Download Karlstad Business School Kundju Atem, Robert Paper on Financial

Karlstad Business School
Kundju Atem, Robert
Paper on Financial assets at Fair Value Disclosure in the
current Financial Crisis
International Financial Accounting (FEAD11)
Karlstads universitet 651
88 Karlstad
D level paper
Date/Term: 09/10/22
Examiner: Berndt Andersson
ABSTRACT
In the heat of the global financial crisis, accounting implementation standards
seems to face debate and challenges from financial pundits, politicians, bankers
etc on their values of financial assets at fair value disclosure. Evidence is drawn
from financial intermediaries. Many financial intermediaries have witnessed
difficulties of valuing financial instruments and investment properties when the
market information is not sufficient to give better decision to bankers, which in
turn report to shareholders to evaluate management performance. Fair value
accounting requirement for financial intermediaries improves transparency and
contributes to investors understanding of the risk profile of the institution,
enhances markets integrity, helps investors be aware of the actual worth of a
company’s assets and liabilities during the crisis. Analysis of the study paper is
from annual reports and other sources.
INTRODUCTION
The global financial crisis can be compared to the great depression of 1930s,
and its impact is being experienced in developed and developing countries,
which has contributed to the failure of key senses, declines in consumer wealth
estimated in trillion of Swedish krono, substantial financial commitments incurred
by governments, and a significant decline in economic activity.
Many companies are now employing concerted effort toward the growth and
stability of their economy. Financial intermediaries have been the cause of
concern during this crisis. They have created everlasting panics in the financial
industry worldwide because the process by which the formal and informal sectors
manage liquidity in the economy, reallocating liquid resources by mobilizing
savings from institutions and individuals and allocating it in the form of credit to
institutions and individuals for investment, has been poorly managed because
liquidity dries up.
In seeking to explain the current financial crisis, spotlight has been turned to
financial assets at fair value disclosure by financial intermediaries in the ongoing
financial crisis. Financial intermediaries have argued that the use of fair value
accounting as opposed to historical cost accounting has helped cause the turmoil
in the financial market, as major part of their assets classified as financial assets
are measured and recognized using the fair value accounting that had been
devalued or under estimated in the changing environment. In this current crisis,
financial assets have been tested and both Financial Accounting standards
Board (FASB) and International Accounting Standard Board (IASB) provide the
option of using fair value accounting in reporting financial assets. Financial
intermediaries are now discovering that fair value means fair weather value (Ray
ball 2007), and according to John M Truseel & Laura C. Rose (June 2009) FASB
should consider an alternative accounting approach that would incorporate both
standards and mitigate the inefficiencies of using just one accounting method.
Studies indicate that progress has been made nearly in all areas of the
accounting standards but a more detail work is needed to meet the original goals
of principal-base standards.
IASB requires that financial intermediaries (Banks) should disclosure financial
assets at fair value in their financial position and the biggest change relate to how
financial intermediaries determine fair value when there is no market. They turn
to write off the value of these assets. As such many financial intermediaries
around the world have tuned into liquidity problems and/or insolvency and later
result to bankruptcy or liquidation, which has caused the financial market
meltdown and at times turn to the politician and /or government for rescue.
The Fair value accounting has put accounting in the hands of the politician.
George Bush (2008) signed into law Emergency Economic stabilization Act of
2008 (EESA) bailout and authorizing the suspension of fair value accounting,
which requires that Security and Exchange Commission (SEC) needs to review
and conduct a study of the fair value ( John M. Trussel & laura C .Rose 2009 ).
Besides, one of the main agendas on November 2008, April 2009 and
September 2009, G20 summit reiterated and hopefully will be a cause of concern
in may 2010 summit has been fair value accounting, that is, to improve standard
on the “valuation and provision” while provisioning is clearly an accounting
function, valuation has a much widely application and is at the root of much
economy decision making in this current crisis.
With many researches carried out in the financial instruments as a whole, these
standards IAS39 and IFRS7 including IAS32 are still most complex because of
the involvement of these Politician’s and the constant pressure on IASB to reform
the standards as the days open up. The problems of the 1970s were largely
economic, plus a smattering of politics. Nowadays, our problems are primarily
concerned with serious issues of fair value focus towards its information effects
on the capital market. According to Maria Carman Hauian (2008), “the biggest
critics of fair value accounting is the financial intermediaries and blame the actual
crisis on fair value rules, which has caused financial assets falling prices and
forced sales to bring about financial instability”. Huge losses reported by financial
firms on sub prime assets have led to debate over the implementation of IAS in
situation where the markets subside and price input aren’t readily available.
