Cost Accounting – Fair Value Measurements Assignment Help
EXECUTIVE SUMMARY
The debate between proponents of historical cost accounting and fair-value measurements has been going on for many years. Those in favor of the first method have argued that the write-downs in values of assets and liabilities due to fair-value accounting “created” the 2008 financial crisis, and it should, therefore, be abandoned. This paper examines the assertion by understanding the extent and nature of impact of fair-value measurements on the balance sheets during the 2008 crisis. The relevant regulations and the changes made by FASB during the crisis have been highlighted. Also, the pros and cons of the two methods have been briefly discussed. Further, the current position of the Australian Accounting Standards Board on fair-value measurement is also highlighted. The application of fair-value and historical cost methods in 2010-2011 by two Australian corporations has also been analyzed. Lastly, ways to further strengthen the fair-value measurements system have been suggested. It appears from the analysis that the 2008 crisis was not created by Fair-value accounting principles. It is also clear that though there may be scope for improvement in the fair-value measurement system, there is no merit in abandoning it totally.
Part A
Introduction:
The existing and prospective stakeholders of a corporation require that the assets and liabilities shown in the balance sheet are valued properly. The two main approaches for valuing these classes are the Historical Cost method and the Fair-value method. As per Pozen (2009), in the historical cost method, the assets and liabilities are shown in the balance sheet at the acquisition price minus or plus adjustments for depreciation (e.g. for fixed assets) or appreciation (e.g. for bonds purchased at discount) respectively. As mentioned in Pozen (2009), in the fair-value method, the market value of the assets & liabilities are assessed from time to time, and the updated values reflected in the Financial Statements. Here, “Fair Value” is defined as follows:
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 techniques of valuation include Market, Cost and Income approach (or a combination of these) (AASB 13 2011, para 62). The “price” can be based on three levels of inputs (level 1, 2 & 3) available from various sources and the judgment exercised by the values (AASB 13 2011, para 76, 81, 86). As per IFRS 13 (2011), this hierarchy of inputs is required to increase consistency and comparability in fair value measurements and related disclosures.
Critical evaluation of the statement
As per Holt (2009), the severe recession that began in December of 2007 was caused by the bursting of the housing bubble and the resulting credit crisis (p. 128). However, the prices of these assets did not reach bubble points due to fair-value accounting. As per Laux and Leuz (2009), the excessive leverage prior to the meltdown was based on the inflated market prices of assets, and not their book values (p. 3). Further, there is an assertion that use of fair value accounting accelerated the downward spiral due to write-downs at “frozen” prices. However, as stated in the article by Pozen (2009), during the crisis, only 31% of the assets were marked-to-market, and a third of these were “available-for-sale” debt securities where marking-to-market did not affect the bank’s regulatory capital or income. Thus, the percentage of assets where write-downs affected the bank’s capital was only 22%. The consequent insolvencies of firms, or freezing of the debt markets cannot, therefore, be solely attributed to the method. Further, the two valuation methods are not as far apart as they are made out to be. Write-downs do take place even in historical cost accounting, especially if impairment is not temporary. Even in 2008, banks wrote-down $25 billion in goodwill. As mentioned in the article by Herz and MacDonald (2008), FASB was reasonably flexible, and as stated in FASB (October 2008), it was open to companies reclassifying trading assets from Level 2 to Level 3 as markets became more illiquid. Thus, instead of using forced or distress sale values, they could have used “marking-to-model” based on their judgment. It is pertinent to mention that Level 1 inputs are defined as ‘The Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date’, Level 2 inputs are ‘Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly’, and Level 3 inputs are ‘Unobservable inputs for the asset or liability’ (AASB 13 2011, p. 35). During the crisis also, these levels carried the same meaning, and there was room for discretion in valuations. FASB (March 2009) mentioned that only the credit-loss portion of impairments would affect a bank’s income and regulatory capital.
Considering above, it appears that impact of write-downs due to fair value accounting on regulatory capital was not as widespread as believed to be. The write-downs could have involved judgment similar to the mark-to-model method, making them above the fire-sale prices. During a crisis situation, market risk is more important than the idiosyncratic risk associated with the company. It is possible that there would have been more uncertainty had the historical cost method been used. However, as mentioned by Pozen (2009), incorrect perceptions about the fair-value method could have aggravated the crisis. Thus, the method itself cannot be blamed for creation of the crisis.
