The Role of Fair Value in the Global Financial Crisis - Literature review Example

Running Header: The Role Fair Value in the Global Financial Crisis Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: The role fair value in the global Financial Crisis Introduction Despite the universal adoption of fair value accounting, it continues to generate intense debates among various business people and regulators. One major element involved in the debates include positions that are conflicting and those adopted by people who are in favour or against the fair value accounting as applied in global financial crisis. Adrian and Hyun (2008) shows the recent financial crisis have raised the level of discussions significantly as fair value is being attacked for example where the U.S government ordered the securities and exchange commission to examine whether fair value accounting contributed to the financial crisis. Sun (2006) puts it that other countries such as Canada have also introduced aspects to waive fair value accounting for financial institutions. The above study shows the role of fair value in the global financial crisis showing all the surrounding views such as the views which agree and those which disagree. It also gives supporting reasons and evidence showing how fair value is involved in global financial crisis. Main body The role of fair value is realised by analysing the conceptual and empirical foundations of fair value accounting. Fair value is the price at which an asset may be exchanged between knowledgeable and willing parties in the current transaction. In case of liabilities, fair value is defined as the amount that would be paid in order to transfer the liability to the new debtor. Fair value is also said to assist consumers of financial information to make rational decisions about their interactions with other companies. Abody et al. (2004, pp. 123-150) shows under the fair value accounting, assets and liabilities are grouped according to the level of judgement and then associated with the input to measure fair value. There are three levels of measuring fair value where the first involves measuring the financial instruments and recording on the company’s balance sheet and income statement according to their market value. This level reflects quoted prices for identical assets and liabilities in active markets. It also provides reliable fair value measurement as it observes market values directly. According to Barth (2007, pp. 7-15) level two way of the assessment of financial instruments include quoted prices in active markets, in markets not active and in inputs which are observable and in correlated prices. This level also involves financial instruments which have no market and which will be valued on the basis of assumptions that reflect market participants’ views and assessments. Level three is also referred as mark-to model as it is the outcome of a mathematical modeling exercise with assumptions basing on the economic and market of specific conditions. In these three cases, any gain on financial instruments translates into an increase in stockholders’ equity and causes an improvement in its capitalisation ratios. From 2007, the decrease in the price of various types of financial instruments caused the financial institutions to reduce on the asset values recorded on the balance sheets and this therefore causes weakening of the capitalisation ratios. To enhance the safety of financial institutions with respect to regulatory capital requirements, the institutions started selling securities and others closed down positions on financial instruments in the increasingly shallow markets and this resulted to the emergence of a liquidity crisis (Landsman 2006). In order to determine whether fair value contributed to the global financial crisis, it is necessary for economists to examine the explicit and implicit connections of the accounting numbers to the actions of the players in the financial market. The economists should therefore be able to examine whether such connections can create the problems occurring in the financial markets. Some of these connections include contracts such as margin requirements, management incentives and regulatory capital requirements. Seay and Ford (2010) describes that fair value accounting role is to freeze the market during a crisis. One method used in valuing a financial instrument is looking at the market transactions and other similar transactions. This is necessary because by selling into a market with few transactions may establish a market value that will require one to take a loss. However, if everybody in the market decides not to sell, one would not recognise the loss. Fair value accounting is therefore the value at which one is willing to sell or buy security in today’s market. This makes more sense in an active market. Various critics have argued that fair value accounting significantly contributed to the financial crisis or exacerbated it to become more severe. However, it is unlikely that fair value accounting contributed to the severity of the financial crisis though there were downward spirals in certain markets which resulted from fair-value accounting. Prochazka (2011) puts it that according to Securities and Exchange Commission (SEC), fair value accounting did not play a meaningful role in the failures of 25 banks. This is because the application of fair value accounting measurements to an inactive and disorderly market for structured credit products facilitated the spread of financial crisis. Critics shows that reporting fair value at illiquid markets creates volatility in earnings and destroys bank capital and this is the reason for calling for temporary suspension. The challenges associated with fair value accounting are now being addressed through the reevaluation of accounting and reporting standards for financial assets. Role of fair value accounting on financial crisis Facilitates more volatile financial results The adoption of Fair value accounting in a company is said to translate into a more volatile financial results. The extreme volatility in the financial markets over the past years has raised the volatility in the financial institutions. This has therefore potentially improved the awareness of the crisis by the investors, regulators and various governments. The drop in the earnings is more dramatic as a result of the record earnings reported. Fair value pushed