Fair Value Accounting

CONTENTS 1. INTRODUCTION..............................................................................................................................52. BACKGROUND................................................................................................................................53. THE FAIR VALUE MODEL...............................................................................................................83.1 DEFINITION ...............................................................................................................................83.2 ARGUMENTS IN FAVOUR OF FULL FAIR VALUE ...................................................................93.3 CRITICISMS OF THE FAIR VALUE MODEL............................................................................103.3.1 Relevance of fair value for banks' accounting practices ..............................................113.3.2 Reliability of fair value .....................................................................................................113.3.3 Comparability of financial information ...........................................................................123.3.4 Impact on the stability of the system..............................................................................134. APPLICATION OF THE FAIR VALUE MODEL .............................................................................134.1 GENERAL POINTS ..................................................................................................................134.2 APPLICATION OF FAIR VALUE TO FINANCIAL INSTRUMENTS ..........................................144.2.1 Instruments with an active market..........................................................................................154.2.2 Financial instruments without a market or with a somewhat inactive market..........................164.2.2 a) Valuation techniques and models: .............................................................................164.2.2.b) Characteristics of valuation techniques: ...................................................................174.2.3 Information disclosure requirements ......................................................................................205. CONCLUSIONS.............................................................................................................................21

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5 1. INTRODUCTION Among the traditional models for valuing financial instruments, the most widely used has been the so-called mixed model, in which instruments held for trading purposes are marked to market (i.e. valuedat market price) while the rest are registered at their historic cost. Against this is the so-called fairvalue method, in which the majority of financial instruments are recorded at their market value. In thecase of credit institutions the application of one method or the other is of fundamental importance asthe lion's share of their balance sheet consists of financial instruments.In the last few years legislators at national and international level have taken steps to extend theapplication of the fair value principle to an ever greater range of assets and liabilities.This paper aims to review the debate that has arisen as a result of the widespread application of fairvalue in accounting and its application to financial instruments in particular. It also looks at thepractical aspects established by the regulations relating to it. It is subdivided as follows: first of all it presents the background to the debate on the application of the principle of fair value; it then goes onto outline the concept and the advantages and drawbacks of its widespread application. Then, the subtleties that need to be taken into account when applying fair value to financial statements arediscussed, focusing on the specific practical criteria laid down by the regulations for the registration,valuation and presentation of financial instruments. Finally, by way of a conclusion, the paper roundsoff with a summary.2. BACKGROUND In the 1980s, financial instruments referred to generically as "derivatives" underwent significantdevelopment as they came to be used to hedge against interest and exchange rate risks. Thisfollowed in the wake of the abandoning of the system of fixed exchange rates and the replacement ofinterest rates by money supply as the instrument of control used by the monetary authorities, with theconsequence that the volatility of exchange and interest rates became much greater. Additionally,derivates started to be used by credit institutions as a source of business with which to supplementtheir traditional activities. The large-scale utilisation of instruments of this kind by large and medium-sized financial and non-financial corporations, together with the ever growing importance of capital markets as a source ofinvestments and finance, has led to major changes in the traditional practices used to prepare financial statements intended for an external audience.Indeed, following the stock market crash of 1929 a year's profits came to be calculated as thedifference between the income accrued and costs incurred. In this context, revaluations, i.e. changes

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6 in value other than those resulting from transactions, were not considered a realised profit and profitsshould only be recognised when the whole production cycle had been completed, which wassomething that only took place when it could be shown that there had been: a) a sale or other form ofdisposal, b) an increase in liquid assets. Nevertheless, in accordance with the prudence principle, unrealised losses were recorded in the year's profit and loss account. This traditional measure of the profits obtained did not prove adequate to the task of registering andvaluing the financial instruments in most widespread use in the second half of the eighties. In somecases this was because there was no cost associated with trading in them1, or more correctly, theywere zero cost (e.g. an interest-rate swap contract) and, therefore, could not be recorded on the basisof their historic cost; and in other cases, because the existence of fairly liquid markets and thedevelopment of valuation methodologies that were accepted and used by participants in financialmarkets to set asset prices had undermined the credibility of the historic-cost based information aboutthese instruments given in the financial statements. In view