Fair Value Accounting and Its Role in Financial Crisis - Coursework Example

Fair Value Accounting and Its Role in Financial Crisis Introduction Fair value accounting is defined as a financial reporting technique where companies are permitted to value and report specific assets and liabilities (mostly financial instruments), as per an ongoing basis where the estimated prices is what the organisations would earn if they choose to sell the specific assets or get relieved of the particular liabilities. Under this kind of accounting method, corporations are liable to report loss in their balance sheets when fair of liabilities increases and that of assets decreases. Inclusion of such losses results in reduction of reported equity of an organisation and also its net income. Fair value accounting has been an important aspect of US GAAP (United States Generally Accepted Accounting Principles) for over five decades yet its implementation increased significantly since issuance of Fair Value Measurement Standard (FAS 157) in 2006 by the Financial Accounting Standards Board (FASB) (Ryan, 2008; Khan, 2010). Fair value accounting, which is also known as mark to market accounting, gained considerable amount of spotlight as a result of its controversial role in the financial crisis of 2007-08. Critics argued that if fair value accounting does not have direct role in the crisis, it at least exacerbated the severity of the crisis. The prominent allegation suggests that fair value accounting results in heightened leverage during the market boom period while market bust resulted in excessive write-downs. The write-downs resulted capital depletion for financial corporations, required them to sell assets, and thereby initiated downward spiral (Ryan, 2008; Laux and Leuz, 2009). The paper scrutinizes the accusation against the accounting approach with respect to various facts. Additionally, the paper assesses benefits and weaknesses of the fair value accounting which has further been compared with traditional accounting for better evaluation. Fair value accounting: advantages and weaknesses The fair value accounting method has been criticised on the notion that in several ways it has potential of hurting investors in contrast to other accounting methods (Ryan, 2008): i. In an illiquid market, fair value accounting can be considered as a weakly defined concept that focuses on hypothetical transaction price which cannot be measured in a reliable manner irrespective of any kind of guideline that is provided by the FASB. ii. Studies suggest that when fair value of an asset or a liability is determined from a source that is different from the liquid markets, the scope of engagement of the corporation in certain accounting behaviour such as discretionary income management increases due to unverifiable nature of the information regarding fair value. iii. One of the major drawbacks of fair value accounting is that it combines permanent income components such as investment interest with temporary unrealised incomes and losses. iv. Under this accounting approach, recognition of unrealised income and losses result in infusion of volatility in shareholder’s capital of a firm and its net income which does not require corresponding to cash flow which is eventually realised. There are certain characteristics of fair value accounting by means of which it benefits various investors (Ryan, 2008): i. The accounting approach requires firm to report values that are timely, comparable and accurate to the values that will be reported under various substituting accounting approaches, even under critical market scenarios. ii. Fair value accounting provides for organisations to report various financial figures at current value that are updated in an ongoing and regular manner. iii. The accounting method restricts organisations from manipulating their net earnings as profit and losses on various assets and liabilities are reported for a specific period instead of when they are realised. iv. Fair value accounting presents true measure of impact of economic events on gain and losses in an organisation due to ongoing incorporation of various changes and often seeks for additional disclosures for better understanding of investors. Possible role of fair value accounting in the crisis The most widespread and commonly discussed mechanism by means of which the fair value accounting technique could make contribution towards the recent financial crisis reflects strong connection between accounting and regulation of bank capital. According to Shleifer and Vishny (1992; 1997), market prices can diverge from their elementary values for several reasons such as liquidity crunch and limits to arbitrage. This suggests that if banks write-down value of its assets with respect to the distorted values then it may witness depletion of regulatory capital. Additionally, the write-down process can force a bank to sell its assets at a comparatively low price resulting to setting off of a downward spiral. It was further suggested by authors that if the low sell price of an asset by a troubled bank becomes pertinent mark for other banks, then the fair value accounting can result in write-downs along with other capital problems financially sound institutions (Cifuentes, Ferrucci and Shin, 2005; Allen and Carletti, 2008; Heaton, Lucas and McDonald, 2010). Contagion issues can also result from situations when management is predominantly focussed on short term accounting objectives such as earnings. The reason being mostly bonuses and similar factors are related to earnings. In such situations, management of an organisation can be forced to sell of its relatively less liquid assets at a price that is moderately less that fundamental value of the same to obstruct anticipated sale by similar market participants. In this process, bank management avoids to have the asset marked to a lower market price. However, in the process of the same it causes contagion effect for others (Plantin, Sapra and Shin, 2008). The aforementioned arguments supports the fact that potential problems lie with the technique of pure mark to market accounting. However, it is noteworthy that when the accounting technique is implemented in practice, its rules