Fair Value Accounting during the Financial Crisis - Research Paper Example

There were a couple of factors that backed up the crisis including the low credit history of borrowers who applied for subprime loans etc (Broadley). The impact of the overall situation of the financial crisis had a severe reaction on the social institutions as well, leading the unemployment rate to increase since a large number of financial institutions had to face failures and ultimately, bankruptcy. As a result, several debates have been observed among investigators that the credit crunch was due to the misinterpretation of assets and hedging strategies in the shape of subprime loans and mortgage-backed securities (Deff and Phelps). The major concern of the debaters was the implication of fair value accounting systems which led to the situation where it has been blamed for facilitating the sustainment of the financial crisis which has led to massive government bailouts of financial institutions.

As a result, it was marked that the Bush administration, FASB, and SEC responded to the financial crisis with Acts and amendments to take a grasp of the situation (Twaronite and Levine). This paper aims to critically evaluate the role of fair value accounting in the financial crisis. This will be done by carefully taking an in-depth analysis of the accounting systems and alternatives. Also, different factors such as subprime loans, mortgage-backed securities, etc, have led the fair accounting system to affect the financial turmoil.

Furthermore, the theoretical background of different cases of failure and bankruptcy will be created to prove the role of fair value accounting in magnifying and prolonging the financial crisis of 2007. Part 2: Background to Accounting Systems: 2.1 Historical Cost Accounting: It is imperative to understand historical cost accounting to assess the role that fair value and other relevant factors have played in the recent financial crisis. As evident from the term, historical cost accounting is an accounting system that records the assets at the point of their historical cost (Casabona and Shoaf).

It should be noted that the recording of assets with a historical cost (the value at which it is purchased in the first place; this equates the fair value accounting and historical accounting) is merely done to provide impairments. The market value of the assets is never recorded when balance sheets are prepared by using historical cost accounting. This means that in case there are fluctuations in the market regarding the market value of the asset then under the historical cost accounting, it will not be presented in the balance sheet (Guni and Negrita).

In simpler words, it can be said that the historical accounting records assets on the historical cost because it will not increase the asset value for amortization. The reason behind the observation of impairment is that the assets at their fair value would decrease to the point of amortization (Fitzsimons, Satenstein, and Silliman). There is a point where both fair value accounting and historical cost accounting becomes equal. That point is when the asset reduces its values to a high extent allowing impairment to become evident (Christian and Christian).

The comparison between fair value accounting and historical cost accounting has been made based on manipulation. Both the systems have been applied to record the assets purchase’s loss and gain.