BAO3309 Advanced Financial Accounting Assignment Help
ABSTRACT
Critics of the fair-value measurement system have argued that the system created and aggravated the 2008 crisis, and hence should be abandoned as a measurement tool. This paper examines whether this criticism is based on facts. It considers the strengths and weaknesses of the fair-value accounting, especially in comparison with the historical cost method. The regulatory environment, and the proactive role played by FASB during the crisis has been mentioned to understand the allowances made by the regulator in the practice of fair value accounting. To understand the present practice in accounting treatment of changes in values of various assets and liabilities, accounting policies of two corporations listed on the ASX have been analyzed. The future of fair-value measurement system, and ways to make it more relevant for stakeholders have also been discussed. From the discussion, it is evident that during the crisis, effect of fair value measurements on the write-downs of assets was not as profound or widespread as normally perceived. The start, or snowballing of the crisis can not be attributed to fair-value system. It is an important measurement tool that requires to be strengthened, and not abandoned.
PART A
BACKGROUND
Under the historical cost method assets are shown at their purchase price with adjustments for depreciation or appreciation. On the other hand, fair-value measurements, measure the assets and liabilities based on their current market value (Pozen, 2009). Australian Accounting Standards Board (AASB) defines “Fair Value” as:
This Standard defines fair value as 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 (AASB 13 2011, para 9).
The objectivity of the fair values depend on the input for the price. As per (AASB 13, 2011), price can be based on level 1, level 2 or level 3 inputs (para 76, 81, 86). Here, Level 1 inputs are the most objective with prices drawn from active markets, level 2 inputs are based on inputs available from observations, and Level 3 inputs involve use of unobservable inputs (p. 35). Disclosure of the level used provides valuable information to the stakeholder about the relative objectivity of the measurement. As mentioned in IFRS 13 (2011), stipulation of the levels increase consistency and comparability in fair value measurements and related disclosures. To arrive at the fair value, one can use the market approach, cost approach or the income approach (AASB 13, 2011, para 62).
Was fair value measurement responsible for the 2008 crisis?
Analysis of this statement cannot be complete without comparing fair value accounting with the historical cost method. The question is, had historical cost method been used, would things have been different? Referring to this debate, Veron (2008) had stated that historical prices would have provided less comparable and much less relevant information (p. 4). As mentioned by Laux and Leuz (2009), inflated market prices of the assets caused the excessive leverage (p. 3). Further, As stated by Veron (2008), ‘markets do not appear to be blinded by ‘artificial’ features of accounting data’ (p. 5). According to an SEC study in late 2008, only 31% of bank assets were marked to the deteriorating market and a third of these write-downs were for assets which did not affect the bank’s regulatory capital. Also, FASB had allowed the companies to use level 3 inputs, if required (Pozen, 2009). As per FASB Staff Position (March 2009), only the credit-loss portion of impairments affected the bank’s regulatory capital. Thus, the write-downs may have been done at distress sale prices for only a small percentage of assets / liabilities, and not all markdowns affected the regulatory capital. Therefore, it is incorrect to blame the fair-value measurement system for creation or spiraling of the 2008 financial crisis.
Should fair-value fair value accounting be abandoned as a measurement tool?
