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The global financial crisis in United State, erupted and engendered a negative impacts from the middle of 2007 and into 2008 (Shah 2010), is continuing to affect the cosmopolitan economic and financial market. Many large financial organizations could not stand up from the pressure of the crisis; therefore, these stock markets have fallen and have collapsed or been bought out (shah 2010). Velde (2008) stated stock markets in many countries was decreased more than 40 per cent.
In the September 2008, Fannie Mae and Freddie Mac have been nationalized by American government and attempt to keep a stability impact in the two firms (The Financial Crisis 2008). The bankrupt of Lehman Brothers after one week transferred a panicky effect around global financial markets. Hence, American government depended on these situation to decide to use rescue packages with a trillion US dollars that could remedied national financial systems through parliament (Shah 2010). According to these rescue pacages, more large organizations have been nationalized, which include Merrill Lynch and American International Group (The Financial Crisis 2008). In the same time, sub - prime mortgage crisis was coming around the American and European financial firms because these economic systems was based on credit which was on the United States housing bubble(Hinton 2009). During the housing markets, large firms was boxed up in high risk (Warwick & Andrew 2009). Therefore, Governments have also decided to released plans to decreased bank interest rates, shipping rates etc (velde 2008) and use these above approach to solve national economical recession.
According to the global financial crisis, economical experts depended on these crisis which include banking crisis, speculative bubbles and crashes, international financial crisis and recession, and have thought the cause of financial crisis is fair value accounting which have the responsibility in the USA for the Global Financial Crisis; however, others have point out there was no any responsibilities from fair value accounting standards through various research and study, and the U.S. Securities and Exchange Commission in the end of 2008 released immediately to congress and make a recommendation that against to stop the suspension of fair value accounting standards (SEC 2008). Therefore, this paper will point out and research the fair value accounting and there have what problems as well as whether the fair value accounting should hold a responsibility for the global financial crisis in the USA. Also,we will examine opponents and proponents of Fair Value Accounting(FVA).
Arguments from various Scholars:
Laux (2009) states in his article that FVA brings volatility to the system. And the tradeoff between liability and transparency needs to be further researched.
Penman (2007) points out that FVA works well for investment funds in which the value of assets or liabilities closely related to the FVA. But when this situation fails, for example, for some companies, their assets are used to produce value in the future, the FVA often confuses financial statement users.
Jones, J. C. (1988) stated that under FVA, the balance sheet becomes the primary sources of information instead of the income statement in the Historical Value Accounting (thereafter referred as "HVA") case. With all assets and liabilities recorded at fair market value, the income is no longer predicting changes of value and earnings are no longer predicting future earnings. They just add value to stockholder's equity.
Cocheo, S. (2009).stated several shortcomings of adopting FVA:
1. FVA brings bubbles into the financial statements;
2. FVA does not comply with matching principle;
3. The option of a different value system for a company creates room for deliberate manipulation;
The adoption of FVA gives the company managers more opportunities to manipulate numbers by choosing a different accounting method. Consequently, it requires analysts to have much more knowledge, wisdom and time to analyze those data. And this means the adoption of FVA will make the current system even more complicated. .
To evaluate stewardship, we raise a question that what is better, the FVA or HCA
Stewardship, in a broad sense, is defined as accountability, the company's performance. A lot of it involves management's strategy to achieve stabilized increases of entire company's value. These strategies include the sale of subsidiaries which constantly generates operating loss; the opening of new shop or subsidiary in a highly developing countries or cities; the decision of when and how to make sales to prompt the income and so on.
From most of the manufacturing companies, HCA is more relevant to evaluation when compared with using FVA. In the old system (HCA), the inventory, Property Plant and Equipment, and liabilities were recorded when they were acquired at cost. After acquisition of these assets, their cost are either expensed or capitalized depending on whether they contribute to generate future income. By reading financial statement, under GAAP--- Historical Method, we are able to see a better matching of cost and benefit, expense and revenue relations in financial reports.
After introducing FVA into accounting reporting system, the income statements are no longer the key report which investors and creditors will take look at. Instead, the balance sheet becomes the main report which most investors and analysts will concentrate on.
However, the financial reports are used limitedly between comparable companies instead of being used for among undefined entities, the HCA application is good enough for satisfying this requirement. The introducing FVA to the system brings noises to the evaluation of a company's performance because it includes the gains and losses from price fluctuation into the net income and some other ratios. Not only people need to take extra effort to analyze what percentage is literally from operating activities and what are from other activities, but also the financial report preparers need to take extra effort to make such adjustments every season to the value of these entities. So, from a Cost and Benefit point of view, is the benefit of adopting FVA really worth the cost? (McCarthy P. D. 2004)
In the case of evaluating a manufacturing company, the consideration of its performance usually has to do with how management can maximize profit by lowering the inventory purchasing prices, improving on production efficiency and streamlining of procedures, quality controls and performing better selling strategies, etc. All of these, however, have little relationship with adjusting the value of its balance sheet accounts due to market fluctuation. Even if there is a huge increase in value of property, plant and equipment, the company cannot sell them because they are used as assets to generate future profit.
