Download TASK: Read the following essay and highlight counter

TASK:

Read the following essay and highlight counter-argument in grey

Highlight any useful language in yellow
[see cover page on Keats]
TITLE: To what extent is “Fair Value Accounting” an effective method in measuring the values of
financial instruments on the financial statements?
In recent years, the breakout of the global financial crisis has raised controversial debates about
whether fair value accounting (FVA) is an effective method in measuring the values of financial
instruments, such as stocks and bonds (Laux & Leuz, 2009). As the main accounting standards around
the world, both International Financial Reporting Standards and US Financial Accounting Standards
have adopted FVA as an accounting method to judge the values of some financial instruments (Mala
and Chand, 2011). However, opponents of FVA criticize that FVA stimulates the global financial crisis
(Allen and Carletti 2008; Bengtsson 2011; Durocher et al. 2012). This essay will argue that although
FVA can provide timely and transparent price information to the users of accounting information in
some cases, the effectiveness of FVA to measure the values of financial instruments may be limited
on account of the unreliable evaluation model, distorted prices in inefficient markets and a negative
price contagion effect. There are three main parts to this essay: firstly, it will define FVA and then it
will analyze why the effectiveness of FVA may be limited from three aspects, namely the unreliable
evaluation model, biased prices in inefficient markets and a negative price contagion effect; finally, it
will draw the conclusion that the three potential problems behind FVA restrict the effectiveness of it.
According to Financial Accounting Standards 157, FVA can be defined as “an accounting method to
measure the values of assets and liabilities based on 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”. 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 replaced historical cost
accounting (HCA) in the development of accounting standards (Boyer, 2007). Compared with FVA, HCA
can be described as an accounting measurement of values based on the original or historical cost when
the company acquired the assets or liabilities (Chiappetta et al. 2007). For example, if a company
bought stock for £50 last year and this year the price of the stock increases to £100, under FVA, the
company should record the value of the stock at £100 this year, while £50 will be recognized under
HCA. So it is clear that FVA focuses on the changing market prices while HCA emphasizes on the
constant original costs. As FVA has been regarded as accelerating the global financial crisis, it draws a
lot of attention in respect of its potential weaknesses in the accounting field from three aspects.
First of all, the evaluation model to estimate fair values of financial instruments in illiquid markets
seems to have insufficient reliability (Laux & Leuz 2009; Chand & Mala 2011). If the markets for the
identical or similar financial instruments whose values need to be evaluated are active, which means
there are many transactions in the markets, the available prices can be used to evaluate the fair values
of them (Laux & Leuz 2009). But, if the markets do not exist, that is to say, the markets are inactive or
illiquid, the evaluation model is needed to estimate the fair values (Ball 2006). Specifically speaking,
this estimation relies on the future cash flow of the financial instruments and borrowing 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 other investments in place of the financial
instruments. In fact, this evaluation model allows the users of it to predict the future cash flow of the
financial instruments firstly and then use the borrowing rate of the company to calculate the present
fair values. Ijiri (2005) states that using the model to estimate the values of financial instruments
provides significant discretionary power to the users and gives uncertainty, which may influence the
objectivity of the valuation of financial instruments. Indeed, the same financial instrument could be
evaluated differently due to different estimation of future cash flows and distinct borrowing rates.
Because 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 because
of distinct industries involved. Thus, the above two uncertain factors affect the objectivity of the fair
evaluation of the financial instruments, which limits the reliability of the evaluation model.
However, Brown (2008) believes that FVA can provide transparent information for the users of
accounting information. Indeed, as Rankin (2009, p. 10) says, the function of FVA is “like that of the
thermometer—it mirrors reality, it does not create it”. In other words, since FVA can reflect what is
happening in the market, it improves the transparency of the information on the financial statements,
which allows the information users to get easy access to transparent market information and benefit
from it. For instance, Hughes (2009 cited in Chand & Mala 2011) states that FVA helps to provide
transparent information to the investors and if transparency is lost, the risk of litigation will rise. As
such, there is no denying that transparency is important. But the controversy lies in whether FVA can
provide enough transparency. As discussed above, the unreliability of the evaluation model for some
financial instruments with illiquid markets limits the effectiveness and reliablity of the information
provided by FVA. Even though FVA could provide “transparent” information based on the reflection
of the market, the limited effectiveness and reliablity makes the “transparent” information useless.
