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Since Enron, some financial institutions hold a critical view of use fair value accounting (FVA), whether fair value should be used as a measure tool become a controversy topic. In recent year, IASB and FASB has increasingly favored in using fair value in its standard, which shows that fair value accounting is a useful tool to reveal the financial situation, especially in financial market. However, does it means that FVA become an important and useful tool to measure the liability and asset in financial Statement, or it would be bring more negative effects? By answering this question, this paper has been and divided into four parts and investigated. The first part will review evolution of FVA by existing conceptions and regulation. It will then go on to compare FVA and HCA, examine the positive impact of FVA In the third section, the essay will illustrate the short coming of the fair value in three aspects by use the case of Enron. Finally, it will evaluate the importance of Fair value accounting.
The evolution of Fair Value Accounting
Fair value has passed through almost a century procedure of evolution. Early fair value was proposed by accounting scholars, Saliers Earl and Paton William. Saliers (1920:282) stated that fair value should consider the influence of depreciation reserve, which would be determined the current value of the asset. In 1946, the notion of fair value was first mentioned by Professor William Paton, in an article named Cost and Value in Accounting (Sheryl 2001). He pointed out that cost not only mean an amount of money paid out, but also virtually represents the fair value of the asset at the purchasing date (Paton 1946).
Even it is can be seen that the increasing number of scholars noticed the importance of fair value, it still did not widely used as a valuing approach. Until 1990, Douglas Breeden, who is the Chairman of U.S. Securities and Exchange Commission, firstly proposed that all the investment should be reported as its market values, and fair value is the only relevant measure way (Barlev 2003:390). Great impacted after this new declaration came out, the standard-making institutions started to study fair value and tried to set standards. In 1991, Financial Accounting Standards Board (FASB) issued Financial Accounting Standard (FAS) 107. This standard stated that all the information of investment should be disclosed as their fair value, including the assets and liabilities which have not been recognized in financial statement (FASB 1990). Then, in 1993, FAS 115 was issued, and it forced banking institutions to use fair value to report certain investments securities (FASB 1993). Since then, the standards regard to fair value are increasing with a surprising speed, including FAS 119 (FASB, 1994), FAS 121 (FASB, 1995a), FAS 123(FASB, 1995b) and FAS 133 (FASB, 1998).
With the appearing of FAS 157 and IFRS 7, shows that the FASB and IASB (International Accounting Standards Board) already strongly tended to adopt fair value accounting for financial instruments and other financial derivatives. FAS157, which issued in September 2006 by FASB, formal defines fair value "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date" (SFAS 2007) Then, in March 2009, an amendment to IFRS 7 was issued by IASB, Financial Instruments: Disclosures. One related amendment is similar to the US accounting standard SFAS 157, which states the disclosure the classification of fair value measurements. This amendment introduces a three hierarchy disclosure of fair value measurement. The three levels are:
Level 1: Inputs price could be observed on an active market of identical assets or liabilities;
Level 2: Quotes the price based on the similar items in other observable market;
Level 3: Estimates the price based on the unobservable market. (KPMG 2009:5)
The positive influence of Fair value accounting
As growing attention of fair value accounting, the adopted of FVA by companies, banks and financial institution would be a future trend. SFAS 159 announces: ''The Board also believes that, with the passage of time, historical prices become irrelevant in assessing an entity's current ¬nancial position" (Benston 2008:102) Compared with HCA, FVA can help firms or stakeholders better in obtain the relevant and timely information. The following two sections that sum up the positive influence of fair value accounting.
Firstly, proponents thought that FVA is more relevant than HCA, because it can better display the underlying economic value and control risk of the financial assets and liabilities. HCA and FVA are considered as the two major measure tools in financial accounting. Fair value emphasizes report should be dynamic and timely reflected the present value of assets and liabilities. Compared with fair value measure, historical cost-based measure is seen as deficient and less informative, and it can reflect fair value only when assets are sold or relief from liabilities, but it cannot show the value during the period when holding assets or liabilities. Therefore, the risk would be extremely high when the carrying amount has a great difference with the fair value. In addition, the fair value method can be a useful way to measure the current market risk. For instance, Credit Suisse annual reports required that fair value method should be used in managing and controlling the risk activities (CSAR 2008).
