Fair Value Accounting and the Global Financial Crisis - Essay Example

Name: University: Course: Instructor: Date: Fair value accounting and the global financial crisis Introduction This paper will try to explain The Global Financial Crisis in brief and the reasons that have led to the Global Financial Crisis the main reasons as to why the world had to under go a financial crisis and the reasons to it. The paper will deal with Issues to do with fair-value accounting; up to what extent did the fair-value accounting had to do with the Global Financial Crisis. Ways in which we could cub down the Global Financial Crisis (GFC), through bodies like the International Accounting Standards Board (IASB) and others. Critically evaluate the roles of the different accounting institution in the development of the situation which is ‘global financial crises.’ What was the situation during this period of the Global Financial Crisis (GFC), what was needed what responses and actions did the International Accounting Standards Board (IASB) have to heal the situation, and to what extent. Which standards that were looked into during the Global Financial Crisis? Like the IAS39.why was it given more attention than the other standards? What were the problems associated with financial instrument? Which changes needed to be done and the improvements that needed to be addressed about the financial standard to improve it. Finally the paper will explain briefly about the Australian Accounting Standards Board (AASB) and what actions it took to cause or solve The Global Financial Crisis (GFC) that the world was going through and what effect did the International Accounting Standards Board (IASB) had on the Australian Accounting Standards Board (AASB) GFC and action to reduce GFC Global financial crises can be explained as the downfall of the financial markets, a drastic decline in the different countries currency that may have been caused by very many things including overleveraging of the global economy, accounting standards inadequate capital in the banking sector, regulator in credit rating agencies and excessive risk taking in accordance with inadequate pricing of risk in the global financial market. This period is a very dreadful period a time when each country had its on pitfall. The crisis would affect all parts of the world hindering them to attain the millennium development goals. Fair valuing accounting is a process where certain financial assets ere measured at fair value with changes in fair value recognized in Profit and loss or Equity, to avoid the ability of companies to hide losses and recognize or unrealized gains from models with no verification of inputs. (Malcolm Ashcroft, 2010, pp 3-9) Due to the adopting of this accounting process when the Global Financial Crisis hit asset prices went down which led to accounting losses, later these losses led to assets untimely sale so as to meet regulatory requirements, the forced sales exacerbated the fall in asset prices thus liquidity in markets evaporated leading to inability to differentiating between distressed and willing transactions. Though we see all these things happening (Malcolm Ashcroft, 2010 pp 1-7) When the international accounting standards board as part of the response had a number of things to implement as recommendations by the 20 leaders.They decided to come up with solution for the GFC problems it a number of things on its table, solutions which would touch on short term solutions like Consolidation and improving accounting for off balance sheet items where the use of special structures by reporting institutions like banks was a big concern current requirements have Resulted in all the assets an entity controls and all its liabilities being brought onto the balance sheet. Similar concerns exist that financial statements do not convey the things addressed. ‘Control of an entity’ application would reduce the problem of evasion by structure (IASCF January 2009, pg 2) Financial instruments like the International Accounting Standards 39 (ias39) amendment was an action taken to reduce the effects of the GFC that the world was facing the exposure draft which was implemented to improve disclosures about financial instruments was another action that the IASB took to reduce the GFC. Forums and training were occasioned to educate on the guidance on the application of fair value measurement of financial instruments when markets become inactive, and would also be used in the development of the fair value measurement (IASCF January 2009, Pg 3). Disclosures included issues to with impairment which would enable any possible change to effect for end year accounts. Accelerations of efforts to address broader issues of impairment on a globally consistent basis as discussed by both the Financial Accounting Standards Board (FASB) and the IASB. Ensuring of consistent treatment of accounting for specific credit-linked investment between the US GAAP and the IFRSs. The FASB is planning to issue mandatory Implementation guidance, and will publish the draft guidance shortly. The guidance