APPLICATION OF FAIR VALUE ACCOUNTING IN NIGERIA: PROBLEMS AND PROSPECT

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND TO THE STUDY

The determination of the overall growth of most cost depends on how efficient and effective the method of financial reporting is, and in the Nigeria case there are still lots of problems, challenges that have hindered the Nigerian financial reporting standard from attaining international status and these pose a greater challenge to implementation of fair value accounting in Nigerian financial system.

Fair value accounting was a term applied widely in the 1980’s within the context of acquisition as a basis for the allocation of entry values and purchase goodwill, though it encountered difficulties and controversies.

Fair Value Accounting is a financial reporting approach in which companies are required or permitted to measure and report on an ongoing bases, certain assets/liabilities (generally financial instruments) at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities. It primarily applies to financial assets and liabilities but however, three major groups of non-financial assets-property, plant, investment property and intangible assets –also subject to fair value measurement.

Whereas the application of fair values induces favorable higher earnings and a steady increase of carrying values in good times, the situation is completely reversing during bad times when price declines put pressure on company’s earnings situationsDuring the times of the financial crisis, the application of fair value accounting led to a recognition of losses from increased risk of default expectation at an earlier stage compared to historical cost accounting.

Thus, critics often argue that the excessive write-downs due to falling market prices set off a downward spiral when the banks were forced to sell their assets at fire prices, which in turn can lead to contagion as prices from asset fire sales from one financial institution become relevant also for other banks.

Generally Accepted Accounting Principles (GAAP), defined fair value as the amount at which an asset can be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale

Fair Value Accounting also refers to a financial reporting approach which requires or permits companies to measure and report on ongoing bases, certain assets/liabilities (generally financial instruments) at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities. The introduction of the fair value concept to financial reporting has meant a change from the classic principles of the accounting system based on prudence and reliability.

The application of fair values in financial reporting results from the adoption of IFRS, which caused major changes compared to local GAAP requirements in many African countries. Unlike the national accounting systems in Nigeria, which are often perceived to be tax driven, law based, creditor oriented and not in particular concerned with the determination of income as a measure of performance, the IFRS have a strict orientation on the investors’ financial information needs.

The International Financial Reporting standards (IFRS) stated that fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction With some slight venation (IASB, 2006).

Therefore, the required adoption of IFRS did not only represent a major change for the preparers of financial statements, but also implied a radical change for users of financialstatements as well. Whereas for example under many local GAAP regulations, the interests of the firm’s stakeholders have been subject to the prudence principle, which forced the company to report earnings only after they are realized, the IFRS follow a different approach.

It should be noted that the idea that is behind this concept is the assumption that providing useful and timely information by preparing the accounts in accordance with a set of high-quality standards does best serve the needs of investors. This might be an important issue especially in the case of fair value accounting and needs to be considered when the implications of fair value accounting for users of accounting information are investigated.

The concept of FVA emerged to cover gaps existing in the historical cost accounting (Holt, 2008). Historical cost accounting has co-existed with major corporate collapses and tremendous pressure from users of financial reports prompting the Financial Accounting Standards Board (IFRS) and International Accounting Standards Board (IASB) to refocus attention from historical cost accounting towards Fair Value Accounting (Rayman, 2007).

The world at large is affected by this move in one way or another. In the face of Nigeria being such a volatile economy, Fair Value Accounting has found its way there. Therefore, it is essential to consider ‘Fair Value Accounting’ in Nigeria context.

It is against this backdrop, that this research study tends to examine the problems and prospect of application of Fair Value Accounting in Nigeria by users of accounting information, accounting procedures, financial statement and foreign investors at large.

1.2 STATEMENT OF PROBLEM

The main problem to be investigated in this study is the identification of challenges of fair value reporting by investors, management of companies, auditors and other users of financial statements, professional bodies, regulators and policy makers who are involved in regulating the practice of accounting and auditing, and mostly auditors.

Thus investigation and earlier research work carried out by authors shows that business owners, investors and other users of financial statements has been in recent time deviate from the use of fair value accounting of asset and liability valuation to historical cost asset valuation as a result of its (FVA) complexity, thus creating a greater challenges to the economic development of an economy.

