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Fair Value Accounting and the 2008 Economic Crisis

Executive summary

Fair value accounting refers to the practice of using the market value for which assets would sell to create financial reports. Historical cost accounting refers to the practice of using the prices for which assets were acquired in financial performance reports. Fair value accounting has been associated with intensifying the volatility of financial markets during the economic crisis. Those arguing against fair value accounting state that it increased the fall of market prices. They also argue that it caused the loss of investor confidence by showing negative results from multiple financial assets. Those who argue in favor of fair value accounting claim that it is only a scoreboard with no effect on financial performance. They also claim that if most firms practiced fair value accounting, they would have reduced the extensive risky behavior. Fair value accounting cannot be blamed for the 2008 economic crisis because most firms that held a large proportion of financial assets in the U.S. did not apply fair value accounting.

Introduction and purpose

Fair value is an accounting practice that requires firms to report current information that may assist investors and creditors to make rational decisions about investments (Scott 2010, p. 500). Mark-to-market accounting requires the income statement to show the real-time changes that have occurred in the market. Chea (2011) discusses that fair value accounting requires the financial instrument to use the market closing price. In the US, the Statement of Financial Accounting Standards No. 157 (FAS 157) describes fair value as the “price that would be received when selling an asset or transferring a liability in an orderly transaction on the measurement date” (Moore & Baker 2010, p. 5).

The 2008 financial crisis is associated with the expansion of securitization and the collapse of the mortgage market (Scott 2010, p. 495). Securitization refers to the innovation of the multiple derivatives of traditional securities (Razaki & Koprowski 2012, p. 3). The collapse of the mortgage-backed securities acted like a starting point. The mortgage market was blamed for the overvaluation of assets. There was a high defaulting rate emerging from the overvalued mortgages. It caused insurance companies that had covered banks to show signs of inability to cover losses. Moore & Baker (2010, p. 4) discuss that the major cause of the 2008 financial crisis is the subprime loans created through financial creativity such as the credit default swaps (CDS), and asset-backed securities (ABS).

The purpose of this paper is to examine those arguments that support the use of fair value and those against its use in accounting. It goes ahead to form an opinion on whether fair value accounting caused the 2008 economic crisis.

The Body

Arguments against fair value

Some proponents blame the fair value of extending the impact of the economic crisis by showing the same negative indicators from many firms. The mark-to-market accounting practice is blamed for causing panic which denied companies with poor financial performance a chance to recover (Scott 2010, p. 494). These proponents argue that fair value exposed poor performance from many sectors and all at the same time (Scott 2010, p. 521. It made financial markets lose their value. It made financial assets fall far below their real value.

Fair value increases uncertainty which increases risk. The future value becomes unpredictable creating a setback in preparing budgets and forecasts (Chea 2011, p. 15).

Proponents against fair value argue that it gives inappropriate values for assets that are in an illiquid market. Illiquid markets do not bear the same perception that market prices incorporate all the information portrayed by risk or opportunities (Scott 2010, p. 523). Chea (2011, p. 14) explains that there are problems in estimating fair value when assets are held in an illiquid market. Moore & Baker (2010, p. 6) explain that banks have a big proportion of their equity held as illiquid assets. For example, Morgan Stanley held 251% of its equity as illiquid assets. Managers may see it as an opportunity for the deliberate miscalculation of estimates. Historical prices are based on known values. Fair value information for illiquid markets is considered unreliable.

Arguments supporting the fair value

Those who support fair value accounting argue that fair value enables investors to choose an investment based on avoiding risk exposure. Fair value is perceived as a form of transparency in the fluctuation of earnings (Scott 2010, 516). Giving the real picture of what is actually happening in the market is considered to reduce volatility in the long run.

Historical cost accounting provides firms with an opportunity to hide poor performance. Scott (2010, p. 519) discusses that historical accounting encourages firms to sell assets that have gained market value to create an impressive financial performance. They retain assets that have lost value because they do not have to indicate the capital losses in financial reports. A firm may appear to have made big capital gains when losses would offset the gains. The fair value would expose the value according to the current market prices.

Scott (2010) explains that analysts and informed investors are able to use components of financial reports to evaluate performance on a fair value basis even without the firms’ report. It shows that concealing the fair value is ineffective in preventing panic.

It is argued that historical accounting makes managers to engage in a lot of risk because they are not transparently reported. When the losses are realized, it is usually too late. It results in panicking. Fair value discourages managers from engaging in high risk ventures.

Fair value on the financial crisis

Scott (2010, p. 531) argues that the 2008 financial crisis occurred because banks had been using historical cost accounting. He follows the argument by the Japanese economic crisis in the 1980s which was also caused by historical cost accounting. The banks in Japan had overvalued mortgages which were used to secure short-term loans at higher interest rates. When the actual value was disclosed, the financial markets collapsed. Investors lost confidence in banks. In the 2008 financial crisis, security derivatives were not covered by fair value accounting. Their uncontrollable expansion and their unknown value caused the crisis. Once investors lost confidence in banks, the overvalued assets dropped below their intrinsic value.

