated as it is seen in the previous chapter that the use of fair value accounting as opposed to historical cost accounting, has helped cause the turmoil in financial markets (Trussel and Rose, 2009). Research indicates that the exclusive use of one accounting method may not be efficient for financial institutions which are discussed in the section 'issues on fair value accounting on the financial crises'.
Evolution of Fair Value Accounting
In this section the development of fair value accounting from the historical accounting approach has been appraised, also its expansion over the years has also been acknowledged. With the introduction of fair value accounting it is seen that the historical accounting approach is not diminished by the standard setters as it provides potential information in certain situations (FASB, 2010).
Further to the approach to historical accounting, the FASB had created new accounting standards in this regard that is known to us by Statement of Financial Accounting Standards no.157; Fair Value Measurements.
Fair value accounting was developed as early as in 1930, but in 1938 President Roosevelt abolished it as he believed that marking to market was the cause of depression during that time. However in 1975 FASB issued FAS 12 known as Accounting for Certain Marketable Securities. Here in, companies were to report the unrealized gains and losses on marketable securities on the income (Cascini and Delfavero, 2011).
The limitations of historical accounting became apparent in the crisis in the late 1980s which was known as the U.S. Savings and Loan Crisis. As the interest rates rose in the 1980s the longer duration fixed rate mortgage loans held by many banks experienced decline in the asset values. To retain deposits, higher interest rates were provided to depositors which further hindered their economic performance and financial viability. Banks incurred further losses by increasing their investments in risky assets. This action along with increasing the interest rates, created conditions that led to the failure of more than 1000 banks (Linsmeier, 2011).In 1984 debates continued over asset valuation with the issuance of SFAC No. 5. This statement entitled "Recognition & Measurement in Financial Statements of Business Enterprise that provided a list of five alternative method for valuation (FASB, 1984) i.e., (i) historical cost, (ii) current cost, (iii) current market value, (iv) net realisable value & (v) present value (Emerson et al, 2010, p. 80).
Following this, the FASB did not rule out when these methods were to be used but believed that each method is appropriate depending on the circumstances. The board adopted the term fair value instead of market value so that estimates can be used as values for the financial instruments which cannot be traded in active markets (Dumitru and Giorgina, 2009).
Following this in 1991, FAS 107; Disclosures about fair value of financial instruments was introduced. In 1992 organizations with over $150 million assets had to record their financial instruments in fair value. In 1993; FASB issued SFAS 115; Accounting for Certain Investment in Debt & Equity Securities. This statement guides in valuing assets and all investment in debt securities at readily determinable fair values wherein debt securities that were held to maturity were to be recorded at amortized cost. Those that were being traded were to be reported at the readily available market values. The remaining that was not designated to the above two was deemed to be available for sale and was recorded at the fair value. In 1994; FASB disclosed FAS 119 wherein derivatives were to be reported at fair values. It was called Disclosure about Derivative Financial instrument and Fair Value of Financial Instruments. Then lately in 2006 FASB added the SFAS 157 & 159 i.e. "Fair Value Measurements & The Fair Value Option for Financial Assets and Financial Liabilities" respectively. The SFAS 157 provided a framework to fair value accounting and requires reporters to disclose all information regarding measurement of the fair value obtained by them.
FASB though has introduced various changes to the accounting model in measuring the financial values over the years; they propose not to do away with the historical cost model as it helps in providing useful information on the potential cash flows. The difference between this model and the fair value accounting model would capture the expected impact of the current economic condition on existing financial instruments. Hence FASB 2010 recommends that both these models to be used while reporting in the financial statements as both these measures would be given adequate attention by the banks and their auditors.
Arguments For And Against Fair Value Accounting
The FASB & IASB supported the thought of fair value accounting stating that historical cost accounting lacked transparency and was out dated and that a move towards fair value accounting was very much necessary (Leone, 2008). Thus in fair value accounting the balance sheet satisfies the valuation objective and the income statement provides information about risk exposure and management performance.
Dumitru and Giorgiana (2009) have supported fair value accounting and have commented that this method of valuing assets and liabilities is not to be blamed for financial problems within an entity. It is the best measure to understand the current standings of the company and helps the investors to gain an up- to- date information about the company and measure its performance accordingly. It also represents and error of valuation in the eyes of the investor in a short interval of time. It even claims to boost transparency to investors (Cherry and Hague, 2009). Though fair value accounting is transparent to investors, it does not provide the intrinsic value of the firm or help in evaluating future cash flows.