down earnings in the current period and boosted earnings in the previous years. This can be illustrated by two examples showing the impact of fair value on the volatility of earnings. One is through credit Suisse which shows that within the context of subprime crisis, the stock market value of the financial institutions depends on the investors’ assessment of their exposure to subprime loans. This shows that the valuation information reported by the financial institutions that have evolved in the same market influences the assessment with recent market quotes driving the valuation. The other example that explains that fair value accounting facilitates volatility of financial institutions is the Lehman brothers’ example. Before the company went bankrupt, it had reported a loss of 2.4 billion dollars for the previous six months ended May 2008 (Linsmeir 2011, pp. 409-456). This is because the shift of 4.8 billion net income was being driven by a fall of 8.5 billion which accounted for Lehman’s revenues from main transactions for example from realised and unrealised gains from financial instruments and other inventory. This therefore shows that accounting at a fair value for financial assets facilitated the downward earnings for Lehman. It can therefore be put forward that fair value accounting has a significant impact on earnings volatility and therefore contributes to heighten investors and governments’ awareness with respect to the severity of the financial crisis. This increased volatility is conducive to be used for equity-based competition and more specifically for stock options (Ragatz and Duska 2011). Allow financial institutions to delay the day of recognition This is the other role of fair value accounting which reflects the underlying business performance as critics argue that apart from enhancing transparency and financial reporting, fair value also provides corporate management with ways of avoiding the day of recognition and also it delays asset destruction. This simply shows that fair value undermines financial statements conventional therefore leading to changes in the managerial behaviour. Ragatz and Duska (2011) puts it that an example is where Ross Watts which is an Institute in Technology argues that fair value accounting brought about the elimination of conservatism and this lead to the capitalisation of future cash flows that were unverifiable in the balance sheet. In the process of making strategic valuations, this leads to costly financial reporting processes for the investors. Fair value accounting also contradicts SEC by moving firms away from transaction based accounting. SEC’s effort is to tighten the measurement of revenue and recognition standards therefore ensuring that only completed sales transactions. Leads to contagion problems These arise more when management is focused on accounting for example in earnings. This is where management inclines to sell relatively illiquid assets at a price lower than the fundamental value in order to anticipate the sales of other market participants. By doing this, management avoids marking the asset to a lower market price and creates contagion effects for other banks. Rya (2008) describes that this shows that potential problems occur with pure mark-to market accounting though the accounting rules fail to stipulate pure mark-to market accounting and therefore it does not show to what extent fair value contributes to the problems in the global financial crisis. Affects accounting and the market Market value integration on corporate balance sheets which is authorized by accounting standard setters contrast with the new trend used by analysts and other sophisticated investors use financial statements to check whether a firm’s stock market value has changed from the intrinsic value. Negurita and Guni (2011, pp. 7-10) describes that these trends have raised questions on the grounds of financial statements and it has been shown that the market uses accounting earnings to value stock and other securities. The prices of these securities, however, find their way into financial statements through fair value accounting. Interface between financial reporting and regulatory capital According to Holthausen and Watts (2002, pp. 3-75) fair value accounting is criticised that its use in the current global financial crisis led to the reduction on the value of assets of various financial institutions. This is said to have led to the reduction of capital ratios forcing them to deleverage and to the sale of further assets as distressed prices which resulted to the downward spiral. However, the issue in this case is not the accounting itself but on how financial regulators make use of accounting information. This shows that fair value accounting based on financial reporting acts as a messenger that undermines a firm’s solvency. This is done through financial strategies or lending practices though regulators have to evaluate on how to use the correct information. Messenger or contributor The role of fair value accounting is to act as a messenger or a contributor. This role downplays its actual importance and relevance to the current crisis as the message is conditioned by accounting standards. However, various issues arise for the use of fair value accounting information for the regulatory oversight. One is because the information provided is highly volatile and unbalanced. Fair value information is therefore not sufficient and should be used with other performance and risk metrics used in identifying various targets for regulatory actions. The other issue is that fair values are red herrings and the real issue is the quality of the disclosure. It is therefore argued that more focus should be placed on disclosure for the regulators and investors to understand the drivers behind fair values estimates (Sun 2006). The supporting reasons and evidence showing that fair value is involved in global financial crisis include the fact that fair value is based on principles that contribute to the increase in liquidity crisis in various financial institutions. The other reason is that in case of a financial crisis, debt market opts to freeze the financial institutions thus leading to write downs in the balance sheets. This increases the problem and the determination of values and therefore financial instability. Lin and Pleskovic (2011, pp. 354-370) puts it that global financial crisis occurs as a result of