former writer 6 | 5
Jan 28, 2009 | #1
An uncompleted paper on fair value accounting... hoping it helps someone!
Credit crunch isn't an accounting problem. It's a banking problem'( Sir David Tweedie, chairman of the International Accounting Standards Board
'Fair value(method) is exacerbating the credit crunch'( John McCain, Republican Presidential Candidate, USA)
International financial markets constantly demand unbiased, fair, reliable and objective accounting systems which, under normal financial transactions and valuations, give a fair value of any asset in focus (See for instance Barth for a detailed discussion on valuations). One popular valuation system constantly in use and adopted by IASB(International Accounting Standards Board ) is fair value accounting. In its most basic essence, fair value accounting encompasses determining the fair value of an asset or liability in a current transaction. The key objective of fair value accounting is to give a value(such a price) to an asset or liability, without necessarily initiating a transaction. In essence then, fair value accounting focuses on providing an objective valuation of an asset or liability without undue influence from the concerned parties, without considering historical costs and basing the value of an asset on mark- to- market accounting rules.
Generally, any accounting valuation system used by financial markets must, without exception, provide fair valuation, be considerably immune to irrational estimation errors, be adaptable and flexible enough to changes in financial architectures for capital markets to be effective in terms of impartiality and objectivity in assets and liabilities valuation(Enria 2004). Obviously, fair value accounting has some distinct advantages, which has made it a fairly popular method of valuation. Firstly, fair value accounting typically requires financial disclosures to value financial elements based on market value, thusly enabling investors and other stakeholders to gauge their investments based on prevailing market values, a credibly helpful aspect in as far as making investment decisions, and determination of the solvency and future potential of a firm is concerned(Enria 2004). Secondly, innovation in financial markets has led to some financial products which cannot be valued using cost method, as it would not only be highly deceptive but irrational as well, leaving market value determined fair price as the only accurate method of valuation(Landsman 2006).
Despite these key and market oriented benefits of fair value accounting, the ongoing credit crises has led to rise of levels of criticism hitherto unheard of before against use of fair value accounting and, specifically, critics attribute the cause of crises, in part, to the use of fair value accounting. Briefly, the ongoing credit crises(Also referred to as subprime mortgage crisis) is global financial malfunctioning of financial markets brought about by unprecedented busting of housing markets in the united states(through massive mortgage default resulting from rapid increase in high risk mortgage loans ) , dysfunctional and inaccurate credit ratings , lack of government regulation and erroneous financial speculations.
Of late, however, a streamlined stream of literature has began to emerge with a common theme of blaming the crisis on fair value accounting. Indeed the common question has been: How fair is fair value accounting and how did it cause the crises?. To investigate the issue in a detailed manner, this essay first analyses major strands of literature linking the crisis to the accounting method in question.
Firstly, critics agree that the cause of the current credit crisis has been an offshoot of a highly speculative and credit reliance financial market with key arteries rooted in credit benefits returns and over-speculation driven by misleading ,mark- to market objectives. At the centre of this financial miscalculation is fair value accounting which, according to some researchers, has been rigidly designed to solely rely on available market information during a valuation process. However, market dynamics demand that such a valuation process be guided by adequate market information within a relatively stable and active market. In the recent and ongoing financial turmoil, it has become evident that information available for ordinary trading and accounting transactions doesn't rhyme with the net cash inflows and credit valuation of the entities being traded. Consequently, firms have been forced to value their assets(mostly under-valuation) based on deceptive market information which is misguided by the available information on the market worth of such assets- a blame that squarely and objectively lie on fair value mode of evaluation. Indeed, this aspect has been exacerbated by inactive markets, which, in relatively normal financial conditions and transactions tend, on average, to devalue assets thus negating the principal of 'fair value' so highly esteemed in fair value accounting methodology. However, recent investigations into this aspect defend fair value accounting method from the financial crises blame.
For instance, an investigatory report by S.E.C (U.S) note that fair value accounting is strategically positioned to deal with transparency in financial report and as such is a good methodology in financial reporting. The report attributes the crisis to banks malfunctioning resulting from credit delinquencies, assets devaluation and loss of confidence by investors. However, some researchers(for instance....)still believe that unreliable market information triggered the crisis.
Still, the very objectives of fair value valuation have been questioned and, in most cases, blamed for the current financial crisis. It has been argued that the very objective of FVA was to enable convincing and accurate valuation of assets. This was to be done(and is done) by assessing the liquidity levels of assets in question(i.e level 1, 2 ,3 ).However, there was no anticipation of high market volatility such as the one being experienced and, particularly, inactivity of financial markets which brings about, among other consequences, write-downs and rigidity in the overall liquidity of markets. Hence(and quite naturally) fair value valuation based on inactive markets has been objectively questioned. However, this perspective is questioned by bankers who see the problem as chiefly a result of laxity in credit policies. Indeed, other scholars have been more bold attributed the crisis purely on lack of liquid cash(brought about by over-borrowing).
Another questionable aspect of FVA has to do with valuation of mortgages(One of the prime causes of the current crisis). In accounting, it is paramount that any valuation method be reflective of price valuations against net values of underlying securities and mortgages. However, with FVA this was not the case and determining such values was an inherent problem, leading to massive losses and lack of returns on mortgages.
