Financial Crisis and Fair Value Accounting

Question: Describe about the Financial Crisis and Fair Value Accounting? Answer: Introduction In 2007-2008 the global economic downturn has emphasized on the role of financial accounting in leading to the financial crisis across the world. Several economist and financial analysis have scrutinized the global financial crisis and expressed significant concern regarding the financial standard, especially the Fair Value Accounting (FVA) which is used as a reporting instrument for the financial organizations. Various studies have demonstrated that Fair Value Accounting is one of the major triggering factors for the global financial crisis. On the other hand, some paper has significantly defended fair value accounting system through highlighting its advantages. Following fair value approach in preparation of financial statements has been a long debated topic in the past few years (Badertscher, Burks and Easton, 2012). Though fair value accounting has several merits, it has been subject to severe criticism in the post global financial crisis era. Several financial institutions have alleged that fair value accounting has played a significant role in leading to the credit crunch. This paper will focus on analyzing the influence of fair value accounting on the global financial crisis through reviewing wide range of literature. Additionally, this paper will also illustrate the advantages as well as disadvantages of the fair value accounting practice. Debate regarding the Role of FVA in Financial Crisis In context of the financial crisis of 2007-2008 and credit crunch, a significant debate on the strengths and disadvantages of the fair value accounting was arisen. The international economy was affected by the severe crisis which was amplified by the significant down fall of the financial markets of the developed countries. In 2007, financial shock was propagated due to the bankruptcy of the mortgage market as the subprime mortgage market of United States was collapsed severely. Prior to the financial crisis, banks had built up huge holdings of the subprime securities as well as mortgages. The financial analysts have concluded that those securities was overestimated as the banks along with the rating organizations have significantly undervalued the level of defaults associated with these securities and mortgages. Additionally, it was observed that the financial institutions had piled up significant exposure to the risky credit and subprime instruments. In 2007- 2008, the prices of th e securities associated to the mortgages gone down significantly. Therefore, the financial institution had to decline their value of assets linked to the subprime mortgages (Barth and Landsman, 2010). During the economic downturn, the value of the financial instruments declined and the firms were forced to sell the securities which made the market more risky and illiquid. Consequently, the financial instruments which were valued at fair value were sold below the fundamental or theoretical value for meeting the requirements of the capital market which led to further drop in the market prices. At this point of time bank had to sell the assets for maintain the required solvency ratio. The financial statements prepared by following the fair value accounting had led to significant uncertainty for the investors and their confidence had declined resulted in further price fall and financial instability. It has been identified that real estate bubble is the major reason behind financial crisis (Benston, 2008). Apart from this, it has been argued that emergence of fair value accounting has led to the financial crisis. The major challenge is to analyze whether introduction of fair value acco unting has significant correlation with the financial crisis or it just coincided with the global financial crisis. According to Laux and Leuz (2010), fair value is one of the major factors for the international economic contraction during 2007 -2008. Additionally, Barth and Landsman (2010) had also expressed the similar idea by accusing fair value accounting as one of key factors for the credit crunch. Some economists and financial analysts have stated that fair value accounting had significantly intensified the negative impact of the financial crisis as it has excessively contributed in leveraging during the boom period. Various studies have partly blamed the adoption of fair value accounting for the credit crisis in US which transformed into the global financial crisis. According to Foster and Shastri (2010), fair value accounting system was adopted by the financial institutions for measuring the assets and liabilities at fair value which has greater relevance in the decision making as reporting of the historical cost may seem irrelevant in most of the time. It has been found that the level of transparency was enhanced by adoption of the fair value accounting (Krumwiede, 2008). However, fair value accounting had received significant criticism from the economists and financial experts. Various studies have depicted that evaluation of most of the assets and liabilities at the fair value when the market was highly volatile led to erroneous valuation. This estimation was used for reporting in the financial statements which was not reliable for the investors. According to Dietrich et al. (2001), fair value has significantly improved the transparency and increased the relevance of the