On the other hand, the Historical Value Accounting system depreciates the cost of property, plant and equipment over their lives because they are used for production of future value. This adoption fits perfectly into the matching principle --- expenses are recorded in the same period when revenue is generated. This provides a better information for investors and creditors.
Furthermore, the application of FVA introduces more noise when evaluating the companies' performance. Because the increase or decrease of value by adopting FVA do not contribute to the accountability of companies, it functions as noise to the analysts, and they have to take extra steps to eliminate these factors in order to have a clean picture of a company's performance.Therefore, FVA is not feasible for manufacturing company.
From a Manager's point of view
From a manager's point of view, the adoption of FVA can shrift his or her concentration away from improving company's performance. Instead, he may focus on enhancing earnings through buying and selling inventory and property investment. We can learn something from an empirical example happened recently in China. Although the Chinese economy has been booming, it is distorted. The GDP increases at an annual rate of 10%, but it is not the same rate with manufacturing companies. Closely following the booming is the rise of the capital market prices.
Facing the international fierce competition, Chinese manufacturing companies cannot win the battle through having advanced technologies or multinational chains. What they have is cheaper costs. And they are losing their only advantage when the national capital market price starts to rise. As a result, they are struggling for survival. While this is going on, some company owners realize that it is more profitable to invest in the stock market than to invest their time and effort into building their companies. Furthermore, the investment turnaround time in the stock market can be much shorter comparing to running a manufacturing company. So some of the owners choose to close their companies and used the money from selling the plants to invest in the stock and real estate market.
Although this situation may not repeat in the United States, it is possible that the managers may consider shifting their attention from striving to improve manufacturing performance to investment activity because of the tradeoff of the easy money.
The idea of FVA enhancing comparability among different companies and making consolidated financial statement reporting easier for multinational companies should not be traded off with the stabilization of the entire capital market.
Concerns of Market stability -- The main change toward the system is the reliability and faithful representation
HITZ, J. M. (2007) stated that the adoption of FVA actually eliminate the possibilities of tradeoffs between relevance and reliability. This means the only concern remaining for financial statement is its relevance.
Watts, R.L. (2003) stated that the closely related concept of conservatism has influence on accounting practice for more than 500 years. And he says that the long survival of conservatism and the ability to stand for criticism strongly suggest that its benefits exceed its pitfalls.
The benefits of conservatism bring to the system includes:
1. Conservatism limited earning management;
2. Conservatism provides efficient financial reporting mechanism;
3. Conservatism keeps the companies from overstating their assets, which is a major cause of potential litigation;
4. For regulators, they have the incentives to favor conservatism.
Other than the above, we have to take consideration of the stability of the stock market. If the stock market is a key indicator of a economy's condition, its stableness should be the most important factor to be taken into consideration by regulators. The current U.S. financial system, developed through long period of time, adopts the Conservatism as the fundamental principle to stabilize stock market and to protect investor's right. Now the introducing of FVA into the financial reporting system inevitably eliminates some of these solid, supportive sustainers from the capital market.
Proponents of Fair Value Accounting
According to the CPA journal in 209, the use of fair value accounting has been expanding in reporting standards under generally accepted accounting principles (GAAP) in recent years. SFAS157 defines fair value, establishes a framework to measure fair value and requires for disclosing fair value measurements. Definition of fair value under SFAS is "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" (CPA Journal, 2009).
In fair value accounting, assets are valued at a calculated current market price. Companies report losses or gains on the assets even when they haven't sold them (Triangle Business Journal, 2008).
Fair value accounting, or mark-to-market accounting was blamed for participating as a substantial role to the current global financial crisis (Christian Leuz, 2010). According to Christian Leuz, professor of the University of Chicago Booth School of Business, and Christian Laux, professor of Goethe-University Frankfurt, fair value accounting is neither responsible for the crisis nor it is merely a measurement system that report asset values without having economic effect of its own. Critics argue the fair value accounting or mark-to-market accounting has significantly contributed to the financial crisis and exacerbated its severity for financial institutions in the U.S. and around the world. On the other extreme, proponents of fair value accounting argue that it merely played the role of the proverbial messenger that is now being shot (Christian Laux and Christian Leuz, 2008).
Fair value accounting was not the cause of the financial meltdown that has brought down the biggest financial institutions in the country, said by the U.S. Securities and Exchange Commission or SEC.
The main arguments in opposition to fair value accounting are that it contributes to lavish leverage in boom periods and causes extravagant write-downs in busts (Christian Leuz, 2008). Many banks and industry organizations have blamed fair value accounting for the downward economic spiral, saying that many organizations became in viable based only on paper losses. Critics have also charged that it is impossible to determine fair market value in an illiquid market, such as the one that began to materialize after the risky trading of mortgage-backed securities reserved course (Triangle Business Journal, 2008). A main problem in the crisis was that the leverage during the boom was too high and collateralized repurchase agreements were heavily relied by banks (Christian Leuz, 2008).