As fair values make financial reports more reliable to the users, the comparability of this report may diminish due to continuous adjustments and impairing of the assets and liabilities value. According to Flegm (2005), fair value accounting was a cause of the largest frauds that have happened till date which includes Enron. Enron's accountants used accounting devices to report cash flow from operations rather than financing and to otherwise cover up fair value overstatements and losses on projects undertaken by managers whose compensation was based on fair values (Benston, 2006). While historical value accounting provides a base to make judgments and opinions for the auditors, fair value accounting reports are not easily auditable.
As the stock markets grow the income statement is more viewed at than the balance sheet by the users. Reviewing this statement, FASB had implemented fair value accounting in order to show the users the company's future. But this adds on to the pressure faced by the accountants and auditors to make judgments on the fair values implemented without any base for an evaluation. McCarthy (2004) also favored historical accounting by saying that it is better than using probabilities for fair value estimates and hence shall be more valuable to the users of the report.
The next criticism that evolved was that fair value accounting helps reporters to manipulate numbers in order to reflect desired earnings. This is usually done to meet one's personal needs. Even with a desired cash flow model values can be understated or overstated as per the requirements of the management. The main objective of financial reporting is to provide useful information to the users in order for them to make rational decisions. The information thus has to be reliable, relevant, and comparable. Though relevance of information is more important than its reliability, some degree of reliable information needs to be considered for it to be relevant. So far fair value accounting has been based on unbiased market prices. But when market prices become biased or when the values are taken based on factors other than the unbiased prices, then these values become less relevant and reliable thus misleading the investors and other users of the financial report.
Thirdly, in developed economies fair value accounting seems to be the best approach as markets are efficient in order to achieve accurate values. But in an emerging economy adopting fair value accounting is very challenging because of the absence of a well functioned market. And as investors find such markets a good investment; they are sceptical in investing because of the historical accounting approach that these economies follow as they find it to be irrelevant and misleading (Peng and Bewley, 2010).
Issues on Fair Value Accounting On the Recent Financial Crisis
Following are some of the many criticisms that were made on the role played by fair value accounting on the recent financial crisis. Chea (2011) stated that fair value accounting boosted the financial crisis by forcing the write down of "good" assets because of reduced market prices.
This accounting method forces bank to reduce capitals without considering the cash flow or the loan performance (Fahnestock and Bostwick, 2011,). It has even been criticized that fair value accounting causes contagion due to overreacting investors and creditors. Thus if fair value accounting was transparent as it claims to be, contagion would not have occurred. Magnan and Thonton (2010) argued that fair value accounting was brought about by standard setters in order to tailor the entity with the information needs of the investors especially shareholders and other financial statement users.
Net income is generally seen as a predictor of the future cash flows. In the traditional system of accounting, changes that occur in the market values were not recorded. Hence how could one be right about the future cash flows? Unrealised gains were realised in the form of cash and were traded assuming they were same as realised gains. Due to this, when the economic down turn occurred, the entities did not have sufficient capital to cover for the losses. The effect of this downturn resulted in contagion. But in fair value accounting these changes are recorded and hence the unrecognised gains and losses are recognised in the income statement thus providing accurate data (Fahnestock and Bostwick, 2011).
Of the 140 U.S. banks that went through the financial crisis in 2009, 120 banks reported data showing positive net worth on their balance sheets. Four to six months later the financial crisis had a hit on these banks. These banks were considered adequately capitalised by the regulators. Their financial statements were prepared in accordance with the U.S. GAAP, and gave only a little indication on their deteriorating condition.
Twenty years ago when bankers used to report values on the basis of historical values, this model then failed to reflect the declining values of the assets and the arising levels of credit risk was being assumed across the banking industry and the failure to recognize the losses and loans had led to delayed recognition in understanding the underlying economic problem which were some of the reasons for the crisis back then. Fair value information warns investors and regulators of the risk levels and the declining asset prices due to changes in the market conditions (Pozen, 2009).
In 2007, as the collateral backing residential and commercial real estate loans plunged into value; it drove down the value of the related loans and debt securities in the portfolio of the U.S and other global banks. The current reporting system failed to measure these changing values and thus led to decline in the value of the assets which resulted into the financial crisis. Hence the shortcoming of the existing accounting model was blamed for in this regard.
