Fair Value Accounting and the Financial Crisis

Advanced Financial Accounting Assignment 2 Fair Value

Fair value can be defined as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arms length transaction. 1 This is the main definition used by the International Accounting Standards and although this varies between different bodies, it represents the main ideas of this accounting system. To break down this definition further, knowledgeable willing parties are independent parties to the transaction that are not under force to accept the agreement. An arms length transaction is a fair value measurement assuming that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation or distress sale). 2 A fair value measurement requires an entity to determine the following: (a) the asset or liability being measured. (b) for a non-financial asset, the highest and best use and whether the asset is used in combination with other assets or on a stand-alone basis. (c) the market in which an orderly transaction would take place for the asset or liability. (d) the appropriate valuation technique(s) to use when measuring fair value. The valuation technique(s) used should maximise observable inputs and minimise unobservable inputs. Those inputs should be consistent with the inputs a market participant would use when pricing the asset or liability.3 The valuation techniques mentioned above are the Cost, Income and Market approaches. Fair value accounting is included in the majority of International Standards issued today, illustrating its importance in accounting. However the use of fair values is a relatively new area. The conceptual framework which was last revised in 2000 has no mention of using the fair value basis. The IASB and the FASB are currently working together to develop a standard which deals with fair value showing that its a preferred option to HCA. To discuss the concept of fair value in greater detail we shall look at some standards which illustrate its features.

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IASB IAS 16 Paragraph 6 IASB International Financial Reporting Standard X Paragraph 11 3 IASB International Financial Reporting Standard X Introduction Paragraph 10

IAS 16 IAS 16, the standard for Property, Plant and Equipment, gives the option of using a cost or revaluation model for measurement subsequent to initial recognition. Under the revaluation model it is required that fair value can be reliably measured. A feature of fair value accounting is that the value is determined using market based evidence. Any figure that is used by reporting entities must be based on reliable information and evidence. In Ireland it is normally required that any valuation is appraised by qualified valuers. An advantage of FVA is that according to paragraph 38 of the standard items in a class can be revalued on a rolling basis. This is a favoured idea at the moment as due to uncertainty in the markets values are subject to constant change. A feature of fair value accounting is the detailed disclosure that is required in the standards. If we take IAS 16 and where there is a revaluation as an example again we can see that paragraph 77 of the standards lays down strict disclosure requirements. The entity must disclose whether or not an independent valuer was involved.4 This allows the users of the financial statements to assess whether the values are accurate or not. IAS 38 Intangible Assets This standard gives us different techniques for measurement for different situations. Fair value for the purpose of revaluations under this Standard, fair value shall be determined by reference to an active market.5 If no active market exists, which is a topical issue at the moment, the standard allows the entity to carry the asset at cost. Conversely the fact that no active market exists can be an indicator of impairment. This is an added advantage of Fair Value as it can be evidence to early warning signs. IAS 40 IAS 40 highlights some of the difficulties connected with fair value accounting. This standard stipulates that if an entity used fair value once they must remain using it, if no active market exists then they may use the most recent price. This poses a difficulty that is highlighted in todays climate, the recent price may not be an accurate one. The fair value model differs from the revaluation model that is permitted for some nonfinancial assets. Under the revaluation model, increases in carrying amount above a costbased measure are recognised as revaluation surplus. However, under the fair value model, all changes in fair value are recognised in profit or loss.6

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IASB IAS16 Paragraph 77 IASB IAS 38 Paragraph 75 6 IASB IAS 40 Introduction Paragraph 14

In my opinion I believe that this is an advantage of FVA. If there is an increase in the value of an asset under revaluation model then its shown as asset on balance sheet but under the fair value model the increase is shown as a gain in the Profit and Loss Statement. This I feel is a better method as the revaluation shown in balance sheet which may be misleading. Again the detailed disclosure requirements are present for this standard also. The methods and assumptions in valuing FV must be separated between market based and other factors. This separation I feel allows the stakeholders see the logical in determining the fair value. Historical Cost Accounting Historical cost accounting is an alternative to Fair Value Accounting. HCA has some limitations which makes fair value a favoured option. HCA ignores specific price level changes, general price level changes and fluctuations in exchange rates for currencies. HCA can become irrelevant in inflationary periods, rendering information ineffective. One argument is to allow entities such as banks to hold their balance sheets at HCA so that they can insulate their assets from market pricing.7 However this may create incentives to banks to sell assets to realise earning early, according to Plantin et al. (2008a) as cited by Laux, C. and Leuz, C. (2009).8 Fair value accounting is seen to be superior to historical cost accounting as it meets the following two requirements more adequately; the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. 9 Financial statements also show the results of stewardship of management, or accountability of management for the resources entrusted to it.10

Although throughout history banks have consistently argued against FVA, the alternative HCA would bring this sector greater benefit. Under HCA impairment testing is less strict, it allows banks to accumulate amass of hidden reserves and show gains/losses advantageously. Fair Value and the Financial Crisis Fair Value Accounting is seen to have played a role in exacerbating the financial crisis. Politicians felt so strongly about its influence that they lobbied to ease its requirements in

