Role of Fair Value Accounting Principal in Global Financial Crisis

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Finance and Accounting Task

Role of Fair Value Accounting Principal in Global Financial Crisis

Table of Contents

Introduction

Role of Fair Value Accounting in Financial Crises

Advantages of Fair Value Accounting

Disadvantage of Fair Value Accounting

Fair Value Accounting and Financial Reporting

Conclusion

References

Introduction

In 2008 plummeting of US housing industry badly affected US financial markets. The big giants like Lehman Brothers got vanish. Other giants merge themselves, and some of them received bailout packages from US government. Such situation caused the unrest and lack of confidence among all the market participants. This unrest had its trickle down effects and its severity across the globe in few months, crushing UK markets too. This global crisis was considered as second greatest mishap after Great Depression. Some economies especially developing countries are still experiencing its aftermath shocks and trying to push themselves out of these shocks (Menke, Langer and Pfingsten, 2014).

The purpose of this essay is to delineate the role of Fair Value Accounting in global financial crises. This paper mentions the details how Fair Value Accounting principle has either initiated the global crises or somewhat aggravated the crises in its severity. It also covers the benefits and drawbacks of Fair Value Accounting principle. In order to describe the role of Fair Value Accounting principal, two opposing point of views is mentioned on the behalf of the opponents of Fair Value Accounting principal and proponents of this principal as well. In addition to this a little background information is also mentioned to describe the reason for introducing this accounting principal. At the end of this essay, the scope of Fair Value Accounting principal and hurdles in the implementation are also discussed. The purpose of describing the scope is to highlight its effective implementation with the reduction of biases, subjectivity, and exploitations.

Role of Fair Value Accounting in Financial Crises

Prior to Fair Value Accounting principal, Historical Cost principal was in practice. Accounting authorities and regulatory bodies introduce Fair Value Accounting principal in order to provide more relevance and comparability in terms latest and updated business position rather than information based on historical events (Okamoto, 2014). Now, the question is how Fair Value Accounting principle became controversial. The reason is that Fair Value Accounting principal enforced to take the inputs from the market for the valuation of assets, but it did not mention any extent to which the information should be incorporated into the valuation. This problem especially surfaced out during the evaluation of tangible assets like property, plant, and equipment because there is no any formal market available for such assets and valuation is executed through auditors (Okamoto, 2014).Another reason is that US industry especially the banking industry was greatly suffered due to global financial crisis. This collapse spread across the globe adversely affecting UK and European markets too. The major opponent of the Fair Value Accounting principal is the banking industry. The arguments used by banking critics give signal that US banks wanted to disguise the underlying true information, but Fair Value Accounting principal did not provide any room to bank for such prudence. The relevance of this principle forced them to value their financial assets with respect to prevailing market conditions and disclose them in a fair manner (Okamoto, 2014).

A financial asset will be considered as fair valued if it is valued and recorded after following three levels described by IFRS under section 157. These three rules can be summed up into Fair Value Accounting principal. These rules require the firms to value and record their financial assets according to the situation prevailing in the current market rather than at some purchased price in the past (Du, Li and Xu, 2014). The critics of the Fair Accounting principal held responsible this principal for the initiation global financial crises or to some extent increase its negative aftermaths. The critics argued that during 2007-08 period, US markets suffered major setbacks and recessions. The US companies were using IFRS regulations and became inevitable for such companies to value and record their financial assets according to the current devastating market conditions. This valuation resulted in the devaluation of companies financial assets. This loss in value was posted to the income statement and pushed companies into the losses(Du, Li and Xu, 2014). On the other side, investors were shocked and unsatisfied with current market conditions as they had doubts in their mind regarding the valuation of financial assets. Thus, such valuation caused additional riskiness and volatility to the market by spreading uncertainty and unrest among investors (Du, Li and Xu, 2014).

