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Topic:

Implications of Fair Value Accounting: The Case of Fiji Sugar Corporation

1.0 Introduction

The essential characteristics of accounting are: the identification, measurement, and


communication of financial information about economic entities to interested parties.
Financial statements are the principal means through which a company communicates its
financial information to those outside it. Financial statements are of no importance within
themselves; the importance of financial statements lies in information they provide to
statement users. (Shamkuts, 2010, pg 4)

Users of these financial reports include investors, creditors, managers, unions, and
government agencies. The selection of the measurement base, used in preparation of financial
statements, is one of the most significant problems of accounting. For example, investors may
wish to know the amount of income earned over a given period of time. Various amounts of
income would be determined, depending upon the method used to measure income as several
methods are available. Measurement is a key aspect of financial reporting. (Shamkuts, 2010,
pg 4)

The traditional basis of accounting has, for a long time, been historical cost. Over the past
few years financial accounting has been moving away from measuring certain assets and
liabilities at historical cost and more toward fair value. Fair value accounting has been a
controversial topic to date and there has been ongoing debate regarding its applicability as a
measurement base, its implications in the financial market, volatility in the markets and the
issue of reliability.

Fair value accounting was brought under the limelight as a result of the Global Financial
Crisis in 2008. The crisis that was triggered in the United States spread like a plague to all
countries in the world. The US subprime mortgage collapse, shattered confidence in major
global financial institutions, led to massive crashing of equity prices, frozen credit market,
and wounded the stock prices (ADB, 2009, pg 9).

Many critics of fair value accounting stated that fair value accounting is at the core of the
crisis, while the proponents state that fair value has been wrongly judged; a messenger of the
crisis is labeled as the contributor. A detailed discussion on this debate, together with an
overview of what constitutes the global financial crisis is presented in a later segment of the
paper.

The main aim of this research paper is to analyze how Fair Value Accounting has had serious
implications in the Pacific. The work consists of three segments. The first segment is devoted
to the overview of fair value accounting, including its definition, impact on financial
statements, and its advantages and disadvantages. Detailed comparison between Historical
Cost Accounting and Fair Value Accounting is also presented. The second segment talks
about recent financial crisis and role of fair value accounting in it. Specific cases of Fiji are
also highlighted to show fair value accounting implications. The third segment, which is
research-based, investigates the serious implications of fair value accounting in Pacific with
reference to a case study on Fiji Sugar Corporation [FSC]. The paper first will look at the
theoretical underpinnings of Fair Value Accounting.
Theoretical Underpinnings

This section evaluates the development of FVA under the notion of the new paradigm being
in the process of gaining legitimacy. Whether fair value achieves legitimacy depends largely
on whether it can be proven to be ‘appropriate’. This implies, of course, that historical cost
may have been appropriate for previous times but is losing legitimacy.

Decision Usefulness Perspective [Theory]

The objective of financial reporting as per FASB is to “provide information that is useful to
present and potential investors and creditors and other users in making rational investment,
credit, and similar decisions”.

This theory stresses that it can only be judged by its predictive power; the ability to make
informed decisions about the future based on the usefulness of the information provided at
present. The decision usefulness approach calls for a “forward-looking” position rather than a
preoccupation with the past. Apart from the stewardship function, investors are also
interested in knowing about the increases and decreases in the value of their investments as
represented by the net assets of the company (Godfrey, 2006, pg 155).

In this paper, fair value is being analyzed from the decision usefulness perspective.

True Income Theory

True Income Theory arose from the normative theory development. True Income theorists
concentrated on deriving a single measure for assets and a unique (and correct) profit figure.
However, there was no agreement on what constituted a correct or true measure of value and
profit (Godfrey, 2006, pg 52). This became an issue since there were various measurement
bases that could be applied in accounting.

In addition, various accounting standards just provide a “guideline” on how balance sheet
items can be measured without exactly telling the preparer of the financial statements which
measurement to apply. This is based on the judgment of the preparers; a move away from the
computation of true income figure.

In this paper, an attempt is made to show that the adoption of fair value, to some extent, has
tried to solve that problem and to calculate a more true profit figure compared to historical
cost; a shift in focus from outdated values to current values.
Agency Theory

Legitimacy Theory

Going Concern Theory

A Theory of Justice or cost attach Theory

Conservatism

Efficient Market Theory

FVA relies on efficient market theory, namely that short term price = value and that
consequently income, assets and liabilities should be adjusted in real time to reflect same.
2.0 Literature Review

2.1 The Shift from Historical Cost Accounting to Fair Value Accounting

To critically analyze the shift from historical cost to fair value accounting, it becomes
imperative to understand the underlying view of accounting and financial statements.

