The Effectiveness of the Fair Value Standards in the Financial Services Sector: Literature Review

Introduction

The primary objective of introducing the new guidelines was to improve comparability and uniformity in financial reporting measurements (McEnally 2007). As a result, fair value practices lay down a platform for assessing financial statements using a three-tier chain of inputs. On the one hand, the first level presents observable inputs that draw on quoted market prices of comparable assets and liabilities in an active market (Thornton 2008). On the other hand, Thornton (2008) observed that the second tier encompasses quoted prices that do not correspond to the initial level. However, they are noticeable either directly or indirectly. The first two tiers are labelled as mark-to-market configurations. The third level consists of unobservable hypotheses, such as company’s internal valuations, which are complex to support using observable data.

Selected Literature

Given the controversy that surrounds the adoption of fair value accounting standards, a number of researchers have investigated the topic. One of the scholars is Shaffer (2011), who assessed the impact of the accounting practice on the financial institutions. In conclusion, Shaffer (2011) observed that the implementation of fair value accounting did not guarantee the provision of financial statements required by the investors. In addition, the practices failed to ensure transparency as well as useful reporting. The researcher proceeded to indicate that, contrary to the popular belief, the fair accounting standards do not guarantee financial stability as they are negatively influenced by the interconnectedness of the economy, markets and financial institutions. Therefore, Shaffer (2011) suggests that the direction bank regulators and stand setters face the problem associated with fair vale accounting standards. The position aligns with the findings of that United States accounting standards setting, which proposed that the fair accounting standard alongside enhanced disclosures can be used in a more targeted way. The regulators addressed the deficiency of the fair value standards through developing novel supervisory methods and alleviating the adverse effect of financial instability.

The reference to the recent financial crisis is also a useful contribution in understanding the effect of fair value accounting standards. Following the economic downturn, many scholars paid attention to the role of pro-cyclical dynamics associated with artificial and excessive market price instability. In practice, volatility could exacerbate the effects of fair value practices on the bank capital. In a bid to understand the phenomenon, Plantin et al. (2008) evaluated its effects. Through the construction of a model, the researchers assessed ‘hold vs. sale’ verdicts in the financial institutions which sought to optimise current earnings through fair value measurements and historical cost regimes. Under the fair value framework, the sales were inefficient during the crisis, leading to a pro-cyclical outcome. The researchers concluded that selling late in the illiquid markets had negative effects. As a result, it appeared that decision-making was based on managers’ perceptions rather than real facts.

Under the historical costing system, Plantin et al. (2008) found a contradictory outcome. According to the authors, historical cost promoted inefficiency of sales in normal circumstances. The regime counters cyclical problems. The implication is that managers arrive at the inefficient decision to sell because they require cash to counteract the unrealized gains in the short-term positions. In addition, pro-cyclical effects linked to the fair value standards are effective for the long-term assets, which often have lower liquidity. The effect of short-term instability in prices was found to be significant for the illiquid assets.

Allen and Carletti (2008) also pursued the topic with specific focus on pro-cyclicality. Their study indicated that links existed between insurance companies and other players in the financial services sector, given that the latter acts as a contagion in the market, an aspect that reinforces the pro-cyclical consequences. Based on their understanding, Allen and Carletti (2008) suggest that long-term assets that are measured based on fair value standards could be the cause. Further afield, the authors observe that the fundamental connection emerges from the correlation between management incentives to supply or hold liquid assets. Consequently, Allen and Carletti (2008) suggest that it is possible to replicate the dynamic across a number of situations, where different classes of assets are involved. Based on the prediction of the model by Allen and Carletti (2008), banks’ assets are measured based on historical costs. Thus, the model insulates the firms from the contagion impact.

