Advantages and Disadvantages of Fair Value Accounting - Example

Advantages and disadvantages of fair value accounting Table of Contents Introduction 3 2.Fair value accounting 3 3.Contribution of fair value accounting to the global financial crisis 4 4.Evidence suggesting no such impact of fair value accounting on the financial crisis 5 5.Fair value accounting and historical cost accounting 6 6.Advantages of fair value accounting 7 6.1.Precise valuation of assets 7 6.2.Reliable information output 8 7.Disadvantages of fair value accounting 8 7.1.Adverse market effects 8 7.2.Value reversal 8 8.Conclusion 9 Reference List 10 1. Introduction The financial turmoil that began in the US in 2007-08 and thereafter crippled the global economy is believed to have been triggered by a number of factors. The use of fair value accounting methods by companies is regarded as one of the primary reasons behind this economic catastrophe. Nevertheless, empirical studies have also pointed out that fair value accounting should not be blamed for the financial crisis. This method was introduced as a better means to conduct accounting and it was its misuse that contributed to the crisis. Therefore, the fundamental purpose of this study is to evaluate the role of fair value accounting in the financial crisis and conclude whether or not it was a major reason behind the crisis. While evaluating its contribution, the researcher will explain the advantages and disadvantages of fair value accounting as well as comparing its efficacy with the historical cost accounting approach (Lauz & Leuz, 2009). 2. Fair value accounting Fair value accounting involves reporting liabilities and assets at their fair value (estimate of the potential market value of an asset). It recognizes any fluctuations in the fair value as losses and gains within the income statement of a company. When the market price is utilized by analysts to determine the fair value of assets and liabilities, fair value accounting is also referred to as mark-to-market accounting. According to studies into the reasons behind the recent global financial crisis, fair value accounting was largely responsible for exacerbating the crisis that pushed the world economy towards a never-ending turmoil (Gorton & Metrick, 2009). The primary accusation is that fair value accounting leads to unnecessary leverages during boom periods and contributes to excessive write downs during economic downturns. Write downs as a result of decreasing market prices of assets deplete the capital reserves of banks, which in turn triggers a downward spiral (Cifuentes, Ferrucci & Shin, 2005) and banks are forced to sell assets at fire sale prices. Consequently, a contagion is triggered as the price determined by the asset fire sale of one bank becomes significantly evident to other banks (Plantin, Sapra & Shin, 2008). These arguments, although relevant, should be considered at face value and the scholars fail to provide sufficient evidence regarding the negative or positive impacts of fair value accounting. Therefore, the researcher will endeavour to explore descriptive evidence that sheds light on the contribution of fair value accounting to the economic crisis that started in the US. 3. Contribution of fair value accounting to the global financial crisis Some of the prominent examples of organizations that assumed substantial exposure of subprime mortgages either indirectly or directly through investment funds are Lehman Brothers, Merrill Lynch and Bear Stearns. However, whether the use of fair value accounting was the major reason behind the downfall of these large investment banks is a widely unexplored question. According to Morris and Shin (2008), Gorton and Metrick (2009) and Brunnermeier (2009), the aforementioned banks went through a bank run triggered by other sophisticated and large financial institutions and they struggled to compensate for the augmented collateral requirements. These banks made concerted efforts to sell their assets in order to raise capital but it was not enough to prevent them from succumbing to the exposure. Considering the extent to which these banks were exposed to subprime mortgages, it is implausible that a different accounting approach would have helped these banks to recover. For large investment banks like Merrill Lynch and Lehman Brothers, the requirement to determine the fair value of assets on a daily basis is not a major issue associated with accounting (Allen & Carletti, 2008). Therefore the determination of the current market value of these assets is extremely important as it helps managers and stakeholders to determine the current value of the company with respect to all its liability exposures (Heaton, Lucas and McDonald, 2010). The above mentioned fact suggests the importance of reporting the fair value of a company’s assets, thus the major complaint against the use of fair value accounting is that it compelled the managers of investment banks to report the realized losses that were quixotically high and driven by inadequate credit flow and short-term ambiguity in the capital market. In addition, evidence suggesting the major contribution of fair value accounting to the international financial crisis reports that this accounting approach forced large banking and financial organizations to sell investment funds. According to several reviews, certain large financial institutions BNP Paribas, Merrill Lynch and Bear Stearns were afraid of selling their investment funds in a highly illiquid market as it might decrease the price of assets to such an extent that it will force the institution to write down those assets acquired by themselves or other investment funds. Researchers and organizational leaders have suggested that the most plausible way that fair value accounting contributed to the international financial crisis is via the link that exists between bank capital regulations and accounting regulations. It is highly probable that the market prices greatly differ from their fundamental values for a number of reasons such as restrictions to