Under the definition of the FAS 157, fair value is “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.” This defines fair value as an exit value that market participants take during an orderly transaction at a particular measurement date.
There is an orderly transaction when the market participants are not in any other way influenced, intimidated, or rushed. In addition, when the definition talked about the measurement date, it means that the fair value represent the current conditions existing as of the balance sheet date. Lastly, the market participants are those that must be unrelated, knowledgeable and are willing to make the transaction.
On the measurement of the fair value, FAS 157 provides for the hierarchy of inputs according to their reliability. First, the Level 1 inputs are the unadjusted quoted markets of identical items on an active market. Next, the Level 2 inputs involve other direct and indirect observable market data. This market data includes the market prices of identical items in inactive markets or that of similar items in an active market, foreign exchange rates, yield curves and empirical correlations. Lastly, the Level 3 inputs are the unobservable estimates made by companies.
Since it is a hierarchy, it follows that inputs from Level 1 are preferred over Level 2 and Level 2 inputs over Level 3. However, it is not a requirement to use the preferred input when other level inputs can be obtained. FAS 157 provides that companies shall assume the level inputs that its market participants are expected to take in the measurement of assets and liabilities.
Safeguards and Mitigation Practices in Fair Value Accounting
Since market prices are vulnerable to distortions, the strict application of fair values even for trading securities based on these market prices is not always required. The use of these distorted market prices that could induce a contagion and downward spiral during a credit crisis. Thus, the safeguards against its use based on the current accounting rules will be discussed.
- Prices from a distress sale or forced liquidation should not serve as a basis for the determination of fair values.
- During fire sale transactions, the use of its price becomes a domino-like effect for several institutions. As more firms engage in similar transactions, prices from fire sales eventually become so heavily distorted that the market experiences a downward spiral. By simply following this rule, the market will have its own circuit breaker especially during a financial crisis.
- Banking institutions can choose the classification of the financial securities at the beginning.
- Thus, firms are given the discretion over the impact of fair value changes on their net income and capital. While some may argue that this choice gives them the flexibility to change the classification of their securities as they deem fit, it actually quite difficult for them to be successfully granted the re-classification given the strict guidelines of the SEC.
- When transaction prices are unavailable for inactive markets, banking institutions are not required to use dealer quotes that have been distorted by market illiquidity.
- In this case, FAS 127 allows the use of valuation models for the measurement of fair values. This is especially useful during a financial crisis when transactions are significantly lower in volume and a reasonable price cannot be accurately estimated. During the credit crunch, a lot of banks have used this option.
Alternative Accounting Methods
An alternative to the fair value accounting is the accrual or amortized cost accounting. Under this method, historical information is incorporated in the measurement of risk adjusted discount rates and future cash flows. Assets are recorded at original cost upon purchase and subsequently adjusted for impairment and amortization except for increases in the fair values of assets. Contrary to fair value accounting, the unrealized gains and losses are only realized upon impairment, disposal through the passage of time or their positions. Otherwise, they are ignored.
The three main issues involved under this accounting method are the following:
- Income will be persistent as long as parties involve maintain their positions but change upon disposal, replacement, or maturity at which the current market terms will require new positions.
- Positions reached during different times will call for inconsistent discount rates and historical information on company portfolios that can result to untimely accounting.
- Companies can manipulate their income through gains trading – when cumulative unrealized gains and losses are selectively realized
In practice, these issues are mitigated in limited ways. For instance, banks are required by the SEC to disclose the details regarding the breakdown of their expenses involved in interest-earning assets and interest-paying liabilities and amortized cost interest revenues. With disclosures, investors can take note of inconsistent interest calculations of different positions and question better the components of amortized cost interest. Despite this, investors are still required to gather information from other sources regarding the average life spans of different assets liabilities held by banks. Moreover, this disclosure is not a requirement for non-banking institutions.
Another alternative is the mixed-attribute accounting model. Under this model, accounting measurements and treatment will vary among the different types of the financial instruments.
Loans and Leases are either classified as held-for-sale or held-for-investment. When they are classified at held-for-sale, they are carried at the lower of cost or fair value. Otherwise, they are carried at amortized cost subject to impairment. The liability is said to have been impaired if it is probably that the creditor can only collect a partial amount of the total outstanding balance. In that case, the loan will be written down to reflect the present value the expected future cash collection.
Financial securities including the treasury bills and bonds, derivatives, and government-backed obligations are either classified as trading assets or other securities. They are classified as trading assets when they are primarily held for the purpose of selling them in the future. Under the mixed-attribute model, they are reported at fair value and any changes in their fair values are reflected in the income statement. This kind of securities is commonly held by banks for propriety trading, brokerage, and market-marking.
When securities are classified as other securities, they can be further classified into held-to-maturity and available-for-sale securities. Available-for-sale securities are reported at fair value but the changes in their fair values are not reflected income statement. Rather, they appear as accumulated other comprehensive income - a separate component of the shareholders’ equity. On the other hand, held-to maturity securities are recorded at amortized cost subject to impairment.