The example of the State Street Corporation is a useful case study in comprehending the effect of fair value accounting standards. The firm might have encountered the issues as it was considered adequately capitalized. Also, it had a reputation of business operating within the regulatory framework of minimum standards (Shaffer, 2011). Despite the observance of the guidelines, the entity witnessed market pressure and instability. One of the factors that differentiated the bank from others was the measurement of a big percentage of its assets on the fair value standards. The firm does not participate in lending activities. Primarily, it extends custody as well as processing services for institutional investors. During the financial meltdown, regulatory capital measures were discarded in favour of conservative  methods, including tangible common equity. When the company’s tangible common equity decreased significantly, the company’s stock also tumbled. The adverse effect of the fair value accounting on the large-size firm serves as a predictor of what traditional banks would face if they were to employ similar methods of management.

The term, ‘decision usefulness’ denotes accounting standard setting processes. It also has the research functions when assessing fair value accounting standards. The concept is defined and applied within the confines of the conceptual framework for financial reporting of FASB. The model proffers guidelines for the development of alternative financial views and new accounting standards. The framework indicates that financial reporting ought to provide useful information to potential and existing investors, creditors and lenders. The reporting should serve the function of a guideline to decision-making (Allen & Carletti 2008). The analysis of the fair value accounting standards is on the second level of the model, which outlines qualitative characteristics for describing the constituents of financial data that is useful in decision-making. Ethical representation and relevance of the information are the most critical aspects of the framework (Shaffer 2011). Relevant information enables proper decisions making for investors, creditors, and lenders. The ethical representation means that data is complete, neutral as well as free from errors.

Herz (2009) observed that in 2006, FASB incorporated the fair value accounting standards into the United States’ Generally Accepted Accounting Principles (U.S. GAAP). Within a period of two years, the FASB agency had codified the new standards. According to Livne and Markarian (2010), the new framework outlined the definition, measures, and requirements of advanced disclosures of the fair value standards. Based on the assessment of Thornton (2008), the fair accounting standards did not necessitate extra fair value measurements, although they standardised measurements and disclosure principles.

Novoa, Scarlata & Solé (2008) also assessed the fair value accounting standards. The authors observed that despite the preference for the mixed method among many managers, bankers, pace setters and academicians, the fair value measurement were desirable. The method approach permits financial organisations to measure loans and/ or securities based on the designated or maturity costs. However, the instruments might lead to impairment in judgment, write downs and/ or allowance variations. According to Plantin, Sapra and Shin (2008), using the fair value standards facilitates adjustments between book and fair value. Based on the above assessment, it is noted that, despite the perception that the method is effective, it is a subject to poor analysis.

According to Allen & Carletti (2008), supporters of the mixed measurement system perceive the approach to be flexible because it facilitates the role of business in holding liabilities or assets. On average, assets held to ease cash flow or collection should be recorded using historical costs. The method factors in the underlying economics of the ‘book and hold’ strategy are the crucial factors. Under the scheme, short-term movement within markets has a negligible likelihood of being realised, hence inconsequential (King 2006). Fluctuations are likely to mislead investors or financial institutions’/ management. On the other hand, liabilities or assets held to generate value due to variations through near-term liquidations or sales should reflect fair value.

Based on the findings of McConnell (2010), the mixed method employs a measurement that does not acknowledge the impact, which the outside events have on assets and liabilities. However, in given instances, historical costs are nonresponsive to the changes. Therefore, the method incorporates the historic data after long time periods. In addition, complex methods have detailed complicated rules that undermine their usability. For example, the complex hedging guidelines, which are backed by detailed interpretations, compound the applicability of the approach. In addition, critics opine that the choice of the assessment method facilitates the engineering and manipulation of the firms’ earnings. Moreover, accepting the use of different methods in measurement allows for inconsistencies, an aspect that decreases transparency.

Further, McConnell (2010) indicated that many users of financial statements agreed that fair value accounting standards gave a relatively accurate approximation of realisable earnings. They reviewed selected assets and liabilities to be traded in the near-term on the basis of market prices to arrive at the above-mentioned conclusion. In addition, the standards were useful in guiding performance management. Conversely, the proceeds are subjected to adjustments and validations as per the actual transactions. Banking institutions’ supervisors concede that the fair value model of accounting might distort earnings when applied to cases of traditional banking (Plantin, Sapra & Shin 2008). Pertaining to loans to increase cash flows, performance is resultant if repayments are made on the basis of the initial contract terms. Under the fair value accounting framework, performance measurement is grounded on the variance between values of existing loans and the sum the loans would attract if sold to independent parties.

