Fair Value Accounting

Introduction

Fair value accounting is a hot topic currently because many people blame it for the current financial crises. This article explains the fair value accounting concept and standards, discusses its impacts on financial markets and investors, and introduces recent changes on fair value accounting rules.

Fair value accounting definition

“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”(FASB, 2006, P6). Fair value accounting records financial assets or liabilities at their current market value in financial statements, which meets the criteria of relevance, objectivity and feasibility in generally accepted accounting principles (GAAP). It provides meaningful and reliable information to investors, but causes fluctuation in financial markets.

Fair value accounting is defined by Financial Accounting Standards Board(FASB). FASB has three important terms in the definition of fair value accounting. The terms are the followings: assets and liabilities, price and principal market terms. The assets and liabilities term explains that a fair value measurement is for a particular asset and liability. The price term is that fair value price should come from a regular transaction. Therefore, the price of an extraordinary transaction such as a forced liquidation should not be considered as a fair value price. The principal market term means a fair value transaction should occur in the principal market. “The principal market is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability” (FASB, 2006, P7).

FAS157 and FAS159

Fair value market accounting is defined by two accounting standards. They are FAS157 and FAS159. Both standards were effective on November 15, 2007. FAS157 defines fair value, establishes a framework and expands disclosures for its measurements. FAS159 permits all entities, including nonprofits, to measure various financial instruments and other certain accounting items at fair value (“fair value option”). It also reduces accounting complexity of financial instruments and earnings volatility caused by measurement inconsistency of financial assets and liabilities. FAS159 also establishes disclosure statements for an entity to disclose information that helps investors understand the effects of fair value accounting on financial assets and liabilities.

An entity may choose to use fair value accounting for the following eligible items (FASB, 2007, P10):

  • A recognized financial asset and liability, with some exceptions such as an investment in a subsidiary required for consolidation or employers’ obligations for pension benefits.
  • A firm’s commitment that would not be recognized at inception and involves only financial instruments.
  • Non-financial insurance contracts and warranties to pay a third party for goods or services.
  • A host financial instrument resulting from the separation of an embedded non-financial derivative instrument from a non-financial hybrid one.

Fair value accounting and financial crises

Fair value accounting has a direct impact on the current financial crises. The reason for the financial crises is that many financial institutions are insolvent due to huge write-downs for their “toxic” financial assets, otherwise known as credit default swaps according to fair value accounting principles. “A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults” (Wikipedia, n.d.).

Many banks hold subprime mortgage-backed CDSs that are used to insure subprime mortgages. When U.S. real estate market meltdown caused a rise in subprime mortgage delinquencies, the market value of the subprime mortgage-backed CDSs has decreased as well. To reflect the decreased value of banks’ CDS holdings, they have to recognize unrealized losses in their accounting statements. As a result, such write-downs force banks to become insolvent or create cash liquidity problems. Based on the arguments provided above, some people argue that fair value accounting caused current financial crises.

Benefits to investors

Despite impact on the financial crises, fair value accounting serves two key benefits to investors. First, fair value accounting represents the most effective way to reflect a company’s value at current market conditions. A company’s value will change if the market values of its financial assets and liabilities change. When a company uses the current market value for its financial assets and liabilities in financial statements, investors can calculate its value from the financial statements and determine whether the investment of the company is worth at the current market conditions. If a company uses its historical price instead of current market price for its financial assets and liabilities, investors can’t determine the company’s current market value based on the financial statements. Consequently, they may lose interest in investments because of the lack of transparency.

Second, fair value accounting provides consistency for investors to compare various companies’ financial statements. Companies may acquire financial assets and liabilities at different prices.  When fair value accounting rules are applied, same financial assets and liabilities are recorded at the same market value in financial statements no matter at what price they were acquired. As a result, investors are able to compare each company’s value based on the same measurement and make the best investment decision. Therefore, fair value accounting is the best accounting method for investors to measure financial assets and liabilities.

Impact on financial markets

However, since fair value accounting impacts companies’ financial statements, it can cause financial market fluctuation. While the market values of financial instruments fluctuate as a result of market price change, the earnings of companies holding those financial instruments can dramatically change from one period to another. For example, companies in the banking industry used to report profitable earnings in the past, but recently they reported losses in their financial reports due to their financial assets write-downs. As a result, the volatility of the financial companies’ earnings can worsen market turbulence.

Meanwhile, companies may face challenges when applying fair value accounting for certain financial assets. The challenges come from different levels of  fair values defined by FASB.  FASB defines three levels of fair value inputs. “Level 1 inputs are quoted price (unadjusted) in active markets for identical assets and liabilities…. Level 2 inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly…. Level 3 inputs are unobservable inputs for the asset or liability”(FASB, 2007, P15). Based on the definitions, only level 1 fair value inputs are objective and unbiased, and level 3 and some level 2 fair values inputs are subjective and hard to implement. Therefore, companies have to estimate market values of level 3 and some level 2 inputs based on different models, but sometimes those estimations are not always precise.

New rules of fair value accounting

Many people criticize the current fair value accounting rules because the rules force many financial companies to unnecessarily write down their financial derivatives’ value at current market prices. They argue that the derivatives should not be recorded at current market prices in financial statements because the underlying assets backed by some derivatives are rarely traded in the financial market. Due to public pressure, FASB recently issued new guidelines on fair value accounting, which were effective in the second quarter of 2009. “The new guidelines allow the financial assets to be valued at what the banks project they might sell for in the future, rather than in the current, distressed environment” (Gordon, 2009).

Summary

In conclusion, fair value accounting provides more relevant information for investors to understand a company’s financial position. Although fair value accounting may impact the current financial crises, I believe it helps improve market efficiency by providing transparency for investors and is the right direction in accounting.

List of references

FASB(September, 2006). Fair value Measurements, Statement of Financial Accounting Standards No: 15. Retrieved Apr 11, 2009 from http://www.fasb.org/pdf/fas157.pdf

FASB (February, 2007). The Fair value Option for Financial Assets and Financial Liabilities, Statement of Financial Accounting Standards No: 159. Retrieved Apr 11, 2009 from http://www.fasb.org/pdf/fas159.pdf

Gordon, M. (Apr 2, 2009). FASB relaxes accounting rules for banks on assets. Retrieved Apr 11, 2009 from http://finance.yahoo.com/news/FASB-relaxes-accounting-rules-apf-14836397.html

Wikipdia (n.d.). Credit Default Swap. Retrieved Apr 11, 2009 from http://en.wikipedia.org/wiki/Credit_default_swap

 

 

Mandy Fang

Accounting Director

CD International Enterprises,Inc. (NASDAQ: CDII)

431 Fairway Drive, Suite 200

Deerfield Beach, FL 33441

Website: www.cdii.net

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