Discuss about the Fair Value Accounting and GFC Causes Scenario.
FVA could be traced back in 1930s. Therefore, FVA had been in use for quite a long time before the great financial crisis. It was common for organization in valuing their assets. It was viewed as a means in measuring financial liabilities and assets. Basically, fair-value accounting is usually the price at which different assets are exchange in the current transaction between willing and knowledgeable parties (Pinnuck, 2012). Furthermore, it is viewed as practice of banking institutes appraising their assets assessments on consistent basis. FVA is also viewed as quantity which would be repaid in transferring liabilities to the new debtors. It is the price which would be received in selling its assets or repaid in transmitting obligations in a logical deal in amongst the market partakers at a specific time. Thus, FVA comprises of the hypothetical market price under the idealized situations (Pozen, 2009). This means that FVA is usually the market-based measures of the value. With these considerations, this paper aims to evaluate to what extent FVA contributed to the 2007/2008 financial crisis. This would provide support for my decision of being against the move to pure fair valuation.
Overview of Global Crisis
The latest global crisis has been a key concern all present society, from the press to the policy-makers, academics as well as regulators across the globe (Laux & Leuz, 2010). Basically, the collapse of some of the prominent financial institutions like Lehman Brothers, Wachovia, Bear Stearns and others followed by almost paralysing of general financial industry with some adverse results to overall economy, making this disaster a sole topic in a sequence of the present financial crisis. Interestingly, the uniqueness of the global financial crisis has impelled some efforts in identifying the determinants and solutions (Landsman, 2007). It is said to have been contributed by the bursting of U.S housing bubbles, though such a complicated occurrence as change in financial accounting could definitely presents some multidimensional profile. To be more specific, micro and macro events such as easy availability of financial loans, complexity of financial instruments associated with the mortgage activities, emergency of nations’ current account surpluses as well as flourishing house-buying activities could be cited to be the list of factors which could have resulted to emergency of the global financial crisis. As a result, aspects contributing to recent global financial crisis could be added extreme leverage as well as extreme risk-taking of the managers as a result of moral hazards (Laux & Leuz, 2009). Apart from these aspects, another occurrence which is referred to as one of the significant determinant of the global financial crisis was an overview or outline of FVA. Implementation of FVA brought about some significant regulatory variations in the accounting history, changing the importance of fair value concept.
FVA contribution to the Global Financial Crisis
To my analysis, I am not in favour of pure fair valuation. This is basically due to the notion that the FVA comprised of using market prices of the banking institutes in financial reports afore their acquisition costs. Under FVA in case market prices are unavailable, owners of liability or assets has to provide best available projections of the current market prices, by placing judgement on assumptions and techniques to be utilized (Kothari & Lester, 2012). Thus, FVA is said to represents administration’s projections of current value of gross forthcoming cash inflows exemplified in the liability or asset, which is reduced in reflecting both management’s projection of risk linked to cash flows and current interest rate.
To start with FVA played a significant role in deepening the 2007/2008 global recession. This is based on the fact that FVA was viewed to have played a greater role in exacerbating its severity for the banks in U.S during the 2007/2008 financial crisis which rapidly changed to the great recession of 2007/2008 (Veron, 2008). In essence, the FVA is said to have attributed to the global crisis in 2007/2008 to a greater extent since it attributed to extreme leverage in the prosperous times and resulted in extreme intolerable in performing reliable market valuation (Khan, 2010). As a result valuation issue resulted in increased or upsurged depreciation; hence, posing greater problem in the financial market. This issue arose when market for the asset valued at fair value accounting became illiquid.
Further, in the year 2008, additional guidance on the manner in which securities in distressed, disrupted or illiquid markets could be accounted for were issued by FASB while others failed to properly assess estimates used by the management in valuing liabilities and assets (Shaffer, 2010). In addition, use of fair value accounting brings about some artificial volatility in the monetary reports, and in the monetary markets. Such instability is mainly supposed to be the significance of implementation of the FVA, deprived of any sign of showing underlying fundamentals. Adoption of the FVA is also said to contribute to latest global recession since it the system is said that it does not correctly reflect the manner in which it manage their main operations, focused particularly on the long-run decision and are less concerned with the short-run variations. André, Cazavan-Jeny, Dick, Richard and Walton (2009) argued that fair value accounting played a greater role to the latest global recession in that it introduces some bias into the asset valuation against the long-run illiquid assets. Such bias arise due to some difficulties that might arise while establishing the market prices for the assets using private information, one of the well-established feature of the financial institutions operations, requiring particular expertise and information.