The historical accounting model was said to capture the deterioration of the capital strength very slow which were of no use to the investors and regulators. The banks were actually deteriorating way prior to the financial crisis. But only few months prior to this crisis the capital ratios slipped to the undercapitalized category and by then it was too late for the banks to do something about this deterioration or for the regulators to help them with this or for the investors and depositors to save themselves from this imminent crisis. Historical accounting is not designed to assess the changes in the interest rates as and when they occur. It does not provide any provisions for these changes. Even if these changes are recorded, they are just estimates made by the management which are generally unreliable (Linsmeier, 2011).
Banks are involved in making or receiving payments. These are generally done by means of a financial contract. The values of these contracts can rise and fall rapidly depending on the changing interest rates, economic conditions, deregulation and other factors. In 2007, as the collateral backing residential and commercial real estate loans plunged into value; it drove down the value of the related loans and debt securities in the portfolio of the U.S and other global banks. The current reporting system failed to measure these changing values and thus led to decline in the value of the assets which resulted into the financial crisis. Hence the shortcoming of the existing accounting model was blamed for in this regard.
The historical accounting model was said to capture the deterioration of the capital strength very slow which were of no use to the investors and regulators. The banks were actually deteriorating way prior to the financial crisis. But only few months prior to this crisis the capital ratios slipped to the undercapitalized category and by then it was too late for the banks to do something about this deterioration or for the regulators to help them with this or for the investors and depositors to save themselves from this imminent crisis.
Historical accounting is not designed to assess the changes in the interest rates as and when they occur. It does not provide any provisions for these changes. Even if these changes are recorded, they are just estimates made by the management which are generally unreliable (Linsmeier, 2011). Studies have shown that fair value accounting provides more information about the performance of a company as compared to any other accounting model. It even provides a better depiction of the economic position and provides accurate values of the assets and liabilities put down in one's balance sheet. Furthermore Koonce (2009) an accounting professor stated that fair value accounting communicated the effects of the bad decisions as granting subprime loans and writing credit default swaps by keeping those loans at the original value would just be providing irrelevant information and ignoring the reality.
Changes Implemented after the Financial Crisis
As discussed earlier that fair value accounting was criticized for bringing about the crisis, the IASB then introduced an amendment to IAS39- Financial Instruments: Recognition & Measurement and to IFRS 7: Disclosures as on 13th October 2008. These amendments permit non derivative financial asset held for trading to be reclassified as either available for sale, or held to maturity in rare circumstances and as loans and receivables if they would have met the definition at initial recognition and if the entity has the intention and ability to hold the financial asset for the foreseeable future or until maturity.
This reclassification gives companies the opportunity to avoid future fair value losses on reclassified assets formerly classified as held for trading. Following the amendments made were the criticisms that were brought by many companies. Some of them were that it favours the IFRS over the competitors that apply US GAAP. From the investors point of view the new changes reduced consistency, comparability and transparency of financial statements. JP Morgan (2008) pointed out that these amendments were adopted during the economic crisis with financial institutions in mind and thus would affect accounting and investors in non-financial institutions.
IFRS 9 was introduced in 2009 to replace IAS39 wherein the aim was to simplify the existing accounting standards with regard to financial instruments. Some of its objectives are to amortize cost calculation, improve depreciation valuation & fair value option. IFRS 9 uses a simplified approach to define whether or not a financial asset should be measured at fair value or at amortised cost, replacing the different rules in IAS39. If a financial asset is being held within a business model whose objective is to hold assets for the purpose of collecting contractual cash flows and its contractual terms produce cash flows on specified dates that are solely payments of principal and interest, on the principal outstanding, then it is measured using amortised cost. If the asset does not fall in the above category, fair value measurement has to apply. In IFRS 9, it calculates effective rate the same way as the IAS39. However changes have been made to identify any potential loss on the future treasury cash flows used to work out the effective rate. Only those assets that are measured at amortised cost are to be depreciated.