arbitrage and economic crunch (Shleifer & Vishny, 1997). In light of this, it can be said that if the manager of a bank were to write down the assets in accordance with the widely diverging prices, as a consequence of which the regulatory capital of the bank is depleted, the write down of the assets at a distorted market price could compel bank managers to sell their assets at a fire sale price. This in turn may trigger a downward spiral which can be hard to tackle. In addition, if the fire sale price of assets in one bank is perceived as alarming by another bank, then fair value accounting can lead to asset write downs and pose regulatory capital distress for otherwise financially stable banking institutions (Allen & Carletti, 2008; Cifuentes, Ferrucci & Shin, 2005; Heaton, Lucas & McDonald, 2010). This is a major argument cited by researchers and organizational leaders in favour of the opinion that fair value accounting was a major contributor to the financial crisis. Contagion-related issues can also become a grave problem for banks to handle if the management is completely focused on short-term accounting figures such as earnings. One of the major reasons behind this is that the payment of bonuses is largely dependent on earnings. Therefore, in such a problematic scenario, bank managers might be more inclined to sell comparatively illiquid assets at a lower price (below the basic value) with the underlying aim of pre-empting the expected sale of assets by other participants in the market (Plantin, Sapra & Shin, 2008). In that way, managers avoid the need to mark assets at a lower price. However, that creates a contagion effect among other banking institutions in the market. Such events were evident during the international financial crisis. This is perhaps why fair value accounting is regarded as a major contributor to the crisis that happened in 2007-08. 4. Evidence suggesting no such impact of fair value accounting on the financial crisis Laux and Leuz (2009) studied the application of fair value accounting by US-based banks and concluded that there is no strong evidence implicating fair value accounting as the major contributor to the global financial crisis. One of the most noteworthy reasons behind the limited impact of fair value accounting is the fact that the treatment of assets with the help of generally accepted accounting principles is considerably more flexible than the general public perceives it to be. According to Laux and Leuz (2009), fair value accounting offers a number of circuit breakers that enable reported values to diverge from the current price established in the market under certain relevant circumstances. For example, the authors explained that rather than utilizing the fire sale prices, fair value accounting offers bank managers the flexibility to determine the value of their assets through the implementation of unobservable inputs and basic cash flow models in cases when the market becomes relatively illiquid. Therefore, the argument that states that fair value accounting compels bank managers to price their assets through the mark-to-market valuation technique, even in situations when the market price is distorted, is disingenuous. Laux and Leuz (2009) also found very limited or no evidence regarding enormous write downs, which means the fair value of assets reported by banks was considerably low. The authors reviewed a number of academic studies which compared the fair value of assets reported by banks and their corresponding market value. The underlying reason for reviewing these studies was to investigate whether fair value accounting may have actually forced bank managers to report excessively low values. Having conducted such an extensive study, the authors conclude that investors priced a dollar of assets which were valued using existing models considerably lower than the dollar of assets which were valued using the quoted price in an active market. The evidence was consistent and indicated that the implementation of fair value accounting/mark-to-market accounting provided bank managers with the option of reporting their level three assets at a relatively higher value instead of reporting them at a lower value as opposed to the valuations made by the investors (Pozen, 2009). Overall, the evidence set forth by Laux and Leuz (2009) indicated that fair value accounting was far from being a major contributor to the 2008 financial crisis. In fact this accounting approach enabled bank managers to use discretion and report their assets at a higher value. 5. Fair value accounting and historical cost accounting Historical cost accounting is considered a fundamental substitute to the fair value accounting approach available to bank managers and accountants. Under this accounting method, assets are reported at a historical price or cost. This cost is usually equivalent to the value at which the asset was originally acquired or purchased. Thereafter, the historical price or cost of the asset is adjusted for impairments and amortization (Allen & Carletti, 2008). This method restricts any type of accounting manipulation in terms of the value of liabilities and assets. Impairments have been an integral aspect of historical cost accounting for more than a decade, now they are accounted for when an asset’s fair value becomes lower than its amortized price. When the value of an asset decreases and the scope of impairment becomes unobstructed, historical cost accounting and fair value accounting become similar in concept and nature (Plantin, Sapra & Shin, 2008). As long as prices for level one inputs are available from the price quoted in the active market, fair value accounting does not provide any room for accounting manipulation and therefore provides consistent and authentic information. When it comes to level two inputs, the adoption of the fair value accounting approach provides the equivalent level of discretion to bank managers. For level three inputs, managers still enjoy a relative degree of discretion through the implementation of fair value accounting. On the contrary, historical cost accounting provides very limited scope for accounting manipulation, but this condition is only applicable if historical purchase prices or the amortized cost of a particular asset is used. Nonetheless, the information output provided by the historical cost accounting approach is often regarded as unreliable and irrelevant. 