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

Fair value accounting Contents Contents 2 Introduction 3 Role of Fair value accounting in the financial crisis 4 Advantages and disadvantages of fairvalue accounting as compared to other methods 8 Conclusion 10 References 12 Introduction The financial crisis of 2008 had major impacts on the economies of various countries across the world. The economic and financial crisis was of an unprecedented degree and had major immediate and long term effects on the world economy. The reasons, impacts and consequences of the financial crisis have been a major topic of concern for regulators, researchers, governments and policy makers around the world. The financial crisis of 2008 was the biggest crisis in the history of world economy after the Great Depression in the 1930s. The bankruptcy of the major financial institutions like Lehman Brothers, Meryl Lynch, Wachovia and Bear Sterns paralyzed the financial sector in the United States followed by other countries across the world. The uniqueness and deep impacts of the financial crisis of 2008 led to a high degree of investigations related to the determinants of the crisis and the solutions improvised and to be implemented in future in different countries to meet the consequences of the financial crisis as well as prevent the occurrence of such high magnitude crisis in the future. Many micro environmental and macro environmental factors were considered and evaluated to understand their roles in driving the financial crisis. The account surpluses of the emerging economies, easily available loans, decreasing price of mortgage backed assets and complex structure of the financial instruments along with the excessive levels of risk taking and leveraging led to the cyclical events of the financial crisis. The role of the Fair Value Accounting (FVA) as a reason driving the financial crisis is identified as a debatable topic. Role of Fair value accounting in the financial crisis The regulatory framework underlying the concepts of fair value accounting is governed mainly by the accounting standards. Earlier, different countries established their own jurisdictional systems with respect to the account ting measures. But the advent of the Generally Accepted Accounting Principles (GAAP) created the need for the global accounting methods to comply with a common regulatory standard. The fair value accounting methods are widely followed under the GAAP in the preparation of the financial statements of companies operating across all types of industries. The International Financial Reporting Standards (IFRS) have emerged as a globally applicable set of accounting and financial reporting standards. Currently, more than 115 countries across the globe have implemented the IFRS systems for financial reporting and accounting purposes. The United States is still the most powerful economy which has the chunk of share in the world market capitalization. The importance of the IFRS standards and the economy of the United States make it necessary to use fair value accounting methods in the global financial markets. The International Accounting Standards Board (IASB) has strongly favoured the implementation of fair value accounting methods for financial reporting across all countries from the early 2000s which has been reflected in the modification of many of its accounting rules. During the financial crisis, the financial markets faced severe liquidity problems. The assets and liabilities also faced problems related to disorder and illiquidity. The financial institutions incurred losses of billions of dollars due to the sharp decrease in the fair value of the securities used in the financial markets. These incidences highlighted the role of fair value method of accounting in fuelling the financial crisis. There are two main problematic factors associated with the fair value accounting processes as used in the time of the financial crisis. The first problem that was identified was the difficulty of estimating the fair values of the securities and other assets in market which was highly illiquid and in a disorderly state. The second problem was that the fair value accounting method follows a pro cyclical pattern which sharply increases the intensity of movements in the financial markets which may eventually create a downward spiral in the whole financial market thereby negatively affecting the financial institutions and financial instruments in the economy (Laux and Leuz, 2010, pp.96-105). The generalization and adoption of valuation methods promoted by the fair value accounting technique are identified as possible stimulants of the financial crisis by some scholars and academicians. On the other hand, some scholars are in the opinion that the fair value accounting methods cannot be established as a direct cause driving the global financial crisis. A number of academic literatures have been prepared by different scholars and researchers through studying and identifying the different factors affecting the global crisis and the role of fair value accounting method as a major factor driving the financial crisis of 2008. Though many financial crises have taken place in different periods of the history of world economy, the global economic downturn of 2008 has been the first economic and financial crunch which encompasses the accounting systems using the fair value accounting methods. The high magnitude of the crisis instigated a multifaceted analysis to identify and evaluate whether there is a direct relation with the crisis and the new accounting approaches using fair value methods of accounting (Andre, Cazavan, Dick, Richard and Walton, 2009, pp.3-24). Many critics have supported the argument that the fair value accounting method also known as mark to market accounting method has been a significant contributor to the financial crisis. Also, they indicate that even when the fair value accounting methods have not directly impacted the crisis factors, they played