Due to its very nature, the historical cost method provides information which is usually old and less relevant for stakeholders. Fair-value measurements, on the other hand, attempt to attribute more contemporary values to the assets / liabilities. Further, the rules do allow use of mark-to-model method in case of illiquid markets. This implies that firms, which use fair value, are not forced to write-downs assets at fire sale prices in crisis situations. This indicates that the system is alive to market realities, and factors various scenarios. Furthermore, as mentioned above, the accounting framework does not require all the write-downs to affect regulatory capital. Another aspect is that all organizations are required to report a “cash flow statement” which gives the stakeholders, an important perspective of the organization, and mitigates some of the alarming, but temporary, changes which may have been captured due to the fair-value measurements. All these factors make fair-value measurement system a good alternative to the historical cost approach. It is also important to remember that the age-old concept of conservatism has an inherent downward bias in valuation. The spirit of the principle, however, requires the assets and income to be reflected at the correct values. This mismatch is attempted to be corrected by fair-value measurements. Fair value measurements system, however, is not perfect. While level 1 inputs do provide reasonably unbiased opinions, level 2 and 3 inputs involve a degree of discretion and judgment about the “fair value”. This may be exploited by opportunistic managers for personal interests. This assertion is based on the key hypothesis of the positive accounting theory, namely, “bonus plan hypothesis” (Healy, 1985) and “debt-convention hypothesis” (Watts & Zimmerman, 1986). However, the same opportunism and inaccuracies are possible if historical cost method is used, especially for derivatives and equity investments. Considering this, it appears that the fair-value system is very much relevant, and requires to be strengthened by better guiding principles for valuations and disclosures (Pozen, 2009).
The two perspectives, historical cost and the fair-value measurements, principally have the same objective of giving proper information to the stakeholders. However, historical cost method has become outdated due to the changes in the financial and economic world. Fair-value measurement system is a more contemporary approach, and has to be continuously improved. There is no case for abandonment of the method.
PART B
Depending upon their type, different assets and liabilities are depicted in the financial statements using the historical cost method or the fair-value method. The accounting policies of the organizations mention the details about the methods being applied for different classes. Further, the type of inputs used in the measurement of “fair value” is also disclosed by the organizations. This is evident from examination of the annual reports of two Australian corporations as per the details in the following sections.
Rio Tinto Limited (RT)
Rio Tinto is in the business of finding, mining and processing mineral resources. The “Principal accounting policies” of RT are mentioned in the notes to the 2011 Financial Statements. Important policies / practices related to fair-value or historical cost are highlighted below.
As disclosed in Rio Tinto (2012), the financial instruments have been measured at fair-value based on level 1, 2 & 3 inputs (p. 183). Details are summarized in the table below:
As evident, RT measures most of the instruments using level 1 inputs. However, compared with 2010, there has been a decline in percentage of valuations based on level 1 inputs. Level 2 inputs are being increasingly used and items not held at fair value have increased slightly. Thus, there could be a decline in objectivity of the values of these instruments being depicted in the financial statements. As mentioned in the report, level 1 & level 3 inputs are mainly used for equity shares and quoted funds, and level 2 inputs are mainly used for derivatives related to net debt.
Principal Accounting Policies (Rio Tinto, 2012, p. 137-151)
The accounting policies have remained materially the same over 2010 to 2011 and any improvements / changes are not material to Group earnings or to shareholders’ funds in the current or prior year (p. 137).
Tangibles & intangibles: Goodwill and intangible assets: Those with indefinite lives are not amortized but tested annually for loss in value due to impairment. Those with a finite life are initially recorded at cost, and subsequently amortized. Exploration and evaluation: The evaluation expenditure is assessed for impairment twice every year. Property, plant and equipment is stated at cost plus /minus adjustments for depreciation / impairment losses.
Financial Assets: These comprise of Financial assets at fair value through profit or loss, Loans and receivables, Held-to-maturity investments and Available-for-sale (AFS) financial assets which are measured at fair value from time to time.
Financial Liabilities: Borrowings and other financial liabilities are recognized initially at fair value and later shown at amortized value.
Derivative financial instruments and hedge accounting: These are recorded at fair value from time to time, and changes recognized directly in income statement or through an equity reserve.
COMMONWEALTH BANK OF AUSTRALIA (CBA)
As mentioned in CBA (2011), the bank provides ‘integrated financial services, including retail, business and institutional banking, superannuation, life insurance, general insurance, funds management, broking services and finance company activities’ (p. 104).
CBA (2011) clearly spells out the techniques and methodology of valuation of financial instruments based on various input levels.
Level 1: Here valuation is determined by reference to the quoted price in active markets.
Level 2: The observable inputs are used, and for that, the valuation techniques include DCF method, option pricing and some other valuation models.