The fair-value method represents a more contemporary picture of the organization, and hence provides more relevant and verifiable information. Further, proper information is a pre-requisite for efficient agency relation between the shareholders, management and the lenders. This state is more easily attainable in the fair-value method. In case of a crisis, an “orderly transaction”, defined in AASB 13 (2011, p. 37) as one ‘which it is not a forced transaction (eg a forced liquidation or distress sale)’, is not practicable. Hence fair-value measurements allow and mandate use of level 2 and level 3 inputs. Further, as per prevalent accounting standards, not all write-downs lead to reduction in regulatory capital. Thus, even today, the method does not lead to forced write-downs at fire-sale prices. However, like all systems, the method can be abused, and there is scope for improvement. Personal preferences & biases are possible during valuations, specially where level 2 and 3 inputs are considered. Some other weaknesses, like the fact that the method does not allow for adjustments due to the “blockage factor” AASB 13 (2011, para 69), make even level 1 inputs less reliable. Furthermore, severe write downs during crisis situations, albeit for a small percentage of assets, can be bad for individual organizations for no fault of theirs. In addition, misconceptions about the method still exist. Factors like this increase the criticism of fair-value accounting as per the current accounting standards.
As discussed in Pozen (2009), better disclosures, de-linking accounting and minimum capital requirements, and reporting of two versions of EPS (one with write-downs and one without) can be ways to make the fair-value system more “fair” for the stakeholders. Thus, though there is scope for improving the fair-value measurement system, there is no merit in abandoning it as a measurement tool.
Part B
To analyze how corporations apply fair value measurement & historical cost principles, Annual Financial Report (2011) of National Australia Bank Ltd. (NAB) and Annual Report (2011) of BHP Billiton Ltd. (BHP) have been analyzed.
National Australia Bank (NAB)
As per NAB, Annual Financial Report (2011), majority of the financial assets (93%) and liabilities (99%) were measured based on level 2 inputs both in 2010 and in 2011 (p. 140). Further, as per the accounting policies stated in NAB, Annual Financial report (2011), based on the classification, assets and liabilities are valued at the fair value from time to time or at historical cost (p. 62-74). The policies are analyzed below.
Accounting Policies
Fair-value measurement
Derivatives (hedging & trading instruments): Fair value hedges are recorded in the Income Statement (I/S), alongwith the changes in fair value of the concerned underlying. In case of cash flow hedges & net investment hedges, the effective portion of fair value difference in the derivatives is recorded in the relevant equity reserve and that related to the ineffective part in the I/S. Trading derivatives are recorded alongwith the related transaction costs in the I/S. Items at fair value through profit & loss (items held for trading): Changes are recognized in the I/S as they arise. Investments available for sale (primarily debt securities): Changes are included in the relevant equity reserve and on disposal, the amount is transferred to the I/S.
Historical cost method
Investments held to maturity (non-derivative) and Loans and advances: Here, changes are measured at amortized cost applying the effective interest method, net of provision for impairment. Impairment of non-financial assets: Assets with an indefinite useful life, including goodwill, are not subjected to amortization but are annually tested for impairment. Other assets / liabilities subject to amortization or depreciation: Assets that are subject to amortization are also tested for impairment as and when deemed necessary. Acceptances of bills, dues to banks, deposits / other borrowings, property, plant & equipment, Bonds, notes, subordinated debt and other debt issues are all depreciated / amortized annually (NAB, Annual Financial report 2011, p. 62-74). There was no impairment of goodwill in 2011 or 2010 (p. 95).
BHP Billiton Ltd (BHP)
As per the BHP, Annual Report (2011), in 2011 75% of financial assets and liabilities were valued based on level 2 inputs (62% in 2010) and 24% based on level 3 inputs (37% in 2010) (p. 214). Thus there has been an increase in objectivity in fair value measurements for BHP. Further, as per the accounting policy stated in BHP, Annual Report (2011), the derivative financial instruments and some financial assets are recorded at fair value from time to time. Other assets / liabilities are recorded on the basis of historical cost principles (p. 166). The policies are analyzed below.
