Accounting

Fair value accounting has been a very controversial step that has brought on by standard setting bodies. It has been at the centre of the debate surrounding the current credit crisis with banks and corporations claiming that the use of fair value leads to many problems and has been responsible to a great extent, for the losses that the companies have had top bear during the crisis. Thus it has been said to lead to volatility in earnings that does not reflect economic reality. However, proponents of fair value accounting content that it is the best representation that can provided to investors because it leads to transparency regarding assets and liabilities on the balance sheet and reflects current market conditions. The debate still rages on about this controversial piece of accounting application and the best way to apply it.

Fair value is basically the price that a business entity would realize if it were to sell an asset today in an arms length transaction or the price to be paid if a liability was fulfilled today. Thus it can be seen to be a rational and unbiased view of the potential market price of some asset or liability as the market forces provides the best estimate of price, as various buyers and sellers interact to determine the price in the market. This has assumed particular importance with regards to financial instruments. In the United States, the fair value measurements are dealt with by SFAS 157. This primarily deals with the valuation of financial assets and liabilities on a fair value basis while the application with regards to valuation of non financial assets and liabilities has been deferred until the year 2009. According to this statement, fair value is defined as price received to sell an asset or the price paid to transfer a liability in a transaction taking place in an active market.

When valuing assets or liabilities at fair value, the use of inputs required for the fair value measurement assumes tremendous importance since an estimation is being made of the current market value of the item in question which is only as good as the inputs employed. That is why under GAAP, a three level tier system is used for the estimation of fair value. Under Level One, the inputs to be used are price quotes from active markets for the assets or liabilities that are alike. There is however the requirement that the entity in question has access to these particular markets. This is the best case available since existing markets provide accurate prices which are not based on evaluations. If quotations from such markets are not present then an evaluation should be based on the most convenient bit of information that is available. If there are multiple existing markets, then price quote should be used from the market that is most advantageous to the entity. This however also requires consideration of the costs of the transaction incurred in availing the prices.

Level two makes use of market observables for the purpose of assigning a value to an asset or a liability. This level has been created because, looking from a practical point of view, active markets do not exist for all items under consideration and even when they do exist, they may not provide the extent of reliable information that is required for the particular item being valued. This level is applicable under three events. Number one is for a situation where there is absence of an active market for the related assets and liabilities. Number two applies when in comparison to items traded in the market, the assets or liabilities being evaluated are similar to but not exactly same as the ones being traded. Number three comes into effect when market trading is absent or comparatively inactive but market data can still be utilized to allow fair value to be calculated. This level makes use of valuation models such as Black Scholes model for option pricing which brings into use variable inputs from observable market data to calculate fair value.

Under Level three, any sort of inputs that can be used for price evaluation are non existent. The use of different valuation techniques thus comes into play in the evaluation process. The relevant inputs at this level have to be collected assuming they are used by market participants in putting a value to the item under consideration because they are non observable inputs. This brings in a lot of subjectivity as now the reporting entity as opposed to buyers and sellers in the market are choosing the inputs. The idea behind the use of this third level however is that provided the inputs that are used are gathered on a best efforts basis and with a desire to represent economic reality rather than with a bias, a significant amount of useful information can be obtained regarding the fair value of the asset or liability under consideration.

There is room for misrepresenting in all the three levels, although with varying degrees. One type of fraud that could be conducted relates to the drawing of conclusions about asset or liability fair value that are not appropriate given the range of price quotes that are available. This could be when there is doubt about whether the asset with an active market is actually similar to the item under consideration, which if it is not, will taint the results that are obtained to be represented on the financial statements. The second opportunity relates to the use of valuation techniques for estimating fair value. Since such techniques are primarily based on future cash flows to be estimated, variations in fair value arise due to changes in estimations regarding the amount of cash flow, timing of the cash flows and the risks linked with the cash flows. If any of these are manipulated to some degree, it changes the value obtained and this is frequently exploited by companies to get over value assets or under valued liabilities. The cost approach to fair value measurement also poses similar risks. Since it is based on the assessment of the cost required to replace the asset which is adjusted for any obsolescence of the asset, any irregularity in coming up with an estimate of either would alter the estimate for the fair value of the asset. Another misrepresentation risk concerns the internal or external estimation of fair value. When fair value has to be determined internally, there is a need for the personnel determining the value to have the required level of expertise in performing the task. With external assessments however, there is also a continuing risk whereby the results of the evaluator can be influenced. This can be carried out through bribery, a sham specialist being utilized or perhaps some conflict of interest existing between the evaluator and the entity that employs it. This subjectivity in the case of non existing active markets provides a lot of room for fraud. Enron exploited this by over valuing its assets through mark to market accounting, using complex, and internally generated models to get fair values for items that were in reality, not worth that much.
There are some differences between the approach to fair value between GAAP and IFRS. The former identifies fair value as price to sell an asset at the time of evaluation between market participants.

While this is appropriate with regards to intangible instruments, it does not work for tangible assets very easily. IFRS takes care of this by identifying fair value as price at which the asset or liability can be exchanged between willing parties who are knowledgeable, in an arms length transaction. If this difference is analyzed to a deeper extent, GAAP relies on market participants to generate a price where the item in question can be sold. However, there is frequent case of no such market existing or no willing participant to buy or sell the asset or liability. This was exemplified in the case of the recent credit crisis where market activity dropped suddenly. GAAP addresses this through its three tiered structure ranging from Level one to Level three. However, it still presents significant problems compared to the approach of the IFRS which takes into account both the buyer of the item as well as the seller. Similarly in case of brand names, it is valued according to GAAP on the basis of the evaluated price another party would be willing to pay for the brand. This makes an important assumption that the third party being considered will actually make use of the brand, which even if it is used, may go down in value significantly in the wake of a drop in marketing of the brand. This would translate into impairment. IFRS takes care of this by valuing brands through their use which does not suffer from such problems or irregularities. Another important difference arises in terms of the revaluation with regards to fair value that are allowed with some assets. GAAP does not allow upward revaluations, while IFRS does. This is particularly important in the case of liabilities with regards to financial institutions. As an example, if the credit rating of a particular firm is dropped, an equivalent and offsetting gain can also be recognized in the accounts against the loss on investments.

The drawbacks with regards to some application of the fair value concept have been aimed to be addresses by the standard setting bodies while other recommendations are in the pipeline to quell misrepresentation that might creep in when measuring at fair value. First, FASB took a measure in the wake of the current financial crisis that saw banks having to make significant write offs by easing the stringent rules surrounding fair value evaluation by allowing them to use significant judgment in gauging prices. This allowed the write offs to be less steep. Although concerns were addresses, many others argued it was not in line with economic reality as the accounting rules had not led to the fall in value but the market forces had which are the best indicators. This has had further impact in that the measure is applicable retroactively. The SEC itself has been fairly active with regards to fair value accounting. Its division of corporate finance has constantly been pushing companies to increase disclosures with regards to fair value application as well as regular letters to public companies about fair value issues. The Chief Accountants office has been active in spurring debate about the issues surrounding fair value accounting and as well as providing clarifications about the rules where there may be room for ambiguity. Actions in this regard included settlement on auction rate securities with the large institutions ranging from Citigroup to the Bank of America as well as against hedge fund managers at Bear Stearns who were able to manipulate the price offered and misrepresent performance as a result. As these steps show, there is a significant need to address the loopholes that abound regarding application of the fair value concept. Furthermore, GAAP could move towards an acceptance of some of the IFRS principles which make less problems when defining fair value and its application. However, it is generally accepted that fair value is the best measure of representation of economic reality to the investors compared to others.