This chapter shed light on the application and evolution of fair value accounting prior to the start of the financial crisis of 2007 and further discussed its effects subsequently after the crisis has simmered down. Several researchers discussed the level of uniformity and conformity in measuring the assets and liabilities of a firm. Furthermore the literature assessed also provided ample argument that reasoned the fact that the fair value accounting did not bring about the financial crisis as different ideas about the lack of knowledge of the financial reporters as well as the fair value losses that were recorded or the low value of the assets measured with the fair value accounting approach that forced bankers to keep their asset which led to writing down of the asset that led to the crisis were discussed with regard to the application of fair value on the crisis.
Evaluating these arguments with relation to fair value accounting it can be seen that financial report preparers have not followed any uniformity in recording their assets/liabilities at fair values which had led to amendments in the standard, IAS 39 wherein assets were reclassified in order to avoid future economic losses. Further to this standard, a mention of the IFRS9 has also been stated in order to recognise the changes it would bring about in the reporting system.
In the next chapter, we thus look into the eight samples of banks drawn and understand the changes in classifications of the financial assets before and after the financial crisis.
Chapter 3: Research Methodology
This chapter will discuss the basic approach used to conduct the research for this topic. To identify and understand the impact of fair value accounting on the recent financial crisis, a detailed analysis of eight banks would be done with the assistance of their annual financial statements. The impact of fair value accounting on their practices will be seen and this is done in order to understand the impact fair value accounting has on global perspective.
To understand the impact of fair value accounting on the financial crisis an analysis of eight banks and their financial statements will be done. Also any changes implemented by them with respect to fair value accounting after the crisis simmered down will be seen. Eight banks from around the world have been chosen for this study and has been done in order to understand the impact fair value accounting has on a global perspective.
The first section of this chapter discusses the research design in order to understand how this research has been conducted. Following this section, the research methodology and its philosophy will be assessed. The next section discusses the data collection and analysis which is followed by the summary of this chapter.
3.2. Research Design
According to Love (2000) it is important for the success of any study to have a proper and stable research design. For an effective research design it is important for the research to correlate the research problem and research questions with methods that would yield the most positive results. For this research study, initially eight financial banks from around the world were selected to understand the global effect of financial crisis on their activities. After this their financial statements will be reviewed to compare the impact of fair value accounting on their activities and performance and finally analyze if the fair value method altered their performance in any possible way.
3.3. Research Methodology
Weiss and Sirbu (1990) identify the use of qualitative methodology as a perfect approach that positions the study towards innovation and the complete understanding of what processes have been going on. According to them the research provides a descriptive analysis of the chosen variables and with details gives the researcher a perfect in-depth understanding of the given content and its processes.
Qualitative data refers to all non-numeric data or data that have not been qualified and can be a product of all research strategies. It can range from a short list of responses to open ended questions to more complex data such as entire policy documents. This allows developing theory from the data obtained.
Financial reports of companies contain qualitative as well as quantitative data. The analysis in this research was based on the footnotes that were available on the financial reports which provided with information to the fair value accounting approach that was used by these institutions. The information recorded is purely qualitative in nature. There are two perspectives that underpin the impact of qualitative analysis i.e. the deductive and the inductive approach (Saunders at al, 2009).
3.3.1 Research Philosophy
For this research paper an inductive logic approach has been used. This approach begins by investigating appropriate important events and their relative data; our situation talks about the financial crisis respectively. Once the data is assessed the researcher then recognizes larger segments of the assumed variables that are supposedly evaluated and hence comprehends their relationship. As given in the philosophy, once the data is calculated the relationship between the financial crisis of 2007 and fair value accounting will be analyzed to derive the existence of a relationship.
The aim of this research is to qualitatively assess the affect fair value accounting had on the global economic crisis and for this to be seen it is important that a qualitative analysis be conducted to critically assess the cause and effect relationship. As our research is qualitative, the inductive approach is the best possible approach to utilize when reasoning with the research method as it provides the research with inspiration to firstly collect the data and then assess it with the chosen variables to identify any affect either one had on the other.
3.3.2 Research Approach
The research approach provides reason to the researcher for choosing his particular tactic. Schadewitz and Jachna (2007) identify two approaches for a study; deductive and inductive. The deductive approach is a hierarchal method of attaining conclusion by firstly developing a theory then identifying an hypothesis and after that once the observation is done the hypothesis confirmation is identified. This approach is preferable for quantitative studies but for qualitative studies the inductive approach is considered impeccable. This works completely oppositely than the deductive method as the initial step is to conduct observation and once a noticeable formula or pattern is derived the researcher then develops a hypothesis and results it with a theory.