Christian Laux and Christian Leuz said that it was unlikely the fair value accounting contributed to bank leverage before to the crisis. They explained that collateral can obtain the amount of debt. Investors were concerned about banks with significant mortgage exposure when the matters in the mortgage market were obvious. Hence, financial institutions that heavily relied on short-term loans and had significant subprime exposures would have forced major difficulties despite the accounting rules. In fact, problems could be worsening if there is less transparency about losses and exposures. The SEC reported said, "Rather than a crisis precipitated by fair value accounting, the crisis was a 'run on the bank' at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm" (Triangle Business Journal, 2008).
The partner at Mayer Brown LLP law firm, Stanley Parzen said, fair value accounting actually helps freeze the market during the crisis. He said, to look at market transactions and similar transaction is the most technical method to value a financial instrument under fair value accounting. "By selling into a market without many transactions, you may be establishing a market value which is going to require you to take a loss."
An article from Bank Accounting & Finance asked a question: what is the root cause of our current economic problems, and is fair value accounting capable of capturing these problems accurately? The authors Wallace and Marsha disagree that fair value accounting is the root of our current economic crisis. Instead, fair value accounting is merely the messenger rather than contributor. And in fact, the situation might be worse without fair value accounting, since the magnitude of the problems would not have been recognized as soon under traditional accounting methods. If we had instituted fair value accounting earlier, we might have avoided the situation that we are in today (Wallace and Marsha, 2008).
Christian Laux and Christian Leuz also pointed out some reasons that fair value accounting did not contribute significantly in this financial crisis. First, the fair value accounting and asset write-ups allow banks to increase their leverage in booms, therefore makes the financial system more vulnerable and financial arises more severe. However, this argument ignores that fair value accounting provides early warning signals for measure earlier. Thereby, fair value accounting may actually reduce the severity of the crisis (Christian Laux and Christian Leuz, 2010). Also, for U.S. bank holding companies, the effect of the changes of fair value on the regulatory capital and bank income is much more limited than the forceful public debate might suggest that are carried at fair value, not all fair value changes have effects on banks' net income (Christian Leuz, 2008).
Furthermore, the treatment of financial assets under U.S. GAAP is more flexible. Leuz and Laux emphasize that reported values to deviate from market prices were allowed by the accounting rules under important circumstances. For example, fire-sale prices are not considered to be used in determining fair value (Christian Leuz, 2008).
According to the U.S. banks' financial statements, Laux and Leuz show evidence that, as the crisis worsen, banks used the accounting rules flexibly enough. For instance, assets were moved if they had been valued using quoted price in active market (Level 1 assets), or that had been valued by observable inputs from similar assets (Level 2 assets), to Level 3 to value them with models (Christian Leuz, 2008).
Laux and Leuz said that there is not many evidence of excessive write-downs, or that fair value reported by banks were relatively too low. They believed that, not being a major contributor to the financial crisis, discretion can be used to keep fair value high, and banks were allowed to do this by the rules of fair value accounting (Christian Leuz, 2008).
According to a journal from Bloomberg Business week, critics had argued that the accounting rules made the current financial crisis worse by forcing banks to sharply reduce the value of assets such as mortgage-backed securities that were severely depressed by market conditions. The journal said the value of mortgage-backed securities, which are bonds backed by home loans, and other risky investment products fell sharply at the beginning of 2007. Because of the accounting rules, banks were required to record hundreds of billions of dollars in non cash charges to reflect the reduced value of those investments. As their value fell, banks became more unwilling to sell the assets as loss, only further weakening the prices and leading to more write-downs (Stephen Bernard, 2009).
According to the CPA journal, fair value accounting stands in contrast to historical cost accounting, which reports assets at the original price paid and with costs allocated over time used. The debate between fair value accounting and historical cost accounting method is usually framed by the issue of relevance versus reliability (CPA Journal, 2009)
Those who support the use of fair value accounting believe that reporting financial assets and liabilities at fair value is more relevant than historical cost. Fair value reflects the amount at which an asset can be bought or sold and provided better insights to current risk. As a result, investors and other decision-makers can exercise better market discipline and corrective acting regarding a company's decision (CPA Journal, 2009).
Prior to the crisis, the market for securitized loans was reasonably liquid and gave banks an opportunity to recognize significant gains from loan organization. Thus, those who critic fair value accounting and call for a return to historical cost accounting have to be careful: historical cost accounting for loans coupled with banks' short term incentives may in fact have been an important factor in the recent surge of securitizations (Allen, F. and Carlettie, E., 2008).
From our findings, we concluded that the adoption of FVA can create many issues to the companies and the standard setters. It also has great effect on the stabilization of the capital market. The market fluctuation it may cause increases the risk of an entire market failure and could scare away current and potential investors, which would be a loss for both the companies and the investors.
In conclusion, in order to enhance the comparability among international companies. The history has proved that the U.S capital market is the healthiest in the world, and the introducing of FVA can potentially brings distortion to the market. If the company's performance is so important when comparing with other factors, HCA is good enough to satisfy the requirement of financial reporting. The principal of Conservatism has been developed and adopted for more than 500 year, and it is the basics for a stabilized capital market.
Therefore, HCA is the answer to the U.S. financial system and FVA is responsible for the U.S. financial crisis