Jul. 2009, Vol.5, No.7 (Serial No.50)
Journal of Modern Accounting and Auditing, ISSN 1548-6583, USA
The defects of fair value under global financial crisis
ZHOU Yuan-yuan, DING Jun
(School of Accounting, Zhongnan University of Economics and Law, Wuhan 430073, China)
Abstract: With the advent of the economic crisis, fair value once again becomes a hot topic. This paper
discusses the issues of fair value from three aspects including the meaning of fair value, its serious impacts and its
inapplicability in China. As for this point, this paper stress that the rub of the fair value is its inaccurate
recognition elements which will inevitably lead to the inaccurate measurement. Finally, the paper puts forward the
viewpoint that China should be careful enough to apply the fair value accounting.
Key words: international accounting standards; fair value; financial crisis; financial institution
1. Introduction
As a coin has two sides, IAS (International Accounting Standards) has been being a “double-blade sword”.
Though our standards of accounting is more and more international and fair value has been promoted widely, we
should consider the advantages and disadvantages of fair value and the difference between international market
and our state’s.
One of the advantages of accounting is providing the document file of the past things to people. Some
scholars ascribed current international financial crisis to financial derivatives and the world’s financial regulatory
environment. However, from the perspective of the international accounting and auditing, fair value accounting
has the unshirkable responsibility to the subprime mortgage crisis. With the tone of financial panic and market
depression, many problems of IAS which once were been covered are emerging quickly. Actually, FASB
(Financial Accounting Standard Board of America) has amended accounting standards on fair value when China is
busy discussing the problem of fair value. Apparently China should grasp this opportunity to analyze the defects
of IAS and work out scientific accounting policy to deal with the impact of subprime mortgage. We will analyze
and discuss the problem of fair value from the following aspects.
2. Fair value measurement attributes and measurement standards: From the aspect of
global financial crisis
The promotion of fair value accounting is much more reflected in the financial business, so that the outcome
of financial crisis spread to these financial businesses more widely. Now we analyze this problem based on the
point of financial business.
Fair value is the price at which the asset could be bought or sold in a current transaction between two willing
parties, or transferred to an equivalent party (2006). If there is an active market, fair value actually is the current
market price, but it must reflect the real wishes of the parties. Actually fair value is not an accounting
ZHOU Yuan-yuan, graduate student of School of Accounting, Zhongnan University of Economics and Law; research field: CPA
audit
DING Jun, graduate student of School of Accounting, Zhongnan University of Economics and Law; research field: CPA audit.
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The defects of fair value under global financial crisis
measurement attributes, just a kind of measurement standard.
Strictly speaking, there are at least three criteria to judge whether the fair value is appropriate.
2.1 The correlation between fair value and future cash flow
We will discuss whether the fair value is highly correlated with the expected future cash flow. From an
accounting point of view, the original intention of historical cost accounting is not to record the changes in the
economic value of enterprises. Historical cost accounting emphasizes the accuracy and verifiability of accounting
data. To the banks in the early, historical cost accounting is enough to record the data exactly. However in the age
which financial derivatives are abused widely, the transactions out of the financial statement are increasing
quickly, a large number of the accounting data of banks reflected in the profit that can not be achieved. So the
historical cost accounting is gradually replaced by fair value accounting. Most cautious investors will doubt:
whether all of the changes of fair value are the profit and loss of the current year? Whether they could make the
important decisions according to the future profit on the income statement? There is no doubt that the profit of
banks is beyond the net value of future cash flows seriously.
2.2 The reliability of fair value
Though the means of impairment is used, historical cost accounting lack of forward-looking on estimating of
the financial risks. Take the impairment for an example, usually impairment is expected on subjective experience
and historical information. It does not take bank credit risk and interest rate risk. However, fair value goes into the
other extremity. It does not only consider the extreme risk of financial derivatives, but also does not strictly
control the confirmation of the financial derivatives. Facing to the financial crisis, fair value has become far from
the initial wishes of people.
2.3 The operability of fair value
Without the advent of the financial crisis, there may be very little opportunity for everyone to reflect on the
shortcomings and issues of IAS. Take the recognition and measurement of the financial assets for an example, the
old IAS allow to determine the lower of cost or market for securities investment, while the new IAS formulate to
recognize and measure according to fair value for financial assets and financial liabilities. In some ways, fair
value indeed not only increased the transparency and fairness of the investment, but also defended the accounting
fraud risk which the financial institutions and traders cover up the decline in market prices with cost price. But the
key question is how we obtain information of fair value. The new standards rule three ways to determine the fair
value. At present, the main obstacles are in the following areas: (1) It will cost a lot to estimate and validate the
fair value strictly; (2) Interest rate, exchange rate, internal rate of return and inflation rate will produce the
difference among the valuation models; (3) Objective data can not be represented by subjective judgment (Sylvie
Matherat, 2008).