The examples often quoted to support fair value is the Savings and Loan Crisis (S&L) crisis in United States, which directly lead more than 3000 Savings and lending institutions run into economic problem, and 747 of them were forced to close in 80s. During that period, the interest rate had decreased significantly. Unfortunately, no one noticed that the fair value of the mortgage loans was less than their face value (Ian 1999:31). However, those institutions based on historical cost accounting to measure in their accounting reports, and which showed a "effective" operating performance and "healthy" financial situation. The value of "losses" was not recorded in the statement, as a result, which misled management decisions made by investors and failed to report financial warning signal to regulators. Conversely, fair value can provide more underlying economic information timely and objective.
Second, fair value can provide useful information to investors, and help them gain profits. Fair value measure based on current market prices, and reflect the effects of managements' decisions to continue to hold assets or owe liabilities; as well as decide to buy or sell asset and incur or settle liabilities, especially for derivatives. Compared with fair value measure, historical cost accounting cannot reflect the current value of the market. That means, the investor cannot found the useful information, including current market risk, current market price and predicted output, to help them achieve the goal. Arthur Levitt (2008) point out that by using fair value to report assets, based on properly obeyed and performed, could help investor make decision and obtain the information easier.
Consider the following example. A company's net profit decreased because of one wrong investment made by finance manager, but the manager want to hide his mistake. He may use the conservative nature of historical cost accounting, and choose more than one way to cover the damaging influence, such as: (1) change the estimation of doubtful debts (2) sell undervalued assets (3) change a depreciation rate of operating (intangible) assets (Ronen & Sadan 1981). If the company used fair value accounting, investors may easier to find the wrong investment by comparing the difference between the market value and the value in the financial statement. For this reason, fair value would be a better tool for stakeholders.
Moreover, from the view of investors and auditors, it can be known the important position of fair value accounting. After financial crisis 2008, criticize voice came out strongly, some of institutions attempt to persuade the SEC and standard-setting organizations forbid fair value used in accounting. In the meanwhile, Consumer Federation of America, Center for Audit Quality, Council of Institutional Investors, Investors Management Association, and CFA Institution wrote a joint letter to US. Securities and Exchange Commission (SEC), stated that "shareholders have a right to know the current value of an investment, even if the investment is falling short of past or future expectations. It, therefore, is imperative at this critical juncture that we not engage in activities that would further obscure reality from investors and do more to damage confidence in the marketplace (SEC 2008)."
The shortcoming of Fair value accounting
There are many problems in the actual using of fair values. In the following parts, the essay will illustrate the main shortcomings of FVA in three aspects as below.
Firstly, Fair values in level 2 and 3 would be hard to verify. By analysis the three levels of fair value measurements, although the standard seems fairly reasonable and complete, we can find that the value in Level 1 would be an objectively price which could be observed on an active market, while for the level 2 and 3, the fair value is hard to estimate accurately. Especially for level 3, based on subjective decisions made by the companies' manager, inaccurate information came from unobservable market, error and ethics risk may lead to the significant mistakes in presenting the value of assets and liabilities both in income statement and balance sheet (Ronen 2008:186).
Enron Corporation, was an American energy, communications, and service companies, which once rated as "100 Best Companies to Work for in America" by the magazine Fortune. At the end of 20th century, the company was not only focus on energy and service industry, but also expanded fast in other business, such as derivative trading. Therefore, it created an internet transaction system named Enron on line (EOL), which used into trading activities of contracts in different industries, such as metals, paper, credit derivatives and commodities (Benston 2007:240). The traders could establish the price on those markets and dominate the markets by using EOL. During the period between 1998 and 2000, derivative trading acquired great amount of profit, and the revenues showed in financial statement sum up to 16 billion (Partnoy 2002:29). Partnoy Frank (2002) found that the reported profit of the derivatives is not accurate, because the earning based on the estimated fair value of derivative contracts, which covered a large time span; also, the value of these contracts cannot be quote from the inactively trading market (Level 3). Bryce (2002:336) also reported that the firm actually was losing money on derivatives transaction, although huge profit showed in using EOL. At the end of 2001, Enron scandal was revealed, which become a well-known example of intentional corporate fraud, and directly caused the dissolution of the Arthur Andersen accounting company in 2002.