will ensure Consistency between IFRS and US GAAP—an objective supported by G20 leaders. Some of the projects had some effects on the GFC on a positive way, some issues stabilized it up to a certain extent, which included, of consolidation was observed after the implementation of the proposed changes where we see that even in the early centuries when the US adopted consolidation led to them being developed early than the rest of the other states (Bores, 1934; Hein, 1978; Mumford, 1982) Revenue recognition is the other area where the proposed changes showed a positive impact in stabilizing the economy to resolve the GFC affair disclosing the sale of assets and shares to increase one’s equity. Leasing improved since the time at which the GFC hit a lot of companies were buying and others leasing but accounting standards for both was not clear, after wards it became clear and a small positive impact on the economy against the GFC. Problems of IAS 39 and its Improvements Surely some parts of the IASB were given much more consideration when it came to finding solution to the Global Financial Crisis since it beard a big cause the situation that led to the GFC since it dealt with investments assets that are moved internationally like shares, sale of equities, assets and most of which carried with them a large amount of finances with them. By changing most of the accounting details under this act would change the situation It is an ridiculous idea that the amendment is not taking things critically where the parliament has endured a significant lobbying effort by corporate derivatives users to exempt accountants from central clearing, but to state that because a imitative trade qualifies for hedge accounting means it is non-speculative and therefore exempt from clearing brings all sorts of problems to the fore. IAS 39 (Matt Cameron 2010) IAS 39 problems are seen as it allows companies to avoid mismatches in accounting between exposures and derivatives used in hedging it all by introduction of concepts of accounting hedging to a cert it where a company has to prove that a hedge is effective on both onset of the trade and on an ongoing basis. So as to be classifies as effective but in real sense the hedge must offset changes in fair value or cash flows attributable to the hedged item within a boundary of 80-125%. If a hedge is not deemed to be effective, fair-value changes in the hedge must be recognized in the income statement, potentially creating unwanted balance-sheet volatility (Matt Cameron 2010) Some of the problems that were associated with the section in the IASB were like; fair-value where it can be grouped around three ideas, these are; the subjectivity of valuation method, the greater volatility induced and the emphasis on short term. (Banco de España 2008 pp 123-124) The aspect raises concerns on the future of the investor’s cash flows of financial instruments and to which degree. The use of fair-value involves the use of valuation methods that allow estimation of what the market price of the instrument could be, this will allow errors in instrument valuation and further more valuation processes would give rise to new information asymmetries which is creating moral hazard problems if no incentives are available to manipulate. Hence a huge problem hence needs resolving. (Banco de España 2008 pg 124) Increase in the spread of volacity on bank balance sheets, that is on profit and loss account and regulatory capital that banks hold hence speed the procyclicality of financial markets which is taking consideration markets at one time, that is the taking of the short term changes in the markets would affect the profits and losses of investors Limitations exposed by the financial turmoil have really exposed the limitation of fair-value the use of previous models of products being used to give the value of newly established products ( default probabilities) . Difficulties in the recent past have been experienced to be greater especially for those companies which before the turmoil had not prepared themselves appropriately in their plans on the fighting or adapting the valuation models (model development, stress testing, laying of contingency plans) hence they are the companies that were affected greatly. Liquidity is not present in this particular problem. These implementation-related limitations of fair value have affected agents’ behavior, offering arguments in favor of the general limitations indicated earlier. In particular, fair value has been seen to induce greater procyclicality in certain circumstances. Indeed, investors in the most senior securitization tranches were not prepared to manage much higher levels of risk than those initially considered. These types of instruments, generally included in the trading portfolio, rapidly began to lose value, meaning that many investors took the decision to sell once the value fell below specific thresholds in the fair value of the instrument. This process exerted downward pressure on valuations, feeding back into further declines. The final effect has been a