some role in accentuating the degree of the crisis and intensified the damages created by the crisis on various economies of the world. The fair value accounting methods follows the reporting of liabilities and assets in the balance sheet in the basis of the fair value. The changes in the fair value are recognized as loss or gain in the income statement of a company. Since, the market prices are often used to determine the fair values of the assets and liabilities, this accounting method is also known as mark to market accounting method. There are major allegations towards fair value accounting methods on the basis of this accounting process being a major contributor of the excessive leverages experienced in the economy during the boom period of the business cycle which was followed by falling market prices during the trough period of the business cycle. The write downs were caused by the decreasing market prices and resulted in the depletion of capital in the banks which started a downward spiral fall in which the banks had to sell their assets at low value. The process acted in a contagious manner being transferred from one bank to another and soon a spiral effect was seen in the economy. In the bank holding business in the United States, the effect of the changes in the fair values on regulatory capital and income of the banks was much limited. The banks also used a number of safeguards and relevant discretions in the implementation of fair value methods of accounting before and during the financial crisis (Khan, 2010, p.24). For example, many banks in the US having huge trading portfolios and high level of exposure in real estate used cash flow based accounting principles and models for the valuation of the mortgage backed securities during the third and the last quarter of 2007. The mortgage backed securities in the banks of US were not the adept users of the mark to market accounting method. The reported fair values of these banks did not face much undervaluation or write downs which could have been caused by the fair value accounting method and which could have led to the stimulation of the financial crisis. The evidence found by many researchers point out that overvaluation of the assets was more predominant in banks in which there was more discretion in the determination of fair value. The role of fair value method of accounting can be identified to be constrained by the limited relevance of the fair value accounting in the capital requirements and balance sheets of the banks. Many scholars identify that the marking the value of the assets to the market prices can intensify the downward spirals in an economic crisis. On the other hand, many researchers identified that the fair value methods of accounting enables a quicker identification of the losses recorded in the financial statements which can help the regulators and the banks in taking prompt and adequate corrective steps to constrain imprudent lending processes in the economy (Ryan, 2008, p.21). The new accounting methods increased the chance of occurrence and the intensity of the financial crisis. The banks in the United States were allowed to finance the investments through the use of assets as collaterals. These assets were accounted under the fair value accounting method during the boom period of the economy. Subsequently, the prices feel to a high extent in the recessionary period. The creation of a vicious cycle through the imprudent lending activities resulted in the banks being forced to reduce the value of the financial assets linked to the subprime loans given by the banks. Hence, the banks had to adjust the value of these assets in the portfolios to a lower level which had a negative economic impact. The values of the equities were decreased and the banks were compelled to sell their assets at lower prices to raise capital (Magnan, 2009, pp.189-213). Since the economic conditions caused undervaluation of the assets, the lending activities also had to be decreased. This caused a pro cyclical effect on the economy. Some researchers argue that the additional effects of the fair value methods of accounting led to further diminishing of the asset valuations for these banks consequently leading to a high degree of depression in the economy. Advantages and disadvantages of fair value accounting as compared to other methods There are certain advantages as well as disadvantages of using the fair value method of accounting for the valuation of assets. The historical methods of valuation guarantee reliability whereas the fair value methods ensure relevance to the market conditions. The fair value method is adapted in practice across the globe and by the international accounting standards like the international Financial Reporting Standards (IFRS) because of its conciseness and transparency. The viewpoint expressed by the use of the fair value accounting method is clear and concise with a higher degree of transparency than that used in the historical accounting methods. The fair value accounting methods are more relevant for the investors as they represent the prevailing conditions of the market. The creditors and investors prefer to use the fair value prices because these values reflect the current market price of the assets and liabilities of a business. The fair value method of accounting is more relevant in the modern times because it provides relevant and timely feedback value which is useful for the investors and shareholders of a company. The historical methods of accounting do not provide relevant information for the investors. The information derived by the historical cost accounting is based on past values and is often out of date. The fair value methods of accounting can be consistent when they apply one standard valuation approach over a specific period of time. The historical cost accounting contains a pluralistic form in which different valuation methods are combined. The past transactions are valued and reported at historical prices whereas the