do not specify pure mark to market accounting. Therefore, an interesting question can be raised that is to what extent practical implication of fair value accounting contributes towards issues underlying the financial crisis. Practical implication of Fair value accounting FASB issued FAS 157 in 2006. The standard states the accounting definition of the term ‘fair value’. It was gathered that the standard outlined a hierarchy of several inputs for deriving the fair value of an asset or a liability. Level 1 input comprise of quoted prices (from various dealers and transactions) for indistinguishable assets or liabilities in live markets. If similar prices are available from methodical transactions, which need to be used for determination of fair value, it will imply marking of the same to the market. The rule strictly explains that methodical transactions are not distress sale or forced liquidation (Magnan, 2009). Under FAS 157, level 2 inputs are observable in nature, which are quoted prices for comparable assets and various other related market data spread between interest rates. Level 3 inputs are referred as unobservable inputs which are employed as and when observable or level 2 inputs are unavailable. It is noteworthy that the practical implication of fair value accounting predates establishment of FAS 157 and consequently, even suspension of the standard cannot stop the practice of the accounting standard (Magnan, 2009). Comparison of fair value accounting with other accounting approaches Amortized or historical cost accounting Research suggests that a prominent alternative to the fair value accounting approach can be amortized or historical cost accounting. Under the latter approach, assets are documented at their historical cost that is equivalent to its fair value at the time of its purchase. Consequently, historical costs can be adjusted with respect to amortization and other kinds of impairments. However, under historical cost accounting, asset value cannot be raised with respect to the market. Since inception of this accounting approach, impairments have been an important part thereof. Impairment occurs when an asset’s fair value goes below its amortized cost. It was determined that conceptually, fair value accounting and amortized cost accounting are identical when impairment is at liberty and asset value declines. Contrastingly, the test of impairment differs from asset to asset in practice. In addition to that, loss with respect to the subject asset is recognised in the firm’s income statement irrespective of the fact that the book value of the impaired asset may or may not be written down and in some cases impairment is considered different from temporary (Laux and Leuz, 2009). It was further gathered that presence of level 1 inputs, that is quoted price from active markets for same assets, under fair value accounting minimises the scope of information manipulation and delivers reliable data thereof. Fair value accounting offers certain level of managerial discretion to banks when level 2 inputs require to be employed. In this regard, level 3 inputs provide significant level of consideration. It was gathered that historical cost accounting approach offers limited or negligible scope for manipulation provided that original amortized cost or purchase prices are used. However, this information is frequently criticised for not being pertinent or reliable. Significant level of discretion is exercised in case of impairment testing as well. Moreover, historical cost accounting can possibly provide scope of incentives for banks for selling and repurchasing assets that have appreciated in terms of value and are traded in liquid markets; as this approach does not recognise anticipated gain or losses (Laux and Leuz, 2009). Role of fair value accounting in worsening the financial crisis The financial crisis initiated in 2007 with several cases of foreclosure and mortgage fraud, subprime lending defaults, declining housing prices and poor rating of mortgage backed securities which in turn affected various complex products known as derivatives. Continuous decline in housing prices and increase in default cases caused severe drop in trading of various financial instruments including derivatives. The trading declined for reasons that are irrelevant to accounting. Most of the mortgage backed assets were backed by investment funds such as hedge fund and special investment vehicles. The onset of crisis witnessed heavy outflow of fund from various investment portfolio and by end of 2007, a number of financial institutions such as BNP Paribas and Bear Stearns impeded redemptions. The step was justified by presenting arguments that suggests that certain securities in various portfolios had zero worth and as a result, it was impossible to value such assets (Laux and Leuz, 2009; Magnan, 2009; House of Commons, 2009). The investment fund creators responded to the issue of fund shortage as a result of withdrawal by adding that they will gain bailouts by mortgaging secured loans and guarantees. Bailing out investment funds by mortgaging assets made institutions assume their assets and risks. This strategy could have sounded reasonable if the assets were severely underpriced as a result of market overreaction or if the corporations had financial independence to control the assets till the market recovered. Contrastingly, all these organisations were substantially financed by means of short term redeemable capitals that are similar in nature to that of the investment funds. Consequently, a number of organisations such as Bear Stearns were bankrupt even after committing their secured loans (Khan, 2010). In this respect, a large number of individual and institutional investors filed lawsuit against banks and financial institutions for misrepresentation of facts regarding asset valuation. Well-known examples of financial institutions that witnessed direct or indirect exposure to subprime crisis are Merrill Lynch, Lehman Brothers, Bear Stearns and others. Fair value accounting cannot be blamed for downfall of these three banks as they faced issues related to increased collateral requirement and fund withdrawal by large scale institutional investors which led to their