In this study the inductive approach has been used as analysis of different banks with respect to their financial statements and accounting methods will be analyzed initially and after that a logical explanation will be given to identify if the fair value accounting method did have an effect on the financial crunch.
3.3.3 Research Strategy
The fair value accounting approach of eight banks will be analysed based on their financial reports. A comparison of the approach adopted in the year 2006 and 2011 has been provided with in the next chapter to understand the impact fair value accounting on the financial reports of these institutions. By using this notion we will get the comparison of the organizations functioning between two different time and economic periods; 2006 market the initial era of the crisis whereas 2011 can be considered as a seemingly post crisis time period. The footnotes on the annual reports provided the necessary information in analysing the data.
3.3.4 Data Collection
The data collected in this research is qualitative. Qualitative data refers to all non-numeric data or data that have not been qualified and can be a product of all research strategies. It can range from a short list of responses to open ended questions to more complex data such as entire policy documents. This allows developing theory from the data obtained. Financial reports of companies contain qualitative as well as quantitative data. The analysis in this research was based on the footnotes that were available on the financial reports which provided with information to the fair value accounting approach that was used by these institutions. The information recorded is purely qualitative in nature.
188.8.131.52 Secondary Data
Secondary data refers to using information previously collected that relates to your study. In this study the only secondary data collected are the different financial statements of two time periods; 2006 and 2011 and this has been done via the internet and the official websites of the eight chosen banks.
Sampling techniques provide a range of methods that enables to reduce the amount of data needed to be collected by considering data only from a subgroup rather than all possible cases or elements (Saunders et al, 2007). In this study the sample size is eight and the data has been collected from the annual reports of banking institutions. Banking institutions have been chosen because the financial crisis has had a high impact on their sector.
Non-probability sampling was preferred for this study. Non probability sampling provides a range of alternative techniques to select samples based on subjective judgements (Saunders et al, 2007). There are various sampling techniques under non probability sampling but the most prominent in the purposive sampling technique which has been used in this study.
Pros and Cons of the Sampling Technique
Purposive sampling enables to use ones judgement to select cases that will best enable to answer the research questions and meet the objectives (Neuman, 2000).
This sampling method basically enables ones judgment to select cases that will best enable to answer the research question and to meet the objectives. This form of sample is often used when working with very small samples wherein cases are selected that are particularly informative (Saunders et al, 2009). The research uses primary data i.e. self-administered financial reports of banks located in different countries to conduct this study.
184.108.40.206.2 Target Sample
BANKS CHOSEN FOR THE ANALYSIS
JP MORGAN CHASE
WELLS FARGO CO.
ICICI BANK LIMITED
AMP BANK LIMITED
NATIONAL BANK OF PAKISTAN
These banks are selected randomly. The main reason for selecting these banks is because they all belong to a similar industry, i.e. the banking industry and a comparison can be done based on its location. As different countries follow different accounting principle, this study is done so as to get an overall perception of the fair value accounting policy adopted and to also check if active or inactive markets in the countries where these banks are located affect the accounting practices followed with regard to fair values. Thus the banks that have been analysed are taken from developed as well as developing economies. These banks selected provide financial services to corporations, individuals and the government. Based on the annual reports of the company for the year 2006 & 2011, the data has been analysed.
3.3.5 Data Analysis
The data collected in this research contains only the financial reports of the eight banks mentioned above for the years 2006 and 2011. These banks were selected based on their location so as to cover the accounting practices with regard to fair value accounting ranging from one corner to the other corner of the world. These banks were also selected on the basis of the economy they fall under in i.e. either developed or developing economy, in order to check whether it plays any role on the financial reports of the banking institutions. The data collected is based on primary observation of the financial reports and the data provided is obtained mostly from the footnotes of the financial reports wherein an elaborate data on the fair value approach is provided by the banks.
3.4 Validity and Reliability
The data collected for this study has been through valid and reliable methods. The banks official websites and their published financial statements have been reviewed for the reliable assessment of the study. The validity is high as the data collected is direct and comes straight from the company rather than an intermediary source such as a database or website providing organizational statistics. The chosen banks are also a reliable choice as they are famous banks that have been spread around the world hence this gives us the benefit of assessing the global effect of fair value accounting on financial crisis rather than focusing mainly on one region of the world and its financial institutions. Plagiarism has only been conducted when the firm's direct statistics have been numbered but they have also been referred and with respect to the study all the researchers that helped or contributed to this study with their literature have been acknowledged and referred.
