Did Fair Value Accounting Contribute to the Financial Crisis - Essay Example

Did fair value accounting contribute to the financial crisis? An enormous amount of literature exists in libraries over the cause(s) of financial crisis. The 2007-2009 financial disaster received immense media attention as the after effects did not remain within a region. They affected the global trade and left thousands unemployed. The most discussed reason for such a calamity was badly judged property based lending and investments. Considering this chain of reasoning, the main party responsible for the crisis turns out to be the IFRS. However, there is a lesser discussed side to the argument. The choice of accounting methodology also played a significant role in triggering the financial crisis, or at least made it a lot worse than it had to be (Singleton-Green, ). It is not logical to blame a single contributor to the financial crisis. Multiple factors caused it and propagated it and fair value accounting is one of them. The fair value accounting or mark to market accounting played a significant role in the last financial crisis (Laux & Leuz, 2009). The concern about fair value accounting (FVA) is not confined to its concept alone, the changes in the technique have also made the matter controversial (Laux & Leuz, 2009). Laux & Leuz (2009) identified four main arguments against the FVA. First, the confusion about the difference and the innovative methodology it offers. Second, the mark-to-market technique in the times of a financial crisis is a very controversial tool as it allows room for deception. Third, the historical cost accounting (HCA) is not a reliable remedy. And lastly, the implementation issues specifically regarding litigation. Due to such ambiguities surrounding the use of FVA, SEC requires firms to explain their FVA choices (Veron, 2008). There is a significant likelihood that many firms can abuse the FVA techniques to protect their profits. Evidence suggests that in the financial crisis of 2007-9, the manner in which the regulators used FVA severely undermined the financial condition of some institutions (Magnan, 2010). The impact was amplified especially for those institutions that were holding assets in the market watched their liquidity dry up during the crisis (Magnan, 2010). The FVA might have amplified the crisis. Critics give many reasons why FAV is also the culprit in the last financial meltdown. Many argue that FAV in US accounting rules exacerbated the crisis by depleting banks’ regulatory capital (Badertscher, Burks & Easton, 2011). This action triggered asset sales and curtailed lending. Exceeding amounts of asset sales lead to an economic turmoil. But the matter should be analyzed from all angles. Here are a few questions that must be looked into before taking action against the FVA policy. Does FVA allows considerable leverage for manipulating profits? Is it possible to eradicate exploitation through FVA with additional check and balance? A study by Goh, Ng, & YONG (2009) analyzed the FVA technique to find out its drawbacks. It turned out that the valuation of banks is positively related to the amount of fair value assets that has, and the organization seems to be weaker for level 3 assets (Goh, Ng, & YONG, 2009). In the purest form the FVA involves reporting assets and liabilities on the balance sheet at their fair value while recognizing changes in fair value as gains and losses in the income statement (Laux, & Leuz, 2010). When a company uses market values to determine the fair value of their assets it is alled mark-to-market. Critics consider FVA among the causes of the financial crisis of 2007-9 as the instruments triggers excessive leverage during booms and excessive down-writes during busts (Laux, & Leuz, 2010). The falling market prices drag down the asset prices, depleting banks’ capital in the process. The banks are forced to sell assets at first sale price, and this trend can become contagious through asset fire sales effecting the prices of other banks. The FVA enjoys its share of staying away from too much scrutiny because the arguments against it do not bear fruition due to lack of evidence (Laux, & Leuz, 2010). It does not prove FVA guilty or innocent, the investigators only need to dig deeper. It is hard to blame FVA responsible for the financial crisis in question. Fair value accounting is a method of reporting. Adhering to it to inflate profits I not a crime or fraud. Therefor it would be better to amend the research question. The aspect in question is how much addition FVA can do to a crisis? Or how much the FVA made the crisis 2007-9 worse? It is difficult to determine the fair value of illiquid assets. Hence, another way to look at the same issue would be how much did FVA contribute in making matters worse regarding reporting of illiquid assets. Another scenario worth discussing is if the banks had chosen other method to report losses instead of FVA would the situation be different? Would the markets have reacted differently? Bignon, Biondi, & Ragot, (2009) support the argument that FVA did not trigger financial crisis but deepened it. They support this claim by showing that when there is a financial crisis marking to market lets the valuation pass through several falls (Bignon, Biondi, & Ragot, 2009). The criterion for asset valuation through fair value makes the matter complicated; the “specificity” and “complementarity” of assets forces accountants to adopt valuation models for determining asset values (Bignon, Biondi, & Ragot, 2009). The FVA introduces the aspect of financial volatility to the equation. The financial volatility is only an after effect of an already bad situation, not the cause. The FVA gives the companies a way out of a bad situation by manipulating their reports. The real estate investments were operational without the FVA. The prime mortgages made their own judgments even when there were no fair value disclosures (Tarr, 2010). This can be verified by tracking the exact timing of the crisis happening. The financial crisis was prompted during the first quarter of 2006 when the housing market turned (Acharya, Philippon, Richardson, & Roubini, 2009). References 1. Acharya, V., Philippon, T., Richardson, M., & Roubini, N. (2009). The financial crisis of 2007‐2009: Causes and remedies. Financial markets, institutions & instruments, 18(2), 89-137. 2. Badertscher, B. A., Burks, J. J., & Easton, P. D. (2011). A convenient scapegoat: Fair value accounting by commercial banks during the financial crisis. The Accounting Review, 87(1), 59-90. 3. Bignon, V., Biondi, Y., & Ragot, X. (2009). An economic analysis of fair value: Accounting as a vector of crisis. Cournot Centre for Economic Studies, Prisme, (15). 4. Goh, B. W., Ng, J., & OW YONG, K. K. (2009). Market pricing of banks’ fair value assets reported under SFAS 157 during the 2008 economic crisis. 5. Laux, C., & Leuz, C. (2009). Did fair-value accounting contribute to the financial crisis? (No. w15515). National Bureau of Economic Research. 6. Laux, C., & Leuz, C. (2009). The crisis of fair-value accounting: Making sense of the recent debate. Accounting, organizations and society, 34(6), 826-834. 7. Laux, C., & Leuz, C. (2010) Did fair-value accounting contribute to the financial crisis? Forthcoming in the Journal of Economic Perspectives 2010. 8. Magnan, M. L. (2009). Fair Value Accounting and the Financial Crisis: Messenger or Contributor?*. Accounting Perspectives, 8(3), 189-213. 9. Tarr, D. G. (2010). The political, regulatory, and market failures that caused the US financial crisis: What are the lessons?. Journal of Financial Economic Policy, 2(2), 163-186. 10. Véron, N. (2008). Fair value accounting is the wrong scapegoat for this crisis. Accounting in Europe, 5(2), 63-69. 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