present transactions are reported and valued at the fair value basis. Therefore, with respect to consistency, fair value method has certain limitations as compared to the historical methods of accounting. Since the fair value methods calculated on the basis of inactive markets, the values may be unreliable. But the historical methods of accounting follow the actual transactions which ensure that the recorded values are verifiable and reliable and are not affected by any biasedness or personal judgement form the management of the company. If the fair value methods are reliably measured, they can enhance the comparability of the assets or liabilities. But in practice, the fair value methods of accounting are better than the historical methods of accounting in the comparability measures of valuation. The historical cost accounting processes are not suitable for comparability of the values of assets or liabilities because these processes may not be able to identify the similarities and differences existing among the elements recorded in the financial statements. The fair value methods also ensure that revenue recognition can be done at a more continuous basis. The earnings are measured on the basis of the changing economic values of obligations and rights. In the historical accounting valuation methods the earnings are measured at periodic intervals in certain discreet points of time when the criteria required for revenue recognition are suitably met. The historical cost accounting uses a combination of different accounting principles and measures to measure the expenses and recognize the revenues incurred in the business. The fair value method of accounting is more applicable in the balance sheets than in the income statements. This is because the balance sheets are the main vehicles for communicating the financial information about the company to the shareholders. The fair value method is globally used in valuing the assets and liabilities recorded in the balance sheet for financial reporting purposes (Dickinson and Liedtke, 2004, pp.561-569). The income statement is used to measure the periodic shifts in the values and kelps the shareholders to be informed about the risk levels associated with the business and the changing economic conditions (Barth, 2004, pp.122-124). The historical methods of cost accounting are more implemented in the income statements because the income statements act as the main modes of conveyance of information about the value created for the shareholders in the business. The earnings management is more effectively done by using the historical cost accounting methods than the fair value accounting methods. The earnings of a business are the changes in the values of assets and liabilities in the present scenario. The earnings are not informative about the future values and future earnings. The fair value accounting methods do not predict the changes in value that can occur in the future (Allen and Carletti, 2006, p.44). On the other hand, the historical cost accounting methods are more informative about the future earnings and values and thus are more useful in creating opportunities with respect to earnings management. Conclusion Though there are contrasting opinions of researchers about the role of the fair value accounting method in the global financial crisis of 2008, yet there are no concrete evidences that indicate that fair value method is responsible for the financial downturn. Instead other macro environmental factors are considered to be more central in driving the intensity of the financial crisis. Summarizing the benefits and drawbacks of the fair value accounting method and comparing it with the historical cost accounting methods, it can be established that the fair value methods are more relevant in the modern business world. It can be identified as it the most effective method of financial reporting in the global economic conditions. The role of the fair value accounting methods ion keeping the shareholders and investors informed about the values and risks associated with the business is critical for the success of a business as well as for the positive growth of an economy. Along with this, it should be identified that the fair value accounting method has many areas to improve upon so as to increase the efficiency and reliability of the accounting process. References Allen, F. & Carletti, E. 2006. Mark-to-Market Accounting and Liquidity Pricing. [Pdf]. Available at http://finance.wharton.upenn.edu/~allenf/download/Vita/Allen-Carletti-MMA-200706-final.pdf. [Accessed on 12 April 2014]. Andre, P., Cazavan, J., Dick, W, Richard, C. & Walton, P. 2009. Fair Value Accounting and the Banking Crisis in 2008: Shooting the Messenger. Accounting in Europe. Vol. 6(1), pp. 3-24. Barth, E. M. 2004. Fair Values and Financial Statement Volatility, International Accounting Standards Board. [Pdf]. Available at http://www.iasb.org/NR/rdonlyres/721AD4A0-42BB-4A09-9A91-140D27D65B84/0/FairValuesandFinancialStatementVolatility.pdf. [Accessed on 12 April 2014]. Dickinson, G. & Liedtke, P. M. 2004. Impact of a Fair Value Financial Reporting System. The Geneva Papers on Risk and Insurance. Issues and Practice. Vol. 29(3), pp. 561-569. Khan, U. 2010. Does Fair Value Accounting Contribute to Systemic Risk in the Banking Industry? [Pdf]. Available at http://www.binghamton.edu/som/files/Khan.pdf. [Accessed on 12 April 2014]. Laux, C. & Leuz, C. 2010. Did Fair-Value Accounting Contribute to the Financial Crisis? Journal of Economic Perspectives. Vol. 24(1), pp. 96-105. Magnan, M. L. 2009. Fair Value Accounting and the Financial Crisis: Messenger or Contributor? Accounting perspectives. Vol. 8(3), pp.189-213. Ryan, S. G. 2008. Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch. [Pdf]. Available at http://www.ifrs.org/current-projects/iasb-projects/amendments-to-ifrs-7-financial-instruments-disclosures/exposure-draft-and-comment-letters/comment-letters/documents/cl66.pdf. [Accessed on 12 April 2014]. Read More