Fair Value Contribution to the Global Financial Crisis - Coursework Example

Running Header: International Accounting Student Name: Institution: Instructor: Course Code & Name: Date of Submission: Introduction The classic definition of fair value in any market is the amount for which an asset could be exchanged or the amount in which a liability could be settled. This is in the case of a transaction between two willing parties transacting at arms length transaction being knowledgeable parties. It is the price used in exchanging an asset or settling any liability thereof as at the measurement date. As discussed by Ragatz and Duska (2011, p. 115), fair value assists consumers of financial information make rational decisions about their interactions with the various companies. Accounting standards give more preference to this method of valuation and critics have linked it to the global financial crisis. The Australian Accounting Standards Board has responded to these claims. The major role or objective of fair value accounting is to enable firms in estimating as best as possible the prices at which the positions they hold could change hands in an orderly transaction given the prevailing conditions. To achieve this goal firms and organizations must be up to date regarding their cash flows and other accounting information. When fair market values are estimated using adjusted or unadjusted market rates, they are referred to as mark to market values. When such rates are not available, models are applied and this is referred to as mark to model values. There is thus a preference by many firms and the Australian Accounting Board to evaluate assets using fair value accounting. Basically, accounting standards have played a major role in the financial crisis globally. As regards to our research the accounting standards will mainly focus on the standard of fair value accounting. Fair value accounting is an approach of financial reporting that companies, organizations and firms are required and so permitted to measure and report on a regular or ongoing basis the current assets and liabilities using estimates regarding the situation of if they were to sell the assets or settle any of the current liabilities. This method is recommended by the International Accounting Standards. Under fair value accounting, the accountant reports losses if the fair value of an asset decreases or the fair value of a liability has increased. This would in effect reduce he equity of the firm or even reduce the income of the firm according to Ryan (2008 p.240).Under fair value accounting the most important aspect is whether the organization or firm in question can estimate fair values accurately and without discretion. It is the most accurate and least discretionary. The concept of fair value can be seen in practice in organizations in two different ways, and the governing accounting standards require that firms disclose qualitative information on how they estimate fair values. Accounting standards also require the disclosure of the valuation inputs used and the sensitivities of their reported fair values. This disclosure helps the investor in assessing the reliability of reported fair values and deciding on whether to use or ignore the information. This way, the investor is able to make a rational decision regarding the company. When firms make unrealized profits or gins, it becomes the role of management to voluntarily disclosure any information that would be of use in the valuation of the fair values and realizing the nature and cause of such profits or losses. In sincere principle, fair value accounting is the best and most reliable measurement attribute and especially for inducing the firms’ management in voluntarily disclosing the firm’s fair values and thereby helping the investor in making critical investment decisions. Accounting standards that require the use and estimation of assets using the fair value method of measurement has considerably increased over the years an across the globe. Fair value contribution to the Global financial crisis (GFC) Fair value accounting is based on various principles and they have been identified to be a contributing factor to the increasing liquidity crisis in financial institutions the world over. The International Accounting Standards Board has prescribed the valuation of asset using the fair value method as per the International Accounting Standards. The basic principle underlying this method is that he value presented in the balance sheets at the end of financial periods be valued at market values that are prevailing as at that particular period. This should be considered as much as possible as prescribed by the accounting standards (Negurita & Guni, 2011, p. 446). They thus have a very great impact on financial assets since a large part of their balance sheets is comprised of assets and liabilities. In the event of a financial crisis, debt markets are more likely to freeze and the financial institutions that have greatly invested in such markets have no way of valuing their investments. This often leads to serious write downs in their balance sheets. This kind of shortcoming of applying the fair value concept has been seen to pose potential instability in financial institutions. Determination of an assets value in this situation requires all manner of valuation models are required and this will further compound the problem (Alles, 2009, p. 139). Also, fair values contribute to the financial crisis since they increase the cost of capital. This method of accounting is also directly correlated to banks’ exposures to interest rates and the credit risk that have led to the consequent