From Earth Common Journal VOL. 3 NO. 2
A Stakeholder's Perspective on the Implications of IFRS and Fair Value Accounting on Valuation of Securities
IN THIS ARTICLE
Due to the complexity of modern financial instruments, accurate valuation can prove difficult even in optimal market conditions. Traditionally International Financial Reporting Standards (IFRS) have allowed securities to be valued based on their historical cost, which results in financial instruments being held on the books at the initial cost paid, until the point at which they are sold. However, this practice may be viewed as problematic when the market value of the financial instrument has not appreciated. Furthermore, market valuation becomes even more difficult to substantiate in illiquid markets, as it may oftentimes be difficult to secure a buyer at any price. Opponents of the historical cost methodology argue that in these circumstances it is unreasonable to allow firms to continue to hold their financial instruments at historical cost, and advocate for a valuation framework that requires the holders of securities to mark their book value to the best estimate of fair market value available. This viewpoint is countered by those who believe that in illiquid markets or markets in crisis, marking to market value is unfair as no functional market exists. In light of the subprime
mortgage crisis the new iteration of IFRS requires the use of fair value accounting and marking to market for investment products of all types, with the exception of those held to maturity (bonds). Through a review of current literature, we sought to determine the optimal method for valuation of investment products. Our goal was to determine a reliable and representationally faithful method of valuation that will balance the needs and requirements of all stakeholders and provide transparency in accounting.
I. Introduction: What is fair value accounting?
Determining an effective and representationally faithful method of valuation of assets and liabilities has been a longstanding issue in accounting theory. The controversy of methods was first recorded in Kenneth MacNeal’s 1939 book Truth in Accounting, when he argued for a market based valuation model for assets and liabilities. Given the increased complexity of investment products and business transactions, the controversy surrounding the relevance, reliability, and representational faithfulness of fair value accounting has continued to grow (Bell & Griffin, 2012, p. 148). This controversy has given way to a longstanding discussion on the development of an optimal system for valuation.
In order to determine the best course of practice for valuation of financial assets and liabilities (specifically, financial investment instruments), it is important to consider which method will be most representationally faithful, and whether this method enhances the reliability and relevance of financial statements. Generally Accepted Accounting Principles (GAAP) requires that firms classify an investment as “held to maturity,” “trading securities,” or “available for sale,” for the purpose of valuation (Zack, 2009, p. 47). Each of these classifications allows the investment to be valued in a specific manner; Held to maturity investments are carried at the historical, amortized cost, while “held for trading” and “available for sale” securities must be carried at fair value. The important distinction between “held for trading” and “available for sale” securities is that while trading securities have their gains and losses included in earnings, the gains or losses in “available for sale” securities flow through other comprehensive income on the income statement, and are not included in earnings (Zack, 2009, p. 47). International Financial Reporting Standards 13: Fair Value Measurement has made an important departure from the valuation guidelines espoused by private entity GAAP IFRS 13 dictates that all financial instruments are measured at fair value, with the exception of those instruments that are held to maturity (such as bonds), and those equity securities that have no reliable market price (Zack, 2009, pp. 46–47).
The valuation process is aided by a hierarchy of three levels, which helps determine whether an investment should be valued at historical cost, or fair value. This hierarchy examines whether there is a verifiable input (such as a quoted stock price), underpinning the valuation. Observable inputs such as current quoted prices on the market allow an instrument to receive a classification of Level I, whereas completely unverifiable inputs necessitate Level 3 classifications. Those instruments with less reliable inputs, but that can be somewhat substantiated or extrapolated on the market, are classified as Level 2 (KPMG, 2011, P. 29). This classification system (as well as much of IFRS 13) requires significant use of professional judgment, especially when performing valuation in depressed markets, or in the instance of forced sales (KPMG, 2011, P. 32). In this case, accounting professionals should seek information to determine whether they should change valuation methods, or use a hybrid of methods to determine the most accurate assessment of value. A debate on the use of fair value accounting in such markets will be presented later. It is important to consider the implications of stating an asset at fair value, when the market dictates that the item is presently non-saleable, or has suffered a temporary loss in value so significant that it could not be liquidated at a price close to its intrinsic value. An asset’s intrinsic value is subjective, and may be calculated based on its ability to generate revenue, or the sum of the value of it components. Intrinsic value does not consider what an asset could be sold for in the market. In illiquid markets, it is possible that the market value (the price an asset can be sold for in the market) of an investment product can fall significantly below its intrinsic value.
As world economies have become increasingly interconnected, the adoption of IFRS and fair value accounting has accelerated across countries (Jeanjean & Stolowy, 2008, p.5). This adoption has been met with varying levels of acceptance from the numerous stakeholders who use, work with, or prepare financial statements. Although the viewpoints on this issue are varied, they can be generalized so as to aid in an understanding of the diverse perspectives on the adoption of IFRS. The differing viewpoints on fair value accounting from the perspectives of users of financial statements, standards setters, financial institutions, preparers of financial statements, and auditors will be examined. This examination will form the basis of presenting the recommendation for a reliable, relevant, and representationally faithful means of accounting for investment products using the framework of IFRS 13.
