Financial Crises and Fair Value Accounting - Essay Example

Financial crises and Fair Value Accounting (Historical cost, deprival value and replacement cost) Contents Contents 2 Introduction 3 Critically appraise the above statement 3 Benefits and drawback of fair value accounting method 7 Conclusion 9 References 11 Introduction Prior to the financial crisis, the Fair Value Accounting method was adopted as a main part of the financial accounting reform process by the FASB and the IASB due to the evaluated benefits of the fair value accounting methods over other accounting methods like historical cost, deprival value costs and replacement cost accounting methods. But after the financial crisis, the opponents of the Fair Value Accounting method pointed out that the fair value accounting method was one of the main factors which intensely fuelled the financial crisis. On the other hand, the supporters of fair value accounting method argued that the role of this method of valuation was minimalistic in the financial crisis and that the use of other methods of accounting could not have prevented the crisis. They identified that certain macro-economic factors like account surpluses, dispersing of loans without credibility checking, excess level of risk taking by the banks and the sharp fall in the prices of mortgage backed assets to be the main factors driving the financial crisis. The financial crisis of 2008 was a deep recession which impacted almost all the nations of the world. Therefore, the reasons that have caused the crisis have been extensively studied by the economists and scholars. One of the most studied topics in this respect is whether the use of the fair value accounting by the financial institutions has been a driving force for the downturn. Critically appraise the above statement The financial crisis of 2008 led to major debates among the researchers, academicians, banks as well as other participants of the financial markets regarding the role of Fair Value accounting in driving the failure of the financial markets in during the financial crisis. The financial crisis of 2008 was characterized by liquidity and volatility problems in the financial markets and the collapse or quasi breakdown of the major financial institutions of Wall Street like Lehman Brothers, Merry Lynch, Royal Bank of Scotland, Citicorp, AIG, Bear Sterns and Dexia (Ryan, 2008, p.14). The non-supporters of Fair Value Accounting argued that the use of fair value accounting methods in the financial reporting of the major financial institutions was the main accelerator and amplifier of the high intensity of the financial downturn. According to them, many financial institutions marked down the asset values in their financial reports due to the drip in the value of many financial instruments. The marked down representation of the asset values in the balance sheets weakened the capitalization ratios of these institutions. The financial institutions started selling off their securities and closing down their hold on certain financial instruments which were becoming more illiquid in order to remain in the safety zone and to maintain the established financial profiles. The sale of these securities and other financial instruments intensified the downward trend of the quoted prices of the instruments which brought about more devaluation in the pricing of these assets. Many opponents of Fair Value Accounting methods have identified this form of valuation to be destructive of the capital of the major Wall Street banks and have criticized this form of accounting to be one of the major causes of the economic downturn and credit crisis of 2008. The financial markets were disrupted by liquidity problems during the financial downturn. The assets and liabilities of these institutions were highly impacted by the problems of illiquidity and disorder. The decrease in the fair values of different financial instruments traded in the financial markets caused the huge losses and eventual collapse of many major banks. The problems of illiquidity, over valuation and sudden drop in the prices of the financial instruments were accredited to the use of fair value accounting methods in the financial reporting of these banks (Allen and Carletti, 2008, p.144). Many bankers used the fair value accounting method as a way of clearing the unprecedented low prices of the major assets and liabilities that the institutions held in their portfolio. The sudden seizing of the capital markets was identified as the main reasons behind the sharp drop in the prices of the assets and liabilities (Magnan, 2009, p.189-213). Other economists indicated that the fair value accounting policy increased the intensity of the crisis leading to frozen markets in which the prices of the assets fell below their true values. The opponents of Fair Value Accounting method also indicated that this accounting method has pushed the financial institutions towards bankruptcy and has compelled the banks to sale off their assets at fire sale values which have caused more decrease in the values of these assets and financial instruments. After the financial crisis, many policy makers in the United States and United Kingdom have supported the idea of suspending the fair value accounting method and replace it by the historical cost accounting methods so that the values of the assets and financial instruments are calculated at purchase price or their original cost (Andre, Cazavan, Dick, Richard and Walton, 2009, pp.3-24). They identified this as a way to prevent a similar financial crisis in the future. There may be two main reasons why the fair value accounting method can be considered to be an intensifier of the financial crisis. The first reason is that the use of this method for the valuation of the disorderly and illiquid assets and securities is not