Valuation for financial reporting
The report has been prepared to highlight various measurement techniques involved in accounting measurements while preparing financial statements. This report focus on insight knowledge of fair value measurements used in accounting measurements. It outlines the Global Crisis and its effect on the world economy. The report outlines the benefit achieved by fair value measurement in financial report preparations. The objective of this report is to discuss if the Fair Value Accounting is responsible for global crisis. This report highlights new development taken by accounting standards in wake of global financial crisis. At last we will focus on Green Accounting model which measures the cost and benefits of environmental friendly products.
Accounting measurement is computation of accounting values in the form of money or units. Based on historical costs, transactions are recorded in the accounts in dollars. Other accounting measurements can be represented in volume like hours spent in direct labor and this can be used to calculate overhead in a cost accounting system.
The standard accounting setters are feeling the necessity of having financial statement preparers so as to move ahead from historical cost accounting to calculating fair value measurement for assets and liabilities. Fair value measurement sets a framework that can be used to for measuring fair value of assets and it discloses details of the fair value measures. Following complex matters need to be judged before estimating the fair value using standard procedure-
- Need to check if an active market exists for the asset and liability and if exists we must be aware of pricing assumptions used by market participants.
- Appropriate model should be decided for estimating the fair value if the active market doesn’t exists.
- Most appropriate of the three acceptable valuation techniques need to be decided for measuring the fair value of the assets or liabilities.
- We need to analyze level of subjectivity of inputs used in calculating fair value.
Seeing to the current turbulent financial situations, the issues related to measurements of the fair value accounting was gradually attracting the attention of governments sectors, policy makers, practitioners, regulators, and the media. The role of standard setters and accounting principles were placed at the centre of the controversy after global crisis.
GLOBAL FINANCIAL CRISIS
The temporary solutions that governed the global economy since 1980 broke down during the global financial crisis. There are number of dimensions involved in the crisis but three of them are most critical described as below –
- Built up of debt which includes both corporate and household debt
- International monetary instability
- Effect of ecological crisis on the world economy
The second half of 2008 showed even worst debt situations and hence becoming the prime culprit in financial crisis. The accumulation of debt in the system was much more than previously thought and hence leading to confusion amongst the ruling class as how to react to increasing number of loans defaults. Mortgage companies Fannie Mae and Freddie Mac were unwillingly forced to nationalise and financial crisis lead to collapse of leading investment bank like Lehman Brothers. The banking crisis resulted in crisis of rest of the economy and as result more general economic crisis started emerging. There was large pressure built due to high rate of recession faced by the people.
FAIR VALUE MEASUREMENT TO IMPROVE FINANCIAL REPORTING
The fair value defines a framework for measuring fair value of asset or liabilities based on generally accepted accounting principles (GAAP) and disclosures about fair value measurements. The Board had concluded that fair value is the relevant measurement attribute in previously accounting pronouncements. The definition of fair value along with the framework for measuring fair value leads to increase comparability and consistency in fair value measurements. The detailed disclosures about the process to calculate fair value of the assets and liabilities enhances the knowledge and understanding of the users of financial statements. On gaining detailed information of fair value and the extent to which it is used to estimate recognized assets and liabilities, the users analyzes the inputs in better way to develop the measurements and the effect of measurements on earnings over a period.
Is Fair Value Accounting responsible for the Financial Crisis?
One of the causes identified responsible for global financial securities was Fair value accounting. It was unfair to accountants, academics, bookkeepers and auditors for making solely responsible for the global financial crisis. The fair value accounting is pro-cyclical i.e. in times of growth, rising value support each other. Financial instruments like Asset backed securities have been benefited by raising shares and bonds values. The increase in value of financial instruments contributes to increase in share prices which reflect as stronger performance of companies hence improving company ratings and freeing up more capitals for further investments. The managers are benefited from good performance indicators and dividends for the company are high. The profit distribution is not calculated on realized gains rather it is derived from a firm’s fair value. During the crises situations falling prices lead to reduce balance sheet values and write downs. Due to depreciating assets values the markets for financial instruments faced a down turn or collapsed. This the time organizations challenged market that it didn’t showed fair value. The organizations didn’t have problems while paying out manager compensation and dividends out of unrealized gains. The collapse of global economy is interpreted as the "inactivity" of markets.
According to Herz, Chairman of Financial Accounting Standard Board (FASB), there is confusion in media about the relationship between financial institution and accounting standards. According to him FASB is not responsible in determining the capital levels a bank need to maintain, but as per stated in laws during any saving or loan crisis the bank regulators need to determine regulatory capital starting with GAAP numbers. The bank regulators have the authorization to adjust the GAAP figures, and they have other tools which can address liquidity issues, capital adequacy and concentrations of risk at regulated institutions. The focus of accounting standard setters is to communicate reliable, transparent, relevant, unbiased and timely financial report of corporate performance and financial situations faced by corporate to capital market and investors. The transparency provided in the financial report results in financial market stability and hence reducing the level of ambiguity in the market and lack of transparency hides the risks factors involved in financial institutions from investors as well as regulators.
Recent developments in response to the credit crisis
Accounting standards can’t be criticized or blamed for the global crisis, but there is still space for accounting standard to improve. In fair value measurement model it revealed the financial report quickly to the policy markets and investors and hence decreasing the asset value and related economic. This model followed a transparent approach and informed the user of financial statements about the current scenario. The current financial global crisis has challenged the current standard and their assumptions and highlighted the problem of using fair value measurement in illiquid markets. In response to the global financial crisis, the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) took several measurements that impacted on fair value accounting. Following are lists of initiatives taken –
- Financial Crisis Advisory Group was set up by IASB and FASB that identifies major accounting issues which require immediate and urgent response by board.
- IASB issued reclassification of the amendment to IAS 39 which introduces the concept of reclassifications of some financial instrument in certain scenarios.
- Financial accounting standards provided the guidance that allows some relaxation of the rules used for calculating the fair value for assets and liabilities. Its gives more freedom to the institutions to use its own evaluation model instead of current market price in the crisis when the market has become illiquid.
GREEN ACCOUNTING MODEL
The increasing demand to save the environment and promoting environment friendly products and services have boosted the need for better identification and evaluation of the costs and associated variables. This in turn enhances the managerial decision making, planning and controlling and better assessment of financial report and their impact on the corporation financial stability. The frameworks that can measure green accounting include inflows and outflows or additional cost involved as well as costs and revenue saved. The cost side will include the environmental, economic, regulatory, community, social and environmental cost involved in production of the product. The inflows measure the additional revenues and profits received, saving, regulatory cost obviated and grants received by the organization. Green Cost Accounting model ensures including all variables to accurately measure benefit and cost of environmental project. Organizations are encouraged to abide with environment regulations and laws.
Every financial institution uses accounting measurements to prepare their financial statements. With the span of time the standard accounting setters realized of moving ahead of historical accounting standard to fair value measurement of assets and liabilities. Fair value accounting measurement plays an important role in financial reporting of an institution. Global crisis was the worst turmoil faced by world economy and this was the time when Fair Value Accounting measurements faced the heat of the global crisis. According to Financial Accounting Standard Board the fair value measurement was not the sole contributor for the collapse of world economy. Green Accounting model follows new measurement techniques while calculating the costs and benefits of the environmental project.
Reference and bibliography
- Valuation for Financial Reporting : Fair Value Measurements and Reporting, Intangible Assets, Goodwill and Impairment By Mard, Michael J. / Hitchner, James R. / Hyden, Steven D.
- Fair Value Measurements: Practical Guidance and Implementation By Mark L. Zyla