3.5 Limitations of the Study
As fair value accounting is adopted for most of the financial assets and liabilities of the banks, an analysis based only on the financial instruments are provided in this research. For the sole reason that the banks chosen mostly deal in financial instruments and because these financial instrument hold a subsequently huge value in the banks. Another limitation would be that, only a general idea is provided about the banks. A detailed description of the banks is not provided in the study because the focus here is mainly on the fair value accounting practices adopted by these banks. Also the data collected is restricted only to the financial reports of the banks.
A final limitation that can be considered while analysing the data from the reports would be to correlate the information from the two reports. As a lot of time would have been passed the structure and design of the reports would be changed which would in turn make it difficult for the research to analyse two variables based on the same context.
This chapter thus focuses on the methods adopted in conducting the research. As discussed the banks selected for the analysis were at random which has covered the developed as well as the developing economies in order to analyse whether markets in such economies play a role in the financial reports of the banks. The sampling technique used was purposive sampling. The data collected is purely qualitative which are obtained from the footnotes of the annual reports. The years 2006 & 2011 have been selected in order to identify the changes in the financial reports with regard to fair value accounting which would help in comparing the data with the arguments discussed in the previous chapter.
Chapter 4: Analysis
This chapter discusses the findings gathered from reviewing the financial statements of the eight chosen banks. The arguments provided by researchers in the literature review have been kept as benchmarks and then the banks have been reviewed on their given statements and conclusions. The study aims to analyse the effect fair value accounting had on the financial crisis and by reviewing the changes brought about by banking institutions around the world it will be easy for us to focus on the shift in their financial statements in during the two specific time periods.
4.2. General Overview
As discussed in the previous chapter, this research chose eight different banking institutions from different parts of the world; U.K, USA, India, Australia, Pakistan and Africa. By choosing different countries the study implements the factor of globalization and also the individual economies operating in the developing and developed countries. These banks use fair value accounting in measuring most of their assets and liabilities and in this research we have focused on identifying the changes adopted by these banking institutions on the fair value accounting approach over their financial instruments. As these banks deal with financial instruments on a large scale, the impact of fair value accounting would thus be more in this area. The following section will provide the findings that have been achieved through the analysis of the data collected.
4.3. Findings from Financial Reports of Various Banks: 2006
This section will focus on the financial activities of the following banks during the year 2006 and this initial information will then be compared to the 2011 data to see the effect fair value had on organizational performance during the crisis.
As defined by the Goldman Sachs Annual Report (2006) the fair value accounting method is detrimental to their financial statements and is also the most "critical" accounting policy. For their financial performance, Goldman Sachs divides their financial instruments into three basic components;
Cash (A Non-Derivative) trading instrument.
The following data has been collected from the Goldman Sach's Annual Report (2006)
(Goldman Sachs Annual Report, 2006)
The above graph taken from the Goldman Sach's report adheres to Dumitru and Giorgiana's claim about fair value accounting providing the exact information about the company and its performance. Without this method the investors in Goldman Sach's wouldn't be able to incorporate the current price of the institution's financial assets. If these assets were reported at historical cost there prices would be insufficient to attract investors but as they are priced with reference to the quoted prices in active markets the investors can see the shift in 2005 and 2006 assets that are currently owned and un-owned.
The organization stated that its cash non-derivatives were valued on current active market prices quoted by brokers or dealer price quotations. The derivative contracts were based on fair values defined by the current market price. The principal investments in Goldman Sachs are deviant from price transparency and the fair value is identified by cost approximation with the assistance of inputs such as financial performance of companies in the sector and also the relative trends prevalent in the sector along with operating cash flows of corporations (Goldman Sachs, 2006).
In the year 2006; the financial assets and liabilities for JP Morgan were measured at fair value as shown by its Annual Report (2006). Depending on the trading activity of these assets, the prices were then determined. Fair value of these assets was documented at quoted prices and these assets were traded actively in the market.
