Fair value measurement

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  1. Introduction--------------------------------------------------------------------2
  2. Case study---------------------------------------------------------------------4
  3. Discuss measurements in enhancing the quality of financial information---------------------------------------------------------------------7
  4. Conclusion-------------------------------------------------------------------12
  5. Reference --------------------------------------------------------------------13

1. Introduction

In the 1980s, the United States suffered insolvencies in the Saving and Loan industry, part of the savings and mortgage institutions through accounting methods covered up problem loans, eventually led to more than 400 financial institutions bankruptcy. The federal deposit insurance corporation unable to compensation cases, so the government decided to use more than $100 billion in federal reserve fund to be remedied. Accounting treatment of financial institutions, due to the price did not reflect the reality of the asset market or the statues of financial institutions, financial executives began to use the fair value measurement under the background of the American financial industry. Fair value was chosen as a preferred solution in a never-ending trade-off between reliability and relevance of accounting information.

Fair value is becoming more and more popular as a measurement basis. It refers to as an exit value that an entity would derive from the item leaving the entity. Fair value is determined using two approaches i.e. 1) ‘the price that would be received when selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’, or 2) market prices. [1] Most accountants prefer the use of fair value with the release of AASB 13/IFRS 13, for example, AASB 116 states, ‘fair value is the amount for which an item could be exchanged between knowledgeable, willing parties in an arm’s length transaction’. [2] Generally, fair value can produce more relevant information because it reflects what items are worth now rather than what they were worth when they were purchased. And the accounting numbers determined using fair value are very relevant from a decision usefulness perspective as they provide useful input into the decision-making process surrounding users’ assessment of the current and future value of the entity, for example market values of the items on a particular reporting date. [1]

The strong debate on fair value measurement has accelerated the global financial crisis since 2007, and result as companies face significantly adverse impacts and challenges i.e. bankruptcy. This crisis has the impact on the global economy which has close interconnection with the health of international enterprises and the life of people around the world. Some opinions were argued that the financial crisis and economic crisis occurred (i.e. Subprime mortgages or credit default swaps) due to fair value measurement. While, other opinions in favour of fair value measurement in accounting as it is important and useful for buyers and sellers when making decisions. This essay is aimed to contribute to discuss the role of fair value measurement connects with the global financial crisis. Also, the paper will discuss the the advantages and disadvantages of fair value measurement comparing with other accounting measurements in enhancing the quality of financial information.

2. Case study

It is sure that the causes of the financial crisis are complex. Many articles and reports have centered around some primary causes of the recent financial crisis such as the bursting of the housing bubble in the USA, default rate rose, credit default swaps, and excessive debts; however, some bankers‘pilloried fair value measurement when the sudden seize-up of credit markets in the fall of 2008 drove the clearing prices for key assets held by their institutions to unprecedented lows’. [3] Fair value measurement is facing to the criticism especially from the banking sector; e.g. according to the President of the American Bankers Association (2008): “The problems that exist in today’s financial markets can be traced to many different factors. One key factor that is recognized as having exacerbated these problems is fair value measurement”. [9]

Some critics touched on accounting standard setting, and they argued that the role in which accounting information contributed to the crisis. In this regard, commentators contended that fair value measurement led financial institutions to evaluate assets at the market price, causing losses and capital adequacy ratio decreased, and the reduced valuations were wrote down on the balance sheet (i.e. huge asset impairments). The series of activities aggravated the severity of the crisis. Assuming that banks did not follow fair-value accounting and thus avoid the assets write-downs, then this crisis would have been averted. For example, nearly 60 members signed a letter to the securities and exchange commission (SEC), calling for a moratorium on using fair value measurement rules in order to protect banks and lessen the impact of the financial crisis because they argued that ‘fair value measurement doomed financial institutions through a flurry of write-downs and asset sales’. [4]

Fair value measurement was blamed of being too real and quickly reflected the status of financial institutions in this global financial crisis. However, in fact, fair value measurement itself has no problem, the main problem might focus on financial institutions which would like to get more benefits and profits from fair value measurement. Thus, financial institutions accused the fair value measurement in this crisis because fair value measurement resulted in significant losses for financial institutions (i.e. Lehman Brothers Holdings Inc.). An important aspect is on the edge of interest in the current debate. Accounting is a tool of transmitting the economic information about subjects operating in economic environment. Therefore, the verdicts on the role of FVA during the crisis ought to be backed up through the corresponding inferences of economic theory.

