In the recent past there has been a strong a desire and need for reforms in the manner in which accounting of financial instruments and statements is done. This has come as a result of a number of developments in the market. These developments have mainly been characterised by diverse financial innovations, which have blurred the establishment of a clear distinction between the existing financial instruments. Consequently, this has contributed to developing markets for those instruments that have been traditionally considered as non tradable and illiquid (Enria et al, 2004). There has also been evident disappearance of the rationale of the existing diverse accounting treatment that is related to securities, banking and insurance services. This is because they all cover and serve similar economic function.
There have been two major approaches which have been recommended in the previous decade as being essential in line with measurements in financial accounting. The first recommendation is anchored on methods of valuation in accordance to past transaction which is referred to as Historical Cost analysis. Second argument is based on the current existing market value, which is referred to as Fair Value Accounting. The Historical based approach has been a fundamental part of America’s accounting systems. Through this approach, assets are always presented on a balance sheet, in terms of their value at the time when they were being acquired, which is essentially the use of purchase cost.
However, in this era where there is intense usage of financial instruments that are highly complicated, the majority of stakeholders are questioning the appropriateness of Historical cost accounting. This has also been fostered by the adoption of strategies for risk management which makes former prices to be obsolete. We are now compelled to come to the conclusion that, replacing the historical cost accounting with a current cost system, will lead financial reporting into being more accurate. This brings on board the adoption of Fair Valuation as being most appropriate financial accounting tool. Recent developments are evident from modifications made by the Financial Accounting Standards Board (FASB), on the Generally Accepted Accounting Principles (GAAP). These changes involve rapid modernisation of these principles in an effort to make financial statements more meaningful to industrial standard bearers, hence brings forward the essence of fair value in financial accounting to all cooperate organisations (Enria et al, 2004).
The releasing of statement 133 by FASB is meant to account for derivative instruments and diverse hedging activities. It requires an entity which will recognise all existing derivatives as being either assets or liabilities in the financial statement, and measure the instruments at a considerable fair value. This shades light on the paramount importance of developing techniques that will be used to refine measuring of fair value in all financial instruments. The valuation of major financial assets or liabilities must be based on cost or prices, which reflects on market assessment in the present conditions and values on the future of the cash flow, which is covered in financial instruments (Rezaee, 2001).
FASB has clearly stated its goals for a fair market valuation. The board noted that it is fully committed to work diligently so as to resolve in a timely way, the contradictory practical and conceptual issues which are related to meaningful determination of fair values and portfolios in financial instruments. Most critics argue that, accounting through historical cost is highly reliable, due to the fact that it is based on transactions that have been historically documented, hence rarely subjected to any debate. Moreover, most observers will determine the original cost by confirming the documented facts in original purchase transaction. Nevertheless, this is not applicable in the current market situation where fairness in value is the basis of cooperate and industrial development.
For financial statements to be useful, they must have reliability and relevance. However, these qualities always conflict one another. These differences have come out more clearly in the middle of a meltdown in international financial stability, and also the increasing use of fair valuation accounting on balance sheet to effectively value liabilities and assets. Although recording assets at Historical Cost may be considered reliable, recording of such assets at their fair value will still not be an effective and reliable indicator of the asset’s true value several years age. It still can be highly reliable but have little resemblance to the present market value of the asset. This has made the International Accounting standards Board (IASB), the FASB, and SEC to question the suitability of historical cost accounting, and develop preference for fair market valuation which is based on GAAP.
Several drawbacks have been attributed to the extensive use and implementation of fair valuation in the Cooperate and business world. The first drawback focuses on expected increased income volatility with the adoption of fair valuation (Barth, 2009). For a long time, there has been heated argument that volatility has the potential to provide accurate and relevant information, and should be fully respected in financial statements. However, relying exclusively on fair value, especially on assets which are not commonly traded in liquid secondary market, will run the risk in which the information being disclosed covers artificial volatility that is supported by fluctuation in the value of the financial market.
The role of banks and other cooperate groups in the transformation of maturity and liquidity acts as a second limitation of fair valuation. Banks jointly provide loan and deposit services, which puts them in a central position to establish liquidity on demand and also support all the needs of the major components of the financial sector. It is however argued that attempting to bring fair valuation into loans, does not recognize the positive and permanent future of banking that comes in through its significant contribution to bridging the asymmetries in information between borrowers and the lenders.
In terms of advantages, the major aspect of fair value accounting is the development of a wide and improved scope in corrective action and market discipline. This accounting system would essentially lead to greater insight into the profile of the bank in terms of risks (Shortridge, Schroeder, & Wagoner, 2006). It will also move many items that are out of the balance sheet into the balance sheet. If uninsured depositors, debt holders and shareholders are able to identify deterioration in the bank’s safety and its soundness, they will benefit efficiently in the financial stability that the world always crave for.
Looking at the opposite side with regards to the cost of the bank, it is important to analyse its role in the transformation of maturity and liquidity. In most cases, banks take advantage of the tools that have been provided by innovations in the financial sector and consequently, rely on instruments that are more sophisticated to be able to perform their function in liquidity transformation. This means that fair value accounting will result to increasing the marketability of current assets that are illiquid.
From time immemorial, financial reporting has evolved with stewardship being the main objective in accounting. In this financial reporting contemporary era, stewardship and provision of information that is useful in making decisions is viewed as being the major objectives for reporting. Barth outlines IASB and FASB pronouncement in the context of advancing their converged conceptual financial reporting framework, in which the boards agree that stewardship and accountability should not be different or separate objectives during financial reporting in business firms. However, the framework has to acknowledge that information in terms of business finance should be useful for credit, investment and decision on resource allocation (Enria et al, 2004).
It is essential to determine if firms that have more asymmetric timely earning, have financial accounting information that is useful in terms of value, and whether firms that have more non-equity stakeholders who are strongly influential, have financial accounting information that is more useful in terms of value. From this perspective non-equity stakeholders incur higher transaction costs during diversifying of unsystematic risks as compare to equity stakeholders (Barth, 2009). As risks related to stewardship are part of the unsystematic problems, the demand for accounting information related to stewardship increases with the influential power of non-equity stakeholders.
Many critics have called for substantial reforms in fair value accounting to be suspended, due to the fact that, it is perceived to be the major contributory factor to the severe financial crisis evident in 2008. Political interference from the European Commission and the U.S congress resulted to standard setter in accounting to considerably relax the rules. However, if a clear analysis is carried out, we will come to the realisation that Fair values played a limited role in the statements of banks income and their regulatory capital ratio, with the exception of only a few banks that have large trading positions. This means claiming that fair value accounting supported the crisis is a notion that is largely unfounded.
In conclusion, the debate that surrounds fair value accounting and historical accounting is not on the vague of ending soon. However, it is important to realise and acknowledge the significance of fair value in developing an efficient and accurate system, which will effectively represent financial information. This will also include information on economical transaction that comes in handy for boards of directors, investors and analysts.