financial statements but it has failed to meet the requirements of reliability criteria. Fair value accounting has declined the level of consistency through distorting the view of the investors regarding the stability and financial performance (Bischof, Daske and Sextroh, 2014). According to Penman (2007), fair value accounting system was accused for integrating the price bubble of the real estate market into the financial statement which influenced the financial institutions for responding to the changes in the market in an abnormal manner. Consequently, fair value accounting significantly contributed in worsening the financial crisis of 2007 2008 (Foster and Shastri, 2010). This is the major reason behind the debated role of fair value accounting in the international financial crisis which was transmitted across the world. According to Trussel and Rose (2009), it will not be possible to deny the fact that fair value accounting practice had led to some issues in the complicated market context. As fair value accounting significantly focused on assigning high level of relevance to the financial information presented in the financial statements of the firms which has assisted in amplification of the economic cycle which contributed to additional volatility of the financial report. Critics have argued that when fair value accounting is applied in case of the illiquid securities, it fails as fair value focuses on both bust and boom which magnified the value of the balance sheets of the banks at the top of cycle (Goncharov and van Triest, 2011). On the other hand, declines those by the same estimate at the bottom. The pro-cyclicality criticism of fair value accounting during the global financial crisis had received highest attention. According to the fair value accounting standard, the entities are allowed to estimate specific liability as well as asset at the fair value at the date of reporting. The changes in the fair value are recognized in terms of loss or gain in the income statement. IASB and FASB have already defined fair value as the amount at which the asset can be exchanged or the liability can be settled. Hence, fair value allows ascertaining the value which can be obtained from the open market transaction. Consequently, market prices have been used instead of historical cost for determining the fair value. Though the accounting professionals have recognized the relevance of the fair value accounting, it has been argued that fair value estimation had played significant role in accelerating the financial. Especially, the banking sector was highly affected by the fair value estimation . The financial institutions have told that during the financial downturn, fair value accounting had forced the companies to recognize the losses which led to the sale of assets. Consequently, the economic position was further degraded. According to the President of the American Bankers Association, there are various factors which triggered the financial crisis and the fair value accounting is responsible for exacerbating the issues during the downturn (American Bankers Association, 2009). Additionally, it as has been argued that the fare value accounting for the financial instruments in the banks have led to extensive credit expansion. FVA has contributed in the excessive leverage in the boom market as well as write down of the asset was overestimated at the time of bust. According to Wallison (2008), fair value is the major factor for accelerating the financial turmoil due to the overestimation of the financial instruments which misguided the investors as well as forced the banks to sell their assets (Rashad Abdel-Khalik, 2010). On the other hand, some economists and the financial analysts have argued that fair value accounting has no direct association with the financial crisis. According to Barth and Landsman (2010), the perceived pro-cyclicality of fair value accounting is not responsible for enhancing the severity of the financial crisis of 2007 - 2008. It has been argued that it only holds in case of bank asset or in the case where fair value is applied at the time of determining impairment. It has been observed that most of the bank holding companies asset is not carried at the fair value in the financial statement (Paolucci and Menicucci, 2014). Additionally, when fair value accounting is applied, the model completely differs from the pure mark to the market accounting. According the studies undertaken by Shaffer (2010) and Laux and Leuz (2010), fair value accounting cannot be blamed for the global financial crisis. The studied shave demonstrated that the insignificant evidence is found for supporting the fact that fair value accounting forced the banks to write own their assets. On the other hand, International Monetary Fund (2008), has agreed on the fact that fair value accounting approach make the impacts of economic volatility on the balance sheet but it has been also found that under specific risk management framework, air value account has the potential to intensify the cyclical movements in the values of asset and liability. Apart from the concerns regarding the measurements difficulties, risk along with pro-cyclicality, FVA provides a measure which best reflects the present condition of a financial institution. Scrutinizing the literatures it can be found various studies have identified that fair value accounting played a significant role in amplifying the negative impact