Sunday, March 3, 2019
Fair Value Accounting Essay
Topic To what achievement is Fair Value Accounting an progenyive method in bill rod the grades of pecuniary instruments in monetary statement?In new-fashioned years, the breakout of global monetary crisis has raised controversial debates about whether or not mean(a) value news report (FVA) is an effective method in measuring the value of fiscal instruments (Laux & Leuz, 2009). As two main chronicle standards around the world, both International monetary Reporting Standards (IFRS) and US Financial Accounting Standards (FAS) have adopted FVA as an news report method to mark the values of close to pecuniary instruments (Mala and Chand, 2011).This essay will argue that although FVA nooky provide timely and innocent price reading to the users of accounting instruction in some cases, there are potential problems of FVA in measuring the values of financial instruments on account of unreliable valuation models, colorful prices in in in force(p) commercialises and a minus price contagion effect. at that place are three main parts in this essay. Firstly, it will touch the definition of FVA and then it will analyze why the effectiveness of FVA may be limited from three aspects, namely unreliable valuation models, biased prices in inefficient grocery stores and a detrimental price contagion effect. At last, it will consider the pros of FVA regarding the timely and transparent discipline it provides in some cases and analyze the pros.According to Financial Accounting Standards 157, fair value accounting can be defined as an accounting method to step the values of assets and liabilities based on the price that would be received to dish out an asset or paid to transfer a liability in an orderly transaction between market participants at the measuring stick season. That is to say, FVA relies on the actual market prices of the financial instruments and records the exact market prices on the financial statements. In fact, FVA replaces his torical cost accounting (HCA) with the development of accounting standards (Boyer, 2007).Compared with FVA, historical cost accounting can be set forth as an accounting invoicement of values based on the original or historical cost when the confederacy got the assets or liabilities. For example, a company bought a stock for 50 pounds last year. In this year, the price of the stock increases to one hundred pounds. Under FVA, the company should record the value ofthe stock at vitamin C pounds this year while 50 pounds will be recognized chthonian HCA. As the replaced FVA has been regarding as accelerating the global financial crisis, it draws a lot of prudence in respect of its potential weaknesses in the accounting field.Firstly, the model to hazard fair values of financial instruments in illiquid markets seems to have insufficient reliableness (Laux & Leuz 2009 and Mala Chand 2011). If the markets for the identical or similar financial instruments whose values need to be eva luated are active, the available prices can be used to evaluate the fair values of them (Laux & Leuz 2009). However, if the markets do not exist, which means the the markets are inactive or illiquid, the fair evaluation model is needed to estimate the fair value of the financial instruments (Ball 2006). Specifically speaking, the model to evaluate fair values of financial instruments rely on the in store(predicate) money flow of the financial instruments and acquire rate of the company.The future cash flow can be described as the future cash inflow (income) and outflow (expense) brought by the financial instruments whilst the borrowing rate of a company can be considered as the cost of capital which can be invested in separate investments sooner than the financial instruments. The users of the evaluation model should firstly predict the future cash flow of the financial instruments and then use the borrowing rate of the company to calculate the present fair values. Ljiri (2005) states that using model to estimate the values of financial instruments provides significant discretionary power to the users and gives uncertainty, which may influence the objectiveness of the valuation of financial instruments.Indeed, the same financial instrument could be evaluated otherwise on account of different estimation of future cash flows and unambiguous borrowing rate. Be earn the users of the evaluation model have the power to forecast the future cash flow, different users may have distinct estimations of the same financial instrument based on their perspectives of its future profitability. In addition, different companies may have different borrowing rates payable to distinct industries involved. Thus, the supra two uncertain factors affects the objectivity of the fair evaluation of the financial instruments, which limits the reliability of the evaluation model.Secondly, the inefficient markets could distort prices, which has a negative effect on the flat coat of FVA (Laux & Leuz 2009). An inefficient market can be defined as a market in which the prices of financial instruments can not be measured accurately due to the inefficient knowledge it provides (Aboody et. al 2002). Additionally, Lim and brook (2010) review the empirical literature about the evolution of market ability over time and find that the market cannot be always efficient and market inefficiency can be easily