There is lot of controversies surrounding the use of fair value accounting but we shall limit ourselves to four basic issues:

 (i)The usefulness of Fair Value Accounting

(ii)Awareness of Fair Value Accounting issues

(iii)Audit Challenges associated with Fair Value Accounting, and

 (iv) Appropriateness of Fair Value Accounting.

Many are of the opinion that the contractual and transaction cost incentives existed to identify any fair value components of goodwill such as brands and intangibles.

Yet despite those complications, this earlier period was marked by more or less tolerance of mixed measurement bases for financial accounting. Notwithstanding the widely acknowledge intellectual defects of historical cost measurement and sometimes large gap between accounting net book value and market capitalization, pressures for a single measurement acquired both on expanded significance and controversial position within the financial accounting policy process thus the status changed completely.

Many also blamed fair value accounting for being responsible for one of the financial and economic crises in Nigeria Financial System. The drop in price of many financial assets measured at fair value led banks to write down the carrying values reported in their balance sheets, thus negatively affecting their capitalization ratios. To consequently improve their capitalization ratios and to comply with regulatory requirements, these banks started to sell securities which even magnified the downdraft in quoted prices and additional devaluations of financial assets became necessary.

The audit of fair values of assets and liabilities subject to inactive markets constitute special challenges to auditors. According to Humphrey et al(2009), prices are obtained by making forecasts of variables such as interest rates, credit spread, default rate and so on, but such forecast are subjective in nature, and hence difficult to audit.

Benston (2008) also notes that in some cases it will be impossible for external auditors to validate the numbers or even challenge management estimates the issue then is the extent to which auditors are technically prepared for the challenges presented by Fair Value Accounting. There is widespread concern about auditor preparedness to audit FVA financial statements he issue then is the extent to which auditors are technically prepared for the challenges presented by Fair Value Accounting.

According to Kumarasin (2011), the concern over the implementation of Fair Value Accounting in developing countries is evident from the need for the Accounting Standard Board to make request for impute on the application of FVA in emerging and transition economies.

Finally, Pacter (2007) outlined some of the major concerns associated with the application of Fair Value Accounting in developing countries such as Nigeria:

(i)Inactive market,             (ii) Cost

(iv)Government controlled markets       (v) Weak regulatory environment and

(vii) Lack of valuation standard and guidance.

1.3 OBJECTIVE OF STUDY

The purpose of this study was to explore the definition and understanding of Fair value accounting (problem and prospect) in Nigeria, identify how fair value is measured in this inflationary economy with a very sizeable market (for shares and property investments).

Other Specific Objectives of this study are:

1. Ascertain the level and contribution of fair value accountings on providing useful information for investor’s in Nigeria.
2.  Determine if Nigeria capital market structure pose a challenge to implementation of fair value accounting.
3. Examine if full fair value of financial instruments fulfills the aim of financial reporting.
4. Eliminate the problem posed in the application of fair value accounting.
5. Determine the extent to which fair value measurement can be applied with precision in the assessment of a firm’s financial position.
6. Identify how fair value is measured in this inflationary economy with a very sizeable market (for shares and property investments).

1.4 RESEARCH QUESTION:

The following research questions were asked in the project study:

1. What are the levels and contribution of fair value accountings on providing useful information for investor’s in Nigeria?
2.  Does Nigeria capital market structure pose a challenge to implementation of fair value accounting?
3. Full fair value of financial instruments fulfills the aim of performance reporting?
4. Are there any constraints in the implementation of fair value accounting?
5. What are the extents to which fair value measurement can be applied with precision in the assessment of a firm’s financial position?
6. What is the effect the application of fair value accounting on the appropriateness of accounting information in the financial statements of the decision-making process?

1.5 STATEMENT OF HYPOTHESIS

FIRST HYPOTHESIS

H1: Implementation of Fair Value Accounting does not give sufficient precision in assessing firm’s financial position and earning potential

H0: Implementation of Fair Value Accounting gives sufficient precision in assessing firm’s financial position and earning potential.

2nd hypothesis

H1: Nigeria capital market structure poses a dangerous challenge to implementation of fair value accounting.

H0: Nigeria capital market structures do not pose a dangerous challenge to implementation of fair value accounting.

