Fair Values in Accounting for Financial Instruments

Fair Values in Accounting for Financial Instruments

Discuss whether the use of fair values in accounting for financial instruments provides information to users of financial statements, which is both useful and reliable.

1. What is fair value of financial instruments?
? Elliott B & Elliott J “Financial accounting & reporting”, 16th Edition, FT Prentice Hall, 2013;
Fair value of financial instruments
According to the main requirements of IFRS7 Financial statement Disclosures
The directors consider that the carrying amount of financial asserts and financial liabilities recorded at amortised cost in the financial statements approximate their fair value. The group is required to analyse financial instruments that are measured subsequent to initial recognition at fair value, grouped into levels 1 to 3 based on the degree to which the fair value is observable.
Level 1 fair value measurements are those derive from quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level2 fair value measurements are those derived from inputs other than quoted prices included within level1 that are observable for the assert or liability, either directly (i.e. as prices) or indirectly (i.e. derived from prices).
Level 3 fair value measurements are those derived from valuation techniques that include inputs for the asset or liability that are not based on observable market data (unobservable inputs).
The above financial asset and liabilities were measured at fair value on level2 fair value measurement bases.
? Laux, C. & Leuz, C. (2009) ‘The crisis of fair-value accounting: Making sense of the recent debate’ in Accounting, Organizations and Society, vol.34, pp.826-834.
FVA is a way to measure assets and liabilities that appear on a com’s balance sheet. FAS157 defines fair value as ‘the rice 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.” When quoted prices in active markets for identical assets or liabilities are available, they have to be used as the measurement or fair value (Level 1 inputs). If not, Level 2 or Level 3 inputs should be used. Level2 applies to cases for which there are observable inputs, which includes quoted prices for similar assets or liabilities in active markets, quoted prices from identical or similar assets in inactive markets, and other relevant market data. Level3 inputs are unobservable inputs (e.g. model assumption). They should be used to derive a fair value if observable inputs are not available, which is commonly referred to as a market-to-model approach.

Fair value id defined similarly under IFRS as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties, in an arm’s length transaction. In determining fair value, IFRS make similar distinctions among inputs as FAS157: Quoted prices inactive markets must be used as fair value when available. In the absence of such prices, an entity should use valuation techniques and all relevant market information that is available so that an entity might have to make significant adjustments to an observed price in order to arrive at the price at which an orderly transaction would have taken place (e.g. IASB Expert Advisory Panel, 2008).
2. Three measurement categories for Financial Assets under IFRS 9
? Fair value through profit or loss (FVTPL)
? Fair value through other comprehensive income
? Amortised cost

? Elliott B & Elliott J “Financial accounting & reporting”, 16th Edition, FT Prentice Hall, 2013;
Initial measurement
Financial assets and liabilities (other than those at fair value through profit or loss) should be mainly measured at fair value plus transactions costs. I almost all cases this would be at cost. For instruments at fair value through profit or loss, transaction costs are not included and instead are expensed as incurred.

Subsequent measurement
The measurement after initial recognition is at either value or amortised cost. The only financial instruments that can be recognised at cost (not amortised) are unquoted equity investments for which there is no measurable fair value. These should be very rare.
The fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s-length transaction.
The methods for fair value measurement allow a number of different bases to be used for the assessment of fair value. These include:
• Published market prices;
• Transactions in similar instruments;
• Discounted futures cash flows;
• Valuation models.
The method used will be the one, which is most reliable for the particular instrument.
In the 2008 financial crisis there were calls on the IASB to either abolish or suspend the fair value measurement basis in IAS39 as it has been perceived as requiring companies to recognise losses greater than their true value. The reason for this is that some claim the market value was being distorted by a lack of liquidity and that markets are not functioning efficiently with willing buyers and sellers. The IASB has resisted the calls but has issued guidance on valuation in illiquid markets that emphasises the different ways that fair value can be determined. For instruments based on valuation models and discounted cash flows, however these models take into account factors that a market participant would consider in the current circumstances.

The impact of profits of moving from fair value to amortised cost
Banks will keep their loan asserts generally in two books, a ‘trading ‘book where the loans are measured at fair value through profit or loss, and a ‘banking’ book where the loans are measured at amortised cost. Up to October 2008, under ISA39, if a company chose to measure its financial asserts or liabilities at fair value through profit or loss it was not allowed to subsequently reclassify those loans and measure them at amortised cost.
Amortised cost is calculated using the effective interest method on asserts and liabilities. For the definition of effective rate is:‘ the rate that exactly discounts estimated future cash receipts or payments through the expected life of the financial instrument.’
The definition then goes on to require that the entity shall:
? Estimate cash flows considering all contractual terms of the financial instrument(for example, prepayment, call and similar options), but not future credit losses;
? Include all necessary fees and points paid or received that are an integral part of the effective yield calculation (IAS18)
? Make a presumption that the cash flows and expected life of a group of similar financial instruments can be estimated reliably.