In fact, it has been consistently shown that with FVA, there was no guarantee that without transparent financial disclosures, there would no fair accounting valuation... cont.d
Fair value accounting and the credit crisis
Credit crunch isn't an accounting problem. It's a banking problem'( Sir David Tweedie, chairman of the International Accounting Standards Board
'Fair value(method) is exacerbating the credit crunch'( John McCain, Republican Presidential Candidate, USA)
International financial markets constantly demand unbiased, fair, reliable and objective accounting systems which, under normal financial transactions and valuations, give a fair value of any asset in focus (See for instance Barth for a detailed discussion on valuations). One popular valuation system constantly in use and adopted by IASB(International Accounting Standards Board ) is fair value accounting. In its most basic essence, fair value accounting encompasses determining the fair value of an asset or liability in a current transaction. The key objective of fair value accounting is to give a value(such a price) to an asset or liability, without necessarily initiating a transaction. In essence then, fair value accounting focuses on providing an objective valuation of an asset or liability without undue influence from the concerned parties, without considering historical costs and basing the value of an asset on mark- to- market accounting rules.Generally, any accounting valuation system used by financial markets must, without exception, provide fair valuation, be considerably immune to irrational estimation errors, be adaptable and flexible enough to changes in financial architectures for capital markets to be effective in terms of impartiality and objectivity in assets and liabilities valuation(Enria 2004). Obviously, fair value accounting has some distinct advantages, which has made it a fairly popular method of valuation. Firstly, fair value accounting typically requires financial disclosures to value financial elements based on market value, thusly enabling investors and other stakeholders to gauge their investments based on prevailing market values, a credibly helpful aspect in as far as making investment decisions, and determination of the solvency and future potential of a firm is concerned(Enria 2004). Secondly, innovation in financial markets has led to some financial products which cannot be valued using cost method, as it would not only be highly deceptive but irrational as well, leaving market value determined fair price as the only accurate method of valuation(Landsman 2006).
Despite these key and market oriented benefits of fair value accounting, the ongoing credit crises has led to rise of levels of criticism hitherto unheard of before against use of fair value accounting and, specifically, critics attribute the cause of crises, in part, to the use of fair value accounting. Briefly, the ongoing credit crises(Also referred to as subprime mortgage crisis) is global financial malfunctioning of financial markets brought about by unprecedented busting of housing markets in the united states(through massive mortgage default resulting from rapid increase in high risk mortgage loans ) , dysfunctional and inaccurate credit ratings , lack of government regulation and erroneous financial speculations.
Of late, however, a streamlined stream of literature has began to emerge with a common theme of blaming the crisis on fair value accounting. Indeed the common question has been: How fair is fair value accounting and how did it cause the crises?. To investigate the issue in a detailed manner, this essay first analyses major strands of literature linking the crisis to the accounting method in question.
Firstly, critics agree that the cause of the current credit crisis has been an offshoot of a highly speculative and credit reliance financial market with key arteries rooted in credit benefits returns and over-speculation driven by misleading ,mark- to market objectives. At the centre of this financial miscalculation is fair value accounting which, according to some researchers, has been rigidly designed to solely rely on available market information during a valuation process. However, market dynamics demand that such a valuation process be guided by adequate market information within a relatively stable and active market. In the recent and ongoing financial turmoil, it has become evident that information available for ordinary trading and accounting transactions doesn't rhyme with the net cash inflows and credit valuation of the entities being traded. Consequently, firms have been forced to value their assets(mostly under-valuation) based on deceptive market information which is misguided by the available information on the market worth of such assets- a blame that squarely and objectively lie on fair value mode of evaluation. Indeed, this aspect has been exacerbated by inactive markets, which, in relatively normal financial conditions and transactions tend, on average, to devalue assets thus negating the principal of 'fair value' so highly esteemed in fair value accounting methodology. However, recent investigations into this aspect defend fair value accounting method from the financial crises blame.
For instance, an investigatory report by S.E.C (U.S) note that fair value accounting is strategically positioned to deal with transparency in financial report and as such is a good methodology in financial reporting. The report attributes the crisis to banks malfunctioning resulting from credit delinquencies, assets devaluation and loss of confidence by investors. However, some researchers(for instance....)still believe that unreliable market information triggered the crisis.
Still, the very objectives of fair value valuation have been questioned and, in most cases, blamed for the current financial crisis. It has been argued that the very objective of FVA was to enable convincing and accurate valuation of assets. This was to be done(and is done) by assessing the liquidity levels of assets in question(i.e level 1, 2 ,3 ).However, there was no anticipation of high market volatility such as the one being experienced and, particularly, inactivity of financial markets which brings about, among other consequences, write-downs and rigidity in the overall liquidity of markets. Hence(and quite naturally) fair value valuation based on inactive markets has been objectively questioned. However, this perspective is questioned by bankers who see the problem as chiefly a result of laxity in credit policies. Indeed, other scholars have been more bold attributed the crisis purely on lack of liquid cash(brought about by over-borrowing).
Another questionable aspect of FVA has to do with valuation of mortgages(One of the prime causes of the current crisis). In accounting, it is paramount that any valuation method be reflective of price valuations against net values of underlying securities and mortgages. However, with FVA this was not the case and determining such values was an inherent problem, leading to massive losses and lack of returns on mortgages.
In fact, it has been consistently shown that with FVA, there was no guarantee that without transparent financial disclosures, there would no fair accounting valuation... cont.d