The debate about the role of Fair Value Accounting principal in global financial crises is not yet resolved. The proponents of this principle argue that there is a strong relationship between the fair value and information asymmetry. Information asymmetry paves the way for the more informed investors to get the advantage of some private undisclosed information. These informed investors are usually board of directors, management, employees of the company or their relatives who have some valuable information regarding future avenues and projects under pipeline. Information asymmetry discourages the efficient market hypothesis (Liao et al., 2013). Fair value emphasizes on the equal spread of all valuable information among stakeholders and provides level playing field to all investors in the market. The proponents of Fair Value accounting principal also argue that US subprime mortgage industry should be held responsible for the financial crises. The complex securitization of mortgages also caused uncertainty in the market. When housing industry suffered the hit, people of US refused to pay their obligation mortgaged against their properties (Liao et al., 2013).

Hence, it would be unfair to blame Fair Value Accounting principal for the global financial crises while the cause was plummeted US housing industry. Fair Value Accounting principal require valuing of financial assets according to the market prevailing condition but not responsible for the market prevailing conditions itself (Liao et al., 2013).

Advantages of Fair Value Accounting

IASB and FASB introduced Fair Value Accounting Principal in response to deficiencies of Historical Cost Accounting Principal. The value measured under Fair Value Accounting principal provides more relevance than measured under Historical Cost principal. Historical Cost principal allow the managers to manipulate the values of assets. Fair Value Accounting principal provides more relevance because under this principal the fair values of financial assets are recorded in the balance sheet and any change in the values of these assets will be transferred to the income statement. Due to this incorporated affect in the income statement fair value is more linked to the stock returns (Barlev and Haddad, 2003). The capital is considered as the life blood of business that can be obtained from two sources either owner’s himself or investment and commercial banks especially in the case of expansion and diversification. Owner is an internal party and investors are spread in the market. The financial statements of the business act as a communication bridge between owner and market. Hence, in order to attract the capital from the market, it’s important to present financial statements as market friendly including current market conditions. The input from the external market discourages the deviations and prudence of the internal parties (Laux and Leuz, 2009).

Another discrepancy of Historical Cost principal was it presented the value of the asset with respect to the historic event rather than current prevailing economic conditions. The important purpose of the financial statement is to provide the true current position of the business to its all stakeholders. Here is an important question how a balance sheet, having the records of assets based on history, can present true current business position. To answer this question, Fair Value Accounting principal plays its role. The Fair Value Accounting principal emphasizes on current economic and market conditions rather than history. Another important purpose of financial statement is to provide consistent and reliable information to its stakeholders to gain their confidence. These users and stakeholders are not only internal but also external. Another question came into minds how financial statements can win the trust of external parties if they are maintained by internal personnel. Under Fair Value Accounting principal financial assets are recorded after incorporating the views and inputs of market. Hence, the confidence of stakeholders increases as the financial statements are not based on the inputs of internal parties. Fair Value Accounting principal is market oriented rather than history oriented with wider scope (Barker and Schulte, 2015).

Disadvantage of Fair Value Accounting

The one of the major purposes of financial statement is to provide the true story of the business to its stakeholders. It would be logical to say that financial statements are an important tool to communicate the situation of the business. Funds raising, determination of share price, allocation of dividends, mergers and acquisitions, sale and purchase of financial and non-financial assets all other important business phenomenon and transactions are executed on the basis of information provided by financial statements and reports. Hence, the uniformity and consistency is a prime requirement for reliability of financial statements. One of the major pitfalls of fair value accounting principle is that it generates inconsistency in financial statements making them less reliable. All the financial and non-financial assets are recorded on the balance sheet. The financial assets are recorded under Fair Value Accounting principal whereas non-financial assets are recorded under Historical Cost principal. These two contrasting principles for recording assets cause the conflicts and less reliability of financial statements leading to the internal and external inconsistency (Benston, 2008).

