Do We Need Fair Value Accounting?

Sudden Decline in Economy:-

Some argue that fair value accounting has exacerbated the current credit crisis. In the current crisis, declining housing prices reduced the value of all mortgage based securities (MBS), since the housing collateral protecting them is much less. Because of the mark-to-market losses, companies have to raise capital for meeting capital adequacy requirements. When MBS or other assets are sold to raise capital, the market value is driven down further. Worse still, the distress prices becomes the new price for valuation of all similar instruments held by all companies. This domino effect results in a downward death spiral. The credit rating agencies downgrade the company’s credit ratings, making borrowings to meet capital requirements more difficult. This eventually results in the collapse of the company. 

Notional Gains and Losses:-

In normal times, fair value accounting would not have been a subject of great debate. However, in boom or bust times, some may argue if fair value accounting results in notional gains and losses, since the eventual settlement price of the financial assets/liabilities could be substantially different. However, those criticising fair value accounting do not seem to provide any credible alternatives.

Historical Cost or Fair Value:-

 Do we go back to historical cost accounting, wherein the financial assets are stated at outdated values and hence are not relevant or reliable? Do we become fortune-tellers and use the crystal ball to determine the futuristic value at which the financial assets would be settled? Is it therefore not appropriate to state financial assets at their fair values prevailing at the balance sheet date? In the current crisis, a question that is raised is, should assets be marked down to their current throw away prices, as companies may not want to sell them at those values. Still others may view the artificially low values as the market values and the best representative value of the asset at the balance sheet date. It is quite evident that irrespective of an entity’s intention to not sell the assets at distressed values liquidity pressures have forced companies to make the so called fire sales. In the current market scenario, any accounting which fails to highlight the liquidity risk, in the way that fair value accounting does, would not serve the interest of investors and other stakeholders. 

Basis of Valuation:-

One of the issues has been finding a reliable basis for the valuation of financial instruments as markets liquidity disappeared. And when comparable transactions are available, some have questioned whether these are representative of normal, active markets, or of distressed sales and therefore, whether these could be ignored for valuation purposes under IFRS or US GAAP. As many assets and liabilities do not have an active market, the inputs and methods for estimating their fair value are subjective making fair valuation less reliable. US Federal Reserve research shows that fair value estimates for bank loans can vary greatly depending on the valuation inputs and methodology used.