II. Users and non-institutional investors
An internationally unified and consistently applied set of financial reporting standards can potentially hold significant value for individual investors and users of financial statements (Ball, 2006, p.6). IFRS 13 can provide users of financial statements with increased understandability, accuracy and reliability of statements, and improve their decision-making capacity. IFRS also offers individual investors a high degree of standardization of financial statement reporting, which garners lower costs, and higher market efficiency (p. 6). Additionally, these non-institutional investors and individual users may find that the improved financial statements produced through the use of international financial reporting standards leads to decreased risk and truer valuation of investment products (p.11). It is important to note that the implementation of IFRS is bound inextricably to the concept of fair value accounting, and that this coupling is likely to increase in strength as IFRS becomes more widely accepted (p. 17).
One of the primary advantages for investors, to the use of fair value accounting in IFRS 13, is the improved accuracy of financial information. As non-institutional investors and individual users oftentimes lack the projection and investigative capabilities of larger investors, fair value accounting gives them an accurate representation of the true value of the firm’s financial health at the present date. This allows them more equality with large-scale institutional investors (Ball, 2006, p.11). Additionally, fair value accounting offers all investors an accurate valuation of how financial instruments are affected by the state of the market at the current time (PWC, 2008, p.2). This knowledge gives investors the power to make more informed decisions regarding their investments, and gives them a clear picture of their investments performance within current market conditions. Historical cost method can hide current performance from investors, especially those that have less market acumen. Curtis and Lewis found that when firms use the historical cost method, a significant difference exists between the value of a firm’s assets on their books, and the actual market valuation of the assets. As such, they observed an upward bias with respect to the actual rate of return (2011, p.5). The existence of these biases in historical cost accounting, and the lack of transparency offered by this method’s valuation practices means that investors will likely prefer the more accurate valuation method of fair value accounting.
III. Standards setters
Standards setters such as the Financial Accounting Standards Board (FASB), and the Securities Exchange Commission (SEC) have mandates to aid in the protection of investors through overseeing the production of reliable and accurate financial information by nongovernmental organizations (FASB, 2013). These standards setters are committed to promoting a consistent method of financial statement creation, which helps investors make sound investment decisions (FASB, 2013). As such, standards setters have endeavored to promote the use of IFRS 13 and fair value accounting as a means to providing transparent, relevant and reliable information to investors. The Securities Exchange Commission states that its primary mission is “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation” (SEC, 2013). Therefore, the SEC has publicly stated their support for the implementation of IFRS 13 (IFRS, 2013). The SEC believes that fair value accounting offers the most reliable means of valuation, and as such, offers individual investors assurance that this is currently the most optimal method of valuation. Given the impartial viewpoint of these organizations, they do not have a vested interest in endorsing a valuation method that is harmful to investors.
Financial institutions have expressed concern over the implementation of fair value accounting. These institutions argue that due to the interconnectedness of financial markets, fair value accounting could negatively impact financial stability of the market in its entirety (Shaffer, 2012, p.14). Many financial institutions believe that in the case of illiquid markets, a drop in the value of securities (caused by marking the securities to market) could cause individual firms value to drop. In turn, this value drop could create contagion in the market and has the power to collapse or severely damage the normal functioning of the market (pp.25-26). Organizations such as the American Bankers Association have lobbied against the use of fair value accounting in illiquid markets. However, the definition of illiquidity is subjective and difficult to quantify. If these organizations wish to advance their arguments against fair value methodology, financial institutions should make determinations on objective measurements for what constitutes an illiquid market.
Financial institutions argue that fair value accounting exacerbates financial downturn by signaling distress to the market (Shaffer, 2012, p.9). These institutions oftentimes advocate for a mixed measurement technique that offers flexibility in valuation by allowing historical cost to be used in illiquid markets, and when an asset is being held for long term. Additionally, the mixed measurement technique does not respond to short-term changes in the market, which proponents of this method argue can falsely signal market downturn and cause contagion.
Those firms, who prepare financial statements for use by investors, have a complex relationship with fair value accounting. They need to balance firm profitability with providing comparable, accurate financial statements. Firms will argue that fair value accounting depresses the value of their assets below what they believe is accurate, and as such, argue against marking securities to market. It is particularly interesting to note that directly preceding the adoption of IFRS in Europe between 2002 and 2005 the markets enjoyed an overall increase in equity valuations (Armstrong, Barth, Jagolinzer, & Riedl 2009, p.30). This may demonstrate that the firms who prepare these statements can benefit from accurate application of fair value accounting. However, these incremental increases in value are overshadowed by more significant issues that firms who prepare financial statements have with fair value accounting. These issues include inaccurate or indeterminable valuation in illiquid markets, problems with the creation of earnings volatility, and problems with the uniform application of fair value accounting principles.
