Fair Value Accounting Flashcards
Explain recognition of assets and liabilities
- Recognition of assets and liabilities => refers to the inclusion on the primary financial statement (balance sheet)
Not all items that meet the definition of an asset or a liability => appear on the financial statement.
Explain the recognition tests that items have to pass.
- To be included in the statement of financial position (SOFP or known as the balance sheet).
- Assets and liabilities must pass a recognition test.
# According to IASB => the test has two parts:
# It must be probable that => the items give rise to future economic benefits which flow to the firm (asset) => or future economic costs flow from the firm .
# The value or cost of the items can be measured reliably. - Once organisation decides to recognise assets or liabilities => then they will face the problems of measuring it.
Two methods of measurement:
Historical Cost
Fair Value Accounting (Current Value)
What are the methods of asset and liabilities’ measurements?
- Historical Cost Accounting
- Fair Value Accounting
Explain HCA for both assets and liabilities.
HCA for Assets:
# The amount of cash or cash equivalent paid => or the fair value consideration given to acquire them => at the time of their acquisition.
HCA for Liabilities:
# The amount of proceeds received => in exchange for the obligation => or in some circumstances, the amount of cash and cash equivalent expected to be paid => to satisfy the liability in the normal course of the business.
Define FVA under IFRS 13
- Fair value is the estimated price => at which an asset can be sold or a liability settled => in an orderly transaction => to a third party => under current market conditions.
- FVA uses current market values => as the basis for recognizing certain assets and liabilities => regardless of whether the market is doing good or bad.
- Under US GAAP and IFRS: FVA are often used for financial assets and liabilities - to explain further.
What is the Fair Value Hierarchy?
- IFRS 13 establishes a system called the fair value hierarchy.
# categorises the inputs => to measure fair value into three levels.
# help determine how reliable the information used.
Briefly explain Level 1, Level 2 and Level 3 inputs.
Level 1: Quoted Prices in Active Markets.
Level 2: Observable inputs other than Quoted Prices.
Level 3: Unobservable Inputs.
Explain Level 1 input.
- are simply prices of assets or liabilities => that are easily found in active markets => for the same or similar items => at the time they are being measured.
- Examples:
# Market prices for stocks listed on major exchanges.
# Quoted prices for actively traded bonds or commodities.
Explain level 2 input.
- often involve using market data or observable inputs => that are similar to those for the asset being valued
- Examples:
# Market prices for similar assets or liabilities traded in less active markets.
# Pricing models based on observable market inputs, such as yield curves or benchmark interest rates.
Explain level 3 input.
- Most illiquid and hardest to value financial assets and liabilities.
- no observable inputs in the market.
- Examples:
# Discounted cash flow (DCF) models for valuing private equity investments or illiquid securities.
# Mark-to-model techniques based on management’s assumptions or internal models.
Conclusions from the FVA hierarchy?
- the higher the level, the more reliable the inputs are.
- Level 1 is more reliable as compared to level 3.
- FVA has a more complex valuation technique as compared to HCA.
2 major issues with FVA?
- Procyclicality.
- Problems in the illiquid markets.
Explain FVA Procyclicality?
- Procyclicality means => exacerbating market cycles.
- Good market conditions due to the economic cycle => market prices make firms, especially banks look strong on paper.
- Bad market conditions => the prices reflect bad financial health / performance of organisations => making investors worried.
# Worried investors => affect market sentiment => leads to fire sales of assets => more decreases in asset values => further declines in asset prices. - Conclusion:
# It is argued that relying solely on market prices to determine the value of assets is flawed.
# It is said to have become the reason for market crashes and Financial Crises 2007-2008.
Explain FVA causes major problems in illiquid markets?
- complex financial instruments especially => mismatch in assets available for sale and number of buyers interested in them => causes market prices to become strange => difficult to tell the worth of these assets based on their ability to generate money in the future.
- Gives huge problems to many organisations and institutions especially banks.
- Decrease in the value of the assets => banks to reflect the decreased value of these assets => decrease in the amount of money that belongs to the shareholders of the bank.
- Banks have to comply with the capital regulatory requirements.
# When FVA leads to losses => banks have to attract additional funds from investors at discounted rates (low prices, hurts current shareholders)
# or they might stop lending as much, which could slow down the economy. - Conclusion:
Banks argue to use HCA => as it provides a more stable and reliable method for valuing assets and liabilities => particularly during times of market volatility.
What is Capital Regulatory Requirements?
the amount of capital that institutions such as banks and insurance companies are required to hold by regulatory authorities =>
to ensure their financial stability and ability to absorb losses =>
act as a buffer during financial shocks =>
designed to protect depositors, policyholders and other stakeholders from the risk of insolvency and default.
