Fair value measurement aim for firms to estimate the best price of future value based on current conditions. In order to achieve the goal, current information including future cash flows and current risk-adjusted discount rate should be fully integrate by the company for fair value measurement (Ryan, 2008). FASB issued a significant controversial new standard which is Statement of Financial Accounting Standard 157 (FAS 157), Fair value measurements on September 2006 to assist companies in fair value's estimation. Fair value is identified as mark-to-market value when it used adjusted or unadjusted market price. According to FAS 157, fair value measurements consist of three levels. Level one applies to the cases when identical assets or liabilities' quoted price are available in active markets. For level two, it applies to the observable inputs that are similar assets and liabilities' quoted price in active markets, identical or similar assets or liabilities' quoted price in not active market and also other relevant market with observable inputs market price while level three is applied for unobservable market price.
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"Decision usefulness" is always seemed as a terms that connected with setting process of accounting standards. Shaffer (2011) argue that there are two qualitative characteristic which are relevance and faithful representation make information in financial reporting useful for decision making. Information provided must be able to make a difference decision and relevant to user. It must also be complete and free from error to deliver a faithful representation. Fair value accounting is view as producing high degree of decision usefulness and relevant information to the investor by the regulatory bodies like IASB and FASB. Prior study by SEC (2003) had proved that fair value is benefits to the investors in terms of transparency, suitability and also accurate information and suggested that fair value measurement should be used in all financial instruments. Enhance of creditability of financial reporting by eliminates the incentives of gain in assets will be another benefits of fair value accounting (Prochazka, 2011). Furthermore, Hitz (2005) claimed that the measurement or valuation perspective and the information economics perspective are the two perspectives of decision usefulness theory. The main idea of measurement perspective is explained by report the necessary information to investors while information perspective is mainly about provide useful information to improve investors' decision. Besides that, he also found that when the price is taken from the active market, decision usefulness could be reconstructed for fair value accounting.
Contrariwise, fair value will lose its purpose if it could not be clearly determined. These can be further explaining by the situation where the quoted market price could not be found in the active market and the fair value measurement have to depend on subjective estimation (Ryan, 2008). Managers may require by FASB to predicts the asset, liabilities and reporting units' fair value and it can be said that the fair value are unverifiable as the predictions cannot be confirmed. When the fair value is unverifiable, private information from manager on future cash flows may occur. According to Ronen and Yaari (2002), presentation of manager will not be truthful at most of the time. Manager may concern on self-interest and tend to be deceit. Also, Zack (2009) states that improper valuation of fair value accounting will result in occurrence of fraud either generated internally or third party experts. Inversely, a research done by Ramanna and Watts (2008) showed that agency theory predicts managers will manage financial reports speculatively by using the unverifiable fair value. They also found that only some information asymmetry appeared between managers and shareholders.
Some critics argue that fair value accounting has contributed to the financial crisis during 2008. When fair value measurement was inconsistent, it can affect user decision especially when investors were made decision on the investment (Abdel-Khalik, 2008). When there is inconsistency measurement of fair value, investor would not know the internal situation in the company and information asymmetry will then occur. Financial crisis may be preventing when there are proper disclosures of financial information. In general, managers are always having more knowledge than investors about the company's condition. In this case, the manager may manipulate the information for self-interest and then declare to the publics. As Laux and Leuz (2009) also said that FAS157 gives various "safeguard" for manager when they are value the asset. Hence, this had lead unreliable market price exist. Agency theory forecasts that excessive decision given to manager, may cause exploited for devious earnings (Beltratti et al, 2010).
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Controversies Surrounding the Use of Fair Value Accounting
Since its implementation in 2006, the use Fair Value Accounting (FVA) has been engulfed in numerous controversies. Aside from being linked, or rather held responsible, for the recent financial crisis, there are also several other issues that had been sparked with the implementation of FVA.