Laux, C. and Leuz, C., 2009, The crisis of fair-value accounting: Making sense of the recent debate, Accounting, Organizations and Society, Vol. 34, p826-834 8 Laux, C. and Leuz, C., 2009, The crisis of fair-value accounting: Making sense of the recent debate, Accounting, Organizations and Society, Vol. 34, p826-834 9 IASB Framework Paragraph 12 10 IASB Framework Paragraph 14

October 2008; it also was one of the first topics for discussion at the G20 summit of world leaders in November 2008.11 One of the main difficulties of FVA was not its application but rather its definition. At the beginning of my essay I have given one of the main definitions that is used to describe fair value, however many more exist. In 2006 the FASB promulgated FAS 157 in order to provide a more uniform definition of fair value and a framework for its use.12 The uniform definition provided was Fair value 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.13 The main reason FVA was held for discussion during the crisis was the fact that its treatment in the accounts required companies to mark down their financial instruments at market prices which often meant large write downs for the companies when the market price was lower than the price paid.14 This affected the companys reputation on the market as investors saw the venture as risky. Due to the financial crisis for some classes of assets, no active market exists which requires entities to use valuation techniques rather than the market deciding the value. For banks this caused greater writing down of asset values further damaging market confidence. However the main cause of the financial crisis was bad corporate governance and complex financial reporting and management holding a shortism view.15 It was lack of knowledge of the markets, credit rating agencies and also an unawareness of the effects of their (banks) actions on the markets. The use of FVA cannot be blamed in aggravating the current crisis in my opinion. The advantages of FVA can be highlighted as solutions to the problems that have build up during the crisis, making it essential that FVA is not abandoned. Advantages of Fair Value Accounting Greater transparency. The use of fair values is more transparent than other methods. When based on quoted prices in liquid markets they often require fewer assumptions than impaired historical cost, for example.16 Fair value also has the advantage to investors and the markets in that it shows the true position of the company, be it good or bad. This transparency lacked during the financial crisis. Due

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http://www.accaglobal.com/general/activities/library/financial_reporting/other http://www.forbes.com/2009/08/19/mark-market-accounting-leadership-governance-directorship.html

FASB FAS 157 http://www.accaglobal.com/general/activities/library/financial_reporting/other 15 http://Blackboard.nuigalway.ie 16 http://www.accaglobal.com/general/activities/library/financial_reporting/other

to the over complexity of the financial products, the public didnt know what they were investing in. More information. The strict disclosure requirements give more comprehensive information regarding fair value valuation, use of a valuer, active markets etc than other techniques. It often requires the inclusion of the historical cost of the asset/liability, so maximum information is given to the user. This makes the financial information investor friendly. Investors during the crisis still favour the use of fair values as it provides relevant information for them. Fair value also has the advantage of being a more information-rich concept, given that it is a market-based value representing the outcome of the views of all the market participants, not just of one such participant, namely the reporting company (historical cost being specific to a single entity).17 Inclusion of derivative contracts. FVA accounts for these contracts where other methods such as a cost-based system would leave them off the balance sheet.

Although I do believe that FVA is the most appropriate method it does have disadvantages that attention should be brought to, for the fairness of this debate.

Disadvantages of Fair Value Accounting Fair value and procyclicality. As fair value recognises profits and losses earlier than the historical cost approach it does hold the risk of over stating values and profits in good times and overstate the declines in value in bad times. This is a direct argument to the fact that although the FV approach provides more information to investors, it drives business behaviour rather than reflecting it.18 Another problem lies in the fair value treatment of liabilities. When a companys credit rating deteriorates, many perceive a counter-intuitive effect which they find difficult to accept. A falling rating would lead to a decline in the fair value of a companys bonds (i.e. its liabilities) for instance, and if they were included at fair value this would create a profit at a time when the companys performance or prospects may have got worse. This is precisely what we have been seeing with some banks recently amid the wash of red ink arising from their asset write-downs there have also been major gains for some as their bond values have declined. 19

FV is a principle based accounting treatment. I feel that it is necessary to continue with this treatment as a rules based system has been a feature of scandals in the past. This was a major factor in the Enron scandal and is an area that needs to be revised in the U.S.
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http://www.accaglobal.com/general/activities/library/financial_reporting/other http://www.accaglobal.com/general/activities/library/financial_reporting/other 19 http://www.accaglobal.com/general/activities/library/financial_reporting/other