Besides, fair value has the double property of market objectivity and subjective judgment. Actually this
character just coincides with the boosting effect of financial instruments. The value of securities and the assets is
easy to overestimate when the market boom and easy to underestimated when the market decline.
3. The promotion of the fair value accounting can not be too ideal
In the current economic environment, the use of fair value has been no longer suitable as people expected.
The adoption of fair value measurement by IAS results in the following types of defects:
3.1 The inaccuracy of the fair value in the market
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The defects of fair value under global financial crisis
As the international financial turmoil, the value of assets and liabilities of financial institution deviate the
consistency in accounting seriously. Any capital market (include America) will exist two cases as “efficiency
market” and “market failure”. When the market is active, because of high prices, it is prone to overestimate the
value of related products. In contrast, when the market decline, it will lead to underestimate the value of the
products. In addition, when the market is not active, the value of securities or assets is evaluated with valuation
model. Under these circumstances, the reasonable value is not easy to be found.
3.2 The negative effects during economic turmoil
The use of fair value seriously reduced the ability of the financial institutions to resist risk. When the market
is active, financial products which are measured by the so-called fair value are always lucrative and managers
usually tend to be unrealistically optimistic. Once the market shows a weaker tendency, the value of financial
assets will be undervalued. According to IAS, financial institutions have to accrue to impairment according to the
measurement attributes of the assets or reduce the owner's equity, which will affect the profitability of the
corporate and the level of capital adequacy ratio. At this time, in order to evade the adverse effect, a large number
of financial institutions will sell assets, causing a further decline in the value of the assets. So the vicious circle
won’t stop until the bank is bankrupt.
3.3 Unreasonable guide to people's economical behavior
The abuse of fair-value induced the public "irrational investment behavior". In financial turmoil, some
financial analysts and rating agencies, which played a central role in some enterprises, often change the credit
rating of the same enterprise or the same bond in a very short time in order to evade their responsibilities. This
behavior will not only exacerbate the market panic, but also enlarge the negative effect.
Actually, fair value should be used in a totally healthy market environment, which must have effective
market regulation and control mechanisms and sound policy system (of course including accounting policies). It is
necessary to prevent the economy from overheating, but also prevent the economy from too cold. We can not add
fuel to the flames in the market when it is booming, and can not blindly sell short when the market is gloomy.
4. Fair value does not fit China’s market entirely
The issues refer to fair value are complicated. So, before we bring fair value into the accounting calculation,
it is necessary to judge whether fair value is feasible to be applied in information disclosure. The activities of fair
value (bank transactions) occur before the accounting recognition and accounting measurement. The tremendous
time lag of information can not meet the need of investors about the usefulness and relativity of the
decision-making information from the fundamental. Relatively static information of the fair value accounting can
not catch up with the rapid changes in financial market activities. Fair value accounting must focus on both return
and risk of the investment market. Only in this way it can realize the true transparency and justice of accounting
information.
What effect it will bring to the global capital market if the current fair value is not fully reasonable? This
issue will be analyzed from two aspects below, one is the accounting environment, and the other one is the degree
of globalization of capital.
4.1 Accounting environment
The fair value accounting standards are completely affected by the local accounting environment and the
environmental of capital. It’s relatively easier to obtain fair value from an active market, thus the result always is
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The defects of fair value under global financial crisis
more representative. But it does not mean that the American accounting environment must be suitable for the fair
value, and Chinese accounting environment must be suitable for the lower of cost or market method. In fact, no
matter we measure in the fair value or the valuation model or even in lower of cost or market method, the first
consideration should be given to the basic accounting or business environment of their own country. For example,
the degree of openness of domestic market and effective market regulation mechanisms are the basic element of
accounting environment and capital market environment. If we ignore these environmental factors and blindly
regard IAS as positive, no doubt we will learn a serious lesson.
4.2 The degree of globalization of capital
The impact to the world caused by the irrationality of the fair value also is bounded by the degree of
capitalization of country. The higher the degree of capitalization and internationalization of accounting standards
is, the greater the loss caused by global financial turmoil is. Of course we can not treat the impact caused by the
IAS to the world too pessimistic during the time of financial crisis. The probability of market failure, after all is
small and the duration may very short.
5. Conclusion
Since it can not resolve the negative impacts of financial crisis even if the overall application of the fair value
accounting, china should be carefully enough to apply the fair value accounting. The flexible use of accounting
standards to prevent the global financial risks need us put the financial regulatory first. Accounting standards has a
closely relationship with financial regulation. The feature of the banking industry decides itself should be the core
area of supervision in each country. The application of fair value requires us to take a cautious attitude. We need to
consider Chinese financial regulatory environment and market characteristics before using the fair value. In order
to avoid the negative effects of fair value, a certain degree of restriction should be adopted once we apply the fair
value.
References:
International Accounting Standards Board. (2006). International Accounting Standards.
Sylvie Matherat. (2008). Fair value accounting and financial stability: Challenges and dynamics. Banque de France • Financial
Stability Review, 53-63.
(Edited by Susan and Betty)
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