With these, it appears the mixed-attribute model gives companies the flexibility in the application of their accounting measurement depending on how they classify their financial securities. In addition, the SEC has expressed that this method allowed “significant accounting-motivated transaction structures”. Thus, the mixed-attribute model also had the same problems as the amortized cost accounting. They both fail to accurately describe the risks and net value of companies’ portfolios of financial instruments due to inconsistent and untimely accounting. Particularly, the risk management of banking institutions can effectively appear as speculation as they pleased.
With these limitations, it is best to consistently use fair value accounting rather than the mixed-attribute accounting model and historical cost accounting. Yet, it is also helpful that companies can still disclose the amortized cost of financial securities as they provide effective monitoring of movements in fair values.
Role During the Credit Crunch
Although it has been common ground that the fair value accounting did not exacerbate the impact during the financial crisis, the three major criticisms and discussions regarding its use are the following:
- There is a great probability that unrealized gains and losses will eventually reverse.
It is already proven the bubble prices exist in the market. Bubble prices are a result of investors’ logical short-term decisions in dynamic market which inflate prices when these decisions expect excess liquidity or highly optimistic and depress prices when these decision expect the opposite. Assuming that bubble prices occurred during the credit crunch, market prices and thus, fair values, are depressed below their real values. As such, the unrealized losses that companies recognized will eventually reverse partially and wholly in the future when market conditions finally normalize.
However, whether bubble prices exist or not shouldn’t significantly affect fair value measurements because it is difficult to predict when they occur and when they burst. Therefore, companies will act differently given their different views regarding this matter.
In addition, when fair values are used, they are also expected to reflect the expected future cash flows based on current information and appropriate discount rates. However, during a financial crisis, securities are more probable to have unfavorable future cash flows. Therefore, it exhibits a skewed distribution of future cash flows where the expected value will actually be different from what will be received later on. As such, fair values will reverse over time.
However, it more useful for investors to incorporate the probability, significance, and average future cash flows that be mostly right and disregard the low probability of highly favorable or unfavorable cash flows.
- The fair value cannot be considered fair when the market is illiquid.
During a credit crunch, it is expected that markets become illiquid and so accountants must establish fair values from other sources. This involves taking into consideration hypothetical orderly transactions that might not actually happen in a long time. In addition, although accountant can solicit actual market biddings for the determination of fair values, the time in between the balance sheet and financial reporting filing dates is insufficient. Thus, fair values might be subjective and can be obtained with great difficulty.
- Fair value accounting can result to systemic risk and adverse feedback.
During a credit crunch, investors might overreact to unrealized gains and losses reported under the fair value accounting and trigger a self-fulfilling prophecy in that it may actually result to adverse feedback effects that would have been avoided had another accounting method was used.
However, fair value accounting allowed for faster adjustment to information asymmetry with the use of constantly updated data that reduced the duration of the credit crunch than if the amortized cost accounting was used.
Benefits of Fair Value Accounting
- Despite the existence of bubble prices, fair values provide more accurate information for different companies and for different financial securities.
- Amortized cost can differ substantially from the actual values and be untimely for long-term securities
- Fair value accounting self-adjusts over time in a logical manner.
- Amortized cost accounting only corrects upon realization of gains and losses.
- Fair values can be compared across different securities that are relevant for the assessment of net value and risks of company portfolio.
- Amortized costs cannot be effectively compared given the inconsistent and untimely accounting.
- Fair value accounting provides companies the choice to consider a more appropriate basis for fair value measurement when the market reflects fire sale values.
- Amortized cost accounting has severe limitation even in liquid markets.
- It does not allow companies to manipulate their income through gains trading because gains and losses are recognized upon occurrence rather than realization.
- Amortized cost accounting allows gains trading of financial institutions.
- It more useful for investors to consider even the low probability of highly favorable or unfavorable cash flows than be right most of the time about the future cash flows.
- It is the best suited for required and voluntary disclosures which encourage investor awareness and question management.
- Amortized cost accounting fails to prompt companies for disclosures explaining gains and losses prior to realization.
Drawbacks of Fair Value Accounting
- Fair value is poorly defined when markets are illiquid.
- Despite this, there are still a lot of accounting contexts for which there is difficult measurement such as noncash exchanges. Therefore, this alone cannot account for as a criticism.
- Fair values not derived from active markets are unverifiable and provide for income management.
- Unlike amortized cost accounting, fair value accounting still requires companies to provide adequate disclosures regarding their fair value measurements.
- Fair value accounting result to volatile equity that does not necessarily correspond to the ultimate realization of future cash flows.
- If securities are intended as held to maturity, considering unrealized gains and losses are impractical since companies are bound to receive or pay the ultimate cash flows. In addition, bubble prices and skewed distribution of cash flows alone do not justify the use of another accounting model that could discourage the use of more accurate and timely information.
- It combines the normal and permanent portions of income such as interests.
- This was taken into consideration with the required disaggregation of income components into permanent and transitory.
- Laux, Christian and Leuz, Christian. Did Fair Value Accounting Contribute to the Financial Crisis?, 2009.
- Ryan, Stephen. Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch, 2008.