The SEC study mandated by the Economic Stabilisation Act of 2008 argued that FVA did not cause the current bank failures because the fraction of assets reported at fair value was minor in most cases.20 It is my view that FVA did not cause the financial crisis, managers had no limit on the amount of information that they could provide on the accounts but they were safeguarding their own business as they were aware of investor response and ligation risks. Solution The question is now where do we go from here. Although I have argued that FVA did not cause the financial crisis, its use in financial reporting is still an area of uncertainty. I believe that to go forward from here as mentioned previously, is the joint collaboration of the IASB and the FASB to develop a standard on Fair Value is essential to its future. The IASB and the FASB in 2005 were working separately on developing a draft on FVA. However with increased global convergence and the current global financial crisis, the IASB and the FASB enhanced their joint efforts to develop a common Fair Value measurement guidance in October2009.21 The objective of doing an IFRS on Fair Value is to give clear guidance on the measurement of fair value, as this is something which is lacking at the minute. They started by ensuring that the definition of Fair Value was the same in IFRS and US GAAP and then ensuring that the FV measurement and disclosure requirements would be the same. It was agreed that FV would be defined as an exit price. The IASB and FASB worked together to reduce the differences between the ED/2009/5 and the Topic 820 (requirements in US GAAP).22 The IASB and the FASBs joint effort to develop a standard on fair value will reduce the different applications of the treatment, reduce the complexity of financial reporting and also help in the continued effort of increasing transparency worldwide.23 Conclusion At the heart of every standard or regulation issued there is an underlying conflict on relevance versus reliability. There will never be a standard without argument for or against its policies, but we need to work towards improving clarity and understanding on it. This is what the IASB and the FASB have set out to achieve.
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Laux, C. and Leuz, C., 2009, The crisis of fair-value accounting: Making sense of the recent debate, Accounting, Organizations and Society, Vol. 34, p826-834 21 http://www.iasplus.com/agenda/fairvalue.htm 22 http://www.iasplus.com/agenda/fairvalue.htm
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http://www.iasplus.com/agenda/fairvalue.htm

FVA supports international harmonization and globalisation; its evitable that its use will be continued. However it must be refined to achieve a uniformed understanding and application, the IASB and FASB therefore need to continue to work together to achieve this task.

References

1. IASB IAS 16 Paragraph 6 2. IASB International Financial Reporting Standard X Paragraph 11 3. IASB International Financial Reporting Standard X Introduction Paragraph 10 4. 5. 6. 7. IASB IAS16 Paragraph 77 IASB IAS 38 Paragraph 75 IASB IAS 40 Introduction Paragraph 14 Laux, C. and Leuz, C., 2009, The crisis of fair-value accounting: Making sense of the recent debate, Accounting, Organizations and Society, Vol. 34, p826-834 8. Laux, C. and Leuz, C., 2009, The crisis of fair-value accounting: Making sense of the recent debate, Accounting, Organizations and Society, Vol. 34, p826-834 9. IASB Framework Paragraph 12 10. IASB Framework Paragraph 14 11. ACCA (2009) ACCA Policy Paper: Fair Value February 2009. Available at: http://www.accaglobal.com/general/activities/library/financial_reporting/other (Accessed:05/11/2010) 12. Cindy Fornelli (2009) The Great Fair Value Debate. Available at : http://www.forbes.com/2009/08/19/mark-market-accounting-leadershipgovernance-directorship.html (Accessed: 05/11/2010) 13. FASB FAS 157 14. ACCA (2009) ACCA Policy Paper: Fair Value February 2009. Available at: http://www.accaglobal.com/general/activities/library/financial_reporting/other (Accessed:05/11/2010) 15. Barrett, M (2010) ACCA Policy Paper: Climbing out of the Credit Crunch September 2008. Advanced Financial Accounting. [Online] Available at: http://Blackboard.nuigalway.ie Accessed: 06/11/2010. 16. ACCA (2009) ACCA Policy Paper: Fair Value February 2009. Available at: http://www.accaglobal.com/general/activities/library/financial_reporting/other (Accessed:05/11/2010) 17. ACCA (2009) ACCA Policy Paper: Fair Value February 2009. Available at: http://www.accaglobal.com/general/activities/library/financial_reporting/other (Accessed:05/11/2010) 18. ACCA (2009) ACCA Policy Paper: Fair Value February 2009. Available at: http://www.accaglobal.com/general/activities/library/financial_reporting/other (Accessed:05/11/2010)

19. ACCA (2009) ACCA Policy Paper: Fair Value February 2009. Available at: http://www.accaglobal.com/general/activities/library/financial_reporting/other (Accessed:05/11/2010) 20. Laux, C. and Leuz, C., 2009, The crisis of fair-value accounting: Making sense of the recent debate, Accounting, Organizations and Society, Vol. 34, p826-834 21. IASB (2010) Project Summary re: Fair Value Measurement- July 2010. Available at: http://www.iasplus.com/agenda/fairvalue.htm (Accessed: 05/11/2010) 22. IASB (2010) Project Summary re: Fair Value Measurement- July 2010. Available at: http://www.iasplus.com/agenda/fairvalue.htm (Accessed: 05/11/2010) 23. IASB (2010) Project Summary re: Fair Value Measurement- July 2010. Available at: http://www.iasplus.com/agenda/fairvalue.htm (Accessed: 05/11/2010)