In cases where the quoted price was unavailable for certain assets the management then made a judgment on the valuation models to be used. It was seen that in 2006 around 83% of its securities were valued on quoted market prices. 13% adopted the observable market price as the market was inactive for them and finally the 4% assets left were valued by the Market Approach described by (Zacharski, Rosenblat, Wagner and Teufel, 2007). As there was no sufficient data available in the market regarding the price of the asset JP Morgan then had to take the prices of similar assets to value their financial assets at the fair value.
(JP Morgan Annual Report, 2006)
In 2006 the derivative receivable market to market value or fair value of the JP Morgan Co. was $56 million.
(JP Morgan Annual Report, 2006)
Wells Fargo and Co
According to the Wells Fargo and Co. 2006 Annual Report, they implemented they FAS 155 "Accounting for Certain Hybrid Financial Instruments". This is contains financial instruments that contain embedded derivatives. Wells Fargo in their Annual Report hence recorded the derivative at fair value. Wells Fargo, as employed in USA did not attain the right to employ fair value accounting on its assets until January 1 2008 hence in 2006 it was still trying to analyse if it needed to employ the FAS 157 earlier than required. They also stated that with the employment of FAS 157 they did not expect a drastic change in their financial statements. The company measured fair value as the price that the company would receive after selling an asset or had to pay after transfer of a liability.
In 2006, Wells Fargo held debt and marketable securities that were primarily for the use of increasing liquidity and interest rate risk management and these were valued at Fair Value.
Apart from this Wells Fargo considers its assets as the right to service mortgage loans for others and these are known as MSR's. During the start of 2006 they implemented the FAS 156 and valued their MSR's at fair value. Once the MSR's are launched they are then purchased and then capitalized at fair value. After implementing the fair value accounting at their given asset of MSR's the company experienced as increase of $101 million retained earnings in their balance sheets.
(Wells Fargo Annual Report, 2006)
Also all the market risk activities of Wells Fargo that include securities, foreign exchange transactions and derivatives are all carried at fair value.
ICICI Bank Ltd.
ICICI Bank Ltd. India did not provide much information on fair value as it discussed no notes based on the accounting method. After assessing the company it was found that the company did value some of its assets at fair value. ICICI implemented Indian GAAP which is somewhat the same as USA GAAP and therefore considers all the market prices of the given investments. ICICI bank considered that if it used the fair value model of accounting its compensation costs would have been much higher. Although they did not use the fair value model they stated in their annual report that if they did measure their diluted earnings per share on that basis then they would use the following assumptions for measurements (ICICI Bank Ltd, 2006):
(ICICI Bank Ltd Annual Report 2006)
ICICI valued its investments on the existing market price and did include the provision for fair value when valuing its investments as shown below;
(ICICI Bank Ltd Annual Report 2006)
In 2006 Standard Bank's annual report focused on financial assets being recognised at fair value plus transaction cost except for the ones being carried at fair value in the profit & loss account.
The asset is recognised when the asset is purchased and is derecognised when no future cash flows come into the company from this asset or when it is sold. In case of securities, if these are to be transferred, they are recognised as "available for sale "assets and the difference between the amortised cost and the fair value is accounted for in equity.
Standard Bank also values all its investments properties at fair value in the balance sheet. With respect to fair value any adjustments made are included in the income statement under the heading of investments gains and losses incurred. Also financial guarantee contracts are also valued at fair value and after than amortized for the rest of their financial life (Standard Bank, 2006).
In 2006 the fair value of Standard Bank's assets and liabilities including all financial instruments was
(Standard Bank Annual Report, 2006)
AMP Bank Limited
AMP Bank Ltd, a wealth management business stated that it measures all its assets, liabilities, revues, expenses and life insurance contracts on the basis of fair value.
Most of AMP's investments are valued at fair value and these investment assets are usually held on the behalf of AMP's policyholders. AMP's basic financial assets such as cash and cash equivalents are based on fair value that is quoted on the market. Its accounts receivables, equity securities and debt securities are all valued at fair value. When measuring equity securities their fair value is calculated by finding out the basic cost of the asset without including any initial transaction costs. Debt securities are also measured using the same process. AMP's derivatives are also valued at fair value but on the basic date they were entered into contract with. With respect to derivatives associated as assets, they were marked as positive whereas the liabilities were considered as negative (AMP Bank Ltd, 2006).