Accounting Concerns

Regardless of the contestations emerging, it is evident that a number of issues in regards to fair value accounting practices need consensus. At a conceptual level, Laux and Leuz (2009) call for the balancing of reliability and relevancy. According to the two authors, relevant accounting data is useful in confirming shareholders decisions. As already observed, the information must be seen to impact stakeholders’ future verdicts. In addition, daily market prices must be a timely reflector and predictor of an entity’s status. On the other hand, reliability focuses on the verifiability of accounting information. For data to meet the standards, it must be unbiased and accurate in the portrayal of the transactions that an organization undertakes. Moreover, stock prices must be a truthful representation of an entity’s performance. Thus, marketing information is expected to apply to accounting information for various stakeholders.

The accounting data should be relevant as well as reliable. When fair values are drawn based on the biased factors, or if market prices are biased, the information adduced is deemed irrelevant and unreliable (Magnan & Thornton 2010). Without a doubt, the information is misleading, and can misguide investors and other players in the market.

Amidst the controversy surrounding the concept and practice, it is observed that balancing measurement and recognition is necessary. In the case of the fair value accounting standards, the two terms of recognition and measurement are at the centre. Whereas recognition focuses on the time when an item should be reported, measurement defines the value that should be entered in the financial statements. During the mortgage crisis, the measurement concern emerged. According to Forbes (2010), observers of the stalemate mark-to-market rules of accounting pushed financial players into valuing securities for the purposes of capital as if they were daily trading accounts. As a result, when the markets panicked, auditors and regulators directed insurers and banks to write down asset values to incredibly low levels. The practice was not justifiable (Forbes 2010). Wesbury and Stein (2009) supported the observation arguing that the pricing of securitised mortgage was below the appropriate value based on the cash flow position.

Laux and Leuz (2009) take the criticism of the fair value standards further by observing that they add volatility and the contagion effect on markets. The position is supported by Forbes (2015) also indicating that the mark-to-market standards of accounting precipitated or contributed indirectly to the credit crunch of 2008. The particular reference was related to the forced write-down of assets. The questions highlight the concern about the requirement that market values should be based on hard-to-price assets. Forcing banks to make capital cuts without referring to cash flows and actual loan performance is counterproductive. The system affects growth, contracts capital, and undermines the effectiveness of the entire banking system.

However, when efficient liquid markets generate quoted prices, the fair value standards provide a true picture of the performance (Allen & Carletti 2008). The view is questionable given that in the 2008 crisis, the market seizure resulted from uncertainty. The market volatility resulted from the valuation of mortgage-supported financial instruments. In particular, market liquidity and collateralised debt requirements contributed significantly (Ealsey & O’Hara 2010).

Literature Gap

The change is permanent. However, many parties resist change owing to its ability to offset existing balances and structures. From the literature, it is discerned that fair value accounting standards are the changes in financial reporting. The change has a direct influence on auditors of financial statements, and indirect effect on individuals that use the information. Accounting officers, who are used to using full-cost accounting, have their bonus packages dependent upon earnings measured based on the approach. Therefore, resistance to change is a logical development.

Based on the literature review, the fair value accounting standards are the controversial measurements. A large section of the available literature posits that the standards interfere and distort the financial reporting landscape significantly. However, few studies such as the one by McConnell (2010) indicate that the approach resulted in highlighting the estimates of realised earnings. Overall, some researchers indicate that fair value practices improve efficiency, while others observe that they bring many distortions to financial reporting. Therefore, it is unclear when the fair value accounting standards improve or undermine effectiveness in the financial services sector, which poses a gap that the present study seeks to address.

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