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One of most important part of a business, accounting is the process of measuring business activity, processing the information into reports and communicating the results to information users, which are the decision makers. It is a heavily researched and analyzed subject which, the more you develop, raises the more questions. But it is a crucial subject which helps relay the most accurate information to users. For Accounting to be thus, the 'language of business', it needs to have a set of rules and regulations which are followed by every business for the ease of communication and understanding, and most of all, reliability and relevance.
A part of accounting, cost is a reliable and objective measure for accounting. It can be confirmed by an independent observer, and supported by invoices. Ideally, accounting records should be based on information that comes from reliable, documented sources. Otherwise, accounting would be based on the whims and opinions of different people and bound to create conflicts. Hence, accountants in the early days, used to emphasize recording goods at their historical cost.
In the recent years, one of the most controversial and highly disputed systems of accounting has been the use of Fair Value System. The Fair Value is an accounting procedure in which the price of an entity, either an asset or a liability, is reported at their market value, i.e., the price at which the good can be exchanged or sold in an arm's length transaction (Horngren, et al, 2001). The fair value accounting system, also known as "mark-to-market," states that goods should be priced at their market value, as opposed to there purchase price or, the historical cost. In the fair value system, all available information that exists in the market is used to estimate the price of the entity, be it an asset or a liability. During the last 15 years, FASB has adopted standards that have expanded and refined the application of fair-value accounting because it has been widely viewed as an important driver of increased transparency. Put simply, applying market information to valuing assets and liabilities gives investors relevant information about the economic realities of the companies in which they choose to invest (Fornelli, 2009).
Fair Value Accounting has drawn a lot of criticism as it questions the two fundamental needs of accounting, which are relevance and reliability. How can an estimate, considered to be the market value for a good, be considered relevant and reliable, without it being confirmed?
How did the Fair Value Method come into practice?
The use of market information to estimate prices of assets has been going on for over 30 years. The historical method of pricing goods was ineffective when Financial Institutions in the 1980s started issuing credit with fluctuating interest rates. Also, the increased use of financial instruments made historical pricing inaccurate and useless, especially when the cost of trading some instruments was zero. This led to various financial and accounting bodies coming together to provide for a more transparent procedure, and developed the system we know today as fair value (Pita, Gutierrez, 2006).
The United States was the first to adopt Fair Value Accounting in their financial Statements in 1992. Although many Banks and Institutions retaliated to this move, other countries followed suit and now, fair value is an important part of Accounting. Also joining the move was the International Accounting Standards Board in 1999, who issued accounting standard IAS 39, which stated that financial instruments, like bonds or securities, were to be priced at fair value, if they were purchased for trading or capital gains purposes.
Advantages of Using Fair Value Accounting
In today's changing economy, investors want to know what an asset is worth 'today' to make their buy and sell decisions. The FASB has concluded that fair value is the most relevant measure of accounting for financial decision making and hence, investors strongly favor the fair value system of accounting.
There are several advantages in pricing assets and liabilities by their fair value.
Firstly, Fair Value encourages transparency in financial reporting. The more your entity is fairly valued, the better understanding the people have of the financial standing of the firm.
Secondly, Fair value is a good measure of risk, demand and supply of a good, its capital worth, and many other factors. For example, companies that have a high level of debt capital are forced to be responsible about the level of risk they are exposed to, as high risk can decrease the value of the asset.
Thirdly, Fair Value helps provide necessary information about the assets and liabilities of a firm compared to their historical costs. Since fair value takes the present economic conditions into perspective for valuing financial instruments, it helps in comparing the value of the instruments at different time periods.
Finally, there are some financial instruments which firm's have that are hard to value, in which case it is necessary that the fair value system is used to estimate their worth (Explanation and Benefits of FVA, 2002).
Problems with Fair Value Accounting and the Effect of the Financial Crises
The Fair Value Mechanism is a very controversial accounting system, which is considered to largely benefit investors and has received a lot of criticism. The concept of fair value is simple, but the problem arises when the concept is applied in practice. As of now, both the IFRS and US GAAP have a mixed attribute model of accounting, in which historical cost and fair value are both applied in valuing assets and liabilities. The US GAAP has a three level hierarchy which indicates how to apply fair value based on the amount of information available in the market. The three hierarchies' are-
Level 1: For which the market values for transactions are readily available and hence, are the most reliable source of fair value information. An example for this would be a stock exchange market where the current prices of all shares are displayed and can be used to value our personal portfolio of shares.
Level 2: For this type of assets or liabilities, the information is not as easily available and hence, reporting entities have to use a less- accurate measure of information to value the object.
Level 3: This type of asset/ liability has hardly any information available and is hardest to value. Hence, it is the entity's most risky asset/liability and internal, unobservable information is used to value the item.