caused by investor irrationality and liquid problems.That is to say, the market prices of financial instruments could be distorted by biased behaviors of investors, such as overconfidence or overreaction to a stock, and liquidity problems, such as illiquid market for a long-term bond. Whats more, the distorted prices can not reflect the real values of financial instruments, which makes FVA lose the reliable basis to measure the fair value of financial instruments. Therefore, the biased prices in the inefficient markets tend to the appropriateness of fair evaluatio n of financial instruments.Thirdly, Laux and Leuz (2009) argues that FVA could enforce negative price contagion in the financial markets, which has been considered as the main cause of rapid spread of global financial crisis. It is argued that FVA has stimulated the financial crisis in a vicious spiral and leading to the spread and depth of the financial crisis (Begtsoon 2011, Allen and Carletti 2007, Appelbaum 2009 and Jones 2009). To be specific, after financial crisis broke out, the liquidity of financial instruments markets change up, which means very hardly a(prenominal) trades of the financial instruments existed in the markets (Begtsoon 2011). As a result, the market pricing mechanism became dysfunctional because the prices should be evaluated from very few trades, which resulted in low prices of financial instruments (ibid).In turn, the low prices put closet on the financial statements of some financial institutions in legal injury of assets disparagement under FVA (Alle n & Carletti 2008). In order to keep capital requirements, the financial institutions had no choice but to sell assets at low prices, which led to trim prices of financial instruments in the markets and stimulated further assets depreciation on other financial instruments financial statements under FVA(Plantin et al. 2008a). To sum up, the prices in the market could negatively influence the evaluation of financial instruments under FVA and at the same time, the evaluation of financial instruments under FVA could have a further negative effect on the market prices, which forms a vicious circle that can hie up the price contagion and fluctuations.Nevertheless, supporters of FVA believe that FVA can provide transparent and timely knowledge for the users of accounting information (Brown 2008). As Hughes (2009) says, the function of FVA is give care that of the thermometer-it mirrors reality, it does not create it. Since FVA can reflect what is happening in the market on the financia l statements immediately, it allows the information users to get easy access to the most timely and transparent market information. In addition, Hinks (2009) argues that the useful information provided by FVA allows the investors and regulators to approach to the up-to-date position of financial institutions and encourage them to make restorative decisions.Indeed, it cannot be denied that FVA can provide prompt and transparent price information in some cases. However, it is not always the case which contributes FVA to an effective measurement to value financial instruments. First of all, in an illiquid or inefficient market for some financial instruments, even if FVA could provide timely price information of the financial instruments, the timely information provided is unreliable, which leads to the uselessness of the timely and transparent information provided by FVA.Secondly, even though the financial instruments have an active or efficient market, FVA cannot result in increased t ransparency of information in financial statements as expected (Krumwiede 2008). Thirdly, under FVA, timely price information would lead to volatility of financial statements (Barth 2004). The continuous volatility of financial statements causes disarray for the users of accounting information and raises the companys cost to keep accounts. Hence, although FVA could offering some timely and transparent information to the users, these information limits to some terminus because of unreliable information, limited transparency and volatility of financial statements.In conclusion, this essay has discussed three aspects limiting the effectiveness of FVA to measure the values of financial instruments, including evaluation model, inefficient markets and price contagion effect. In addition, it also considers the pros of FVA in terms of timely and transparent information provided in some cases. It can be concluded that even though up-to-date and transparent information could be provided by FVA occasionally, the effectiveness of FVA to measure the values of financial instruments has been limited due to the unreliable evaluation model, distorted prices in inefficient markets and a negative price contagion effect.Because of word limit, this essay cannot cover the detailed practise of FVA to specific kind of financial instrument. However, the above discussion can intelligibly show that FVA has some general problems in measuring the values of financial instruments. Based on above analysis, it can be suggested that the problematic aspects of FVA could be improved or revised by providing more clear translation and more specific regulations by the constitutors of accounting standards and for some specific financial instruments with illiquid or inefficient markets, it is better to use some other methods to measure their values.