Level 3: Here, the fair-values are generally derived from observable inputs for instruments with similar risk by using various models. Examples of the inputs are timing & amount of future cash flows, discount rates, volatility etc.
Details of the fair-values of financial instruments mentioned in the financial statements (CBA, 2011, p. 224) are summarized below:
As evident, majority of financial instruments are valued using level 2 inputs (~63%) and level 1 inputs (~37%). Liabilities, are being measured mainly using level 2 inputs, while the assets are measured almost equally through both level 1 and level 2 inputs. The pattern of usage of various levels has remained consistent between 2010 & 2011. The assets comprise of assets at fair value through Income Statement (including trading, insurance and other assets), derivative assets and available-for-sale (AFS) investments. Liabilities include those measured at fair value through Income Statement, derivatives, and life investment contracts.
Accounting policies (CBA, 2011, p. 104 to 117)
As mentioned in the policy, CBA uses historical cost method except for AFS investment securities and some assets and liabilities (e.g derivatives) which are measured at fair value.
Barring technical and clarifying amendments to standards, the accounting policies have remained the same between 2010 and 2011 Annual report, and do not have a material impact on the Bank or the Group (p. 104).
Some major policies are highlighted below:
Tangibles & intangibles Land and buildings are measured at fair value and changes recognized in the relevant reserve in the balance sheet. Equipment is measured at cost less accumulated depreciation and provision for impairment. Intangibles: Goodwill and other intangibles with indefinite lives are reviewed for impairment, and other intangibles are measured at cost less accumulated amortization.
Financial Assets: Financial assets at fair value through Income Statement, derivative assets, loans and receivables, and available-for-sale investments are recorded at fair value.
Financial Liabilities: Liabilities at fair value through Income Statement and derivatives liabilities are measured at fair-value from time to time. Liabilities at amortized cost are initially recognized at fair value and later measured at amortized cost.
Derivative Financial Instruments
Derivative financial instruments are recognized initially at the fair value of consideration given or received. Subsequent gains or losses are recognized in the Income Statement, unless designated within a cash flow hedging relationship. Fair Value Hedges are measured at fair value and changes are recorded in the I/S. Cash Flow & Net-investment Hedges: Changes related to the effective portion are recorded through other comprehensive income in equity.
Summary:
It appears that more speculative / volatile instruments (like derivatives) are measured at fair value from time to time, and the other assets / liabilities are valued more conservatively at historical cost. The choice depends on the purpose of acquiring the asset / incurring the liability and also its type. This helps disclose the impact of the speculative risk being taken by the management from time to time. For operational assets, like plant & equipment, a fixed schedule of amortization is more preferred as they are not acquired for selling. Intangibles like goodwill which have an indefinite life, are valued for impairment as it would be improper to amortize them at a fixed rate. For financial instruments, RT mostly uses level 1 inputs for valuation, while CBA uses level 2 inputs, especially for liabilities. The annual report of CBA clarifies the methodology of use of hierarchy of inputs (for financial instruments) in more details which helps in understanding the treatments better. Other subtle differences in accounting method of the two companies can be attributed to the differences in the nature of their businesses.
PART C
As mentioned by Pozen (2009), the two methods are much closer to each other than people think. Fair-value system gives are more up-to-date picture of the financial state of affairs of the organization. This is specially true for derivatives and other financial instruments where valuations may increase or decrease substantially in a short span of time. Methods of depreciation are not relevant for those assets / liabilities, and holding them at historical cost would be against stakeholders interests. However, the discretion in measuring fair value makes it prone to misuse for serving vested interests. Further, the subjectivity in measurements makes it prone to errors. As stated by Warren Buffett (2003), mark to model can degenerate into “mark to myth.” Further, insolvency of organizations due to erosion of regulatory capital is uncalled for, especially if it is due to a temporary financial crisis. Fair-value measurement system needs to be mainly strengthened on these two aspects. A few suggestions on the way forward are mentioned below.