The traditional view of accounting was that of stewardship which emanated from the need of
investors to know what managers do with the capital funds entrusted to them. This is the
perspective that gave rise to the role of historical-cost basis in financial reporting because the
price that a manager had paid for an asset, coupled with documented evidence, is an
indication of specific uses of funds. Funds not used remain in a liquid (cash) account and the
investors will, therefore, be able to account for the uses of all the funds they provided to the
company. Hence, the concept of stewardship has traditionally been backward looking
because it aims at providing information to answer the question of ―what did you, the
management, do with my money?(khalik, 2008, pg 16)

In contrast, the present view of accounting is that of decision-usefulness. This is the


perspective that gave rise to fair value accounting which is a forward-looking basis of
reporting because the market value of an asset (whether observed or estimated) is the
discounted net cash inflows expected to be generated from using the asset. Investors make
decisions based on expectations and, to that extent, fair value is in agreement with investors’
viewpoint. Hence, the concept of decision-usefulness is forward-looking because it aims at
providing information to answer the following question of – how the management decides to
use the funds and what the management expects to get for that use of those funds? khalik,
2008, pg 16)

2.2 Comparison of Historical Cost Accounting and Fair Value Accounting

The Conceptual Framework of Accounting identifies relevance and reliability as the primary
qualitative characteristics of useful financial information. While both are theoretical
ingredients of ideal information, a tension exists between relevance and reliability in practice.
Based on the tradeoff, a comparison has been made between historical cost and fair value as
follows;

Relevance
Information is relevant when it is capable of making a difference in a decision. It must have
predictive value - help users to predict the ultimate outcome of the past, present and future
events. It must have feedback value - help users to confirm or correct prior expectations. And
finally it must have timeliness - be available to decision makers before it loses its capacity to
influence their decisions.

Historical Cost Fair Value


Unless the value of fixed assets are assumed to Allow users of financial statements to obtain a
remain same over time, historical cost truer and fairer view of the company's real
information is relevant only upon obtaining the financial situation since it reflects the
asset prevailing economic conditions, the changes in
Since historical cost information measures them and reflects the current market price of
remain unchanged over time, users do not get asset/liability
valuable feedback about appreciation and
depreciation following the purchase of the
asset.
Figure 1: Comparison between HCA and FVA under the concept of Relevance

Reliability

Information is reliable, when it is verifiable, is a faithful representation, and is reasonably


free of error and bias. Verifiability occurs when independent measurers, using same
methods, obtain similar results. Representational faithfulness means that the numbers and
descriptions match what really existed or happened. Neutrality means that a company cannot
select information to favor one set of interested parties over another. (Shamkuts, 2010, pg 17)

Historical Cost Fair Value


Is based on actual transactions, the recorded Fair value estimates based on inactive
amounts are reliable and verifiable and free markets, subjective input data and
from management bias and manipulation, estimations /judgments by management may
appraisals or any other valuation techniques prove to be unreliable. [refer Fair Value
hierarchy]
Provides management with the opportunity to
manipulate the accounting numbers
Figure 2: Comparison of HCA and FVA under the concept of Reliability
FAIR-VALUE ACCOUNTING: A BETTER REFLECTION OF REALITY

Example:

Fair-value accounting prices an asset based on its current value. So, for example, if my stock
investment, purchased for $1,000, falls in value to $400, then fair-value accounting would
show that investment on my financial statements at $400, not the original cost of $1,000.

Those who contend fair-value accounting exacerbated the financial crisis, argue that it
brought turbulence to the financial system because companies were forced to take billions in
write-downs on their balance sheets, as housing prices fell and mortgage- backed securities
crashed. These reduced valuations caused financial institutions to look less solid to bank
regulators. It was argued, by some, that if banks did not have to follow fair-value accounting
(and thus avoid those write-downs), then this crisis would have been averted.

However, this is simply a case of blaming the messenger. Fair-value accounting is not the
cause of the current crisis. Rather, it communicated the effects of such bad decisions as
granting subprime loans and writing credit default swaps. Even with the difficult issues
surrounding measuring the fair value of loans and investments in an illiquid market, as we
have seen recently, fair-value accounting only brings transparency to the market. The
alternative, keeping those loans on the books at their original amounts, is akin to ignoring
reality.

Use this as explanation in the seminar


This to be included in later part

To fully understand the role of fair value in the financial crisis, it is necessary to first know
what constitutes the global financial crisis. The subprime mortgage crisis triggered by a
dramatic rise in mortgage delinquencies and foreclosures in the US had major adverse
consequences for banks and financial markets around the globe. The crisis, which has its
roots in the closing years of the 20th century, became apparent in 2007 and has exposed
pervasive weaknesses in financial industry regulation and the global financial system. The
subprime mortgage crisis is an ongoing economic problem manifesting itself through
liquidity issues, which accelerated in the United States in late 2006 and triggered a global
financial crisis during 2007 and 2008. (Masood, 2010, Pg 52)

According to Wikipedia, the immediate cause or trigger of the crisis was the bursting of the
United States housing bubble which peaked in approximately 2005–2006. Housing bubbles,
in their late stages, are typically characterized by rapid increases in the valuations of real
property until unsustainable levels are reached relative to incomes, price-to-rent ratios, and
other economic indicators of affordability. This may be followed by decreases in home prices
that result in many owners finding themselves in a position of negative equity—a mortgage
debt higher than the value of the property. When this is the case, subprime mortgagor would
favor the notion of defaulting on the mortgage rather than paying it; hence the financial crisis
develops.

The reason lies in the description of a subprime mortgagor. A subprime mortgagor will
usually have a poorer credit history, a lower and less stable income, and be able to offer little
or no deposit on house loan. So, they are at a much higher risk of default. If this was the case,
then, why was subprime mortgage offered in the first place? There are two simple reasons –
firstly, offering subprime mortgages increase a bank’s number of potential customers.
Secondly, a bank can charge a higher interest rate to make up for the greater risk involved at
the individual customer level. (Forster, 2010, Pg 39)

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