1.6 SIGNIFICANCE OF STUDY

In consideration of reliability and relevance of fair value accounting explanation to share prices. They gave substantial evidence that recognized and disclosed fair value measures to be relevant to investors and reliable enough to be reflected in share prices.

Fair value accounting which have consistency in definition, incorporate all elements of financial instrument measurement, invoke some degree of market discipline and which are more relevant to investment decision-making are better measurements for recognition of financial instruments within the basic financial statements the general tenor of the fair value criticisms is that fair value information, particularly in the context of the Financial Crisis, lacks sufficient quality to be informative to investors and other financial statement users.

This study is motivated by an absence of empirical studies on the relationship between the fair value accounting and financial reporting in Nigeria or even in other countries.

This project study, will also also presents a framework that can be used as a practical tool for teaching and learning existing and emerging standards on fair value accounting. It will also identifies financial instruments, including the basic ones which can be defined in terms of assets, liabilities, and owners’ equity, and the derivative instruments which may be based on contingent events and may require special treatment.

The study contributes to the existing literature addressing Fair Value Accounting issues particularly in a developing country like Nigeria. The study is considered unique at least in Nigeria because it also considers FVA auditing issues from the perspective of the auditors themselves. There is no doubt fair value accounting auditing issues will continue to be of interest in Nigeria, just like in other countries of the world.

This study will also provide an additional insight into the accounting literature, and provided useful input to audit profession, research academic, and related governmental departments such as Income Tax and Companies Controlling Department.. It will enable a better understanding of Fair Value Accounting issues and facilitate the process that will improve the preparation and auditing of financial statements under Fair Value Accounting basis.

The study will also be of importance to professional bodies, regulators and policy makers who are involved in regulating the practice of accounting and auditing.

Finally this study will be of great significance to schools and students, it will serve as a reference point for future researchers who will want to research more on the topic.

1.7 RESEARCH METHODOLOGY

Description of the Study Population and Data Collection The method of data collection used in this study was field survey method involving the use of questionnaire. A sample of 80 persons drawn from a population consisting of members of Nigerian Accounting Standard Board, members of Institute of Chartered Accountants of Nigeria/Association of National Accountant of Nigeria, financial institutions, Government agencies and mostly companies listed in Nigeria Capital market.

Also Secondary data was also generated from textbooks, journals and published annual financial statement of certified banks or clean banks (according to the CBN classification) for a period of four years (2011-2014) was employed. Because of homogeneity of already collected data, and owing to the fact that some of the banks considered in this study have gone extinct or have gone into merger data for 2011-2013 was excluded.

1.8 SCOPE AND LIMITATION OF STUDY

This project focused on the problems and prospect in the application and implementation of Fair Value Accounting on financial reporting of various organizations in within the Lagos Metropolis, using selected companies listed on the stock exchange Market and Accounting firms in Lagos metropolis as case study.

The limitation of the study includes:

Financial constraints: Financial was one of the major constraint that limited the study.  This is consequent of the fact that the researcher’s sources of financial support were not able to adequately take care of her academic financial responsibilities and the project work.

Time constraint: Another major constraint that affected this study was time. This was due to the fact that the study was conducted amidst normal academic studies.  To this end therefore, it was difficult for the researcher to meet up some of the appointments with respondents.

Unavailability of materials: Another major constraint to this study was unavailability of materials.

1.9 DEFINITION OF TERMS

1. Fair Value Accounting: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
2. Active market A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis
3. Exit Price: The price that would be received to sell an asset or paid to transfer a liability
4. Historical cost is the original nominal monetary value of an economic item.
5. Book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset.
6. Deprival value is a concept used in accounting theory to determine the appropriate measurement basis for assets. It is an alternative to historical cost and fair value or mark to market accounting
7. Efficient-Market Hypothesis (EMH) states that asset prices fully reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information or changes in discount rates
8. Depreciation:the decrease in value of an asset or the allocation of the cost of assets to periods in which the assets are used.
9. Balance sheet or statement of financial position: is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation or other business organization, such as an LLC or an LLP. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year.

10. Equity: this is the difference between the value of the assets/interest and the cost of the liabilities of something owned.

11. Asset:A resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit.