Good Example Of Report On Financial Reporting
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Debate on Fair Value Accounting versus Principles and Rules-Based Accounting
In the aftermath of the global financial crisis of 2008, the role of fair value accounting in the crisis has been debated. Most analysts have argued that the use of fair value accounting by financial institutions exacerbated the occurrence of the financial crisis(Schmidt, 2014). On November 13, 2008, the American Banking Association wrote a letter to the Financial Accounting Standards Board concerning the issue. In the letter, the association noted that fair value accounting results in recognizing greater than the actual credit losses. It also results in the recognition of losses on financial instruments that do not have credit problems and are performing as per their terms. The Association further argued that it is misleading that the accounting method erodes the earnings and capital of the institution just because of the market’s perception of losses.
The 2008 financial crisis started with the housing crisis. Mortgage interest loans increased and the supply of homes exceeded demand. Many consumers defaulted in paying their mortgage obligations since they could not afford the high rates of interest. Financial intermediaries held several of these mortgages and tried to sell them in vain. They were then marked as ‘held to maturity.’ Under fair value accounting, assets held to maturity are not revalued to fair values unless the cause of the losses is temporary. However, the trend of the housing market suggested that the losses on toxic assets could not be recovered in the near future. Most financial institutions therefore revalued them to fair value and recognized the losses. They marked these assets to market in attempts to recover from the erosion of earnings and capital (Schmidt, 2014). The problems in the housing market affected the entire global financial system as US mortgage-backed securities were held in the whole system.
In the article ‘Bank of America’s Bad Accounting, Floyd Norris describes how the use of fair value accounting by the Bank of America led to losses and misstatements in its financial statements (Norris, 2014). He argues that the rule allows banks to mark financial assets to market value and recognize the losses and gains resulting from the revaluation. The banks enjoyed the accounting rule between 2006 and 2009 when the economy was in financial crisis. Interest rates increased hence the value of financial assets declined. The unrealized gains on the value of these financial assets were reflected in the income statement, and capital was increased accordingly, in order to offset the losses. It also allows banks and financial institutions to adjust both their earnings and capitals to reflect realized losses on the financial assets.
Norris further states that the rules allowed the banks to reflect both in earnings and capitals, the variations in the value of financial assets resulting from movements in the stock index and market interest rates. However, changes resulting from the change in the bank’s credit standing are only reflected in earnings. The Bank of American overstated its capital with an item of capital whose correct value was $157.7 billion being reported at $161.5 billion (Norris, 2014). This mistake made the bank withdraw its capital plan with the Federal Reserve. It in turn led to a fall in the bank’s stock market price. The company lost 6.3% of its stock value thus shading about $10 billion of its market capitalization (Norris, 2014).
The debate on the effectiveness of fair value accounting and its contribution to the financial crisis remains a contentious issue. The next section of this paper describes fair value accounting and the arguments for and against its use. It also describes principles and rules-based accounting and how they could have prevented the financial crisis of 2008.
Fair Value Accounting SFAS 157
FASB defines fair value as the price an entity would receive if it sells an asset or transfers a liability in an arm's length transaction between market participants (Ryan, 2007). The fair value accounting requires all publicly traded companies to measure and report their financial assets at fair values. Under this rule, FASB classifies financial assets into three levels. Level 1 financial assets consist of financial assets that are actively traded in the market and hence have an active market price. Level 2 financial assets are those that do not have an active market price and are valued at the observable market prices of similar securities. Level 3 financial assets are those assets that lack observable market prices as well as similar assets that have observable market prices (Ryan, 2007). Valuation of level 3 financial instruments is based on a forecast of expected cash flows. It implies that the valuation of level 3 assets depends on the accountant’s judgment and assumptions in the determination of the expected cash flows.
The fair value accounting classifies financial assets into three categories in the balance sheet; assets available for sale, assets held to maturity and trading financial assets. Trading financial assets are those purchased for resale at a higher price and are expected to be sold in the near future. Securities classified as available for sale are those the company intends to sell and not hold to maturity but are not expected to be sold in the near future. Lastly, held to maturity securities are those financial assets an entity does not plan to resell until their maturities.
Fair value measurement and reporting depend on the classification of the financial assets. Initially, all financial assets are recorded at cost irrespective of the class of the security. Trading financial assets are periodically revalued at fair values, and the resulting gains or losses are recognized in the institution’s income statement. These losses and gains are unrealized since the securities are not yet sold (Schmidt, 2014). They only become realizable when the respective securities are sold. Any unrealized losses or gains on valuation of financial assets held for sale to market value are not recognized in the financial statements so long as such losses are temporary. The fair value accounting prohibits marking financial assets held to maturity to market values. They are, therefore, reported at amortized costs.
The application of fair value accounting involves professional judgment especially in the classification of the financial assets into the three levels (Schmidt, 2014). In addition, determining whether unrealized gains or losses on financial assets is temporary or not, requires professional judgment.
Proponents of the fair value accounting argue that users of financial information have the right to accurate information. Some securities cannot be reasonably valued unless the accountants use market dynamics to assess their values. They argue that users of financial information can make informed decisions if they have accurate information and fair values of the assets rather than other measures such as costs.
Limitations of or arguments against fair value accounting
Fair value accounting implies that the information reflected in the financial statements is too sensitive to time. Financial assets are reported at fair values at the date of preparing of the financial statements (Schmidt, 2014). Fair values depend on market factors that change on a daily basis. This implies that the fair value of a security may only be relevant on the date of the preparation of the financial statements.
Recognizing unrealized gains and losses on revaluation of securities to fair values is misleading. These unrealized losses and gains may reflect a substantial volatility in the financial assets. The implied volatility may be eliminated by the time the company is selling the securities hence the fair values may not reflect the true financial health of the company. The effect of adjusting these gains and losses on fair value measurement may increase or decrease the balance sheet figures. In this case, the balance sheet and income statement figures may be high or low but will not be reflecting the financial health of the company (Schmidt, 2014). For instance, a bank’s may be making losses but recognizes a large gain on fair value measurement that offsets the losses. The bank will thus appear to be profitable while the actual condition is otherwise.
Fair value accounting may create an adverse shock to the entire financial system as witnessed in the run-up to the 2008 financial crisis. Securities are held by so many institutions. Fair value measurement implies that all the entities holding a security will report a decline in the value of the security at the same time. This results in capital reduction causing the institutions and investors holding the securities to try ‘fire sales.’ Investors may therefore lose confidence in the financial market thus making the value of these securities to fall further. Some analysts, like Warren Buffet, believe that fair value measurement of mortgage-backed securities caused the financial crisis in 2008 by creating the negative feedback loop.
In addition, there are no uniform standards guiding the classification and valuation of some financial assets especially those in levels 2 and 3. Accountants rely on unobservable inputs and assumptions. This implies that two financial institutions can hold similar securities but end up reporting the securities at different values since the unobservable assumptions since they are unlikely to rely on varying assumptions.
For some assets, it is unrealistic to value them at fair or market values since they are purchased for a different purpose. Fair value is the amount a bank expects to receive from the sale of a security. It will, therefore, be misleading to value a financial asset the bank is not intending to sell at fair values.
Principles and Rules-Based accounting
Rules-Based Accounting permits accountants to be creative in financial reporting. Under Rules-based accounting, accountants are allowed to do anything so long there is no rule prohibiting such actions. This implies that rules-based accounting can easily be misused by managers in order to achieve their interests. Principles-based accounting, on the other hand, requires accountants to base their reporting on the substance of a particular transaction and not on whether the accounting rules permit such actions. The difference between the two approaches is that under rules-based, accountants are not required to observe principles. They can do anything, even those not backed by principles, so as long the existing rules do not prohibit such actions.
Unlike IFRS, US-GAAPs are rules-based although the FASB and SEC have taken steps to make the standards more principles-based. This is meant to eliminate the short-comings of the rules-based accounting that can be misused by financial accountants and managers to manipulate their financial statements. The joint efforts by the FASB and IASB to achieve harmonization of accounting standards have also encouraged the shift from rules-based to principles-based accounting.
Measures to improve fair value accounting
FASB and IASB in their attempts to seek harmonization have brought amendments to the US accounting standards. These amendments are meant to improve the quality of fair value accounting practices. During the financial crisis, intermediary financial institutions, that held large volumes of mortgage-backed securities, recognized losses due the collapse of the market. They believed that the changes in the housing market were not temporary hence used the provisions of the accounting rules to include such losses in the income statement. The negative feedback loop of this fair value measurement aggregated the financial crisis. Defendants of fair value accounting argue that had these financial institutions treated the toxic financial assets as those available for sale or those held to maturity, the financial crisis would have been avoided. They would have not recognized the unrealized losses and eroded their capitals. Investors and consumers lost confidence in the financial system as a result of that action.
The above developments imply that professional judgment has become an important aspect in financial reporting, especially those items involving fair value measurement. AICPA, through its statement 203 ‘Departure from Established Accounting Principles,’ allows accountants to use ways not recognized by the existing accounting rules if the circumstances demand so. In unusual circumstances, where compliance to GAAPs would not lead to fair financial reporting, accountants can depart from the established accounting principles. In order to discourage rules-based approach in such issues, AICPA requires its members to make full disclosures of such circumstances. A detailed description of the unusual situation must be included in the disclosure. In addition, the accountant must disclose the estimated effect as well as an explanation of why the compliance to the existing principles would be misleading.
Amendments to Fair Value Accounting (Topic 820)
Level 3 assets had been subject to manipulation since they do not have observable market prices and lack similar assets that have observable market prices. Their valuation is based on unobservable inputs and premises made by the valuing accountant. Accountants could, therefore, use unreasonable assumptions in the valuation in order to manipulate the financial statements. The amendment to Topic 820 adds further disclosure requirements that will ensure that the accountant justifies the used assumptions (Fasb.org, 2015). The accountant must fully disclose the process used in the valuation of the asset. The accountant must also provide a sensitivity report explaining the sensitivity of the determined fair value to the changes in unobservable inputs used in its valuation.
In addition, if an entity uses a non-financial in a way other than the highest and best use of the asset, it must make a disclosure if it measures such an asset at fair value (Fasb.org, 2015). The accountant must also disclose this fact if the fair value of the asset is determined based on the highest and best use concept.
Some financial instruments are measured and reported in the statement of financial position at amortized cost and not at fair values. A disclosure of the fair value of these financial instruments is required in the notes. The amendment to Topic 820 requires additional disclosure on such financial instruments (Fasb.org, 2015). Under the new rule, the reporting entity must disclose the calcification of such financial instruments into the three levels of fair value hierarchy.
Summary and Conclusion
The debate on the fair value measurement has some aspect of ethics and integrity for accountants. As outlined above, some analysts criticize the application of fair value method for its role in the financial crisis of 2008. Its weakness of potential use in manipulation of statements has been highlighted. An ethical accountant should always strive to ensure faithful presentation of the financial aspects of an entity in the financial statements. For level 3 assets that can only be valued based on unobservable assumptions, integrity and ethics in professional judgment are critical. An accountant should, therefore, avoid making unreasonable assumptions manipulate the value of the assets. Inappropriate application of fair value accounting by institutions that held US mortgage-backed securities led to the 2008 financial crisis. The institutions recognized losses on securities as the housing market declined, and households defaulted in mortgage payment obligations. They believed the conditions were not temporary and marked the securities to market with the view of making ‘fire sales.’ The response to this action was negative as the entire global financial system crashed. Some analysts believe that the situation would have been different had the institutions not recognized the unrealized losses.
The inadequacies of the accounting principles in respect to level 3 assets were reduced in 2011 when FASB amended Topic 820. The amendment reduces possible manipulation of fair value accounting for level 3 assets. The amendment prohibits the application of the high and best use concept in valuing financial assets. Additional disclosure requirements on the valuation of level 3 assets also enhance the reliability of fair value measurement. Compliance to these amended rules will help in eliminating the deficiencies of the fair value accounting. The recent developments in the US accounting framework have led to a shift to principles-based accounting. This implies that accountants have to think out the box and determine if compliance to accounting rules does not result in fair reporting. Accountants can therefore use professional judgment and depart from established principles if circumstances necessitate.
Fasb.org, 2015. Proposed ASU Fair Value Measurements and Disclosures (Topic 820): Amendments for Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. [online] Available at: http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176156961629 [Accessed 13 Apr. 2015].
Norris, F., 2014. Bank of America's Bad Accounting. [online] DealBook. Available at: http://dealbook.nytimes.com/2014/04/28/bank-of-americas-bad-accounting/?module=ArrowsNav&contentCollection=Business%20Day&action=keypress%C2%AEion=FixedLeft&pgtype=Blogs&_r=0 [Accessed 13 Apr. 2015].
Ryan, S., 2007. Financial instruments and institutions. 2nd ed. New York: John Wiley.
Schmidt, A., 2014. Fair Value Accounting and the Financial Market Crisis. Berlin: GmbH.
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