appropriate. When the financial instruments exist in a market characterized by the problems of illiquidity and disorder, the fair value accounting method becomes inappropriate to calculate the prices of these instruments (Dickinson and Liedtke, 2004, pp.561-567). The second reason was identified as the pro cyclical pattern followed by the mark to market accounting process or fair value accounting method which may transfer the effects of downward fall of the prices of one category of financial instruments to another category of financial instruments thereby spreading the crisis through the financial markets and causing the intensity of the financial downturn to increase. Also, the fair value accounting method promotes certain valuation patterns which are more generalized and can be identified as stimulants in the financial crisis. On the other hand, the supporters of fair value accounting method are of the idea that this accounting method cannot be identified as the direct and main reason for the financial crisis. One of the prime causes of financial crisis is identified as the approach of the Wall Street banks towards the Collateralized Debt Obligations (CDOs). The collateralized debt obligations are financial structures in which bonds, loans and assets are grouped into separate portfolios which can be traded in the financial market. The subprime mortgage problems caused the fall in the value of the major traded CDOs at the time of the financial crisis. Therefore, the banks in the United States giving loan to the general people without checking their ability to repay the loans and their credit histories was one of the main factors which caused the financial markets to plummet in 2008. The banks being more inclined to risk taking and flexibility and less prone to adopting proper mechanisms in their treatment of loan repayments can be identified as another main driver of the financial crisis. The Securities Exchange and commission (SEC) of the United States presented a report commenting that the mark to market or fair value accounting did not appear as the main cause of the failures of the banks and financial institutions in the United States. The report also indicated the crisis was not precipitated by the fair value accounting method and that the crisis was majorly caused by the various risk and credit exposures that the financial institutions undertook. Other economists like Laux and Leuz (2010) also spoke in favour of the fair value accounting method in their work. They suggested that the opinion of fair value accounting method being an amplifier of the credit crisis is a largely unfound opinion (Laux and Leuz, 2010, pp.96-105). According to their analysis, there were almost no reason to identify fair value accounting method to be an elaborator of the credit crunch and that the role of this method is much constrained in the financial reporting of the financial institutions an in the regulatory capital ratios, in exception for a hand counted number of high volume trading banks. But also, in these trading banks, the investors were more worried about the subprime mortgage problems which would have caused them to take their own positions in the financial markets even in the absence of the mark to market or fair value accounting method. The financial institutions have discretionary powers to safeguard themselves against the distortions in the existing valuation systems in the market and that before reforming the accounting policies, more research should be undertaken to understand the effect of fair value accounting in economic booms and troughs and to evaluate the actual role of fair value accounting the financial crisis of 2008. Benefits and drawback of fair value accounting method The fair value accounting method was adopted by the IASB and FASB in 2007 as the main from of accounting to be used by the financial institutions to use in their financial reporting process (Whittington, 2008, pp.139-168). This is because the fair value accounting method is considered to be more appropriate in ensuring the direct relevance with the existing market conditions (Wang, 2010, pp.109-134). In practice, there are many benefits and few drawbacks of the fair value accounting method as compared to other accounting methods like historical cost accounting, replacement cost accounting and deprival value accounting. The fair value accounting is more practical in approach because it mirrors the prevailing conditions of the market in the pricing of the assets and financial instruments whereas the other methods of accounting are based on past prices which do not ensure relevance to the present conditions in the market. But the historical cost accounting methods are still considered to be more reliable for valuation purposes. The fair value accounting is adapted by the international accounting standards because of the extended level of transparency and conciseness displayed by this method. The fair value accounting method is strongly advocated by the International Financial Reporting Standards (IFRS) to be practiced as a main form of accounting on a global basis. The fair value accounting method displays more transparency and clarity that other methods of accounting are more useful for the investors because the investors are majorly concerned with the present values of an asset or security rather than on the historical or replacement costs of these instruments or assets. Most investors and creditors show a preference towards the fair value accounting method because it helps the assets, liabilities and financial instruments to be valued at their present values in the financial market i.e. their tradable values. On the other hand, the information provided by the historical cost accounting and replacement cost accounting processes are considered to be irrelevant for the practical application