From the above case it is not difficult to find that fair value could be a useful and objective tool, when the value can be observed in active market (in Level 1). However, when in the market without observational data (level 2&3), a wide range use of fair value may cause inflate revenues and ignore liabilities in financial statements; moreover, fair value could be easily controlled by opportunistic and overoptimistic managers, and which would be very hard for auditors to verify (Benston 2008).
Secondly, fair value accounting could cause asset and liabilities excessive volatility. The fluctuation requires firms' to incur losses or increase assets which may never actually happen. Under the fair value accounting, the change of economic environment, risk and enterprises' credit can cause dramatic fluctuation of financial statements. Those fluctuations might not provide relevant and useful information, or even mislead the users of financial statement. Especially for banks or the companies who hold the financial products, uncorrelated and inaccurate fluctuations probably will bring extraneous risks, or would miss favorable investment opportunities.
For example, the critic of fair value cites the case of Washington Mutual. Washington Mutual, was the American largest savings and loan association until it bankrupted (Ari & Elizabeth 2008). The assets and debt obligations of Washington Mutual were purchased by JPMorgan Chase at a fire-sale price, including $307 billion in assets and $188 billion in deposits for only $1.9 billion from the FDIC (CNN 2008). In this case, historical cost based on real transaction might be a better option than a risky and less accurate assessment of fair value. Perhaps this is main reason that lot of banks do not apply to FVA as their financial measure.
Thirdly, using fair value is costly. Using fair value accounting measurement, it is requested that the enterprise accountants analysis various factors in every final accounting period, and determined the fair value of assets and liabilities. Compared with the historical cost accounting, the process of fair value is more complex and expensive, especially in enormous manpower, and information cost. For instance, political costs may be collect fee by adaptation of FVA system. It is possible that some authorities may verify strictly for the risk levels and financial activities of reporting; it is also possible that IRS may revise the content of income and will tax unrealized gains. Such rules often become an obstacle for management activities, and impose high costs on companies (Barle & Haddad 2003:405).
Evaluation- whether Fair Value Accounting should be used?
Although fair value is considered by critics as an unreliable, excessive volatility tool, until now, it is the only method to measure the derivatives and other financial products. SEC (2008) also clarified in report that Fair-value accounting did not cause or contribute to the financial crisis, but still need a long time to be complete. Nevertheless, the report also recommended several measures to use in improving fair-value accounting. In the following paragraph, the essay will summarize some measures which probably can avoid the adverse impact of FVA.
Firstly, it would be necessary to build a strict internal control system and hire effective external audit to assess their fair value. From the case of Enron, it can be sure that a long term running business must focus on accounting transparency, which means shareholder can obtain accurate and complete information about the business activities. Moreover, regarding the unreliable and excessive volatility of FVA in using, HCA is an acceptable alternative option for the financial institutions, especially for the price of some assets and liabilities cannot be observed in inactivity market (Level 2&3). However, substantial adequate financial information should be including in report or in disclosure notes, and must be corrected as soon as possible when the current market condition changed.
As has been shown, FVA is not a perfect measure tool. Compared with HCA, FVA reflect the information currently and in future while HCA only provides the company's financial information. But the two methods are not contradict, both of them discovery
and a deep understanding of fair value of theory and practical significance and face up to its intrinsic defects
Accounting transparency means that the ¬nancial statements provide true, accurate, and complete information about the business activities and the ¬nancial position of a ¬rm.
The essay analysis the advantage The essay demonstrated the disadvantage of FAV, cite the case of S&L crisis, Enron,
Breaking or tweaking the ¬nancial accounting thermometer would not improve the health of the patient, and would only make the doctors' task that bit harder. (Veron 2008:67) Those who support the elimination of fair value accounting have forgotten that the implementation of various fair value accounting standards were a direct result of past economic catastrophes where banks failed and accounting was blamed for the failure. We should not make the same mistake again.