The use of FVA has led to arguments on how it had impacted companies' transparency. According to Laux and Leuz (2009), the use of FVA for measuring assets and liabilities provides a reflection of current market situation. This then provides timely information that allows for better informed decisions with the increase in transparency. This is further supported by Cherry and Hague (2009) who mentioned that FVA "is the best measure that allows investors and other market stakeholders to clearly understand the current health of a company and make decisions based on that understanding". Cherry and Hague explains that the use of market-based exchange values rather than entity-based values allows for better transparency of companies when there is a change in the economic condition. Fahnestock and Bostwick (2011) however argued this, stating that both transparency and integrity are removed when using FVA. This occurs when the determinants underlying the measurement are other than that of an unbiased market prices, or even in cases of biased market prices. They then further elaborate that this could possibly lead to less relevant or reliable information being presented.
Another controversy surrounding the implementation of the FVA is that it emphasises the financial information needs of investors at the cost of possibly disadvantaging other users of the financial statements. Magnan and Thornton (2010) mentions that although past studies that support FVA provide results which states that "FVA-based numbers are associated with companies' share prices - they are value relevant", accounting is also useful for other users besides shareholders. They then illustrated this by explaining how reluctant lenders would be to agree with a company's policy of using unrealised, expected cash flows to distribute dividends. This then shows how FVA can result in the deviation of accounting from its traditional stewardship role where "verifiability and conservatism ensure that pay-outs are based on delivered, not expected, performance". Grand Thornton (2008) also agreed to this, suggesting how the use of FVA would create an entirely new area of audit risk for auditors. Auditors would now have to rely more on the expertise of external specialists when they "assess the process and assumptions made by management with regard to assets valued," (Magnan and Thornton, 2010).
Controversies also surround the implementation of FVA in regards to how reliability of financial statement information is affected. Fair value is an example of a system that faces the old accounting issue that is the trade-off between relevance and reliability, where in terms of FVA, reliability of accounting information formed are questionable. In regards to the use of Level 1 and Level 2 instruments, the use of fair value accounting can result in reliable information. Fahnestock and Bostwick (2011) explained this, mentioning that since the values the instruments used are underlined by unbiased market prices, fair value then provides both relevant and reliable accounting information. On the other hand, in the use of Level 3 instruments of fair value measurements where an active market is absent, the fair value evaluation for numerous assets and liabilities would be more subjective, thus less reliable (Ting Yieng Sing and Soo Choon Meng, 2005). Barth, Beaver, and Landsman (2001) agrees with this, mentioning that when the duty to determine fair values rest on the managers, there would be a higher possibility for less reliable information. These claims were then evident with the support of Heflin and Valencia (2012) who reported evidence that "bank managers manipulate the fair-value estimates of Level 3 instruments to report current earnings that are positive and more than prior quarter earnings", and this explains the measures regulators took to further develop disclosures related to SFAS 157 (FASB, 2009).
The implementation of fair value accounting has created an arena where accountants are not yet fully prepared to participate in. Lack of understanding of not only how the system works, but also of how it translates in practice, and this has created numerous debates. This lack of knowledge on FVA not only surrounds it with even more controversies, but had also led to it being blamed for the recent financial crisis.
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The fair value debate has been under the spotlight since the Global Financial Crisis (GFC) in 2008, there have been different opinions as to whether the fair value accounting has contributed to the Global Financial Crisis (GFC) in the banking industry in the US and also around the world. The usefulness in decision making has been questioned. However, there has been research on the information on fair value of certain assets and liabilities and the information is said to be useful to a wide group of users in making economic decision (Prochazka, n.d.). The chairman of Forbes Media, also a political candidate viewed that mark-to-market accounting was the underlying primary reason that caused the crisis in the U.S. financial system in 2008 instead of the subprime mortgages, credit default swaps, or extreme debt (Pozen, 2009). The US and UK's politicians have put the blame on fair value accounting for the recent financial crisis that some of the politicians think that there is only one measure that was necessary which was to scrap fair value accounting when the Congress didn't managed to receive the $700-bn bailout plan (Kallapur, 2008). In contrast, it is also mentioned that current market values will precisely reveals the underlying market volatility thus making fair value accounting relevant for decision making (Kallapur, 2008).
