Fair value accounting is the practice of measuring assets and liabilities at estimates of their current value in their balance sheet. Under the fair value estimation of assets and liabilities, organizations are allowed to use the quoted market price as the basis for their measurements. In today’s dynamic markets, people are interested in the value of asset today. This kind of estimation provides more transparency as compared to the historical cost based measurements. The historical cost method deals with the initial value of the asset when it was required and the same figure is entered into the books of accounts every year. The comparison between these two methods can show that the use of fair value method is more transparent and current.
The use of fair value has been a source of controversy with its critics arguing that it had a role to play in the financial crisis that happened in 2007-2009. According to Brousseau et al, (2014), the value of today’s complex financial instruments such as mortgage-based securities is subject to market volatility and liquidity. The critics have criticized fair value saying that it produces inaccurate results in unusual market conditions such as the financial crisis in 2008 (Brousseau et al, 2014). Many would agree that fair value is the best method of financial measurements while others would disagree. This article will be based on the financial crisis of 2007-2009 and if fair view had anything to do with the crisis.
This article will show that fair value accounting had no relationship or any direct effect in the global financial crisis that happened in 2007-2009. There is no empirical evidence that shows that fair value accounting contributed to the financial crisis. There was a large holding of subprime securities and mortgages that were overvalued in the years preceding the crisis. The banks thought that the housing prices would keep on rising but when they suddenly dropped the bubble burst, which triggered defaults on the loans, (Matt Pinnuck, 2012). This is what caused the financial crisis. The article will also show that more research is required to show the relationship of the fair value accounting and any financial crisis.
Features of fair value
In the past few years, the international standards setters and regulators has begun to favour the use of fair value. The introduction of fair value discredited the usage of historical based method of financial reporting. The main reason for this was to improve the relevancy of the information that is contained in the financial reports. Fair value helps investors and regulators help sound and informed decisions when it comes to the value of an asset. The fair value provides the current market conditions, which contains a strong basis for what is expected in the future.
Fair value accounting remains the most relevant tool for financial measurements. It allows in the increase or decrease of a particular assets value. Any problem that attributed to fair value accounting can either be because of accounting or from its implementation. A firm that uses fair value will be required to report any profit or loss that arises from the change in the fair value of the asset or liability. Fair value accounting could be said to be the solution to the problems of financial reporting.
Advantages of fair value
Fair value has implications across the world of business because accounting affects a lot of management decisions and investment choices. These decisions usually have cumulative economic repercussions. According to Ramanna Karthik (2013), fair value accounting makes accounting information more relevant. Fair value accounting allows for an accurate valuation of assets and liabilities. If the prices are expected to decrease or increase then the valuation will do the same. This means that the current market prices will allow the businesses to know exactly where they stand financially. The fair value for assets and liabilities record the current market conditions, which means that they provide timely information, which means that there is transparency.
The generally accepted accounting principles (GAAP) profits that are defined on a fair value basis speed up the recognition of gains especially in periods of rising asset prices. Fair value accounting will make firms survive during difficult economy times. This is because reduction in the values of assets are allowed to decrease unlike with the Historical valuation method where the initial price of the assets goes into the balance sheet each trading period. This will increase the efficiency of the firm in any financial situation.
Fair value and the 2007-2009 financial crisis
Fair value accounting came under fire in the 2007-2009 financial critics saying that it was the main cause. The most commonly suggested way in which fair value accounting would contribute to a financial crisis involves the link between accounting and bank capital regulation. Market prices can digress from their fundamental values for different reasons. If a bank were to write down its assets with these distorted prices then its regulatory capital would be depleted. This could force the bank to sell its assets at a fire-sale price and start a downward spiral. Fair value accounting has some rules that safeguard banks from marking distorted market prices. One rule states that prices from a distress sale should not be used in determining fair value. This means that if fare sales do occur, banks should mark their assets to these prices. Even if it might be quite difficult to know the figures that come from fire sales, the banks have a legitimate reason to disregard these prices.
When markets become inactive, banks may be forced to use dealer quotes, which might be twisted by illiquidity. The banks are allowed to use valuation models when they are deriving fair values. As the financial crisis in 2007-2009 deepened, they used this alternative.
Based on the analysis that has been and the above discussions, it is unlikely that fair value led to the financial crisis. The crisis started when the housing prices declined and the default rates increased. The harsh illiquidity of the many markets posed a real challenge of determining the fair values of the financial assets. This means that most banks did not actually use fair value, which means that the method did not have any connection with the crisis.
Fair value accounting only plays a limited role for banks’ income statements. There are also existing rules that safeguard the banks by offering them discretion an allowing them to avoid marking the distorted market prices. Banks used this in the crisis. Even with that, there is little evidence to show that the prices were actually distorted. This was because banks might have been forced to take excessive write-downs during the crisis. There is no close connection that using of fair value accounting method had anything to do with the crisis. More research is needed to show the effects of fair value accounting during boom and busts period in order to guide efforts to reform the rules regarding the same.
Bischof, J., Daske, H., & Sextroh, C. (2014). Fair Value-related Information in Analysts’ Decision Processes: Evidence from the Financial Crisis. Journal of Business Finance & Accounting, 41(3/4), 363-400.
Brousseau, C., Gendron, M., Bélanger, P. & Coupland, J. (2014). Does fair value accounting contribute to market price volatility? An experimental approach. Accounting & Finance, 54(4): 1033-1061. doi:10.1111/acfi.12030
Pinnuck, M. (2012). A Review of the Role of Financial Reporting in the Global Financial Crisis. Australian Accounting Review, 22(1), 1-14.
Ramanna, K. (2013). Why “Fair Value” Is the Rule. Harvard Business Review, 91(3), 99-101.
Schmidt A. (2014). Fair Value Accounting and the Financial Market Crisis: To What Extent is Fair Valuation Responsible for the Financial Crisis? Berlin: epubli GmbH.