Scott (2010, p. 532) argues that a survey by the Securities and Exchange Commission (SEC) showed that only 45% of the firms that represented a 75% value of financial assets applied fair value accounting. Only 25% made a fair value alterations effect on their income statements. Chea (2011, p. 16) reports that “only 27% of the total assets of the S&P 500 companies that had adopted FAS 157 were actually reporting at fair value”. It shows that a very small proportion of the firms that held financial assets actually applied fair value accounting. As a result of the survey, it can be concluded that fair value accounting did not cause the financial crisis because it was not applied on a large scale basis.

Fair value reduces lending by financial institutions because they want to avoid reporting losses or exposure to wide fluctuations in their assets. Banks would be forced to take precautions to avoid exposure to fluctuations if they were using fair value. Moore & Baker (2010, p. 2) explain that one of the causes of the financial crisis was the extensive availability of credit. Unsecured loans became common and people spent more than they could afford. People were buying homes they could not afford. Tarraf & Majeske (2013, p. 13) argue that extensive risk taking by banks caused the financial crisis. From these arguments, fair value accounting could have forced banks to act restrictively which could have prevented the subprime credit boom or crunch.

The economic crisis is also blamed on the lack of warning by auditing firms. Moore & Baker (2010, p. 7) discuss that auditing firms did not see the need to alarm the public about the bankruptcy of some firms. If warning financial institutions can prevent them from taking more risk, fair value is a good indicator of good or bad performance. Moore & Baker (2010) suggest that warning by auditors should protect the public from financial failures. The extent of the economic crisis was enlarged by the delay to recognize failure. The extent of the ABS and CDS was unknown. Fair value could not be used to account for the invented derivatives which were the main cause of the downfall. Some scholars argue that fair value acts like a scoreboard (Fahnestock & Bostwick 2011, p. 6). It only shows the performance indicators. It does not create good or bad performance. Beisland (2010) claims that fair value caused the increase of derivatives used for hedging accounting. In that case, it could have caused the boom of derivatives.

Fahnestock & Bostwick (2011, p. 4) argue that fair value accounting made financial institutions to overvalue their assets to generate capital gains in their reports. After investors started panicking, fair value was again used to portray lower prices which were lower than the cash flow of firms. Fair value was seen as upsetting those involved in financial markets. Fahnestock & Bostwick (2011, p. 8) argue that illiteracy on fair value accounting was the cause of the problem. Managers viewed gains and losses reported by fair value as if they were actual cash flows (Ryan 2008, p. 11). The management should have ignored changes reported by fair value accounting instead of issuing more securities with unrealized capital gains reported through fair value accounting. Beisland (2010, p. 4) claims that during a crisis it is necessary to have regulations that require derivatives pay offs to match underlying cash flows.

Conclusion

Fair value accounting should not be blamed for the 2008 economic crisis because most of the firms that had agreed to comply with the FAS 157 requirements did not apply it. Most of the firms blamed with engaging in risky behavior did not use fair value accounting. Avoiding fair value accounting does not prevent financial analysts and investors from generating their own fair values from financial statements and market indicators. They would read the same indicators that firms are trying to hide. Fair value accounting limits firms from extending their credit to the levels that can create an economic crisis. It exposes risk taken by financial institutions. It gives warning to investors and may prevent bubbles created by the overvaluation of assets. Fair value accounting could have prevented the economic crisis.

Reference List

Beisland, L 2010, ‘A note on fair value accounting in a crisis: The Influence of the hedge accounting regulations’, Business and Economics Journal, vol. 2010, no. 13, pp. 1-6. Web.

Chea, C 2011, ‘Fair value accounting: Its impact on financial reporting and how it can be enhanced to provide more clarity and reliability of information for users of financial statements’, International Journal of Business and Social Science, vol. 2, no. 20, pp. 12-20.

Fahnestock, R & Bostwick, E 2011, ‘An analysis of the fair value controversy’, Journal of Finance and Accountancy, vol. 8, no.6, pp. 1-12.

Moore, W & Baker, C 2010, ‘The 2008 Financial Crisis: FAS 157 and SAS 59 – did they reflect realty?’ Journal of Finance and Accountancy, vol.4, no. 6, pp. 1-10.

Razaki, K & Koprowski, W 2012, ‘The paucity of Fed enforcement actions leading to the subprime mortgage crisis’, Journal of Finance and Accountancy, vol. 11, no. 9, pp. 1-21.

Ryan, S 2008, Fair value accounting: understanding issues raised by the credit crunch, Council of Institutional Investors, New York, NY.

Scott, I 2010, ‘Fair value accounting: friend or foe?’, William and Mary Business Law Review, vol.1, no. 2, pp. 491-542. Web.

Tarraf, H & Majeske, K 2013, ‘Impact of risk taking on bank financial performance during the 2008 financial crisis’, Journal of Finance and Accountancy, vol. 13, no.11, pp. 1-18.

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