Historical Cost principal was easily manipulated by accounting managers. Another purpose of introducing Fair Value Accounting principal was to prevent the manipulation of accounting by managers. Under Fair Value Accounting principal, the manipulation of accounting by Enron put a big question mark on the efficacy of this system. One important aspect of Fair Value Accounting principle is mark to market accounting under which the increase or decrease in asset’s value is recorded in the income statement. If there will be an increase in value, there will be a profit and vice versa. Enron created SPEs (Special Purpose Entities). The purpose of such entities was to hide the setbacks of Enron. Any loss or decrease in value of assets was transferred to financial statements of these SPEs, keeping Enron’s financial statements neat and clean from the losses. Meanwhile, Enron massively diversified and expanded its operations across the borders. Investors and shareholders showed confidence due to the rapid growth but in 2001, CEO of Enron filed bankruptcy when problems and their consequences surfaced out. Prior to this no one knew what’s beneath the carpet except few management personnel. Enron overstated the profits of almost $600 million using such manipulation (Gwilliam and Jackson, 2008).

Fair Value Accounting and Financial Reporting

It is important to note that financial assets are normally valued under Fair Value Accounting principal but not intangible assets like property, plant, and equipment. The main reason for this discrimination is tangible financial assets are normally traded in capital and money markets, and this trading is properly regulated by the Domestic Security and Exchange Commission (Yao, Percy and Hu, 2015). On the other hand, there is not any proper, and formal market exists for trading intangible assets like property, plant, and equipment. However, accounting authorities, and regulatory bodies have allowed organizations to use either Fair Value Accounting principal or Historical Cost principal. If a company wants to value their tangible assets under the fair value principle, then there should be some market pertaining to such trading. Otherwise, a firm can also hire external consultants or auditors to value its assets by comparison with market conditions. However, this method will have apprehensions about relevance of the information because such valuation will totally be dependent on the auditor’s decision making and assumptions. These assumptions would be different from the auditor to auditor leaving too much room for subjectivity. There will also be strong possibilities of exploiting and manipulating the accounting system(Yao, Percy and Hu, 2015).

Since globalization and technology advancement, efforts have been made to create uniformity and consistencies in financial reports. The introduction of Fair Value Accounting principal is also a step in pursuance to achieve uniformity and comparability (Webinger, Comer and Bloom, 2013). The accounting bodies and regulatory authorities laid rules and regulations sometimes prior of confronting a particular dilemma and sometimes after experiencing dilemma. After describing the rules, issues and conflicts surface out during implementation. Such implementation becomes more problematic when it comes to the principle like Fair Value Accounting principle. This principal has been under scrutiny and criticism for last four to five years. These implementation problems vary from country to country and can be categorized as absence of formal market, rhetorical situation, local accounting cultures and subjectivity issue especially in the case when there is no any formal market exists for comparison (Webinger, Comer and Bloom, 2013).

Here is an important thing to note that fair value of an asset is determined by comparing with the market value, but it is named as “fair value” rather than “market value”. The reason is that accounting bodies and regulatory authorities define rules and regulations for worldwide acceptability. It is strong possibility that markets of developed countries are more developed and efficient compare to developing countries. It is also possible that in some countries market for a particular asset might not exist. Therefore, to counter such situation and to respond critics, it was preferred to term as “fair value” instead of “market value”(Khurana and Kim, 2003).

The opponents of Fair Value Accounting principal have also raised the concerns about underlying principal of relevance. The accounting bodies and regulatory authorities have replaced Historical Cost principal with Fair Value Accounting principal on the basis relevance. According to opponents relevance, comes under question because valuation of assets is based purely on estimates of market conditions. The relevance comes under scrutiny in the case of wrong estimates or insufficient information about prevailing conditions of the market (Eng, Saudagaran and Yoon, 2009).