Additionally, there are some supporting views also certifying that the fair value measurement helps users to receive more information about the value of their assets. Lisa Koonce, Deloitte & Touche Professor of Accounting, wrote on a website: “fair value measurement communicated the effects of such bad decisions as granting sub-prime loans and writing credit default swaps in that fair value measurement only brings transparency to the illiquid market with difficult issues recently. The alternative, keeping those loans on the books at their original amounts, is akin to ignoring reality”. [5] Abdel-Khalik (2008) contends that fair value measurement from the point of inconsistency of measurement within financial statements.[8] According to Abdel-Khalik states, the mixture of measurement bases used hinder the users from making judgments on what occurred with their money such as stewardship function of accounting and what management will be able to do with their money (i.e. function of accounting as a source of information for decision-making). [8] While, Abdel-Khalik does not call for abandoning the fair value measurement, he adheres to separate sets of financal statements each using a single measurement basis.

Some accounting profession and economists think that the financial sector created a real housing bubble through unregulated and opaque financial innovations, for example, asset securitization techniques amplify the financial asset bubble, and finally led to the sub-prime crisis. With fair value measurement model, timely, transparent and open disclosure of financial asset bubbles, prompting the financial sector, investors and financial regulatory authorities to face and resolve financial asset bubbles. If there is no use of fair value measurement, investors may be always concealed in the illusion of the foam created by the financial sector.

3. Discuss measurements in enhancing the quality of financial information

Enhancing the quality of financial information helps users to have more operating information as well as financial data, so users will get a clear picture of a company’s performance and have more opportunities in investments. Therefore, accounting measurements are useful tools for company to measure changes in financial condition of the entities and enhance the quality of financial statements under different market conditions. The following paragraphs will discuss the benefits and drawbacks of fair value, and comparing with some other accounting measurements such as historical cost, current cost, and deprival value in enhancing the quality of financial information.

fair value measurement reflects a financial reporting standard which aims to present financial statements to be measured via fair value as a valuation technique rather than with their historical cost.[10] With recent development in accounting standard-setting process, FASB has proposed a series of Update about accounting standard so that certain amendments may result in a change to existing practice such as the amendment of No.157-fair value measurement provides the three-level fair value hierarchy. The first level is the main market price based on active market quote; second level is based on observable variable modeling techniques; and the third level inputs are unobservable inputs used for market data which are not available.[7] In fact, the fair value measurement of financial instruments will be authenticity when fair value measurement combinate market-specific risks associated with environmental considerations. Moreover, IFRS also reported annual improvements (May, 2012) about the receivables and payables of IFRS 13-fair value measurement in short-term period. The annual improvements to IFRS describes that “the IASB do not intend to change the measurement requirements for short-term receivables and payables because IFRS 13 includes the guidance for using present value techniques to measure fair value, and IAS 8 addresses materiality in applying accounting policies; however, some users argued that the deletion means the measurement requirements have changed in practices”. [6]

In general, the advantages of fair value are that:

1. Reliable. Fair value is considered a reliable measurement as it is neutral which cannot be influenced by an entity’s management. Fair value is independent from management and determined via market forces.

2. Relevant. If managers know clearly the amount of payment or will receive is relevant when purchasing or selling an item.

3. Understandable and comparable. Because fair value is determined at the same point of time, so the value is easy to understand for all the stakeholders.

On the other side, fair value also has some disadvantages, issues and criticisms.

1. Relevance. Because the entity was to liquidate which depends on the circumstances (i.e. current market circumstances), so fair value may ignore the assumption made in accounting such as the entity is a going concern. Also, fair value is measured at the current date. Many investments, or item may be held for long-term gain, but fair value may not be relevant in the short-term fluctuations. [3]

2. Subjectivity. Not all items are regularly traded, so an estimate needs to be made of the fair value.

3. Market prices. Fair values are market prices which represent the expectations of the buyers and sellers in the market. However, their expectations may not be correct if the volatility in market prices i.e. the past prices were considered to be too high or too low. Another argument is based on the belief that part of the role of accounting information is to assess the validity of prices. [3]

Until recent years, historical cost has become the most dominant measurement basis in the preparation of financial statements, and this measurement is used to record all the transactions which actually occurred in the past. [11] All the amounts recorded on the historical cost basis are based on transactions which actually occurred in the past.

Historical cost is one of the basic instruments helping users to measure changes in financial condition of the entities. Nowadays the majority of the policy and decision makers on the side of fair value, however, it does not mean that historical cost is not useful at all but it is old fashioned, according to Onur Serakibi states. [10] The main advantages of historical cost is its reality because the payment for an item can be proved via documentation which is objective and easy to understood by users. But the amounts recorded via historical cost lose its relevance because historical cost is a suck cost which can not influence any future decisions or actions.