Thus FVA could not indeed be helpful in offering transparent information for the financial instruments
with illiquid markets. Inefficient markets could distort prices, which has a negative effect on the basis
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 information provided by
it (Aboody et. al 2002). Brooks and Lim (2010) review the empirical literature about the evolution of
market efficiency over time and find that market inefficiency can be caused easily by investor
irrationality and liquidity problems. That is to say, the market prices 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. Furthermore, the distorted prices can not reflect the real
values of financial instruments, which makes FVA lose the reliable basis to measure the fair values of
them. Therefore, the biased prices in the inefficient markets tend to limit the appropriateness of fair
evaluation of financial instruments.
Nevertheless, supporters of FVA assert that FVA can provide prompt information for the investors and
regulators (Hinks 2008; O’Hara 2009). It is believed that this timely information could assist the users
of accounting information in monitoring the timely position of financial institutions and making
corrective decisions (ibid). Indeed, FVA could provide timely information in some cases because under
FVA, the up-to-date market prices of financial instruments will be recorded on the financial statements
directly. However, the prices in the inefficient markets could be distorted. Even if FVA could record
the timely prices on the financial statements, the biased prices cannot help the users of accounting
information to take prompt corrective actions. In addition, timely information could lead to volatility
of financial statements since accountants should adjust the values of the financial instruments on the
financial statements in accordance with the changing prices of them. This fluatution may result in
unnecessary confusion to the users of accounting information. Therefore, although FVA could offer
some timely information to the users, the usefulness of the information is limited to some extent
because of unreliable price information and volatility of financial statements.
Laux and Leuz (2009) argue that FVA could enforce a negative price contagion in the financial markets,
which has been considered as the main cause of rapid spread of the global financial crisis. It is claimed
that FVA has stimulated the financial crisis in a vicious spiral leading to the spread and depth of the
financial crisis (Allen and Carletti 2008; Bengtsson 2011; Durocher et al. 2012). To be specific, after
financial crisis broke out, the liquidity of the financial instruments’ markets dried up, which means
very few trades existed in the markets (Begtsoon 2011). As a result, the market pricing mechanism
became dysfunctional because the prices had to be evaluated from very few trades, which led to low
prices of financial instruments (ibid). Meanwhile, the low prices put pressure on the financial
statements of some financial institutions in terms of assets depreciation under FVA (Allen & Carletti
2008). In order to keep capital requirements, the financial institutions had no choice but to sell assets
at low prices, which led to lower prices of financial instruments in the markets and stimulated further
assets depreciation on other financial instruments’ financial statements (Allen & Faff 2012). To sum
up, the prices in the markets 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 speed up the price contagion
and fluctuations.
To solve the negative price contagion effect caused by FVA, HCA could be re-introduced to value the
financial instruments (Allen & Carletti 2008). However, opponents of HCA assert that using HCA
encourages the banks to engage in inefficient financial instruments sales in order to realize ealier
earnings (Plantin et al. 2008). Since the values of financial instruments under HCA are not affected by
market prices, the financial instruments could be sold inefficiently so as to realize gains early
regardless of the changing market prices. There is no doubt that some banks may engage in inefficient
financial instruments sales under HCA, but the behaviour of these banks will not affect the actions
taken by other banks, which means it will not cause a price contagion under HCA (Laux & Leuz 2009).
Additionally, because the sales of financial instruments depend on the financial strategies of the
financial institutions, adopting more conservative strategies could depress the inefficient sales of
financial instruments. Therefore, HCA could replace FVA to tackle the negative price contagion effect.
In conclusion, this essay has defined FVA and discussed three aspects limiting the effectiveness of FVA
to measure the values of financial instruments, including the unreliable evaluation model, inefficient
markets and the price contagion effect. It can be concluded that even though up-todate and
transparent information could be provided by FVA occasionally, there are some potential problems,
namely the unreliable evaluation model, biased prices in inefficient markets and a negative price
contagion effect, limiting the effectiveness of FVA in measuring the values of financial instruments.
Because of word limit, this essay cannot cover the detailed application of FVA to specific kinds of
financial instruments. However, the above discussion can clearly show that FVA has some general
problems in measuring the values of financial instruments. Based on the analysis above, it can be
suggested that the problematic aspects of FVA could be revised by providing clear explanation and
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 replace FVA.
See bibliography online