Fair Value Accounting Essay

This paper attempts to answer the questions: Is Fair Value Fair? In so answering the question there is a need to determine whether the use of fair value accurately portray the value underlying financial and economic transactions; to determine whether there is basis to have one universal standard of valuing the assets and obligations of all firms; to find out whether accounting standards would allow for both historical and fair value and still produce meaningful information for decision making; and establish one is more important between relevancy and reliability and whether one’s the importance each depend upon the financial user. 2. Analysis and Discussion 2. 1 What is meant by being fair? To be fair means giving what is due to a person. If applied to an asset purchased or liability assumed in business, fair value would simply mean that said asset or liability is neither overpriced nor underpriced as a matter of perception. Under the law of economics, fair value would refer to that market price which is approximated by the equilibrium price of a thing or good, which is the value of the something from a seller that is not forced to sell or from a buyer that is not forced to buy. In a business transaction there are always are investors, creditors, and other persons who must get their due in transactions that they will enter into. An investor will know what is fair if the person or entity will earn just enough return above cost of capital and in exchange for the risk that such person or entity is taking. The same must be true with a creditor that the person must also get paid on time on his credit plus a sufficient return for the risk in form of interest and penalties. In terms of viewing the corporation as a business entity, what is fair to it is what will allow it to have a sufficient return for the risk that it is taking above its cost of doing business or cost of capital. To arrive at what is fair the investors and creditors who are called users of financial information, these users must know the true or accurate information about of the company so that they will know whether they are going to earn or lose and make the necessary decision whether they will sell, buy or hold to their investments. In other words, to have the chance of being treated fairly from a transaction, one must have the opportunity to have the true or accurate value of asset or liability being dealt with in a business transaction. The opportunity is thus normally supplied by financial reports prepared by companies and which are made public. It is in these financial reports where values whether fair or historical are reported in accordance with prescribed accounting standards that may come from the Financial Accounting Standards Board (FASB) in the case of US companies and IFRS in case of companies operating in the European Union and in other countries which have adopted the IAS or IFRS. Fair value accounting was made pursuant to FAS 157 as issued by US FASB for companies to reflect the accounting information on how much are the real values of assets, liabilities and equity in the balance sheet as contrasted with presenting the information using the historical cost accounting. The purpose of FAS 157 then was built on a framework whereby financial users are given the chance about the true state or fair value of assets, liabilities and equity for decision making under the impression that things will be fair to users of financial information about a company. Incidentally, FAS 157 defines fair value almost very closely to what was discussed and analyzed so far. It is the price that would be received â€Å"to sell an asset or paid to transfer a liability in an orderly transaction between market participants in a measurement date† (Sortur, 2007). 2. 2 Does the use of fair value accurately portray the value underlying financial and economic transactions? To the extent that fair value concept is discussed so far, there is the presumed proposition that the use of fair value will accurately portray the value underlying the financial economic transaction. As to whether this is true, this subsection will have to evaluate the subsequent result on what happened upon the application of 157. In the case of banks, there are those who have to write down the value of assets because of their perception that values have declined due to existing market conditions (Chasan, 2008: Rees-Mogg, 2007). The economic effects however were not favorable to affected interested parties since this action of the banks has produced a backlash. Investors of these banks have lost values of their investments. As a result, the banks have become more risky and depositors lost their trust too in the banking system. If indeed the banks were just reflecting the true values of the assets, how come the reaction of these banks as matter of complying with the requirements of the FAS I57 was not good for many of the affected parties? Would it proper then to deduce that the application of FAS 157 is not fair or that FAS 157 fair value is not fair? If the answers to both of these questions are in the affirmative, then this would have the connotation that what is unfavorable to others is not fair. But how if the values being reflected in the write down are indeed the true values, would the fact that users of financially information get adversely affected make the FAS 157 not fair any more? It would seem that it would be not correct to say fair value accounting or the use of fair value will not be fair if users get affected or have the perception of not getting what they feel or perceive to deserve even if the information is indeed accurate. Otherwise, fair value accounting would be equated with sure profits which could never be within the contemplation of the use of information in decision making. Being fair therefore must first and foremost be characterized to represent the true and accurate information and consequence would be justified by such quality of information. To answer squarely whether the use of fair value accurately portray the value underlying financial and economic transactions, this paper would have to answer in the affirmative. Based on foregoing analysis the FAS 157 aims to reflect the values what would approximate