Fair value in accounting is the price value an entity can make if it were to sell assets or rather the amount paid to settle liabilities in a business entity. From the definition of Generally Accepted Accounting Principle, fair value is the amount at which an asset or a liability can be sold or bought in a current transaction. This is possible only if the transaction is done between willing parties. The best approach for fair values is use of prices quoted in the market but in situation where these prices do no exist, then it calls for the use of reliable information available in the market to determine prices. It is widely recognized that companies employ the use of fair value in recording its assets and liabilities and other financial instruments. An example of a model used in estimating fair values is the valuation model which considers data such as: economic conditions, status of the market and prices of other competing instruments. To ensure accuracy in arriving at fair values, business establishments must have a strong internal control system. The end result is a consistent and reasonable valuation process. In recognition of the fact that market conditions varies overtime, appraisal of valuation models must be done on a continuous basis (Barrisonic, 2007).
This paper presents a discussion on fair market value accounting contributing to global financial crisis. It will entail a thorough examination of some financial systems that were victims of the effects of fair market value.
Complexity and Techniques of Measurement
Measurement in accounting involves the process of determining the value of an asset or liability for the benefit of third parties. Measurement can act as a barrier to business among human being while conducting businesses. To develop economic institutions, measurement of value must be considered with care. FASB distinguish that present value (PV) technique is important in measuring fair value for long lived assets. The indication of the terms such as expected fair value and estimated future cash flows shows some kind of uncertainty involved in measurement of assets (Copeland, 2000). When present value is employed in measuring fair value, there is a possibility that the data obtained will not be reliable. One of the points to note is the projection made by management on the cash flows expected in the future from a specific asset group.
Projection would examine both the time and amount involved. The estimated cash flows in the future are discounted to the present time (Krugman, 2004). Since the discount rate is involved, the whole process of calculating with the use of premiums requires high level skills. Present value technique therefore is not reliable posing a great problem to fair value accounting. When goodwill is involved in calculating fair value it becomes extremely difficult since management has to exercise judgment in the estimation process. FASB recognizes the difficulty of measuring risk by advising on the use of risk premium in calculating the present value (Copeland, 2000). So as to comprehend the difficulty of measuring the risk premium, debt problems related with securities will be analyzed. Mortgage backed securities and collateralized debt obligations are some of the parts of cash flows. The uncertainty in measuring risk even though cash flows are expected in the future shows the difficult of making accurate forecast to be used in determining the fair value (Venkatachalam, 2000).
Another approach to be used in measuring fair value is the discounted cash flow (DCF) approach which necessitates grouping of assets together. The complexity nature of this method is the allocation of asset’s fair value to the different assets within the group. In a situation where there is plant, property, intangible assets and equipment, it might not be possible to measure the fair value of assets. Market values for intangible assets are not always available. This calls for the use of DCF method. One of the disadvantages of fair value measurement is the possibility of dishonest managers manipulating the prediction criteria to reflect magnified figures so that they achieve their selfish ambitions. With the DCF model of measuring fair values, there is space to understate or overstate values by managers (Martin, 2007).
Fair Value Accounting
Fair value accounting is a framework provided by FASB and IASB to be used in reporting assets and liabilities (Marshall, 2004). There have been opinions on the contributions made by fair value accounting to the current financial crisis. These opinions are worth being investigated to determine the actual cause of financial crisis. Researchers have considered differentiating approaches used in measuring assets. Integration of both historical and present value valuation approaches is an absolute way of arriving at a refined measurement system (Copeland, 2000).
The cause of the current financial crisis is partly as a result of pressures from the government, financial instruments which are complex in nature and timing in the market. The federal government by the use of administrative powers conferred to them by the constitution pressured the Federal Reserve Bank to lower their lending standards to the intermediary banks (Copeland, 2000). This necessitated the use of securities that were mortgage-backed. People or rather investors went to borrow monies in order to invest in the housing finance. A subsequent collapse of the housing sector led to reduction in value of securities. Valuation of these marketable securities was as a result of fair value system. Considering the fact that fair value requires the use of prices at the present time under a specific market condition, mortgage-backed securities were therefore undervalued. Continued employment of present market value when in real terms a market does not exist has destroyed the financial market (Bodie, 2004).
The benefit attached to the use of fair value is its ability to provide information on financial assets and liabilities contrary to the historical cost approach. Fair value system also provides comparability of assets bought or sold at different time period since it reflects the condition of the market at the present time. Investors are also more concerned with details of the balance sheet and other financial statements (Bodie, 2004). For this reason, its preparation and disclosure will go along in supplementing on the information they have before a critical step of choosing an investment.