Although the aim of fair value accounting to provide the most accurate representation of valuation of investment products is noble, preparers of financial statements are quick to bring attention to its shortcomings. As outlined in the April 2008 edition of Point of View, fair value accounting has trouble addressing valuation in illiquid markets, and its process of marking to market mean that its use can cause earnings volatility as the valuation of assets and liabilities are in constant flux with market changes (PWC, 2008, p. 2).
When assigning a fair value to financial instruments in an illiquid market, the use of models and professional judgment are crucial. However, it is arguable that in these situations an assignment of value merely fulfills rules and does not serve to increase the reliability or relevance of financial information (Chasan, 2008, para. 5). Companies have argued that when markets are illiquid, the use of fair value accounting (which dictates that instruments be marked to market at statement dates) is unrealistic and can have serious long-term ramifications for the health of the firm (PWC, 2008, p.1). In turn, they argue that inaccurate valuations by way of fair valuation can artificially diminish the value of a firm (PWC, 2008, p.1). Incorrectly decreasing the value of a firm can place an otherwise viable company in danger of insolvency, when their financial position was not otherwise in danger. These firms believe that by marking down securities during times of severe market depression, these assets will be represented below their intrinsic value. The American Bankers Association argues that in illiquid markets, holders of financial instruments recognize that their assets are undervalued, and thus cannot and will not attempt to sell them on the market. In turn, this causes a slowing or seizing of the markets, which contributes to illiquidity (ABA, 2012, para. 7). Preparers are troubled by the practice of assigning value to an asset that could not currently be sold on the market. They are uncomfortable with the practice of using any method other than true market value (i.e. models and professional judgment) to assess an asset that is supposed to be valued using market prices. It is argued that when utilizing fair value accounting models and professional judgment to assign a value to assets in illiquid markets, there is no way of gaining an accurate valuation. Therefore, the viewpoint of many financial institutions is that as the markets are seized and illiquid, it is impossible to gain an accurate representation of fair value, because fair market value does not exist at this point.
Firms (and specifically those who hold financial instruments on their balance sheets as a regular part of operations) have been critical of the use of fair value accounting due to its ability to imbue earning volatility that is not caused by management or general operations. Although fair value accounting is a powerful tool for providing accurate and timely information of the financial state of a company, it is also responsible for the presentation of a great deal of undesirable earnings volatility (PWC, 2008, p.2). As securities must be marked to market on a regular basis, their valuation is represented in a constant state of fluctuation on the books of the financial statement preparers and can thus contribute to volatility (Laux & Leuz, 2009, p.31). Earnings volatility is undesirable from the perspective of management and investors, so any accounting standard that creates it is troubling (Venkatachalam, 2000, p.204). Such volatility can oftentimes be indicative of risky investments or corporate mismanagement, which further explains the apprehension of firms towards standards that promote volatility in earnings. In an empirical study by Ronnie Barnes at the London Business School, earnings volatility showed a significant impact on the market value of a firm. This study revealed that volatile earnings are often accompanied by decreased share values, and demonstrated the importance of judicious consideration of accounting standards usage (2001. p. 21). These empirical findings support the view by many firms that fair value accounting can negatively impact their business valuation and the overall health of their firm. Any earnings volatility has the power to impact the robustness of the share price, and decrease shareholder returns. As such, many of the public, non-governmental firms that would be impacted by mandatory fair value accounting are strong advocates against its widespread implementation.
The increased use of professional judgment in the application of fair value accounting and IFRS 13 is especially concerning as it may result in inequalities in application of accounting standards (Zack, 2009, p. 13). As institutions rely upon accurate valuation of their financial assets for their continued sustainability, they are weary of a method that has thus far been difficult to apply uniformly. Specifically, the issue of misclassifying securities poses major risks to organizations. Institutions are interested in assuring that their competitors are all subject to the same classification standards, as the misclassification of one firms securities can place them at an advantage above their competitors (Zack, 2009, p.53). IFRS 13 had mandated the use of fair value accounting for securities, but many firms do not feel that they have done an adequate job protecting their interests by assuring uniform application of standards. In illiquid markets especially, it is important that firms are assured the most accurate and uniform practices of valuation of their securities. IFRS 13 has struggled to provide a way of giving firms assurance of consistently applied, reliable and accurate valuation in both stable and unstable markets. In order to gain support from those institutions that hold securities on their balance sheets, standards setters must endeavor to provide a more concrete method for the application of fair valuation practices and should provide more diligent monitoring and allow for less professional judgment in the application of financial accounting reporting standards.
Without a clear and defensible value of a financial instrument in the market, the fair valuation method fails to provide any increased assurance of relevance, reliability, or representational faithfulness beyond that offered by the historical cost method. Additionally, the argument that fair value accounting can be detrimental to the overall health of a firm causes discomfort among many companies. Given the issues surrounding fair valuation, it can be difficult for firms to justify the use of fair value accounting in place of the use of historical cost valuation.Continued on Next Page »