The report aims to explain the idea of fair value of accounting and why IASB and FASB have begun moving towards this new method rather than keeping the more traditional historical cost accounting. The report will also highlight the key advantages and disadvantages when using the fair value method why it is so important when pertaining to financial assets. The argument that fair value accounting was a contributing factor to the financial crisis of 2008 will also be critiqued. Lastly, recommendations will be given regarding how and when both accounting methods should be used in today's economy.
The Move to Fair Value Accounting
The notion of applying fair value accounting, recording assets based on the price at which the assets could be exchanged between two unrelated and willing individuals, is a relatively new method. Prior to the 1970's and before the movement towards fair value, historical cost accounting was largely accepted as the only true form of representing assets for financial reporting (Jensen, 2010) . Historical cost was viewed as the preferred form for valuing assets because it was a non- subjective, verifiable and reliable means of measuring a corporation's assets (Jensen, 2010). Investors also preferred historical cost as it gave them a concrete measure of how much the asset is worth. For example, if an asset was worth five million, there was evidence to prove the assets worth. Thus, the asset's value was not subjective to what management believed to be the assets value and it was also verifiable by the purchase receipts.
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However, in the mid 1970's, as the use financial instruments rose and became a more prominent part of a corporation's assets, traders began to lobby for a fairer accounting method that would recognize the unrealized gains earned from financial assets (Pita, 2006). Critics of historical cost accounting began highlighting its disadvantages and contented historical cost is not as useful as it once was. Firstly, historical cost accounting is too simplistic when one hopes to measure the value of complex financial instruments (Jensen, 2010). For example, a financial derivative that maybe worth a million dollar today may have had a zero or a very negligible historical cost. Other financial instruments such as forward contracts and 'swaps' faced a similar dilemma when trying to apply historical cost accounting. Furthermore, historical cost isn't able to accurately measure assets in times when the rate of inflation is high (Jensen, 2010). Historical ends up overstating assets in economies where inflation rates are significantly high (Jensen, 2010).
In 1975, in an attempt to resolve the recently problems with historical cost accounting, FASB (Financial Accounting Standards Board) introduced SFAS 12 "accounting for certain marketable securities." This initial document, which initiated the move towards fair value, differentiated between current and non-current marketable securities and outlined the process of treating each one (FASB, 2011). Since then FASB has introduced many SFAS documents regarding fair value that improve the way assets are measured reported on financial statements. SFAS 115 and SFAS 133 are two of the most important documents issued by FASB as they outline the treatment of equity securities and derivative instruments (Wilterink,).
During the same time the International Accounting Standards Board (IASB) also began shifting toward applying fair value asset valuation for many asset types including financial instruments (Deloitte, 2010). Initially the IAS 39 was published to outline the treatment of most financial instruments. Currently, the IASB is improving the way in which fair value is used for asset valuation (Deloitte, 2010). In 2011, the IASB will replace IAS 39 with IFRS 9, which aims to lessen the differences between FASB and IASB in terms of applying fair value ( IFRS, 2011).
Why Fair Value? - Analysing the Advantages of Fair Value Accounting
Since the 1980's, the use of the fair value method has been extensively debated between supporters and critics (Pita, 2006). Supporters of fair value accounting propose that the fundamental advantage of the fair value method is its ability to value assets based on the current market prices. Furthermore, fair value is a truer and fairer method of reflecting the value of assets as it the assets are a representative of the prevailing economic conditions (Pita, 2006). In contrast, historical value simply shows the economic conditions that existed when the assets was purchased (Pita, 2006). By not keeping the asset at fair value, the historical cost method creates a lack of inaccuracy within the financial reports.
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Another benefit of using the fair value method is the firm ability to compare similar assets. When many within the same industry use the fair value method, corporations can compare their assets with the market much more efficiently as financial instruments are valued during the same time and are using the same principle or discount rate (Pita, 2006). If the historical cost method was used for valuing financial assets, identical assets with identical cash flows would be valued differently based on the time they were purchased (Pita, 2006).
Lastly, proponents also argue that fair value is more unbiased and thus a fairer method in determining an assets price. With fair value, as the worth of the asset is constantly updated, the history of the asset, or the date at which it was acquired becomes irrelevant (McLean, 2009). Also, fair value does not distinguish between different entities that purchase the asset (McLean, 2009). Under historical cost, different entities would record different prices for the same asset depending on the accessibility of markets and the entities credit standing (McLean, 2009). Fair value helps to eliminate the differences in the price of the asset due to factors affecting the entity rather than the industry.