6. Advantages of fair value accounting 6.1. Precise valuation of assets One of the major advantages of fair value accounting is that it provides companies with an accurate means of valuing their liabilities and assets when presenting financial results. When the value/price of an asset has augmented or is anticipated to augment in the near future, managers of a particular company decide to mark up the value of the asset or liability by increasing it to its current value in the market (Hitchner, 2011). The underlying rationale behind marking up the asset or liability is to reflect the price at which an asset can be sold currently or the price that needs to be paid to clear financial obligations. In a similar way, the value of an asset or liability is marked down if their market price falls or is expected to fall (Way, 2015). 6.2. Reliable information output The implementation of fair value accounting restricts a company’s scope to manipulate the disclosure of its earnings. This is precisely because managers may often choose to arrange the sale of certain assets purposefully with the underlying aim of using the losses or gains resulting from the sale to decrease or augment its earnings as disclosed at a favourable time (Walton, 2012). Therefore, the implementation of fair value accounting compels managers to report losses or gains due to any price fluctuations in the period when they occur. An augmentation in assets’ value and contraction of liabilities’ value results in an increase in net earnings, and in the opposing scenario, the net income is reduced (Way, 2015). 7. Disadvantages of fair value accounting 7.1. Adverse market effects The implementation of the fair value accounting approach may have a significantly negative impact on a bear market. For instance, after the downward re-evaluation of an asset due to decreasing current market price, the lower asset value may compel managers to sell the asset at an even lower price (Needles, Powers & Crosson, 2012). However, without a marked down evaluation, a company is not required to sell an asset at a bear market to stop further devaluation of the asset. Therefore, if adverse market scenarios do not prevail, the use of a different accounting method will allow the managers to wait for market stabilization, which will help them to mark up the value of their asset (Way, 2015). 7.2. Value reversal The use of fair value accounting may generate misleading information, which in turn may prove to be considerably challenging when it comes to the valuation of liabilities and assets conducted by the users of that information (for example, stakeholders) (Procházka, 2011). Market conditions may fluctuate and become highly volatile at any time and valuing assets and liabilities under such volatile conditions may prove to be misleading as it may create large deviations in the value of the assets and liabilities. When the market stabilizes, this value of assets and liabilities reverts back to its original value; this, in turn, will make any disclosed profit or loss temporary, thereby providing misleading information to the users of such information (Way, 2015). 8. Conclusion Although fair value accounting is regarded by many as one of the major contributors to the global financial crisis that started in the US in 2007-08, this study finds there is insufficient evidence to support such a claim. In fact, the evidence suggests that if fair value accounting had been used appropriately by bank managers, the downfall could have been avoided. Fair value accounting method has certain drawbacks but if implemented properly, the adoption of fair value accounting can help companies to value their assets and liabilities with more precision. Reference List Allen, F. & Carletti, E. 2008. Mark-to-market accounting and liquidity pricing. Journal of accounting and economics, 45(2), pp. 358-378. Brunnermeier, M. K. 2008. Deciphering the liquidity and credit crunch 2007-08. Journal of Economic Perspectives, 23(1), pp. 77-100 Cifuentes, R., Ferrucci, G. & Shin, H. S. 2005. Liquidity risk and contagion. Journal of the European Economic Association, 3(2‐3), pp. 556-566. Gorton, G. B. & Metrick, A. 2009. Securitized Banking and the Run on Repo. [online] Available at: [Accessed 23 February 2015]. Heaton, J. C., Lucas, D. & McDonald, R. L. 2010. Is mark-to-market accounting destabilizing? Analysis and implications for policy. Journal of Monetary Economics, 57(1), pp. 64-75. Hitchner, J. R. 2011. Financial valuation: applications and models. New York: John Wiley & Sons. Lauz, C. & Leuz, C. 2009. Did fair-value accounting contribute to the financial crisis? [pdf] NBER. Available at: http://www.nber.org/papers/w15515.pdf [Accessed 23 February 2015]. Morris, S. & Shin, H. S. 2008. Financial regulation in a system context. Brookings Papers on Economic Activity, 2008(2), pp. 229-274. Needles, B., Powers, M. & Crosson, S. 2012. Principles of accounting. Connecticut: Cengage Learning. Plantin, G., Sapra, H. & Shin, H. S. 2008. Marking‐to‐market: Panacea or Pandoras box? Journal of Accounting Research, 46(2), pp. 435-460. Pozen, R. C. 2009. Is It Fair to Blame Fair Value Accounting for the Financial Crisis? [online] Available at: [Accessed 23 February 2015]. Procházka, D. 2011. The role of fair value measurement in the recent financial crunch. Economics, Management, and Financial Markets, 1, pp. 989-1001. Shleifer, A. & Vishny, R. W. 1997. The limits of arbitrage. The Journal of Finance, 52(1), pp. 35-55. Walton, P. 2012. The Routledge companion to fair value and financial reporting. London: Routledge. Way, J. 2015. Advantages or Disadvantages of Fair Value Accounting. [online] Available at: [Accessed 23 February 2015]. Read More