Financial assets include stocks and bonds. These are fairly simple securities th

Question

Financial assets include stocks and bonds. These are fairly simple securities that can often be valued using quoted market prices. However, there are more complex financial instruments that do not have quoted market prices. These complex securities must still be valued on the balance sheet at fair value. Generally accepted accounting principles require that the reporting entity use assumptions in valuing investments when market prices or critical valuation inputs are unobservable.
What are the ethical considerations in making subjective valuations of these complex financial instruments?

Explanation / Answer

Valuation of these complex financial instruments when there are multiple classes of stock or fixed income securities with embedded derivatives is extremely complicated.

Selecting assumptions that are not congruent with a market participant's perspective or applying an incorrect financial model may result in incorrect valuation conclusions.

Without an actual transaction of that asset or liability , the objective of fair value measurement is to estimate an exchange price for the asses or liability being measured.

This analysis requires significant judgments and creates risks, including :

1.Model Risks [ using an incorrect model or inputs]

2. Liquidity Risk. [ Not considered the impact of liquidity relative to the valuation of financial instruments ]

3. Accounting Risk. [ Not properly applying GAAP]

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