When the company needs to buy a similar asset to replace a lost or old item, accountants have to calculate the cost of replacing resources and reflect the amounts on the financial statements, they prefer to using replacement cost and current cost. Current cost can deal with problems such as how to value assets that have no fair value but are used through an entity to provide future economic benefits. [1] Also, this measurement is reliable in the sense that the use of market prices, and less open to manipulation and influenced by management. [11] Actually, there is no a direct relationship between fair value measurement and replacement cost measurement, but both of these two measurements can help readers to understand the performance of a company through viewing the financial reporting.

Another alternative measurement is called deprival value that has been used in accounting. Deprival value refers to the loss that a rational person would suffer if they were deprived of the asset. It is unique because it is neither a specific cost nor value which is placed on an item, and its value based on a scenario that may never happen. Definitely, most financial executives think that the adoption of fair value measurement for assets and liabilities is better to reflect the impact of varying market conditions rather than deprival value measurement. However, deprival value measurement can be used to solve some problems on balance sheets and income statements which subject to accounting for the effects of price changes, and that is no sufficient to resolve issues of the appropriate timing of profit recognition. [12]

4. Conclusion

Fair value measurement is also an important accounting tool adopted to reflect the value of an item for current decision-making whatever how fair value contributed to the global financial crisis as fair value changes the trade-off indirectly. The conclusion of Khan notes that “fair value merely accelerates the price and resource allocation adjustment processes resulting in a relatively speed return to financial stability”. [12] Fair value as a market price always encompasses the expectation of market participants about future course of demand for and supply of particular economic goods. Thus, market prices, of which fair value is the most powerful representative, play an important role for smooth functioning of market economy and all efforts calling for its suspension are odd. [14] Additionally, some institutions such as IFRS, IASB, and etc will continue to make new innovations and improvements on accounting principles and measurements with different marketing conditions.

5. Reference

  1. Margaret Drever, Patricia Stanton, Sue McGowan, (2007). Contemporary issues in accounting. 1ST ed. John Wiley & Sons Australia, Ltd, Chapter 4.
  2. The staff of the Australian Accounting Standards Board, (Oct, 2013). AASB 116-Property, plant and equipment. PO Box 204, Collins Street West, Victoria 8007. [Available from]: http://www.aasb.gov.au/admin/file/content105/c9/AASB116_07-04_COMPsep12_07-13.pdf
  3. Robert C. Pozen, (2009). Is It Fair to Blame fair value measurement for the Financial Crisis? [Available from]: http://hbr.org/2009/11/is-it-fair-to-blame-fair-value-accounting-for-the-financial-crisis/ar/1
  4. Melissa Hoffmann, (2009). SEC upholds fair value measurement. [Available from]: http://www.nysscpa.org/ezine/ETPArticles/ML1809.htm
  5. Lisa Koonce, (2009). fair value measurement: a better reflection of reality. [Available from]: http://www.today.mccombs.utexas.edu/2009/02/fair-value-accounting-a-better-reflection-of-reality
  6. IFRS, (May, 2012). The annual improvements of IFRSs. [Available from]: http://www.ifrs.org/current-projects/iasb-projects/annual-improvements/short-term-receivables-payables/Pages/Narrow-scope-amendment-to-IFRS-13.aspx
  7. IFRS, (June, 2010). IASB proposes improvements to disclosure requirements for Level 3 fair value measurements. [Available from]: http://www.ifrs.org/News/Press-Releases/Pages/improvements-to-disclosure-requirements-Level-3-FVM.aspx
  8. Abdel-Khalik, R. A. (2008), “The Case against fair value measurement.” University of Illinois, [Available from]: http://www.aislab.aueb.gr/accfi n/DownLoads/seminars/ATT00007.pdf.
  9. American Bankers Association (2008), Letter to SEC on Fair Value and Other Accounting Standards. Washington: September 23, 2008.
  10. Onur Serakibi, (2013). Historical cost vs fair value. [Available from]: http://www.academia.edu/3805195/Historical_Cost_vs_Fair_Market_Value
  11. Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto, Matthew Tilling, (2012). Contemporary issues in accounting. 1ST ed. John Wiley & Sons Australia, Ltd, Chapter 4.
  12. R.H. Macve & G. Serafeim, (2006). Deprival value vs fair value measurement. [Available from]: http://grammatikhilfe.com/accounting/facultyAndStaff/liabrevrec300606ssrn.pdf
  13. Khan, U. (2010), The Economic Consequences of Relaxing Fair Value Accounting and Impairment Rules on Banks during the Financial Crisis of 2008-2009. Istanbul, 33rd Annual Congress of the European Accounting Association, 18. 5. 2010 – 21. 5. 2010.