In the late 1970s, some of you might have read in history books that SEC was dealing with price level accounting and replacement accounting.
These experiments died because they did not provide useful information. In theory, current values and fair values are better than historical costs.
“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. “
“It is a price at which belongings will change hands between an eager buyer and willing seller, neither being under any compulsion to buy or sell and both having realistic knowledge of the relevant facts.”
In accounting and economics, fair value is the rational and impartial estimate of the potential market price of a good, service, or asset. It takes into account independent factors such as:
- Acquisition, production, distribution cost, replacement cost, and cost of close substitutes.
- Actual usefulness at a given level of development of a social productive capability.
- Supply versus demand
- Subjective factors include risk characteristics, cost of, and return on capital, individually perceived utility.
The three levels of the fair value hierarchy are:
- Level 1 – Quoted prices in active markets for assets and liabilities
- Level 2 – Variations based on market observables
- Level 3 – Valuation based on unobservable or marking-to-model
Fair value is best represented by the price that two parties are willing to pay for an asset or liability in an active market.
A less accurate measure of fair value is when there is an active market for a similar item, while the least accurate method is to use the discounted cash flows associated with future performance.
Why use fair value accounting?
What are the advantages of fair value accounting?
Fair value provides timely and relevant information that allows investors to exercise better market discipline on an organization’s decision.
Other advantages of fair value include increased transparency, more reliable information, and calculation of real worth of assets as of the date.
- Timely and relevant information -Since fair value accounting utilizes the information, specific for the time and current market conditions, it attempts to provide the most relevant estimates possible. It has excellent informative value for an organization itself and encourages prompt corrective actions.
- Possibility of more information in the financial statements – Fair value accounting enhances the informative power of a financial statement as opposed to the other accounting method, i.e., historical cost. Fair value requires an organization to disclose extensive information about the methodology used, the assumptions made, risk exposure, related sensitivities, and other issues that result in a thorough financial statement.
- Increased financial transparency – Such produced financial statements, therefore, increases the transparency of an organization, which is particularly useful to potential investors, contractors, and lenders as they get a better perception of the stability of that organization and insight into its wealth.
- Reliable information – For financial data to be reliable, they ought to be verifiable and neutral. Fair value provides that reliable information.
- Provides real worth of assets – In this dynamic and volatile market, people desire to know the real value of an asset as of that date.
- As per the Financial Accounting Standards Board – FV is the most relevant measure for financial investments.
Over the years, fair values have become very popular. Many people started talking about it in the recent financial crisis, but this is not something new. Fair value has been around for years.
One of the first standards that required users to use fair value goes as back as the 1980s. It was right after the savings and loans crisis when the financial accounting moved towards a fair-value oriented theme.
What is the problem in using fair value accounting method?
Disadvantages of fair value accounting?
Right around 2008, when the financial crisis was at its worst, many different things were blamed for causing the financial crisis. And fair value accounting happened to be one of them.
So, the critics of fair value accounting believe that the way we account for assets under the fair value reporting regime can make the contagion worse and cause a systemic crisis.
The IMF said that certain investment decisions based on fair value accounting could lead to forced sales, causing prices to fall further and increase the risk to the entire banking sector.
And this will happen when fair value accounting interacts with certain thresholds, which could be self-imposed by the firms that might be required by the regulators. That was the significant criticism of fair value accounting.
- Price deviations – One of the most often quoted disadvantages of fair value accounting is the vagueness of the measurement procedure of assets for financial statements. This vagueness of measurement procedure creates loopholes for pricing deviations.
- Manipulations – Manipulation of the price by the firms themselves also presents a risk in obtaining fair value estimates. In illiquid markets, trading by firms can affect both traded and quoted prices.
- In the absence of market price – if a market for a given asset is not available in the active market, a fair value estimate, that is supposed to provide the most reliable information, is more difficult to obtain.
- Limited reliability – Information available in the financial statements provided by the FVA method is relevant and reliable only for a limited period. As the information included in the financial statements is time-specific for given market conditions, a change in the market environment could cause a significant difference in the actual financial situation of an entity.
- The problem of volatility – It is closely related to the issue mentioned above, i.e., limited reliability. If an asset’s fair value follows a market environment’s development, the volatility of a market can adversely affect a firm’s investment capacity.
How can fair value accounting exacerbate Financial Crisis?
Fair value accounting controversy?
Interaction of FVA and externally imposed regulatory solvency requirements may create a vicious circle of falling prices, leading to an increase in a systematic risk (Cifuentes Ferrucci and Shun, 2005)
- An event that depresses the market value of the assets can lead to forced disposals to avoid the violation of the solvency ratios. There are some regulatory constraints on banks to maintain certain ratios. Following a shock, they might be forced to sell these assets.
- During the crisis, forced disposals can lead to a further fall in the short-run prices.
- Under the fair value regime, banks that were not initially violating the regulatory ratios will have to mark assets to the new lower prices (i.e., the new fair value). This marking down can lead to further disposal of assets.
This causes a spiral effect of falling prices and is called a feedback loop of fair value accounting. This spiral effect increases systemic risk in the banking industry.
You can have the same effect when you have certain debts contracts based on certain fair value numbers or compensation contracts.
When there is a similar decrease in market value or fair value of assets, managers will be faced with the same incentives to dispose of their assets.