this instability and the increased cost of capital. This therefore shows that fair values have an impact on the global financial crisis. This has also disguised risks and leverage as unstable gains have invaded financial institutions. Financial systems have also lost stability worsening the financial crisis. Though it is good to believe the facilitation of the crisis by fair value accounting, the conclusion is interpreted cautiously showing the important of fair values. However, the lack of evidence showing that fair value accounting was responsible for the weakened banks and that they caused contagion among banks, loosening fair values rules is also equally weak. Various models have to be used on fair values as they lose desirable properties when there are no prices from the active markets. It is therefore necessary to improve accounting rules as relaxing the rules or having a flexible management gives way to manipulation and decreases the reliability of accounting information. Empirical evidence on bank accounting in times of crisis show that investors believe that banks use accounting discretion to overstate the value of their assets. The result is lack of transparency on the solvency of the bank which is a major problem in crises as compared to the effects of the potential corruption from the implementation of fair value accounting. The other empirical evidence show that although fair value accounting contributed to the downward spirals and disruption, the negative effects which occurred in the financial crisis should be weighed against the positive effects of fair value accounting as well as those of timely loss recognition (Leonard 2010). Once banks write down the values of assets as losses occur, they are offered incentives to take corrective actions and for limiting imprudent lending therefore reducing the severity of the problem. A lesson top the U.S government is that when their savings and loan crisis are held back by regulators from the financial institutions to confront their losses, the losses become much higher. This is also the reason that brings problem once the accounting rules are suspended when a financial crisis arise since banks are able to anticipate such changes therefore diminishing their incentives to avoid risks. Banks regulators should therefore aim at adjusting capital requirements instead of changing the accounting standards (Economy Stabilization Act of 2008, pp. 85-100). The fair value accounting trend undermines decades of accounting practices and concepts which include conservatism and verifiability which required particular skills and knowledge. McMahon (2011) shows one serious challenge to the trend is the current global financial crisis which particularly affected fair value accounting which will give empirical research after some years allowing researchers to better assess the advantages and the disadvantages of fair value accounting. The regulators argue that there is no better alternative measurement model apart from fair value accounting. Conclusion There has been an increased need to suspend reform of fair value accounting as it is perceived to have increased the severity of the financial crisis of 2008. This critics and the political influence in U.S have increased pressure on the accounting standard setters who have been forced to slow down the rules. Basing ob the available evidence, there are few reasons showing that fair value accounting contributed to the problem of financial crisis. This is because fair values play a limited role for banks’ income statements in the regulation of capital ratios. To banks with large trading positions, fair values enable the investors not to worry about exposures to subprime mortgages. There is also little evidence showing that banks were forced to take excessive write-downs during the crisis. The relevance of fair value accounting for investors however cannot be questioned since some of its qualities may have been overlooked by regulators and standard setters. This therefore shows that fair value accounting in a broader trend in accounting standard setting of moving from accounting to fore-counting which involves estimating the expected future cash flows and incorporating them with the financial statements. References Abody, D, Mary, E & Ron, K 2004, Firms’ voluntary recognition of stock-based compensation expense, Journal of Accounting Research, vol. 42, no. 2, pp. 123-150. Adrian, T & Hyun, S 2008, Liquidity and leverage, Journal of Financial Intermediation, forthcoming. Barth, M 2007, Standard setting measurement issues and the relevance of research, Accounting and business research, special issue, pp. 7-15. Economy Stabilization Act of 2008, Study on mark-to- market Accounting, DIANE publishing, Darby, Pennsylvania, pp. 85-100. Holthausen, R & Watts, R 2002, The relevance of the value-relevance literature for financial accounting standard setting, Journal of accounting and economics, vol. 31, no. 3, pp. 3-75. Landsman, W 2006, Fair value accounting for financial instrument, Some implications for bank regulation, Bank for international settlement paper. Leonard, B 2010, Reports and Recommendations Pursuant to section 133 of the Emergency. Lin, J & Pleskovic, B 2011, Annual World Bank Conference on Development Economics, World Bank Publications, London, pp. 354-370. Linsmeir, T 2011, ‘Financial institutions and financial crisis’, A journal on fair value accounting. vol. 25, no. 2, pp. 409-456. McMahon, G 2011, Mark- to-market real role in the crisis, The CPA journal vol. 81, no. 2 pp. 466-560. Negurita, O & Guni, N 2011, Accounting standards and financial reports, Guilty for the actual crisis?’ Journal on Accounting Standards, vol. 6, no.1, pp. 7-10. Prochazka, D 2011, ‘The role of fair value accounting in the recent financial crunch’, Journal on Economics, management and Financial Markets, vol. 6, no.1, pp. 300-432.  Ragatz, J & Duska, B 2011, Accounting ethics, John Wiley and Sons Publishers, New Jersey. Rya, G 2008, Fair value accounting, Understanding issues raised by the current crunch, New York University Publishers, New York. Seay, S & Ford, W 2010, An ethical presentation of fair value accounting’, Journal of Legal, Ethical and Regulatory Issues, vol.13, no.1, p. 53. Sun, L 2006, A reevaluation of auditor’s opinion versus statistical models of bankruptcy prediction’, Journal on Bankruptcy prediction models, vol. 25, no.6, pp. 130-150. Read More