Conclusion

Accounting is considered as a language of business for all times. In past each and every country was using this language according to its needs, desires, biases and local culture. The rapid boom in technology and globalization of firms operations created the need to organize the accounting language for uniformity, relevance, reliability, and comparability. Since globalization, accounting bodies and regulatory authorities have combined to delineate rules and regulations for worldwide acceptability. The introduction of Fair Value Accounting principal is an effort for this objective especially for financial assets in place of Historical Cost principal.

Fair Value Accounting principal is also important because it has been in debates after 2007-08 global financial crises. The critics of this principle argue that Fair Value Accounting principal was responsible for initiating global crises or somehow sparked its severity. They argue that it became inevitable for the firms to value their financial assets with respect to the prevalent stagnant market conditions, causing a huge devaluation of their assets and losses in their income statements. On the other hand, proponents argue that Fair Value Accounting principal is merely responsible for valuing assets according to the market situation but not for prevalent market conditions. The stagnation occurred due to the slump in US Housing industry. The main purpose of introducing Fair Value Accounting principal was to enhance the relevance, information symmetry and comparability of financial statements across the borders. Despite critics, Fair Value Accounting principal is still preferred by the firms across the globe, gained recognition and acceptability.

References

Barker, and Schulte, (2015) 'Accounting, Organizations and Society', Representing the Market Perspective: Fair Value Measurement for Non-Financial Assets, January.

Barlev, B. and Haddad, , (2003) 'Fair Value Accounting and Management of the Firm', Critical Perspectives on Accounting, vol. 14, no. 4, May, p. 383–415.

Benston, , (2008) 'The Shortcomings of Fair-Value Accounting Described in SFAS 157', Journal of Accounting and Public Policy, vol. 27, no. 2, April, p. 101–114.

Du, , Li, , and Xu, , (2014) 'Adjustment of Valuation Inputs and its Effect on Value Relevance of Fair Value Measurement', Research in Accounting Regulation, vol. 26, no. 1, April, p. Pages 54–66.

Eng, L., , Saudagaran, and Yoon, S. (2009) 'A Note on Value Relevance of Mark-to-Market Values of Energy Contracts Under EITF Issue No. 98-10', Journal of Accounting and Public Policy, vol. 28, no. 3, June, p. 251–261.

Gwilliam, and Jackson, R., (2008) 'Fair Value in Financial Reporting: Problems and Pitfalls in Practice: A Case Study Analysis of the Use of Fair Valuation at Enron', Accounting Forum, vol. 32, no. 3, September, p. 240–259.

Khurana, I., and Kim, -S. (2003) 'Relative Value Relevance of Historical Cost vs. Fair Value: Evidence from Bank Holding Companies', Journal of Accounting and Public Policy, vol. 22, no. 1, Febraury, p. 19–42.

Laux, C. and Leuz, C. (2009) 'Accounting, Organizations and Society', The Crisis of Fair-Value Accounting: Making Sense of the Recent Debate, vol. 34, no. 7, October, p. 826–834.

Liao, L., Kang, H., Morris, , and Tang, Q. (2013) 'Information Asymmetry of Fair Value Accounting during the Financial Crisis', Journal of Contemporary Accounting & Economics, vol. 9, no. 2, December, p. 221–236.

Menke, G., Langer, and Pfingsten , (2014) 'Impact of the Financial Crisis on Bank Run Risk – Danger of the Days After', Journal of Banking & Finance, vol. 40, March, p. 522–533.

Okamoto, N. (2014) 'Fair Value Accounting from a Distributed Cognition Perspective', Accounting Forum, vol. 38, no. 3, September, p. 170–183.

Webinger, , Comer, and Bloom, (2013) 'The Effect of Additional Guidance on Fair Value Measurement and Disclosure in Illiquid or Inactive Markets', Research in Accounting Regulation, vol. 25, no. 2, November, p. 220–229.

Yao, F.(., Percy, and Hu, (2015) 'Fair value accounting for Non-Current Assets and Audit Fees: Evidence from Australian Companies', Journal of Contemporary Accounting & Economics, vol. 11, no. 1, April, p. 31–45.

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