Impacts of Fair Value Accounting in the Financial Industry - Term Paper Example

Mark-to-Market Accounting: Practices and Implications Name: Institution Introduction Mark-to-Market Accounting: Practices and Implications Fair value accounting or mark-to-market accounting involves accounting for the fair value of a liability or an asset based on the current market price or for similar liabilities and assets or any other fair value, which has been objectively assessed. It is part of the GAAP in the United States of America. In mark-to-market rules, recording of assets and liabilities in the financial statements are done at their market values. A swing in the market will therefore result in a swing in the financial statements. The current market conditions has shown the implications of the applications of this accounting rules in financial reporting, for instance pro-cyclical behaviors and fall of financial institutions. This paper looks into arguments of various individuals who had discussed impacts of fair value accounting in the financial industry. Paul E. Kanjorski: Congressman Mr. Paul starts his statement by stating that initially he was not for the idea of allowing congress to engage in creation of the accounting rules. He argues that financial experts, standard setters and regulators should create these accounting rules and policies. He noted that the then mark-to-market accounting accelerated the economic crisis that was witnessed worldwide. He warns the relevant authorities to come up with relevant measures to curb economic crisis before the congress steps in. Even though he acknowledges the transparency of mark-to-market accounting rules to investors, he is not for its full application since it facilitates economic distortion. He further states that financial sector is one of the industries that the mark-to-market rules hit hard. He also states that each economic sector requires specific accounting rules and a single mark-to-market rule cannot apply in all the sectors. He calls upon the bank regulators to liberalize regulatory capital requirements. Mr. Paul is for the idea that relevant authorities should separate losses of asset due to liquidity risk from losses due to credit risk when applying mark-to-market rules. He also clarifies that mark-to-market accounting is not fully the cause of economic crisis but the application of its fundamental principles should be improved in order to help solve economic crisis. Finally, he calls upon the relevant authorities such as the Securities and Exchange Commission and Financial Accounting Standard Board to come up with the relevant accounting rules to help curb economic crisis. Robert H. Herz: Chairman Financial Accounting Standards Board Mr. Herz in his report analyses the roles of Financial Accounting Standards Boards. He states that the main role of FASB is to come up with accounting and financial reporting standards for private, public and not-for-profit organizations. These standards when fully implemented provide investors with reliable, relevant and transparent information concerning the financial performance of a company. FASB is tasked with coming up with standards that would enhance transparency in financial statements reporting so as to enable investors make decisions regarding capital allocation. He states that the current reporting system takes into consideration the fair value measurements and historical costs. In the report, he states that financial institutions and brokers use mark-to-market accounting to measure liabilities and assets in the trading accounts. However, most banks measure their liabilities and assets based on the historical costs. Analysis of the report shows that FASB support the use of fair value accounting even though is has been associated with the economic crisis. He argues that the users of fair value accounting believe that it provides financial information, which is comparable and relevant for interpretation of the market risks. He states that doing away with these rules will affect the transparency and quality of financial information that investor’s access. He also noted that so many people had campaigned for the extension of the use of fair value accounting to all the financial assets, since investors have a belief that bank assets are overstated. FASB chairperson, Herz, also responded to congress request to Securities and Exchange Commission on the modification or suspension of fair value accounting. The Securities and Exchange Commission on mark-to-market stated that fair value accounting should not be suspended since it was not solely responsible for the economic crisis that led to bank failures. SEC associates bank failures with the lack of investor and lender confidence, expected future drop in quality of an asset and probable credit losses. Having acknowledged the current mark-to-market rules have some weaknesses, Securities and Exchange Commission made some recommendations. Firstly, he stated that SEC and FASB members would continue giving guidance on how to apply fair value accounting rules, especially concerning the valuation of illiquid and complex securities. Secondly, he noted that several roundtables had been held between International Accounting Standards Board and FASB and with other stakeholders in order to discuss financial reporting issues that could originate from financial crisis. Furthermore, he stated that FASB had undertaken various measures to help curb the economic situation and give guidance to all stakeholders on the valuation of various assets under the current economic condition. These measures would also help in eliminating or reducing inconsistencies in mark-to-market rules that relates to impairment and disclosure of securities. Thirdly, he noted that FASB and IASB came up with projects that would enable them team up to improve on the financial accounting instruments. To be more effective FASB created Financial Crisis Advisory Group was established to help in evaluation of the financial reporting issues that originate from the global financial crisis and to evaluate major issues that accelerate financial crisis. Finally, FASB reported that even good accounting and reporting could have economic effects that could lead to pro-cyclical behavior. A financial institution reporting deterioration of its financial condition would create fear of loss to investors making them to sell their assets while lenders unwilling to lend to companies trying to dispose its assets. Capital markets and regulators will finally realize that such a company requires more capital since it may fail at any time. These may even force various