Accounting Policies
Fair-value measurements
Derivatives: Changes in fair value hedges are recorded in the I/S, alongwith with changes in the underlying asset or liability. For cash flow hedges, the effective portion of change is recognized in relevant equity reserve. The change relating to the ineffective part is recorded immediately in the I/S. In the event of expiry, termination or ineffectiveness of the hedge, the accumulations in reserves are transferred to I/S. In case of trading derivatives, changes are recorded immediately in the I/S. Financial instruments (non-derivative): When carried at fair value, gains and losses are recorded directly in equity. When held at fair value through profit or loss, changes are recognized directly in the I/S. All financial liabilities (excluding the derivatives) are later carried at amortized cost. Available for sale (AFS) and trading investments: Changes in AFS investments are recorded directly in equity and later recorded in the I/S (after being realized through sale or redemption or in case of impairment). Changes in trading investments are directly recorded in the I/S.
Historical cost method
Intangible assets are recorded at cost minus accumulated amortization & impairment charges. Impairment of Goodwill & other non-current assets: Goodwill is not subjected to amortization but tested every year for impairment. Even assets which are amortized are tested for impairments as & when deemed necessary. The losses due to such impairments are charged to the I/S. Due adjustments are made in the carrying amount being shown in the balance sheet. Tangibles like Property, Plant & Equipment’s are shown at cost minus accumulated depreciation & impairments. Fair value for mineral assets is generally calculated as the discounted present value of the estimated future cash flows (BHP, Annual Report 2011, p. 166-173). Like in 2010, there was no impairment in goodwill and other intangible assets in 2011 (p. 181).
Analysis of the accounting treatment of changes in values of assets and liabilities by the two companies:
Based on above, it appears that in case of both the companies, derivatives and some other financial assets are measured at fair value, and changes affect the balance sheet on a continuous basis. Non-derivative assets / liabilities are recorded at historical cost, and the changes affect the balance sheet only periodically based on an amortization schedule (e.g. annually) or at the time of impairment. Further, there are differences in accounting treatment of changes in value of different types of derivatives.
Differences in treatment for different assets / liabilities are based on the nature of the asset / liability and the reason for the management to undertake the risk or make the investment. For example, in a speculative derivative investment measured at fair value, it is important to inform the stakeholders about the extent and impact of the risk being taken by the management from time to time. Thus, changes are recorded immediately in the I/S, and hence affect the EPS / net worth. In less speculative investments like the cash flow hedge and the net investment hedges, the I/S is not affected till these “protections” cease to be effective. Similarly, changes in values of debt securities do not impact the net income till they are disposed. This is because, these investments are not made for speculative purposes. However, if these hedging decisions go wrong (when they cease to be effective), the error should be reflected in the EPS so that the stakeholders know.
Non-financial assets with indefinite useful life like goodwill are not amortized, but impairments are recorded as and when ascertained. The non-derivative investments, loans & advances, and tangibles like property, plant & equipment which have a finite life are not measured at fair-value but amortized over time and, in addition, impaired if deemed necessary. These affect the net income when amortized or impaired, which is usually based on a prescribed schedule (e.g annually). This is because, these investments are made for running the business operations and proper utilization of idle assets. These are not made for selling for a profit or any other speculative purposes. By nature, these investments are conservative, and hence require annual re-valuation rather than fair-value measurement from time to time.
Considering above, it is evident that both the companies classify and treat assets and liabilities in similar manner. While relatively speculative investments are treated at fair value, historical cost method is used for the operational assets and liabilities.
Part C
The idea behind both the methods of valuation is to be objective and reflect the true and fair picture of the financial position of the organization. While historical cost values lose relevance with time, the “fair-values” are less objective especially if level 2 & 3 inputs are used. In addition, the reduction in capital due to write-downs in fair value accounting sometimes leads to undesirably harsh consequences for corporations. However, as suggested by Pozen (2009), the way forward is to retain the fair value accounting system, but create a hybrid method of reporting. For example, for regulatory purposes, capital could be calculated on the basis of the weighted average market value of the assets or liabilities over the past few quarters. This would avoid unwarranted insolvencies especially during crisis. This method can also be applied to other assets and liabilities (especially where level 3 inputs are applied) to increase the objectivity of fair-value measurements. This is because weighted average valuations would be relatively difficult to manipulate. Importantly, the recent “historical” prices of the assets / liabilities would get reflected in the valuations. Based on this, the corporations can publish two versions of its earnings per share (EPS) each quarter, the first arrived at with fair value accounting based on the weighted averages, and the other based on historical cost. In a way, it is like taking a few steps backwards towards “conservatism” principles, while retaining a strong bias towards dynamic valuations. In addition, as mentioned by Pozen (2009), de-linking accounting and minimum capital requirements, and better disclosures can further improve the system.
