The Move to Fair Value Accounting, Case Study Example

Owing to the recent decisions for the company to move to the fair value accounting method, I write this letter to address concerns that I believe are pertinent to this decision making. It is important that management realizes that fair value accounting in its own way has numerous disadvantages associated with it. As a result, this document will seek to highlight the advantages and disadvantages of fair value accounting to help management make an informed decision,

Fair value accountinginvolves the use of available market information so as to come up with estimates of the most likely cost to settle a given liability or the sale price of a given asset (Nayak). This accounting technique is founded on the premise that by applying the current market information in the valuation of liabilities and assets is the best technique to give investors the latest information on the company’s economic status.

Advantages

The most significant advantage associate with this accounting technique is the fact that in spite its use of estimates and judgements, the accounting method always delivers timely and pertinent information to both the company’s management and to the investors (Venezia and Wiener).

Disadvantages

It is however important to consider the fact that this information is almost always irrelevant. This is because the information tends to give investors jitters about a given liability of the asset while this is not the real picture (Venezia and Wiener).

The Financial Crisis

In the most recent financial crisis, there have been claims that thefair-value accounting technique contributed to and exacerbated the crisis. I believe this to be partially true. This is because, in the boom markets, the fair-value accounting technique leads to excessive leverage (Nayak). Furthermore, during the bust, fair-value accounting leads to overstated write-downs of assets.

This claim is only partially true because, I do not believe that the fair-value accounting technique caused the recent financial crisis. However, it sped up the effects and impacts of the crisis. The fair value accounting method is associated with high volatility in the valuing of assets and liabilities. This volatility in the event of slightly harsh economic conditions can lead to a faster dip into a financial crisis as the risks associated with volatile valuation of assets increases exponentially.

During the financial crisis, banks treated CDOs on the fair-value basis. This led to the banks giving high-risk loans to individuals whose credit rating history was poor (Davies). This fall in values in the manner in which the banks applied credit rules at a very fast rate. This led to the quick liquidation of assetswhich only served to push the prices further down.

Risky Business

The main problem with fair value accounting leads to companies taking on excessive risks (Nayak). This means that when the market wakes up to this underlying fact, the company would face a potential crisis. This is usually fuelled by a poor risk management and liquidity policies.

Recommendation

I would highly recommend that the company’s management reconsiders switching to the fair value accounting method. This is because this technique is associated with high risks that may lead to the fast liquidation of assets. However, if the management does choose to retain this accounting technique, it is paramount that effective and efficient risk management and liquidation policies. Without a firm risk management policy, the risks would outweigh the actual value and gain realizable from the assets leading to fast liquidation of these assets.

Works Cited

Davies, Howard. The financial crisis : who is to blame? Cambridge: Polity Press, 2010. Print.

Nayak, Satyendra. The Global Financial Crisis : Genesis, Policy Response and Road Ahead. Dordecht: Springer, 2013. Print.

Ojo, Marianne. Recovering from the global financial crisis : achieving financial stability in times of uncertainty. New York: Business Expert Express, 2013. Print.

Venezia, Itzhak and Zvi Wiener. Bridging the Gaap : Recent Advances in Finance and Accounting. Singapore: World Scientific, 2012. Print.