families to sell their investments in order to raise money and spend less money during hard economic times. FASB is against altering of the financial information since they could mislead investors. Therefore, firms should do accurate reporting in order to enable relevant authorities to take appropriate measures to correct the existing situations by use of monetary and fiscal policies. Thomas Bailey: President and CEO, Brentwood Bank Thomas Bailey on his speech represents the work done by the PACB’s committee. He acknowledges that mark-to-market, fair value accounting and other than temporary impairment rules are exacerbating factors in the financial crisis. PACB was formed to assess the issues that surround the fair value accounting. PACB role was to study issues behind the economic crisis and come up with the best ways to solve the problem. The committee wants the Securities and Exchange Commission and Financial Accounting Standards Board’s members to be held accountable for the raging economic crisis. He states that mark-to-market rules application is the main reason behind economic crisis. The committee calls upon FASB to quickly act and solve the economic problem. The committee therefore offered other than temporary impairment solution to the economic crisis problem. Some of the factors that make the committee suggest for a change in the mark-to-market rules include: The current OTTI rules present a distorted financial picture of fair value The PACB committee acknowledges that the current mark-to-market accounting standards deter transparency and distorts the true condition of financial institution holding debt securities. This interferes with flow of credit in the financial sectors. Negative Impact of Current Accounting Rules The committee stated that the existing accounting standards are preventing the revival of market and establishment of a pricing that is market driven. The current accounting rules are deterring financial institutions from purchasing assets that could present losses at a future date. The committee acknowledges that the existing rules are reducing the number of transactions taking place in the financial sector. The existing requirements for financial reporting are factors behind the decline in the prices of market based securities and debt securities. Current other than temporary impairment rules weakens the capital positions of various assets in the market. Theses current accounting rules also contribute to hoarding of capital in various financial institutions. These are further expected to negatively affect the flow of credit in the market. The current accounting rules are creating illiquidity in the market making it impossible to sell various securities in the market even if investors are willing to sell them. Investors are giving up their future expected income and selling assets at loss thus freezing the securities market. The committee also noted that members of various banks such as FHLBank members are holding non-earning assets. The current accounting rules are also associated with the high costs funds in various banks especially those who borrow from FHLBank. The current other than temporary impairment rules are rendering the expensive efforts of institutions like the Treasury Department, Congress, the Federal Deposit Insurance Corporation and the Federal Reserve useless since the rules are shooting up the cost of containing the economic crisis. The current rules are leading to paper loss since a lot of capital is poured into the financial industry to correct the financial crisis. Proposed Committee’s Solutions Firstly, the committee does not believe that congress should be allowed to write accounting rules. The committee calls upon the congress to hold Financial Accounting Standards Board for allowing the economic crisis to take place. The congress should further pressurize FASB to correct the current economic situation through adjusting the current OTTI rules in order to improve the current financial reporting standards. The committee also suggested that Congress should encourage FASB and SEC to encourage the use of accounting rules that apply to loans that are held in portfolio to debt securities that financial institutions can hold. Secondly, the committee suggested that relevant OTTI should give a true picture of economic loss that is expected future loss. A change in the economic loss should be reflected directly on the investor’s earnings. It was further observed that to facilitate transparency and take into consideration the current GAAP framework, the OTTI loss held to maturity should be reported through: earnings of expected future losses and financial statements to facilitate disclosure of securities’ fair value. The committee stated that these changes would enhance consistency, comparability and transparency. The committee also observed that the recently FASB increased the requirement for financial reporting to quarterly. This rule is in line with the International Accounting Standards financial reporting rules, which also acknowledges market based securities OTTI rules that recognizes probable gains against the OTTI probable loss. Conclusion In Support of the Views From the views summarized above, i am for the idea that fair value accounting rules has been pro-cyclical and has therefore contributed part to the severity of the global financial crisis. For instance, a financial institution reporting deterioration of its financial condition would create fear of loss to investors making them to sell their assets while lenders unwilling to lend to companies trying to dispose its assets. These may even force various families to sell their investments in order to raise money and spend less money during hard economic times. In addition, in case of securities banks will make losses, since the bank will not be in a position to sell its securities at the previously estimated market value as the cash flows estimates and security values is so high compared to that market could be willing to pay. As a result, tension is created in the financial sector hence affecting the flow of credit, thus the financial crisis. FASB easing accounting rules is a cause of concern since stakeholders in various industries would like to know if they could lead to economic recovery in the short term and long term. References Mark-to-Market Accounting: Practices and Implications, Available at http://archives.financialservices.house.gov/Hearings/hearingDetails.aspx?NewsID=1290), August, 2015 Fair Value and Mark-to-Market Accounting, Available at http://www.aba.com/Issues/Index/Pages/Issues_FairValue.aspx, August 2015 Read More