the market price since it is â€Å"the price to sell an asset or paid to transfer a liability in an orderly transaction between market participants in a measurement date† (Sortur, 2007). FAS 157 fair value is therefore the result of the business transaction using the exit price (Sortur, 2007) and is determined by the buyers and sellers in the market. It is therefore not the job of FAS 157 to create what is unfair but would have only to reflect the true values of assets or liabilities that would have to be reported. Therefore, fair value accounting or the use of fair value must be upheld to be fair if it would reflect or would cause the reflection of what are true values. Indeed, it must be the capital markets or the buyers and sellers who will determine the market value or fair value and not the accounting standard. The only role of the accounting standard is to cause its reflection in financial reports of companies because of the requirement to make public their financial statement to investors which would reflect the fair values of assets and liabilities. There is argument that the intention of 157 Accounting rule FAS 157 is good but one cannot prevent people from taking advantage of the new rule to what could further their interest. It is further argued that in whatever one would like to look at it, the generic thing about business is still the desire for profit by which people are motivated with their personal interest to get more wealth (Brigham and Houston, 2002). In response, the use of fair value does consent to allowing people to be taken advantage but cannot prevent those who would want to and those who do not know how to process information for decision making. If the banks which wrote down asset values are indeed taking advantage of the use of fair value accounting, it is still the transactions between the previous buyer or seller that have caused the reaction which started it and the role of accounting standard is just to reflect them (Meigs and Meigs, 1995). If the requirement to report what is happening is unfair, what will then be fair? Chasan (2008) narrated about some investors expressing their doubts on the effectiveness or fairness of fair value accounting method used especially in the context of evaporating markets caused by the financial crisis. The author however admitted that the use of FAS 157 as an accounting standard was made to improve transparency to investors. Citing big write-downs being made big companies like Citigroup and Merrill Lynch & Co Inc. which has made multibillion-dollar reductions on subprime-related asset-backed securities and other assets described as hard-to-price assets, the issue of whether fair value is still fair has become a controversial question (Chasan, 2008). The argument being asserted is about the volatility of being caused the use of fair value. Rephrased simply, can fair value justify the volatility? Volatility is a term used in business which connotes changes in market prices and which causes risks to investors (Droms, 1990; Helfert, 1994). It is feared that with the desire to create transparency, increased risk from the use of fair value is coming out as a result. To resolve the issue, the previous answer to the question on whether the use of fair value could justify big losses if what is being reflected or reported about company values are still true, would in effect cover the issue of volatility being blamed on the use of fair value. Hence, this paper believes, that fair value which stands for what is true must be upheld as argued earlier. There are concerns that because of volatility caused by the use of fair value accounting, the money makers would just be benefiting hedge funds since they are those to profit from volatility (Chasan 2008). In answer, it could argued that such is the nature of fair value accounting, to allow the market forces to move freely without people being compelled to enter into buying and selling transactions. If there are losers, there are also losers and they are part of the process. It is also argued that those who are complaining about the effects of credits being blamed on the use of fair value accounting are investors or groups of them, who may have been instrumental in pushing for the shift to fair value accounting. One of these groups is called the CFA Centre for Financial Market Integrity, with analysts and portfolio managers composing the group (Chasan 2008). The group and other groups 2007 had their aggressive lobbying to use fair value more in financials. These investor groups could not be only be winners in a market transaction, they could also be losers sometimes; otherwise the market is not operating efficiently. 2. 3 Should there be one universal standard of valuing the assets and obligations of all firms? The issue of whether there should be universal standard for valuing the assets and obligation may be very ideal since when one now talks of universal fair value as a universal standard for example, one will have to consider macroeconomic conditions of the different companies in the world. Since not all nations are similarly situated, at least economically, there is the strong probability that universal value could not be implemented. The question is being propounded to help in setting what is the fair value in accounting like the universality of human rights. However its impracticality will prevent the attainment of the objective. Accounting values are not human rights. Another thing is the difficulty of measuring the risks in business in different countries which are factors in determining the cost of capital of doing business. The difference in risks depends upon many factors including macroeconomic conditions which are affected by political developments. In answer therefore to the question, it will have to plainly say that the vision of universal standard is laudatory and this could be a part of an approximate desire to the internationalization of accounting in many part of the world. There is the plan to harmonize all accounting standards in the world. The FAS 157 definition was actually made part of the plan of IASB which makes IFRS, to adopt the former for the use of those using the IAS or IFRS (Sortur, 2007). In other words, efforts are made to approximate universality of standard in valuing the assets and obligations of all firms but its realization could only possibly become when the time will come for a universal government. 