very significant impact on the profit and loss accounts of numerous institutions, many of which have had to shore up their capital position under difficult market conditions. (Banque de France 2008 Pg 126) Thus due to these problems the economy controllers and the global lord (G20) had to sit down and to come up with ideas to help the IAS 39 situation through the IASB which came up with a number of solutions that bettered the amendment to suit the accounting system and the world at large. Amendment of the IAS 39 classification of financial assets is one area that the IASB assisted in solving some of the problems IAS 39 has in the sense that due to the crisis and many complaints from various institutions which were using the IFRS were disadvantaged compared to their US counterparts. Now that the IASB is on board it permitted the reclassification of some financial assets. All this was done by slowly trying to apply the US Generally accepted accounting principles (GAAP). (IASCF 2009 pg2) Exposure Draft improving disclosures about financial instruments in the late 2008 the law amend ended to disclose the three necessities of the fair-value hierarchy which are in close resemblance as that of the IFRS in which the measurements are categorized in their entirety resulting from the use of certain inputs to valuation technique. Liquidity risk improvement was also clarified to strengthen the relationship between qualitative and quantitative disclosures about it. (IASCF 2009 meeting, pg 4) Education and guidance on the application of the fair-value measurements of financial instruments during inactiveness of the market was another act that the IASB helped the IAS39 problem. The document seemed to be in context with the advisory body which associated in the measuring of the fair-value of financial instruments when the markets were inactive. The clause indulged itself with the US Financial Accounting Standards Board and took into consideration its documents. by the Office of the Chief Accountant of the US Securities and Exchange Commission (SEC) and FASB staff on 30 September .(IASCF 2009 meeting , pg 4) . The report of the expert advisory panel is a summary of the seven meetings of experts who were users, preparers and auditors of financial statements, as well as regulators and others. In the report, the panel identifies practices that experts use for measuring the fair value of financial instruments when markets become inactive and useful practices for fair value disclosures in such situations. The report provides useful information and educational guidance about the processes used and judgments made when measuring and disclosing fair value. (IASCF meeting 2009, pp. 15-16) Hedging in accounting? IAS 39 deals with all assets and liabilities, including derivatives, loans, borrowings, receivables and payables, and equity investments in other entities (PWC, 2011 Meeting, and pp. 112-123). Hedging requires all financial assets and financial liabilities classified into five categories these categories determine how the financial instrument is measured subsequent to its recognition (at fair value or amortized cost) if there are any changes in the income statement or equity. Instruments that can be designated as hedging instruments are unique and require the hedging instrument to be identified and designated at the inception of the hedge. Most derivatives are mostly from external parties are financial instruments.( PWC 2011 Meeting ,PP122-126) Derivatives from the same group do not qualify as financial instruments thus helping a lot in solving a lot of financial problems. The IASB again option which are written cannot be hedged due to possibility of losses instability may be created when it comes to options on the same entity hence discouraged. A derivative may be used as a hedging instrument as put be the IASB only if entirety or proportionately. An example of how it may work out is the interest rate component of a cross currency interest swap or the first three years of the derivative, cannot be considered as a hedging instrument. (PWC 2011 Meeting, PP. 120-125) IAS 39 allowed two exceptions to this rule; the forward points of the contract and time value of an option may be excluded from the designation, not including these components. (PWC 2011 Meeting, pp. 123-130) AASB response to the GFC Due to the Global Financial Crisis that really affected the Australian Accounting Standards Board had to evaluate their documents and rectify the areas which they thought could have driven them into the crisis and came up with a number of changes which included changing their rules of accounting. (Tess, Liaison, 2011) The AASB issues improvements to accounting requirements for consolidated financial statements, joint arrangements and off balance sheet vehicles was just one the responses. Central Control of entities in disclosure was another part where it responded to and decided that risk will not only be the only focus. Though the GFC hade moderate effects on the Australian market especially on the Art industry the AASB did not undermine