on the financial market at the time of economic downturn. Some researchers and economist have argued that fair value accounting has accelerated the financial crisis and significantly contributed in closing the ferocious circle of the asset fire sales. In contrast, some economists have argued that international financial crisis was led by the poor risk management practice and wrong credit grant decisions made by the financial institutions. Hence, the fair value accounting does not play a major role in enhancing the impact of financial crisis. During the economic downturn, fair value accounting has focused on reflecting the market condition in the balance sheet of the financial institution (Paolucci and Menicucci, 2014). From the wide range of literature, it can be found that the fair value accounting cannot be considered as the main reason behind the financial instability. Benefits of Fair Value Accounting Fair value accounting provides lot of advantages by considering the market value and enhancing the relevance of the information. Principle benefits of fair value accounting in relation to enhancing the quality of financial information are provided in this section: Accuracy and Transparency In fair value accounting, the financial information is presented considering the present market value instead of the historical cost. One of the major objectives of fair value accounting is to provide accurate information to the stakeholders (Okamoto, 2014). The internal control procedure of the organization must focus on reflecting actual market condition. Thus, adoption of fair value leads to estimation of the asset and liabilities in the current market and reporting those in the financial statement. Different valuation models are used for estimation of the asset and liabilities of the organization which ensures accurate and transparent information (Magnan, 2009). Enhanced Relevance It has been found that use of the present market value in reporting the assets and liabilities help in enhancing the relevance of the financial information presented in the balance sheet. In case of historical accounting the assets and liabilities are reported at the value of the acquiring date. Adoption of fair value accounting has enabled the organization to compare the assets and liabilities in different time period as those are valued at current price (Khurana and Kim, 2003). True Income Fair value accounting has limited the capability of the company in manipulating the net income presented in the financial statement. It has been observed that sometimes, the management purposely facilitate sale of assets to enhance or decline the net gain from the gain or loss from the sale proceeds. Drawbacks of Fair Value Accounting Though fair value accounting significantly contribute in enhancing the transparency and relevance of the financial information, it has some limitations. It has been observed that fair value accounting worsen the impact of economic downturn (Lilien, Sarath and Schrader, 2013). Analyzing wide range of literature some major disadvantages of fair value accounting has been identified and those will be discussed in this section. Value Reversal It has been observed that fair value accounting poses challenge to the organization as the market condition is reflected in the financial information. It has been observed that the market may become highly volatile and adoption of fair value accounting leads to reevaluation of the assets and liabilities in thee volatile condition. Consequently, significant swings in the value of the assets and liabilities are observed. However, in the stabilized market, the value of the assets and liabilities get back to the normal level. Thus, temporary loss and gain is reported which often mislead the investors (Kusano, n.d.). Market Effect Various studies have depicted that use of fair value accounting can significantly affect the market at the time of economic downturn. At the time of global financial crisis, the value of the assets were re-estimated and as it considered the current market condition, the value of the assets were estimated to be very low (Liao et al., 2013). Additionally, it is evident that the lower value of asset forced the organization to sell assets. This results further devaluation of assets and thus fair value accounting significantly contribute in worsening the impact of economic downturn (LaCalamito, 2013). Conclusion: This paper has provided an insight to the perspective of different economists and financial analysts regarding the role of fair value accounting practice in the global financial crisis 2007- 2008. It has been observed that various researcher have argued that fair value accounting reflected the economic downturn in the financial information which has devaluated the asset and forced the banks to sell assets so that the solvency requirement is met. Consequently it led to further financial instability across the world. Thus, fair value accounting has amplified the negative impact of financial crisis. On the other hand, some economists have argued that the global financial crisis was triggered by the poor risk management structure along with the wrong credit grant decision making. Hence, fair value accounting has no direct association with the global financial crisis. This paper has also discussed the major benefits of FVA such as improved accuracy, transparency and relevance. 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