2. 4 Can accounting standards allow for both historical and fair value and still produce meaningful information for decision making? Accounting standards are in effect guides to users to help users make informed decisions in business. Having both historical and fair value must strike the balance of getting to the extreme of having one and disregarding the other. In other words, one needs to know what is historical for comparison to what is fair value or market value to make an informed judgment. Accounting standards must then work for the attainment for the creation of balance between the two values. As to whether the accounting standards can allow for both historical and fair value and still produce meaningful information for decision making, is answered again in the affirmative. This can be tackled better by breaking the given statement into two propositions first and then combine them latter. The first proposition would be declared settled in the fact the accounting standards can allow both historical and fair value together. The second proposition is that the use of both will still produce meaningful information. This first proposition is accomplished since the practice have been done for a long time already since in the case of valuing of inventories, accounting standards allow the valuing them of lower of cost or market under the IAS 2. (Deloitte Touche Tohmatsu, 2008). The fact that inventories can be valued at cost means the historical cost is maintained but requirement of presenting the fair value of inventory if it has gone down in the market is also a part of the standard which in effect allows the working of fair value concept. There are other IAS concepts which allowed fair value accounting and historical value accounting. Thus this section is not much of a problem. The second proposition appears to also to have been fulfilled by the use of IAS as illustrated. More meaningful information is in fact reflected by allowing a combination of fair value and historical cost in the valuation of assets and liabilities of companies. By combining the validation done is confirming the application of two proposition, it could be sufficient to strongly answer the question in the affirmative. 5. Relevancy and Reliability: Is one more important than the other, depending upon the financial user? Both relevancy and reliability are requirements for qualitative characteristics of accounting information. Forcing one to be is more important than the other would be asking the wrong question if the objective is only to determine whether preparing financial information using their fair values is fair. In fact to say that an information must be relevant carries the presupposition that the information must also be reliable. This is on premise that reliability connotes objectivity of information which is very much akin to being truth or fair. Information is relevant or has is relevancy character if it influences one’s decision about a particular issue. On the other hand, reliability deals with the objectivity or accuracy of the information. How could a decision maker consider information as relevant when there is no reliability of the information? On the other hand having reliable information would be of no value if the same is not needed in the decision to be made. The two characteristics must therefore go together. 3. Conclusion The issue of whether fair value accounting or the use of fair in accounting for company assets and liabilities is fair must be answered in the affirmative. What is fair is not what has caused much damaged to a person or entity if such damage was a result of failure to follow the basic rules of making investment. The effect of fair value should not be used to allow one to just justify greed while disregarding the rights of others. A loser under a fair value accounting is comparable to a person who is taking too much risk thus the return could also be high but could be low because of the working of the market. As long as buyers and sellers are not being compelled to complete their transaction, fair value is still fair. Fair value accounting will lead to the truth but its value will also depend on the users of information after they have done their roles in the market. The user will still need to make a comparison with what is historical and what is the current fair value as caused by economic conditions. Present accounting standards have caused the reporting of both kind of information but users must also be intelligent in doing their part. Fair value as a concept in accounting standard was just made to correct the apparent failure of purely historical cost accounting. If fair value accounting is fair, it does not imply that the standard must go back to historical accounting but historical information must still be reported and allow the user to make a difference in how to process the information. Since fair value and historical cost could co-exist together, the same must be the better option as it will provide a balance between historical and fair value accounting. References: Brigham and Houston, Introduction to Financial Management, Thomson-South Western, USA, 2002 Chasan, Emily (2008), Is fair value accounting really fair? {www document} URL, http://www. reuters. com/article/reutersEdge/idUSN1546484120080226, Accessed October 20, 2008 Deloitte Touche Tohmatsu (2008), Summary of IFRS for IAS 2, {www document} URL http://www. iasplus. com/standard/ias02. htm , Accessed October 21, 2008. Droms (1990) Finance and Accounting for Non Financial Managers, Addison-Wesley Publishing Company, England Helfert, Erich (1994), Techniques for Financial Analysis, IRWIN, Sydney, Australia Meigs and Meigs, 1995, Financial Accounting, McGraw-Hill, Inc, London, UK Rees-Mogg (2007), Why FAS 157 strikes dread into bankers, {www document} URL http://www. timesonline. co. uk/tol/comment/columnists/william_rees_mogg/article2852547. ece, Accessed October 21, 2008. Sortur (2007) Fair Value Measurement, The Chartered Accountant {www document} URL, http://icai. org/resource_file/96471564-1574. pdf, Accessed October 21, 2008. ]