the need to revise their books thus needed to change their handling of accounting books and their accounting strategies. AASB 10 is one area that needed change on the definition control was reverted to depending on circumstances there might be more entities identified as being controlled. (Tess, Liaison, 2011). Potential voting rights on AASB 10 which explains voting rites used even when not required, changing the clause gave way to a bigger number of companies being controlled. AASB 12 was another clause which was revised to curb down the situation of financial crisis on disclosures all to move relevant information which will be available to users on financial statement to minimize risk on the long run (Tess, Liaison, 2011). Convergence and its benefits. Convergence can be explained as the process of two or more bodies or institutions coming together and sharing ideas and implementing them both to be in a particular flow of control. The convergence of the Australian Accounting Standards Board and the IASB where the AASB had already converged with the IFRS and included their standards in their Australian standards made it easy work when they bonded with the IASB since it was some how close as the IFRS. However the AASB did include some of the things from the IASB the main body is mostly from the AASB. Extra standards with no IASB equivalents meaning that though they complied with the IASB, they preferred convergence with IASB a little of the IFRS. ‘This may be true, but the Australian process seems like very close convergence with IFRS rather than exact adoption of IFRS. In 2007, the AASB changed its mind about this, partly to avoid confusion at the SEC and elsewhere about whether Australian companies comply with IFRS’.(Tess, Liaison, 2011) It was not expected though a normal practice in Australia for accountants and auditors to only comply with the Australians laws only if it’s not clear on the IFRS. Shortly but later in 2007 it was fully incorporated. Benefits of Convergence Due to the convergence of the two bodies there were some benefits which accompanied them, on both international and local increased comparability of financial record being prepared in the different countries under the IASB rule and in the capital markets with a wider range and reliable information on which either investment or credit decisions. . It will also reduce financial analysis costs through analysts not having to recast information on a common basis and requiring knowledge of only one set of financial reporting standards rather than several, (Tess, Liaison, 2011) Barriers that reduce the flow of cash on international grounds by reducing the differences in financial reporting and increasing the understanding off foreign investors in the Australian financial ways. (CPA Australia 2006) Reducing financial reporting costs for Australian multinational companies and foreign companies operating in Australia and reporting elsewhere (CPA Australia 2006) Facilitating more meaningful comparisons of the financial Performance and financial position of Australian and foreign public sector reporting entities Improving the quality of financial reporting in Australia to Best international practice. (CPA Australia 2006) Conclusion It is safe to say that the GFC had a great impact on the lives of a lot of people in the continent investors lost a lot of fortune due to incorrect and not revised accounting standards like the faire value which are in the international Accounting Standards 10, 12, and 39 as mentioned above. Later on the standards were changed in the aim of rescuing the economy from going down the drain still amendments that are new laws that would prevent the global economy from going through what it went through. Though not fully accountable for the GFC the IASB is partly the reason. It has also proven that it can get the international market back on track by the changes it made. The convergence of the different accounting bodies of the world did help the economy as would help the economy from going back to a crisis. Benefits are seen as a result of the major accounting bodies coming together thus it should be encouraged References Accounting Standard AASB. (2012). Disclosing the Impacts of Adopting Australian Equivalents to International Financial Reporting Standards, PP34-37 IASCF January (2009).Valuation and financial stability Financial Stability Review No. 12 PP. 2-16 Barrett , P (2010). Auditing in an Evolving Environment: A focus on Auditing Based on information provided in the IASB’s Project Summary and Feedback Statement: IFRS 10 PP. 23-45 CPA Australia (2006). Accounting Handbook 2011, Pearson Australia Group Consolidated Financial Statements and IFRS 12 Entities (May 2011) Disclosure of Interests in Other 2-15  Tess, Liaison. (2011) .Derivatives, Clearing and Settlement Risk Magazine: Australia, CPA Forum 2010, Singapore 20 August 2010 PP 12-27 Malcolm Ashcroft. (2010). Parliamentary Joint Committee on Corporations and Securities Report on Standards and Framework: Institute of Certified Public Accountants & CPA Read More