Accounting as not a Root Cause of the Financial Crisis - Essay Example

? Accounting is not a root cause of the financial crisis, but it has an important role to play in its resolution Table of content Accounting is not aroot cause of the financial crisis, but it has an important role to play in its resolution 1 Table of content 2 Introduction 3 Conclusion 6 References 6 Introduction Many economists consider the financial crisis also known as the sub-prime crisis that shocked the world in the year 2007-08 to be one of the worst crisis of all times. The United States of America was the epicenter of this crisis. The sub-prime crisis caused many key businesses to close down and equity markets all around the world recorded tremendous decrease of their respective indices. This financial crisis almost created mass scale unemployment around the world. It is very interesting to study the role of financial accounting in this crisis. Many experts have expressed the view that the method of fair value accounting have exacerbated this crisis but did not initiate it. The first part of this essay will aim to analyze the role that fair value accounting played during this crisis and whether it has enhanced the crisis or not. Second part of this essay tries to find out whether accounting can provide remedial solutions to this crisis. Role of accounting in the financial crisis According to Financial Accounting Standards, even in the absence of active market or during unfavorable market conditions the banks are required to calculate the values of its assets which will be different and lower than the true value. The final figures of various financial instruments like the Credit Default Swap are calculated at fair value and as a result create misleading impressions. Due to the fair value accounting the banks will sell the various securities at a relatively cheaper price. This would trigger the panic button in the markets and as a result there would be a global meltdown. Through the fair value method of accounting it is not possible for the banks to measure the financial instruments accurately. As a result the banks are forced to incur losses because it sells its assets at lower prices. These losses affect the entire financial markets. There is also a possibility that the banks spent large amount of money to acquire assets at market value calculated according to the fair value accounting method but these investments eventually becomes a burden and cause huge losses. But a closer examination of the situation will bring out the fact that the role of fair value accounting in this financial crisis is very minimal. The US banks lost most of their fortune on loans that they made to non credible borrowers. Losses due to mark to market were far lower than the losses the bank made from bad loans to non credible borrowers. The banks recorded high losses even when they have not valued the price of their various financial instruments under the method of fair value accounting. The major portion of the losses constitute of defaulting loans that their debtors failed to pay off in time. Economists like Easton, Burks and Badertscher have tried to find whether due to the fair value accounting the banks during the sub-prime crisis had sold their securities at lower prices than the actual but they have not found any evidences which would support this idea. According to another expert Shaffer the impact of loan losses was much greater than the losses suffered by the bank due to fair value accounting. So it is quite clear that fair value accounting method did not play any significant role to create the financial crisis but it only helped to worsen the crisis further1. Role of accounting in the recovery from the crisis Generally, most of the organizations use a method of accounting that combines the methods of historical cost accounting and fair value accounting. This creates confusion in the minds of the investors. Panic among the investors accelerated the crisis as the companies failed to give their investors a clear picture of the net asset values and the total values of its assets. The common investors lost all their trust due to lack of transparency and the fear of losing their investments spread like wildfire throughout the world. So, the foremost priority for the companies and banks are to gain back the confidence of their investors. To achieve this, the method of fair value accounting should be set as a standard method for accounting. A unified rule of accounting will help to improve the trust and the moral of the investors as it will provide better comparability and give the true valuation of the assets. But the main problem that the fair value accounting method faces is that it will not give the true and exact asset values when there is no active markets. In the absence of active markets the companies and banks would again face the same dilemma as it would have to sell is assets at lower prices than the price given by the fair value accounting method. To solve this problem Huian proposed that the accounting method is to be followed by the organizations should be flexible. In absence of active markets the companies should be allowed to use the historic cost accounting method instead of the fair value accounting. Historic cost accounting provides the banks with more flexibility. They can choose the appropriate prices for their assets so that they do not suffer loss at the time of inactive market conditions. But flexibility does not mean relaxation of standards that may provide the companies with scope for manipulation and misleading its investors. The Financial Accounting Standards Board should keep a keen eye on the performance and the accounting procedures of the companies and should not tolerate any indescrepencies. Conclusion Accounting cannot be held responsible for creating the financial crisis because this crisis was not triggered by the reporting of asset values. But fair value accounting does have an impact on it. So it can be said that accounting is not the main cause of subprime crisis but it can help to resolve this crisis. Implementations of standard accounting principles will help to gain back the trust and confidence of the investors and would provide a transparency. Flexible accounting laws would help the bank to reduce their losses. References M.L. Zyla, Fair Value Measurements: Practical Guidance and Implementation, John Wiley & Sons,Inc, New Jersey,2012, p.22. Read More