Ernest and Young (2005) In the current crisis, financial intermediaries have had
to reduce the value of mortgages and mortgage back securities to reflect current
prices. Those prices declined severely with the collapse of credit markets as
mortgage default escalated. Ecobank Annual report (2009).
The concept of financial assets at fair value disclosure is correct and useful, but
the application during the periods of crisis is problematic. Andrew R. Sorkin
(2008) The fair value accounting in this crisis has made the value of financial
instruments to become ambiguous, probably because of no active market to
actually recognize the relevance of financial assets in financial intermediaries.
OBJECTIVES AND IMPLICATION
The main objective of this paper is to examine financial assets at fair value
disclosure in recent and ongoing financial turmoil, and how investors react when
looking at some financial intermediaries in Europe, America and Africa.
Most
financial
instruments
and
investment
property
held
by
financial
intermediaries for trading are measured using fair value accounting that has led
to financial intermediaries publishing some the very dispiriting financial results.
Major debate has been on the fair value accounting and financial assets which
has been that convergence topic or theme for politician, financial statement user,
professionals regulators and scholar because of it enormous impacts in this
tremor.
Fair value accounting is to give a value to assets without necessary initiating a
transaction Nelson (1969). In real meaning, fair value accounting focuses on
providing an objective valuation of asset, without undue in influence from the
concerned parties .Nelson (1996), without considering historical costs and basing
the value of an asset on the mark-to-market accounting rules landsman (2006);
and has been the only realistic way of accounting for derivative and getting them
on the balance sheet, this is evidence of its worth. ACCA Publication (2009)
The primarily audience of accounts are the shareholders, who have the desire to
see the true worth of their firm. Hence, disclosure of financial instruments
(assets) is a vital informative source to investors in their decision making.
With the fall down of the active market in the recent and ongoing financial crisis
investors observed considerable drop down in value of financial assets figure
disclose at fair value, as it will now depend on subjective base on valuation
model. Thus, the value relevance of financial assets at fair value disclosure
during crisis period is ambiguous and there’s a need to take a look at; it is
obvious that such a paper is needed.
SIGNIFICANCE OF THE PAPER
Today and more than ever, the financial intermediaries are so much exposed to
blame and risk such as the inability to determine financial assets figure at fair
value in the market on time, in full or even partially and the mismanagement of
various financial assets, other risk and blames are notified around the area of
accounting standards.
The importance of this paper will enhance the capacity of managers, politicians,
investors, regulators, scholars to make relevant information in decision making
gearing towards fair value for financial assets in this crisis period. Finally, the
background of information to the area of study will focus on specific financial
intermediaries (banks) in order to know if results from decisions taken eventually
led to profit and growth in this crisis.
FINANCIAL ASSETS AT FAIR VALUE
Background and Definition of fair value
The International accounting standards Committee (IASC) first used the term fair
value which was defined as: The amount of which asset could be exchanged
between a knowledgeable, willing buyer and seller in an arm’s length transaction.
In 1988, the IASC began its financial instruments project 1, which extends the
use of fair values; the definition was broadened to cover liabilities as well as
assets. The term “Seller and buyer” were replaced by the more generic term
parties. The IASB defines “Fair value” as the amount for which assets could be
exchanged or liability settled between knowledgeable and willing parties in an
arm’s length transaction. IAS39 paragraphs 9 (With some slight variations in
wording in different standards like investment and property, which define fair
value as
the amount for which an asset could be exchanged between
knowledgeable willing parties in an arm’s length transaction. . IAS40, paragraph
5
Paragraph 5 of SFAS 157 defines fair value as: “The price that would be received
to sell assets or paid to transfer a liability in an orderly transaction between
market participants at measurement date.”
Difference can be sorted out from the definition of fair value of FAS 157 and
IFRSs:
-
The definition in SFAS 157 is explicitly an exit (selling) price, while IFRSs
is neither explicitly an exit price nor an entry (buying) price.
-
In the definition of SFAS 157 explicitly refers to market participants,
whereas in IFRSs refers to knowledgeable, willing parties in an arm’s
length transaction.
-
For liabilities, the definition of fair value in SFAS 157 rests on the notion
that the liability is transferred (the liability to the counter party continues; it
is not settled with the counterparty), on the hand , IFRSs refers to the
amount at which a liability could be settled between knowledgeable, willing
parties in an
arm’s length transaction.
The IASB believes that establishing a concise definition of fair value and a single
source of guidance for all fair value measurement required by IFRSs will both
simplify IFRS and improve the quality of fair value information included in
financial report because both definition concentrates on the “value in use”
between market participants that refers to the companies solvency which is an
important aspect of the current financial crisis.
Financial Assets and financial Instruments plus Points
Financial asset include:
-
Cash;
-
An equity instrument of another entity;
-
A contractual right to exchange financial instruments with another entity
under conditions that are potentially favorable;
-
A contractual right to receive cash or another financial asset from another
entity
David Alexander, Anne Britton & Ann Jorissen (2007)
Financial Instruments
A financial instrument is any contracts that give rise to both a financial asset in
one entity and a financial liability or equity instrument in another entity.
International financial Reporting Standard (IFRS) are the standards that are used
all over the world including nearly all Europe. IAS32, IAS39 and IFRS7 prescribe
the accounting and disclosure of financial accounting classification of instruments
and specifically addressing the accounting treatment for these instruments.
IAS39 includes when to recognize or derecognize a financial instrument, and
how the different types of financial instruments are measured especially for
derivatives. Which classify financial instrument into four categories and shall be
disclosed as:
-
Fair Value through profit and loss (Held for trading or designated at
initial recognition): That is, all derivatives (outside designated hedges)
other items intended to be actively traded. Any item designated as such
that meets criteria.
-
Held-to-Maturity (HTM): Debt assets acquired by the entity to be held to
maturity.
-
Loans and Receivables (LR): Conventional loan assets that are
unquoted (originated or acquired), trade receivables.
-
Available-for-sales (AFS): All assets not in the above categories, it is a
residual category and does not mean that the entity stands ready to sell
these.-
Investment Property
Properties held with the purpose of generating rental income and/or value
appreciation, not for the purpose to be used in the production or supply of
goods on services or administration purpose of sale in the ordinary course of
business.
With the advent of the crisis investors do judge the value of the financial
instruments and investment property disclose, as a result of the excessive
volatility: What do the accounting rules lead to additional volatility that is,
separated from the underlying economy fundamentals? If so, then decision
may be soiled by accounting practice. Reporting financial assets at fair value
is more relevant, fair value reflects the amount at which an asset can be
bought or sold, and provides better insights into the current risk, as such
investors and other decision makers can exercise better market discipline and
corrective action regarding the usefulness of the financial asset information in
making decisions that would help them to evaluate present, past, and future
situation or correct their past evaluations. (IASB 2009).
IMPACTS OF THE AMENDMENTS AND IMPLEMENTATION PUT UP IN
THE CURRENT CRISIS
The application of financial assets at fair value disclosure in these periods of
crisis has been a problematic issue Andrew R. Sorkin (2008) With the
amendment of IAS39 and IFRS7
which was published in October 2008
resulted into the reclassification of financial assets; this means that financial
assets excluding derivative which were formally held for trading purpose can
be reclassified subject to meeting criteria and this classification under IAS39
has limited the effect of large write downs, and hence turned into massive
losses. These changes have been done due to results of high pressure on
IASB by a combination of financial pundits, politicians, bankers, news paper
and others. This has helped financial intermediaries to move their assets from
available-for-sale to held-to-maturity.
In the current economic environment, the use of fair value is no longer
suitable as expected, the amendment of IAS in the financial turmoil, and the
valuation of financial instruments and investment property has deviated the
consistency in accounting seriously as there is efficiency and failure in the
market. When the market is active, fair value are always lucrative and
management usually tends to be unrealistically optimistic because of the high
prices, prone to over value or over estimate the value. In contrast, when the
market shows a weaker tendency, the value of the financial assets will be
undervalued or underestimated. Besides, where in a short period, the market
has ceased to exist a situation Gary Gorton (2007) called “no trade theorem”.
Hence financial intermediaries have to accrue to impairment according to IAS
to measure those financial assets attributed , that they hold for which there
used to be active market but inactive or no market now, which will obviously
reduce shareholder’s worth and affect the profitability.
The use of fair value seems to be criticized by investors uncertainty and
continuous widespread in the financial turmoil, despite its clarity, additional
information, accounts properly for derivatives, transparency and less
subjected to earnings management source. Sarlata J. Nvoa., A., Sole, J.
(2008). That is why managers become so upset with fair value when it shows
their blameworthiness Huian (2008)
The question therefore is, with the pressure on IASB and FASB financial
instrument amendment and implementation during this crisis, will the financial
assets at fair value disclosure seriously reduce the ability of financial
intermediaries to resist risk under this condition or within the global
convergence and harmonization of a single accounting standard? Will it bring
certainty in the financial instruments (assets) at fair value disclosure in the
nearest future to investors?
Method used in the study
Secondary data was collected to meet the purpose of this paper, in order to
obtain the specific information sources from textbooks, internet (websites),
news media, and annual reports 2006, 2007, and 2008 focusing on financial
intermediaries
in
Africa
(ECOBANK)
and
Europe
(SWEDBANK
&
COMMERZBANK) since they have branches in many countries in their
continent. These financial intermediaries are considered because they usually
prepare their annual reports using International accounting Standard Board
(IASB) on December 31st each year and their share prices are being traded in
the stock exchange market.
FINANCIAL INTERMEDIARIES IN AFRICA AND THE FINANCIAL CRISIS
African banking system in the recent turbulence in the global market were not
affected because few sub prime loans and credit default swaps and all these
fancy derivative instruments that have seen in America and in Europe that
may have created some of the problems. According to the chief economist of
Africa region at the World Bank, Shanta Devarajan says, Africa financial
intermediaries hardly ever take loans and then turn them into other
instruments break them up into mortgage securities and trade them. In a
sense, it is a simpler system and therefore it is less prone to the particular
kind of downfall that financial intermediaries in Europe and America, and their
financial systems are facing.
The interbank market is small, and the market for securitized or derivative
instruments is either small or non existence, although some Africa countries’
financial intermediaries have significant foreign ownership, the parent
financial intermediaries are typically not in America and Europe: Moreover,
financial instruments like bonds, convertible bonds, share and other
interesting securities, assets for which customers bear the investment risk ,
and the share percentage is less than five percent compared to developed
countries average of forty percent ,especially some of the interest bearing
securities are the main assets affected by the current crisis. Most of these
items are absent in the balance sheet of African financial intermediaries and
their financial assets at fair value disclosure using the IASB new classification
amendment of the standard for financial instruments have been of no
consequence during crisis period. This has kept investors optimistic and
keeps their emotions level low. Hence financial intermediaries did not have
that consistency of bad news witnessed in America and Europe, and
therefore, they are still in the short horizon period, evidence from the increase
in share prices in Africa during the turbulence. For example ECOBANK has
enjoyed significant appreciation as their share prices had an increment.
(ECOBANK annual report, 2008)
FINANCIAL INTERMEDIARIES IN EUROPE/ AMERICA AND THE FINANCIAL
CRISIS
With the advent of the financial crisis many financial intermediaries in developed
countries in Europe and America have experienced liquidity problems. For
example, Citibank group alone has written off more than 39billion in losses Ellot
(2008) and others like the SWEDBANK have suffered from interest bearing
securities and uses more valuations model than before. Thus, where there is no
market, general acceptable models are used.
The disclosed financial assets figures are derived from quoted market prices in
an active market and the fair value is the current bid price of the asset. With the
outbreak of the financial crisis news in 2007 according to Nicholas et al (1998),
during this period security prices under react to news (bad news of financial
crisis) because the news is incorporated slowly into prices, they called this period
as the period of under reaction of share price, this was realized in the 2008
annual report of Swedbank falling price of value for financial instruments at fair
value in the stock exchange market that witness an average of forty five
percentage fall in the share in 2008 and the stock exchange index felt, couple
with the credit crunch which increase the risk that the recovery could be delayed.
As a result of the instability, market situation of Europe and America
characterized by liquidity problems created investors to loose confidence
because of the lack of quoted prices on active market, and also the declining in
investment and property (IAS40) in the market, after a decade of stable price
increase, and the market for single family home fell by an average of five percent
for the year 2008. Swedbank Annual report (2008), as a result of higher
borrowing costs that affected households. Furthermore, households have been
affected by gradually declining confidence in the future as the global financial
crisis has chocked the real economy because of extensive lay offs of major
Swedish companies and other companies in Europe and America, the impacts
of the amendment IASB was of great importance to financial intermediaries using
this standard, some financial instruments that were classified under available for
sale were reclassified to Held- to- trading in special situation, While
Commerzbank in the fourth quarter their securities in the Public Finance portfolio
for which there was no active market were reclassified from the IAS 39 Availablefor- Sale (A category to the IAS 39 Loans and Receivables (LaR) category. In
respect of the reclassified holdings, the Bank has the intention and ability to hold
the securities for the foreseeable future or to final maturity. Commerzbank annual
report (2008) The fair value of the reclassified securities as at the reclassification
date is recognized as the new carrying amount of the securities holdings. The
holdings in question are mainly securities issued by public sector borrowers
(including European and North American local authorities) and financial
institutions.