The recent Financial Crisis, which began around 2007 and 2008, has played an important role in the arguments against Fair Value. Some of the reasons why fair value is not preferred are-
Firstly, Market Volatility acts strongly against fair value accounting. In times of a credit crunch, or a financial crisis, most markets are illiquid, meaning markets are in a stationary period in which nobody wants to buy or sell any commodity till the conditions improve. Hence, there is no cash flow in the market. In such a case, the value of assets/ liabilities is generally low, and in some cases, there is no value at all. Though that does not mean that the commodity in itself has no value, most banks and institutions have been forced to write off such assets according to the fair value method. "All these write-offs aren't real losses; they're just mark to market," said Stephen Ross, chief executive of Related Cos, one of the largest U.S. real estate developers (Chasan, 2008). For example, when the financial crisis erupted in 2008, Banks had to write- off $350 billion as losses, because there was no market for the securities. Citibank alone suffered a $40 billion loss in its first quarter and had a 60% drop in the value of its securities in the market (Moyer, 2008)
Secondly, markets tend to exhibit bubble prices, which are prices inflated by market optimism and excess liquidity, or market pessimism and illiquidity. According to the fair value hierarchy, it is always preferable to get market prices for such input positions, but when they do not exist, firms can use level 2 or level 3 methods to value the inputs. If in a financial crisis, markets exhibit bubble prices, there will be unrealised losses, which may be reversed in the later periods. As these losses once written off cannot be written back, it may show an unnecessary loss in the financial statements of a company.
Thirdly, as written above, firms will record unrealised gains and losses in times of a financial crisis when bubble prices exist. If the investors overreact to losses, it further decreases the amount of trade and increases the risk of a product, there by decreasing the fair value of a product. Hence, the value of a product may be understated as a result to adverse feedback effects and systematic risk (Ryan, 2008).
As the credit crunch caused a high volatility in the markets, the arguments against fair value accounting got so strong that some top business leaders, like Steve Forbes, requested the Government to temporarily suspend mark- to- market accounting. There argument was that fair value was not the most relevant, or reliable measure for financial instruments. Of course, there are opponents from institutes like the Council of Institutional Investors (CII), the Consumer Federation of America, and the Chartered Financial Analysts (CFA) who state that fair value was not responsible for the credit crisis, nor will its suspension improve conditions. Rather, fair value helped investors get a critical transparency of the financial situation, which if fair value had not been applied, would have been easily masked by the firm's with the help of historical data (Fornelli, 2009).
Even without the financial crisis, the fair value system is not the most effective in accounting for some items. For example, how do you value a product if it has more than one market for itself? For example, if a car bought from dealer cost $19,000, where its original price was $20,000, the fair value would consider $19,000 the accurate value of the car. If the bank is willing to fund only $17,500 for the same car, then would the fair value be $19,000 or $17,500? As the investor has to nonetheless pay $19,000 for the car, what would it account as the fair value? If after two weeks, the dealer is willing to buy the car back for $21,000 in exchange for another car worth $30,000, would its fair value be $21,000? The fair value states that the market "today" is more relevant than the market yesterday. But the truth is that there is more than one market for a product and more than one value, and in such a case, determining the value of a product is difficult (King, 2003: 54).
Is Fair Value System Really Useful?
Though there are critics who firmly blame fair value for causing distress and panic, and thereby worsening the financial crisis situation, it remains true that the economic downturn was a result of poorly managed operating, investing, and financing decisions by investors, financial institutions and firms. Fair value system forces firms to act responsibly as it maintains transparency and also increases investor loyalty, as the investors feel less uncertain when the information, whether good or bad, is laid bare to make financial decisions. The argument against reliability of fair value amounts is also weak as competitive analysts can determine accurate fair values in a cost effective manner. And even though fair value has its own flaws in accounting, it is not true that historical costing can be the remedy. So which is the best system of accounting that can be applied?
Although the financial crisis caused a major credit crunch and illiquidity in the market, the crisis did help in bringing some major aspects of fair value accounting into perspective. It put a lot of pressure on accountants to come up with a better accounting practice for valuing assets and liabilities, and as a result, the FASB in 2008 issued a new accounting standard, SFAS 157 which hopes to improve the process of fair value accounting. The SFAS 157 states that when fair value is used in financial reporting, the measurement should represent a current market price as part of it's adjustment of fair value recording method (MacDonald, 2010: 24). The framework is intended to increase comparability and relevance and reliability of fair value measures. But the drawback of this standard is that it does not specify when to use the fair value system.
As of now, the best available accounting system, especially for measuring the value of financial instruments is the fair value system. But it would be better if the fair value system improved to show a better picture of market conditions in the financial statements, rather than cause huge losses as a result of decrease in market for financial instruments.