failure of banks in the recent global financial crisis. Currently, banks value their financial instruments including marketable securities at their fair values. As much as fair values reflect the current condition of the firm, they increase the credit and risk exposures of banks (Linsmeir, 2011, p.332). It also leads to premature recognition of profits and this could lead to the management being compelled to adverse selections in a bid to reach targets and set objectives. On the organizational level, fair value accounting leads to the asymmetry of information and this subsequently leads to lack of transparency of financial statements. The low reliability of fair values can also be explained where markets are rapidly falling or when they suffer from lack of liquidity. The fair values may become distorted in the event of forced sales or fire sales and at this case the definition of fair values does not take into account any forced sales (Prochazka, 2011, p. 77). Why and how the Australian Accounting Responded to the Global Financial Crisis Fair value has in such ways contributed to the global financial crisis and this has led to various implications in the field of accounting. This has led the Accounting Board to look into the matter to avoid future crisis. The market players have significantly seen the effect of fair value accounting. Risk and leverage as a result has become camouflaged and the qualities of most organizations have been comprised not to mention the unstable gains hat have invaded the financial institutions in the recent past. The cyclical nature of asset prices is inevitable but the potency is not. This is gaining disclosure on the fair values. An implication of using his method of measuring assets has been effective in increasing transparency. However, it has incorporated unrealized derivative and premature gains that have led to the distortion of financial position and leverage due to failure to distinguish them from real gains. This gives room for increase in unhealthy derivatives that serve to hedge of the increased risks. All this reduce transparency of financial statements of various firms and organizations. This being cited as the main sources of the global financial crisis leave the fair value accounting a major contributor in the recent and current crisis (McMahon, 2011, p. 46). The Australian Board of Accountants has responded to the issue by focusing on the real causes of the global crisis and bringing them to light. The current crises in accounting perspective have been caused by the credit rate and risk mechanisms that are in place. These mechanisms have failed due to the pro-cyclist nature of such mechanisms. Such mechanisms encourage the taking up of high risks investments or undertaking of such activities in low volatility environments. Credits are also taken by firms and organizations to cater for short term goals rather than long term objectives. Poor risk management and poor credit mechanisms have led to this global crisis in the accounting front. Stability of the financial systems has been threatened and the collapse of the available mechanisms have worsened the crisis even further (Lin and Pleskovic, 2011, p. 354).Other accountants argue that it is not entirely the fault of fair values that the financial crisis came by, but the reason the financial crisis is there is due to poor operating, poor financial and investment decisions, poor risk management and in some instances fraud. Conclusion Researchers have found the use of financial records and statements to signal financial distress very important. The International Accounting Standards still hold that using fair value accounting is the best method of valuation. Despite the critics of this method, the solution is not going back to traditional methods but reducing the flows of fair value accounting and capitalizing on its strengths. The Australian Accounting Board has responded to the issue of global financial crisis and has found the root causes to be failed mechanisms and to a small extent the fair value accounting. The board has therefore come up with working mechanisms and a solution of remaining with fair value accounting. The Global Financial Crisis has affected the economy in various ways and this can be traced to the International Accounting Standards being rehabilitated. Some of the standards that contribute to such crisis are being rehabilitated for better standards that can better deal with such crisis in the future. However, as regards to the scope of this research, fair value accounting has had very little impact or contribution to the financial crises. The Australian Accounting Board and the International Accounting Standards still view it as the best method of valuation and measurement. References Lin, J & Pleskovic B 2011. Annual World Bank Conference on Development Economics, World Bank Publications, London. Pp. 354-370. Linsmeir, T 2011. ‘Financial institutions and financial crisis’. A Journal on Fair Value Accounting. Vol. 25 no.2 pp. 409-456. McMahon, G 2011. ‘Mark- to-market real role in the crisis’. The CPA Journal vol.81 no.2 pp. 466-560. Negurita, O. & Guni N. (2011). ‘Accounting Standards and Financial Reports; Guilty for the actual crisis?’ Journal on Accounting Standards.vol. 6 no.1. pp. 7-10. Prochazka, D 2011. ‘The role of fair value accounting in the recent financial crunch’. Journal On Economics, management and Financial Markets.vol. 6 no.1 pp. 300-432 Ragatz, J & Duska, B 2011. Accounting Ethics, John Wiley and Sons Publishers, New Jersey. Ryan G 2008. Fair value accounting: understanding h issues raised by the current crunch, New York University Publishers, New York. Read More