bankruptcy. It can be easily argued from the scenario that it was impossible for the investment banks to save themselves from bankruptcy by adopting a different accounting approach. The investment funds were heavily dependent on short term debt and redeemable capital and needed regular determination of fair value of the assets and it is clear from the above discussion that the crisis did not commence because of accounting issues. Even if the assets of the investment banks were recorded in historical cost, even then the investors would have remained concern about value of their investment. Therefore, it is unlikely to suggest that fair value accounting rules and write-downs played a strong role in dismissing the investment portfolios and the banks as well (Laux and Leuz, 2009; Magnan, 2009; House of Commons, 2009). Losses at financial institutions are evitable and this forms no supportive allegation against the accounting approach that has been implemented. On the other hand, the allegation against fair value accounting could have been related to the fact that it forced the banks to exhibit losses in their balance sheets that were unrealistically high and was result of illiquid market and short term uncertainty. Ironically, it was observed that the asset values that have been reported by these banks in their respective balance sheets were unacceptably high compared to what actually was available for resale. It was determined that fair value accounting approach was not exactly pushing the values low. Instead, the investment banks were indulged in overstating their assets for achieving maximum confidence of investors (Laux and Leuz, 2009; House of Commons, 2009). From the aforementioned discussion, it can be suggested that the fair value accounting approach played a significant role in the process of decision making regarding bailing investment funds by financial institutions. It is possible that management of these corporations were reasonably worried that selling off the assets related to investment fund in an illiquid market would depress the value thereof and will involve forced write-down. The fear of contagion effect can be induced by the accounting approach; however, it is difficult to accept that this was the only reason for bailout. Contrastingly, there are possibilities where institutions got involved in bailout activities only for saving market reputation of the organisation. More specifically, it can be argued that financial issues at the investment banks was result of short term debt financing, poor quality of investment, increasing level of leverage and investors’ concern regarding true value of assets, underlying various instruments rather than insistent write-down process that has been initiated by fair value accounting (Laux and Leuz, 2009; Magnan, 2009). Conclusion The concept of fair value accounting has been in existence for more than few decades, yet it gained significant spotlight only when it was held as a contributor in the recent financial crisis. The allegations resulted in call for suspension and changes in the standards of fair value accounting. However, the current assessment revealed that one has only few reasons to question the accounting approach regarding its contribution in the crisis. It was determined that the accounting standard played a very nominal role in income statements and capital ratios of banks with respect to their assets. Contrastingly, most banks were heavily burdened with subprime mortgages and collateral securities which lead to bankruptcy. The accounting standard is not devoid of flaws as it tends to lose its prominent characteristics under situations when quoted prices for assets are no longer available from active markets. The paper specifically highlights various advantages and disadvantages of the accounting standard. Alongside, during assessment it was determined that the fair value accounting is not responsible for fuelling financial crisis and the crisis was inevitable considering the given situation while adopting any other accounting approach. Reference list Allen, F. and Carletti, E., 2008. Mark-to-market accounting and liquidity pricing.Journal of accounting and economics, 45(2), pp. 358-378. Cifuentes, R., Ferrucci, G., and Shin, H. S., 2005. Liquidity risk and contagion.Journal of the European Economic Association, 3(2‐3), pp. 556-566. Heaton, J. C., Lucas, D., and McDonald, R. L., 2010. Is mark-to-market accounting destabilizing? Analysis and implications for policy. Journal of Monetary Economics, 57(1), 64-75. House of Commons, 2009. Banking crisis: Written evidence. Treasury committee, 2, pp. 1-596. Khan, U., 2010. Does fair value accounting contribute to systemic risk in the banking industry? Columbia Business School Research Paper, pp. 1-56. Laux, C., and Leuz, C., 2009. Did fair-value accounting contribute to the financial crisis?  National Bureau of Economic Research. Magnan, M. L., 2009. Fair Value Accounting and the Financial Crisis: Messenger or Contributor?. Accounting Perspectives, 8(3), pp. 189-213. Plantin, G., Sapra, H., and Shin, H. S., 2008. Marking‐to‐Market: Panacea or Pandoras Box? Journal of accounting research, 46(2), pp. 435-460. Ryan, S. G., 2008. Fair value accounting: Understanding the issues raised by the credit crunch. Livre blanc à destination du Council of Institutional Investors, pp. 1-18. Shleifer, A. and Vishny, R. W., 1992. Liquidation values and debt capacity: A market equilibrium approach. The Journal of Finance, 47(4), pp. 1343-1366. Shleifer, A. and Vishny, R. W., 1997. The limits of arbitrage. The Journal of Finance, 52(1), pp. 35-55. Bibliography Badertscher, B. A., Burks, J. J., and Easton, P. D., 2011. A convenient scapegoat: Fair value accounting by commercial banks during the financial crisis. The Accounting Review, 87(1), pp. 59-90. Laux, C. and Leuz, C., 2009. The crisis of fair-value accounting: Making sense of the recent debate. Accounting, organizations and society, 34(6), pp. 826-834. Pozen, R. C., 2009. Is it fair to blame fair value accounting for the financial crisis. Harvard Business Review, 87(11), pp. 84-92. Véron, N. 2008. Fair value accounting is the wrong scapegoat for this crisis. Accounting in Europe, 5(2), pp. 63-69. Read More