Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch (Pieter-Jan Wils Summary)
Fair value accounting: a financial reporting approach in which companies are required or permitted to measure and report on an ongoing basis certain assets and liabilities (generally financial instruments) at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities. Under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. Those losses reduce companies’ reported equity and may also reduce companies’ reported net income. September 2006: (FASB) issued an important and controversial new standard, Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157). * more comprehensive guidance to assist companies in estimating fair values * guidance has been tested by the extreme market conditions during the ongoing credit crunch Criticism (after crisis):
* Unrealized, reported losses are misleading because they are temporary and will reverse as markets return to normal * Fair values are difficult to estimate and thus are unreliable * Reported losses have adversely affected market prices yielding further losses and increasing the overall risk of the financial system. Criticism is overstated, some of the key reasons why fair value accounting benefits investors include: * It requires or permits companies to report amounts that are more accurate, timely, and comparable than the amounts that would be reported under existing alternative accounting approaches, even during extreme market conditions * It requires or permits companies to report amounts that are updated on a regular and ongoing basis * It limits companies’ ability to manipulate their net income because gains and losses on assets and liabilities are reported in the period they occur, not when they are realized as the result of a transaction * Gains and losses resulting from changes in fair value estimates indicate economic events that companies and investors may find worthy of additional disclosures. Section 2: Background information abstracting form the credit crunch A. Fair Value Accounting
Goal: for firms to estimate as best as possible the prices at which the positions they currently hold would change hands in orderly transactions based on current information and conditions. If market prices are available: FAS 157 generally requires firms to use these prices in estimating fair values (market prices should reflect all publicly available information about future cash flows, including investors’ private information that is revealed through their trading, as well as current risk-adjusted discount rates) = market to market values If market prices are not available: firms must estimate fair values using valuation models, using observable market inputs (e.g. interest rates and yield curves) and unobservable firm-supplied inputs (e.g. expected cash flows from company data) = market to model values firms also report the periodic changes in the fair value of the positions they currently hold, referred to as unrealized gains and losses, on their income statements. Main issue with fair value accounting is whether firms can and do estimate fair values accurately and without discretion: * unadjusted mark-to-market values: fair value generally is the most accurate and least discretionary possible measurement * adjusted mark-to-market values: adjustments for market illiquidity or for the dissimilarity of the position being fair valued from the position for which the market price is observed. These adjustments can be large and judgmental in some circumstances * mark-to-model values: choices about which valuation models to use and about which inputs to use in applying the chosen models. valuation models are limited, and different models capture the...
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