3. Weather the use of fair values in accounting for financial instruments provides information to users of financial statements?

? Ball, R. (2006) ‘International Financial Reporting Standards (IFRS): pros and cons for investors’ in Accounting and Business Research. vol. 36, sup. 1, pp.5-27.
The fundamental case in favour of fair value accounting seems obvious to most economists: fair value incorporates more information into the financial statements. Fair values contain more information than historical costs whenever there exist either:
1. Observable market prices that managers cannot materially influence due to less than perfect market liquidity; or
2. Independently observable, accurate estimates of liquid market prices.

Incorporating more information in the financial statements by definition makes them more informative, with potential advantages to investors, and other things equal it makes them more useful for purposes of contracting with lenders, managers and other parties.

In sum, I have mixed views about the extent to which IFRS are becoming imbued with the current IASB/FASB fascination with “fair value accounting”. On the other hand, this philosophy promises to incorporate more information in the financial statements than hitherto. On the other hand, it does not necessarily make investors better off and its usefulness in other contexts has not been clearly demonstrated. Worse, it could make investors and other users worse off, for a variety of reasons. The jury is still out on this issue.

? Nicolas veron
Two criticism of fair value accounting which centering respectively on illiquidity and procyclicality. The illiquidity criticism focuses on complex products resulting from securitisation of assets such as mortgage loans, which are at the core of the current financial crisis. Both IFRS and US GAAP define the fair value of the financial instrument, or (absent the former) the observable market price of a similar item, or (if none of the previous two can be found) the result of a financial valuation model.
The illiquidity criticism note that market conditions of many complex financial instruments since last August are marked by an imbalance between supply and demand, which means that market prices re rendered abnormal by the evaporation of liquidity and may bear no relation to underlying value defined as the potential to generate future cash flows. Indications of price for instruments that may be considered ‘similar’ for accounting purposes (the second level in the fair value definition),such as the ABX indices published by the financial information firm Markit, have considerably dropped in value since August 2007, and trading volumes on the indices are themselves limited. Thus, the argument goes, fair value bilges banks to record a drop in value unjustified by economic fundamentals, with a corresponding reduction in shareholders’ equity. To maintain their solvency ratios, they are then forced either to raise new capital under depressed valuation conditions to the detriment of existing shareholders, or to reduce lending with the risk of a depressive effect on the economy as a whole.
The procyclicality criticism is much broader in scope. According to it, the very idea that market prices when observable provide the best possible indication of value id flawed, because it boosts the apparent robustness of banks’ balance sheets at the top of the cycle and reduces it by the same measure at the bottom. The champions of this argument frequently refer to economic ties and all the more so in periods of speculative bubbles or of collective panic, especially because of information asymmetries differences among market participants in terms of beliefs and behaviour. By granting too much relevance to markets, accounting standards would thus be culprits of accentuating both booms and busts. This criticism questions fair value accounting not only when applied to illiquid securities, but also in much more general terms as the guiding principle for accounting recognition of a broad range of financial instruments.

4. Which is both useful and reliable?

? Laux, C. & Leuz, C. (2009) ‘The crisis of fair-value accounting: Making sense of the recent debate’ in Accounting, Organizations and Society, vol.34, pp.826-834.
Under both U.S. GAAP and IFRS,fair values are most frequently used for financial assets and liabilities. But even for financial assets and liabilities, there is a mixed attribute model with a multitude of rules stipulating that some items are reported at fair value and others are reported at historical cost. Moreover, unrealized gains and losses of items that are reported at fair value may or may not affect net income, depending on their classification. For instance, FAS 115, which was already implemented in 1994, requires that both trading securities and available-for-sale securities are reported in the balance sheet at fair value. But in the income statement, unrealized gains and losses, i.e. changes in these values are recognized for trading securities only. In contrast, financial instruments that are held-to-maturity are reported at amortized costs but fair values could be used in determining impairments for these items. In addition, fair values are used for disclosures in the notes to the financial statements (e.g. FAS 107).
Proponents argue that fair values for assets or liabilities reflect current market conditions and hence provide timely information, thereby increasing transparency and encouraging prompt corrective actions. Few dispute that transparency and whether it leads undesirable actions on the part of banks and firms. Opponents claim that fair value is not relevant and potentially misleading for assets that are held for a long period and, in particular, to maturity; that prices could be distorted by market inefficiencies, investor irrationality or liquidity problems; that fair values based on models are not reliable ; and that FVA contributes to the procyclicality of the financial system.

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