Fair Value And Historical Costing Essay

612 words - 2 pages

Laux and Leuz’s view that lack of transparency under Historical Cost Accounting could make matters worse during financial crises, and could be evaluated using accounting theories focusing on the Global Financial Crisis (GFC). The discussion below looks at the measurement issues faced in a crisis and in particular, the Fair Value (FV) and the Historical Costing (HC) while focusing on the 2008 financial crisis. In the discussion, there will be comparison on which of the two makes the crises worse.
Fair value is the price received on sale of an item or transfer of a liability between the two willing parties at the measurement date. The three levels in which FV values its items include; Level 1 ‘mark to market’, level 2 ‘mark to similar and level 3 ‘mark to model’. Level 1 is used when quoted prices in active markets for identical assets or liabilities are available. Level 2 is used to cases for which there are no observable inputs while level 3 inputs are unobservable inputs like in model assumptions. According to Whittington (2010), FV is the single measure basis because of its relevance and reliability in efficient markets but it elicits a problem to FVA since market inefficiency and investor irrationality lead to volatile market conditions.
FV is viewed as an amplifier of GFC. This is because in times of liquidity crisis, prices never indicate the right discounted value of future expected cash flows but are determined by the available cash in the market at the time. In addition, marking assets to market prices in times of crisis is tied to several contracts and regulations making market prices to underestimate the fundamental values and distort portfolio and contract choices. This weakened the capitalization ratios of financial institutions. The financial institutions were forced to sell securities or close down positions on some financial instruments...

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