CONCLUSION
With the constraint of time limit, this paper would have worth more than this in
other to make an in-depth research and investigate more on those financial
instruments and investment and property affected financial intermediaries
(banks) during the ongoing crisis.
The controversy surrounding the financial assets at fair value disclosure is not a
new one, it has become particular relevance as the financial crisis developed and
still difficult to give a concrete judgment. This is because of a lot of debate among
financial pundits, politicians, bankers and the IASB.
According to David Tweedie, chairman of the IASB argued that financial assets
at fair value disclosure recognized current problems faster than alternative
valuation methods would have done “the beauty about fair value accounting is
that it brought this crisis very very quickly into open, and if it had not then, we
might still be having sub-prime lending going on even now, and the disaster
would have been worse. Hence blame financial intermediaries for their
reckless/bad lending methods which is the main cause of the global financial
crisis, While financial intermediaries attributes this blame to fair value accounting,
that has exacerbated problems in the financial crisis when the crisis stop
operating. On the part of the politicians the international Accounting Standards
board needs to review their assets valuation standards; and had to replenish
liquidity to some financial intermediaries suffering from insolvency and warned
them to be prudent in their lending methods.
Investor and other stakeholders do judge their investments based on market
value, as the share price of investors gradually fall during crisis period they
consider fair value as informative and a credibly helpful aspect in as far as
making investment decisions and determination of the solvency and future
potential of their resources, as these could be seen in an average increase and
decrease of share price of financial intermediaries in Africa and Europe
respectively in 2008 annual report.
Users of financial statements needs relevant understanding, timely, comparable,
verifiable, and which faithfully represent facts that would enhance the quality of
financial instruments and investment property be disclosed by just one valuation
method.
In a nutshell, the efficiency and effectiveness of financial instruments and
investment property disclosure in the ongoing financial crisis depends on the
point of view you look at it.
REFERENCES
-
A Report of the G-20 summit, April 2009 and September 2009 ACCA
-
Austin Murphy (2008) An Analysis of the Financial Crisis of 2008:
Causes and Solutions, Social Science Research Network
-
David Alexander, Anne Britton and Ann Jorissen (2007) (Textbook)
International Financial Reporting and Analysis, 3rd Edition
-
Francis A. Long staff (2005) Asset Pricing in Market with Illiquid
Assets, Social Science Research Network
-
Gary Gorton, 2008, The Panic of 2007, Social Science Research Network
-
IASB Accountancy, August (2009) Vol. 144 Issue 1392, p60-61, 2p; (AN
44195941)
-
Maria Carmen HUIAN, 2008, The Role of Fair Value Accounting
During the Current Financial Crisis, Social Science Research Network
-
Ray Ball, (2007) International Financial Reporting Standards (IFRS):
Pros and Cons for Investors, Science Research Network
- Scott Bob (2008) Economists say World Financial Crisis Affecting
Africa
-
Trussel, John M.; Rose, Laura C. CPA Journal, June (2009) Fair value
Accounting and the current Financial Crisis Vol. 79 Issue 6, p26-30,
5p; (AN 41877715)
-
Wayne R. Landsman (2007) Fair Value Accounting Information
Relevant and Reliable? Evidence from Capital Market Research,
Journal of Accounting and Business Research.
-ZHO U Yuan-yuan, DING JUN, The defect of fair value under global
financial crisis
-
Annual Reports
-
Commerzbank Annual report 2008
-
Ecobank Annual Report 2007 and 2008
-
Swedbank Annual Report 2007 and 2008
-
IASB papers
-
http://www.iasb.org/News/Press+Releases/IASB+publishes+Discussion+P
aper+on+fair+value+measurements.htm
-
http://www.iasb.org/About+Us/About+the+IASB/Response+to+the+credit+
crisis.htm