The ongoing financial crisis has affected basically every business in the entire globe with prices of goods going up drastically while finance sources continue to dwindle in the process. Accounting applications have especially been hit hard with new intricate challenges becoming more imminent every day. Various opponents of fair value accounting have blamed the system’s difficulty in financial instrument valuations especially where there is insufficient market information. For this reason, significant arguments about fair value accounting have emerged and opponents blamed the system partly for the global financial crisis.
Could fair value accounting actually be a catalyst of the economic crisis? This is the most prevalent question among the proponents of fair value accounting who contend with Ryan (2008) that fair value is beneficial; to investors. They argue that it promotes transparency and enhances the process of decision making. The decision on which side is right however cannot yet be determined until both sides of the issue at are examined. This paper seeks to analyse the pros and cons of fair value accounting in determining the value of assets.
The fair value accounting has faced by many debates over the years with different views about the method being given in comparison to other accounting methods. Commonly used as comparison is the historical cost. Fair value is defined as the process by which the value of assets is determined on the basis of the price in which the asset would be bought at that particular time.
It could also represent value in terms of the price that would be paid for a liability that was due. According to Ryan (2008: 3), accountants and valuers come up with this figure after considering expected future cash flows, discount rates which must be adjusted to risks and any other factor that could influence the current price of a good.
Advantages of fair value accounting
The use of fair value is of great importance not only to investors but to the company as well. Hartman (2007: 34) notes that the value shown is a bit fairer than that presented by other methods of valuation as it considers the value of a good at the current market price. This means that a value that is as close as possible to the actual value is determined (Horngren et al, 2002: 23).
Investors in the stocks and money markets are assured of ready prices which have already been determined by experts using the required formulas so that they have complete information on the current prices in the market (Kieso, 2002: 47). This way, investors do not have to worry about losing out to proprietors who are out to make money through over-charging. In a similar way, businesses are assured that they obtain assets at the right value so that they do not make unnecessary losses.
Calculation of asset value by the use of fair value benefits investors considerably. This is because of the transparency involved in the process (Aslanertik, 2009: 9). Calculation of the fair value of an asset is a process that requires commitment to set standards and scientific formulas. All derivatives must be accounted for so that there are no cases of foul play in coming up with the value. Since the calculation of fair value is a detailed process, it provides additional information which can still be reviewed in future to determine whether the value calculated is correct.
Fair value accounting reflects more current values than other methods such as historical costs (Kieso et al, 2001: 43). Companies can therefore gauge their financial position using current prices so that their balances are up to date. This proves to be an advantage for companies whose assets are appreciating in terms of credit access. These companies can attract favourable borrowing rates with their attractive balance sheets. This also applies to businesses that are planning to sell some of their assets or part of the business since they are likely to gain more in the transaction.
Disadvantages of fair value accounting
Fair value accounting can be highly unreliable because the fair values are often based on estimates such that there is no way of knowing whether the value given is the true value of the asset. Kieso et al (2002: 45) notes that it is only in the case of assets which are exchanged at arms length and the value is available publicly that the value is not based on estimates. An example is the sale of quoted shares. Furthermore fair values involve tedious calculations which are done using scientific methods and require high levels of proficiency (Horngren, 2002: 26). Inexperienced persons are therefore likely to make errors leading to wrong values. More critics argue that an inactive market cannot be used to obtain fair values because these values may not represent the assets’ true value (Aslanertik, 2009: 5).
Another disadvantage about fair value accounting is that these values are at times known to fluctuate considerably within short time ps which could lead to deleterious effects on a business. This is more so when the state in the economy is not stable. Such fluctuations could lead to major swings in the recorded financial results (Hartman, 2007: 28).
For example, decrease in fair value of assets or increase in liability leads to a reduction in the reported equity. Consequently, profits are constrained and losses are likely to occur (Aslanertik, 2009: 6-7). This is one of the reasons that have contributed to the high levels of opposition from opponents of fair value accounting. Financial institutions for example maintain that the temporary losses reported are creating a false misconception yet the conditions are likely to reverse back to normal once market conditions are better (Ryan, 2008: 1).
Following the loss misconception, the reported losses bring about injurious effects in the financial system through the rise in prices as a result of unpleasant feedback effects (Ryan, 2008: 1). This leads to further losses in the market and it is this kind of situation that leads to more procyclicality as described by Borio, Furfine and Lowe (2007:11-12). Banks tend to keep the little amount they have to avoid liquidity problems. Credit is constrained and traders cannot access enough finances. This results in a credit crunch thus leading to a financial crisis (Borio, Furfine and Lowe, 2007: 13). This is largely facilitated by the fact that the future is uncertain especially for assets whose value is likely to fluctuate from time to time.
The above discussion is an indication that fair value accounting is still faced with controversies. Its use has proved useful to investors yet it could cause harmful effects to the economy. The use of fair value accounting promotes transparency in the valuation process and presents the fairest value of an asset. On the other hand, it could lead to distortions in businesses’ balance sheets thus leading to losses and high prices of goods. As Ryan (2008) notes, financial institutions are present the largest group of opponents of fair value accounting since they believe that it this method of accounting that leads to financial crises. The use of fair value accounting can therefore be said to have strengths as well as shortcomings. Each of the side is justified in supporting its arguments as they are true in each case.
Aslanertik, B. E. (2009). Fair value considerations during the current financial crisis. Paper
presented at EconAnadolu 2009: Anadolu International Conference in Economics.
Borine, C, Furfine, C. & Lowe, P. (2007). Polyclicality and financial stability: issues and policy
actions. Economic Review, July 2006.
Hartman, H. H. (2007). Fair value: the meaning and application of the term “fair valuation” as
used by utility commissioners. Boston, MA: Houghton Mifflin
Horngren, C. T. et al. (2002). Accounting. New York: Prentice Hall.
Kieso, D. E. et al (2002). Intermediate Accounting. New York: John Wiley.
Ryan, S. G. (2008). Fair value accounting: Understanding the issues raised by the credit crunch.
New York University: for the Council of Institutional Investors.
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