The value of AMP's debt and equity securities in 2006 were as followed and all valued at fair value.
(AMP Bank Annual Report, 2006)
Also its net gains by employing fair value accounting technique on its investment property were
(AMP Bank Ltd Annual Report, 2006)
Also while calculating its cash flows, AMP realized gains from changes in fair value with respect to cash flow hedges reserve and this increased their cash flow from $3mn to $15mn.
When assessing Barclays Annual Report it was seen that, in 2006 adopted the IFRS accounting method. Even though there wasn't much content related to fair value in the Annual Report with respect to additional footnotes it was easy to analyse where Barclays had implemented fair value. With respect to its assets Barclays measured all its trading and financial assets at fair value.
(Barclays Bank Annual Report, 2006)
Apart from that when calculating its net trading income, Barclays again used fair value accounting to derive the net income from its financial instruments.
(Barclays Bank Annual Report, 2006)
After implementing the fair value accounting method Barclays stated that many of its assets and liabilities were valued at fair value and these movements were reported within net trading income and net investments income but only depending on the nature of the given transaction. By using the fair value accounting method, Barclays experienced around £317m increase in investment income. Barclays also valued its commodity derivatives at fair value and by doing this they again experienced an increase in the value of their contracts by the end of 2006.
(Barclays Bank Annual Report, 2006)
Barclays stated that most of its financial instruments such as derivatives held for both trading and risk are valued at fair value. According to them the fair value of any instruments it the amount at which the instrument could be sold or exchanged between willing parties (Barclays, 2006).
National Bank of Pakistan
According to the Annual Report (2006) National Bank of Pakistan values all its derivatives on the basis of fair value at quotes the active market prices. In case the derivatives are not available on the market they are then valued by using Market Approach technique by using the interest rates as the input for calculating the exact value. National Bank of Pakistan usually sell their equity once the decline in fair value goes below its cost and hence in not profitable to keep.
The bank's investments are initially recognized at their cost but fair value is considered when inquisition cost is calculated. The derivatives recorded in the financial statement consist of foreign exchange contracts, equity futures and interest rate swaps. They were measured at fair value when initially recognized and re measured at fair value subsequently. The bank also reported that when quoted market price was not available then the discounted cash flow model was used to determine the fair value and any changes in the fair values were recorded in the profit & loss account (National Bank of Pakistan, 2006).
In 2006, National Bank of Pakistan's financial instruments with respect to fair value accounting accounted as
(National Bank of Pakistan Annual Report, 2006)
4.4. Findings from Various Banks: 2011
(i) Goldman Sachs
In 2011, Goldman Sachs used fair value to value most of its assets such as commercial paper, mortgage and other asset backed loans and securities, bank loans, corporate and debt equities and others as identified below
(Goldman Sachs Annual Report, 2011)
If we compare this to Goldman Sach's previous asset value of debt obligation in 2006 we can see that by using the fair value hierarchy they increased their value of debt obligation from $192 to $ 4362 in 2011. With respect to equities held by Goldman Sachs in 2011, by using fair value accounting they experienced a net gain of $596 million. Considering the market was still suffering the turmoil of the crisis this gain was quite a lot. In 2011, the cost of financial instruments held by Goldman Sachs accounted to around $364,206 whereas in 2006 their total value was around $328,536 million and this showed an increase in the value of the financial assets based at fair value and could be due to hedging or increase in active market prices (Goldman Sachs, 2011).
As assessed by their Annual Report, when quoted prices are not available in the market, the company uses valuation adjustments like the credit valuation adjustment where in the adjustments are done to reflect the credit quality of each derivative counterparty to arrive at fair value; debit value adjustments, this is done in order to reflect the credit value of the firm and reflects it being consistent with the credit value adjustments. The fair values that are measured by the company on the basis of their own valuation models do not reflect the net realizable value of the asset/liability of provide future fair values.
These fair values pertain only for the time when the asset/liability is being valued. In the consolidated balance sheet, some of the assets and liabilities are not carried at fair values but on approximate values due to their short term nature and because they do not impose a high credit risk in the market.
These include cash, bank deposits, accounts payables, accrued liabilities, short term receivables etc. the carrying value and estimated value for these assets and liabilities are mentioned as notes to in the financial report. The estimated value is drawn from the discounted cash flow models adopted by the company. And the dif