According to (Pozen, 2009), economist Brian Wesbury delivered his opinion that "Mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value." It is said that fair value accounting contributed to extreme volatility in times of economic downfall (Scott, 2010). There have been argument that the banks need to compel to trade assets at extremely discounted prices that leads to major write-downs caused by the decreasing in market prices that drain off the bank capital and triggered a downward spiral which the selling assets at "fire-sale" would become a contagion that affects the other banks (Laux and Leuz, 2010). Fair value is to be blamed for leading to unjustified decreasing in lending as the assumption that the basic values of assets were sound that the financial institutions protect themselves from the decreasing market prices by possessing securities and gathering the underlying cash flows for long-term (Badertscher, Burks and Easton, 2010). However, according to (Laux and Leux, 2010) there are not enough evidence that could proved that downward spirals and the asset "fire-sale" happened as directly resulted from fair value accounting and that historical cost accounting would not resolved the problems too. Despite fair value accounting being blamed for the severity of the financial crises, fair value accounting actually act as a warning signal for the forthcoming crisis that could in turned helped the financial institutions to take proper action which could also decrease the severity of the financial crisis (Laux and Leux, 2010).
There have been concerns that procyclicality in the price of the assets is caused by fair value accounting where it would affect the assets' price to decrease below the real economic value (Scott, 2010). Procyclicality in accounting measures decreased the assets' figures in the statement of financial position resulted panic and insufficient confidence that then causes a repercussion effect in the market (Scott, 2010). This is because the market has frozen and that the financial institutions have difficulties in finding clients that need new credit financing (Procházka, n.d.). This has then lead to economic contraction and thus causing a decline in the financial instruments' market prices (Procházka, n.d.). Financial institutions are needed to decrease the "infected" assets therefore in order to achieve lowest capital requirements, financial institutions are needed to sell their assets at an unrealistically low price (Procházka, n.d.). Losses in fair value resulting regulators to pronounce financial institutions to be insolvent that caused indebtedness that further decrease the market prices resulted from less than perfect liquidity (Allen and Carletti, 2008 as cited in Badertscher, Burks and Easton, 2010). However, the defenders of U.S. accounting and bank regulatory systems oppose that fair value accounting contributed to the procyclicality in the asset's price as there has been a limited fair value accounting provisions that are not likely to have resulted in the procyclical effects (Badertscher, Burks and Easton, 2010). According to (Procházka, n.d.), commercial banks which caused the economic slowdown did not resulted from the fair value accounting's procyclicality, instead the commercial banks have real economic roots (Procházka, n.d.). On the other hand, procyclicality should not be justifying for whether fair value accounting is procyclical or not (Procházka, n.d.).
In contrast that fair value accounting contributed to the financial crisis, (Scott, 2010) mentioned that customers no longer have confidence towards banks as banks were already not doing well even during the using of historical cost accounting. In addition, it is unlikely that fair value accounting contributes to the failures in the financial institutions as for example Canadian banks which are filers of foreign United States are required to adhere with U.S GAAP prior to 2008 and therefore could apply fair value in certain asset (Scott, 2010). Therefore, if the fair value accounting is to be blamed for contributing to the financial crisis, there would already be failures in bank happening in Canada but the Canadian banks are successful as there are no failures in bank (Scott, 2010). In addition, according to Emergency Economic Stabilization Act of 2008 (the Act) which conducted a research on mark-to-market accounting, it has concluded that fair value accounting did not contributed to the bank failures instead bank failures are resulted from the increasing credit losses and also the quality of the asset (Scott, 2010).
Furthermore, financial crisis in the subprime mortgage sector has exacerbate when the fourth-largest investment bank in the US, Lehman Brothers collapsed and the credit crunch was severe (Zhao, Haswell and Evans, n.d.). However, according to (Scott, 2010), it is mentioned that the collapse in Lehman Brothers are not resulted from fair value accounting. There are financial problems with Lehman Brothers when their stock started declining and its debt decreased and the company was having difficulties finding for buyer in order to get extra financing (Scott, 2010). It was also mentioned in (Scott, 2010) that the collapse of the bank is resulted from the due diligence done by Lehman Brothers has scared the investors away.
The main problem that contributed the economic downfall and the credit crunch was due to the financial reporting instead of the fair value measurement (Procházka, n.d.). However, the fair value accounting is an important measurement that could differentiate companies that are in good condition from those companies that are not (Procházka, n.d.). According to (Khan, 2010 as cited in Procházka, n.d.), "FVA merely accelerates the price and resource allocation adjustment processes resulting in a relatively speedy return to financial stability". Therefore, fair value's market prices are vital for the stability of the market economy (Procházka, n.d.).