by the investors and creditors because the valuation done by these accounting methods mirror the past prices of the assets and liabilities which are often nullified for consideration in the current situation. The fair value accounting method needs to adapt more considerations to volatility which would make the valuation approach more consistent (Barth, 2004, p.90). The international accounting policies are often in favour of a combination of the past values being estimated by the historical cost accounting method while the present prices of the assets and liabilities being valued using the mark to market accounting method. Fair value accounting method is limited in its use in respect to the consistency factor which may be improved if a standard approach of pricing is embedded in the accounting process. Also, the fair value accounting method involves the pricing of the assets and liabilities based on an inactive financial market which may often make the values unreliable (Khan, 2010, p.99). This problem is not faced in other forms of accounting, especially in the historical cost accounting method which is acclaimed for the reliability of the information that it provides. If the reliability factor is taken up in the fair value accounting method it would be equipped to act as the most appropriate form of accounting to be used in the financial reporting processes as it will ensure a high quality of financial information to be disclosed in the financial reports (Veron, 2008, pp.1-6). The fair value accounting method is not suitable for estimating the changes in the prices of assets and liabilities that may occur in the coming years with the changing dynamics in the financial markets. But, in contrast to the historical and replacement cost accounting methods, this method is suitable for ensuring comparability of assets and liabilities with respect to valuations. The fair value accounting method is appropriate for comparability because it takes into consideration the differences and similarities among the different instruments used in the financial reporting process (Zijl and Whittington, 2005, pp.1-25). Thus, the fair value accounting method is better in terms of comparability but less useful in terms of predicting future values of assets, liabilities and financial instruments. Conclusion There are diverse opinions of various economists and researchers with respect to the role that the fair value accounting method played in intensifying the credit crisis of 2008. The opponents of this method blame it as being a direct cause for the financial crisis while the supporters argue that other macro environmental factors are the main reasons of the credit crisis. The proper evaluation of the actual contribution of the fair value accounting method is still being done by economists across the globe with an objective of understanding the actual factors that have driving the huge financial crisis. It can be summarized that there are many benefits fair value accounting as compared to other accounting methods combined with few minor drawbacks as well. In the present situation, it can be identified that the fair value accounting is the most appropriate method to be used in financial reporting due to its usefulness of representing the changes in the market conditions and of identifying the risks and benefits for the shareholders which is critical to keep the economy growing. But there are many ways in which the fair value accounting method can be improved upon to make it more useful for financial reporting of major financial institutions. References Allen, F. & Carletti, E. 2008. Mark-to-Market Accounting and Liquidity Pricing. [Pdf]. Available at http://finance.wharton.upenn.edu/~allenf/download/Vita/Allen-Carletti-MMA-200706-final.pdf. [Accessed on 21 April 2014]. Andre, P., Cazavan, J., Dick, W, Richard, C. & Walton, P. 2009. Fair Value Accounting and the Banking Crisis in 2008: Shooting the Messenger. Accounting in Europe. Vol. 6(1), pp. 3-24. Barth, E. M. 2004. Fair Values and Financial Statement Volatility, International Accounting Standards Board. [Pdf]. Available at http://www.iasb.org/NR/rdonlyres/721AD4A0-42BB-4A09-9A91-140D27D65B84/0/FairValuesandFinancialStatementVolatility.pdf. [Accessed on 21 April 2014]. Dickinson, G. & Liedtke, P. M. 2004. Impact of a Fair Value Financial Reporting System. The Geneva Papers on Risk and Insurance. Issues and Practice. Vol. 29(3), pp. 561-569. Khan, U. 2010. Does Fair Value Accounting Contribute to Systemic Risk in the Banking Industry? [Pdf]. Available at http://www.binghamton.edu/som/files/Khan.pdf. [Accessed on 21 April 2014]. Laux, C. & Leuz, C. 2010. Did Fair-Value Accounting Contribute to the Financial Crisis? Journal of Economic Perspectives. Vol. 24(1), pp. 96-105. Magnan, M. L. 2009. Fair Value Accounting and the Financial Crisis: Messenger or Contributor? Accounting perspectives. Vol. 8(3), pp.189-213. Ryan, S. G. 2008. Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch. [Pdf]. Available at http://www.ifrs.org/current-projects/iasb-projects/amendments-to-ifrs-7-financial-instruments-disclosures/exposure-draft-and-comment-letters/comment-letters/documents/cl66.pdf. [Accessed on 21 April 2014]. Veron, N. 2008. Fair Value Accounting Is the Wrong Scapegoat for This Crisis. Revue dEconomie Financière and Risqué. Vol. 4(1), pp. 1-6. Wang, K. J. 2010. Negotiating a Fair Value under Accounting Uncertainty: A Laboratory Experiment. Behavioural Research in Accounting. Vol. 22 (1), pp. 109-134. Whittington, G. 2008. Fair Value and the IASB/FASB Conceptual Framework Project: An Alternative View. ABACUS. Vol. 44(2), pp. 139-168. Zijl, T.V. & Whittington, G. 2005. Deprival Value and Fair Value: A Reinterpretation and Reconciliation. Centre for Accounting, Governance and Taxation Research. Working Paper No. 16(1), pp. 1-25. Read More