Criticisms Against the Use of Fair Value Accounting
While international standards move towards the implementation of fair value accounting, many criticise the method and claim it does more harm than good. To begin with, opponents of fair value argue that the method is not as comparable as it seems. Fair value accounting invites the issue of subjective measurement (Ramesh, 2004). Though non-financial assets usually have a cost price, when managers are allowed to disregard the cost price and value the asset based on their subjective estimations on what the asset might be worth or the amount of future cash flows the asset will be able to generate, comparability between corporations may not be possible (Ramesh, 2004). Financial assets also go through subjective measure however; with financial instruments it may be even harder for entities to compare financial assets. For example, 'contract swaps' do not a particular market where they are traded, thus their value is almost completely dependent on the estimations of management (Ramesh, 2004).
Another criticism against fair value accounting is the amount of volatility created by letting entities record unrealized gains (McLean, 2009). When pricing an asset based on fair value, a corporation is able to recognize the price increases and decreases as unrealized gains and losses on their financial statements. Opponents argue that this volatility is unneeded and simply creates instability in capital ratios (Ramesh, 2004). Lastly, fair value accounting gives room fraudulent activities by management. When management is able to subjectively estimate an assets value, there is an incentive for management to over estimate the assets worth and record unrealized gains on the asset (Ramesh, 2004). Since there a risk that management may have over estimated assets, there is a negative impact on an auditor as well he must be more cautious when auditing financial reports.
Did Fair Value Contribute to the Financial Crisis in 2008?
Beginning in 2007, the "credit crunch" caused by declining house prices, defaults by subprime borrowers and cases of mortgage fraud created an economic environment not seen since the 1930's. Many argue that fair value accounting contributed to the financial crisis of 2008. However research suggests that fair value accounting was not a primary contributing cause of the financial crisis, rather it was the wrongful estimation of subprime mortgages that ultimately buried investment banks such as Merrill Lynch and Lehman Brothers (Luax, 2009).
Though fair value accounting may not have originally started the crisis, researchers say it may be contributed to slow recovery of the markets (Luax, 2009). When investment bank began to realize the amount of default loans, they tried to value them based on mark- to- market pricing. However, there wasn't a market for these bad loans as the money dried up and the subprime market became highly illiquid (Luax, 2009). Due to uncertainty in the economy, investment banks began to revalue their bad loans using estimations in an attempt to sell their bad loans and raise capital to survive (Luax, 2009). These estimations made by management were highly overstated and inaccurate thus, investment banks were not able to sell the default mortgages and inevitably the bank could not raise enough capital to survive (Luax, 2009). Here, fair value slowed down the recovery of the economy as inaccurate estimations contributed to the closure of investment banks.
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What Should be Done Going Forward? - Recommendations When Applying Fair Value Accounting.
Going forward, international accounting boards must realize that there are advantages of both the historical cost method as well the fair value method. Here, one must remember that the prime reason for both of the methods is to give the most accurate and reliable information possible. To do this one cannot disregard the use of the historical cost method and completely rely on the fair value method or vice - versa. A mixed model that encompasses the advantages of both methods would be the most efficient way of valuing assets in the current economy.
Firstly, international accounting boards such as IASB must differentiate between assets that usually would increase or decrease in value over time and those that are relatively stationary. Once assets are categorized, IASB can publish which assets should follow the fair value method and which should follow historical cost. For example, since the price of property usually rises over time, the fair value method should be used for this asset as apposed to historical cost. Second, to avoid volatility, IASB could let entities revalue assets every five years as apposed to every year. Lastly, the most difficult assets to value are financial instruments. A new accounting method may be needed in the future to correctly value financial assets; perhaps one that lets entities revalue their financial assets on an incremental five year basis and record unrealized gains while also finding a way to make these unrealized gains more reliable.
Since the 1970's, the economy has changed drastically as new financial instruments are becoming a more prominent part of an entities financial statements. To correctly value these assets, the traditional method of historical cost accounting is not applicable and thus the fair value method of accounting must be used. There are many advantages and disadvantages of using the fair value method and there are even allegations claiming the current financial crisis was caused due to the fair value method.
In conclusion, when comparing the historical cost method and the fair value method, one realizes the trade off between using historical cost and being more reliable or using the fair value method and being more relevant. Moving forward, accounting boards must find a way to keep asset values reliable while also making them relevant.