Collapse of Major Financial Institution
The beginning of the crisis was a very simple pointer in the financial market. It was triggered by a housing plan where credit was given to people to buy houses whereas they could not afford. Since they didn’t have enough savings, the only option was to go for mortgage from financial institution (Larry, 2003). The long run effect was a failure in paying back their debts and a subsequent collapse of major banking institutions. Statistics shows that there was an estimate of 6 trillion US dollars mortgage debt in 1999 which translated to 12 trillion US dollars in 2007 and a further higher level in later years (Krugman, 2009). If these figures are compared with annual value of gross domestic product of approximately 11.5 trillion US dollars with a debt of 9 trillion US dollars then it was not possible to pay the losses. This acted as the beginning of the present predicament of never ending financial crisis. Although stimulus package has been recommended by US administration, minimum results have been registered (Marshall, 2004).
Unpredictable Financial Results
Research in the past indicates that when fair value is adopted, it results to unpredictable earnings. In the past two years, banks and other financial institutions have been unstable such that the fair value accounting has magnified the perception of investors, government and regulators that the marker is in real financial crisis (Lahart, 2000). A drop in earnings compared with the past years is a clear indication of the effects of fair value accounting. To illustrate this point, the paper presents credit crunch (Lahart, 2007).
The value of stocks in the stock market depends entirely on the assessment by the investors. Therefore, the level of exposure matters most before the investors makes a decision on the subprime loans. Information on valuation presented by the financial institutions influences the frame of mind of the investors because of the most recent quotations. This forms part of the reason for the release of earnings in 2007 by credit Suisse. Beginning of February, 2008, credit Suisse made approximately 8.5 billion Swiss francs then a week later announced an adjustment of some asset-backed positions following a new structure in its credit trading business (Barry, 2007). The value was reduced by an estimate of 2.85 billion US dollars. In 2008, operating income for credit Suisse was cut by 10% thus illustrating the difficulty of deducing the fair value when in real terms, assumptions about the future changes frequently (Martin, 2007).
Before the company ran out of finance, it had a record loss of 4.8 billion US dollars for the year ended May 2008. This amount of loss was contributed by a drastic fall of revenues for principal transactions including earnings from financial instruments and other assets owned by the company (Martin, 2004). The downward shift in transactions can be explained by unrealized losses of US dollars 1.6 in the year 2008with unrealized gains of 200 million US dollars in 2007 (Lahart, 2007). For this reason, accounting by the use fair value enlarged the earnings of Lehman in a downward orientation.
Cardinal point worth noting is the reduction in value of assets in financial institutions after using the fair value accounting. This translates into a severe contraction of capital ratios thus forcing the financial institution to sell its assets at a distressed price (Copeland, 2000). The final result is a downward inclination. The application of fair value accounting sends a message that a company’s solvency is deeply undermined by strategies in financial institutions or rather their practices of lending and depositing fund but it is the duty of the regulators to specify the information to use when deciding on the market prices.
Critics argue that fair value accounting values distracts attention from the main issue. The main concern is the quality of the associated disclosure. Former governor of Federal Reserve Bank held that the main focus should be on disclosure so that investors and other beneficiaries of financial statement comprehend the drivers behind fair values (Copeland, 2000). Fair value estimate failed to elaborate on the extent of risk credit Suisse and Lehman brothers faced if events did not turn as expected. AIG faced adverse risk because of exposure to credit evasion swaps. If the balance sheet of the mentioned financial institution is evaluated before the crisis, it would have been difficult to investigate the amount of losses following the risks. From this discussion it can be concluded that fair value accounting is not a good mirror image of value that is at risk (Larry, 2007).
This paper began by discussing the definition of fair value as the price a firm would charge if it were to sell an asset to a willing buyer in a given period of time. The value also encompasses the liabilities to be paid to creditors. To arrive at fair values, valuation model is used. The model captures the market environment, prices of other marketable securities and the economy in general. Pressure initiated by government on Federal Reserve banks to lower their lending standards to include the use of mortgage-backed securities affected their values and ultimately investor’s confidence. Situation occurred where people borrowed more than they were able to pay. While investigating the contribution of fair value accounting to global financial crisis, the paper offered an illustration of credit Suisse, AIG and Lehman brothers who were affected
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