In addition, fair value accounting is said to have accelerated the 2007/2008 global financial crisis since it permitted financial institutions to finance their operations in short-term utilizing assets as security, which were dignified at extraordinary market value whenever country’s frugality was thriving (Katz, 2008). As the global financial crisis set up a vicious cycle, financial institutions had to detect a decrease in worth of their financial assets, particularly associated with the sub-prime loans. As a result value of these affects was adjusted to a lower level (Badertscher, Burks and Easton, 2010). Those financial institutions whose adjustments were not necessarily justified by the economic essentials argued that the intention of the adjustment was mainly to keep instruments till they mature. Such decline resulted to a decrease in shareholders’ equity. As they tried to uphold or preserve solvency levels at a obligatory point, financial institutions were mainly confronted with a predicament; hence, were enforced to increase their wealth underneath the miserable appraisal situations, sell some assets or lessen their loaning causing adverse impacts on overall economy. Sales of these assets depressed the market value of these firms and got more contaminated because of FVA (Masoud & Daas, 2014).
Fair value accounting is also said to attribute to the global financial crisis in that it resulted in inconsistent application across different nations (Bignon, Biondi & Ragot, 2009). This is on the basis that under fair value accounting, financial institutions could present specific quantity of the transaction assets underneath the US GAAP and in turn over double the quantity. This discrepancy did not just distresses dependability of the FVA, but it also affected efficiency of the Basel II regulations which in turn resulted to global financial crisis. Introduction of FVA increased banks’ leverage which in turn was dangerous whenever minimum capital needs acted as the amplifier as a result of the pro-cyclicality. In this case, through good times, the accounting returns, which are measured at the fair value could increase and in turn organizations could raise their leverage (Magnan, 2009). As a result, so long all organizations purchasing at same time and moving in similar direction, price of assets were expected to increase even more. By trying to keep the assets on organization’s statement of financial position at fair value, organizations are given a chance to utilize these assets as improved collateral and then increase leverage further (Barth & Landsman, 2010). Further, during the good times financial institutions tried to acquire other financial institutions at a higher price and any difference in between price paid and book value were recorded as goodwill. As crisis spread, the goodwill was another deadly asset and was therefore to be acknowledged at a value near to zero as a result of FVA; hence, forcing organization’s leverage ratio up (Glavan, 2010). Fair value accounting is also said to contribute to the recent global financial crisis since it resulted in the excessive write-down of the financial institution’s assets and to overvaluation of the banks’ assets.
Further, FVA contributed to the recent global financial crisis since it brought about price bubbles, making financial institutions or banks to respond to the variations in the manner in which they could not act and this resulted in voyage to the superiority; hence, disappointing the stock prices. It also had incremental power on the stock prices while conditioning opinions in interest and favour of sensitive liabilities and assets. FVA also worsened the global financial crisis by generating some sliding spiral trend and decreasing market prices considerably to a level below assets’ primary values (Badertscher, Burks and Easton, 2011). Furthermore, FVA is said to be the main cause of the unparalleled decrease in the asset values, an unparalleled increase in variability amongst different financial institutions as well as the worst crisis in U.S. In essence, fair value accounting is said to contribute greatly to the global recession as it attributed to extreme leverage in flourishing time and resulted in extreme write-downs in the busts (Magnan, 2009). This write-down depleted the financial institution money and could set-off the sliding spiral, as the financial institutions are enforced in selling at the fire-sale prices that resulted in contagion as the price from the asset-fire sales was relevant for the other financial institutions.
In conclusion, I am not in favour of a move to pure fair valuation since introduction of the FVA is cited to have a significant influence to the global financial crisis. For instance, the 2007/2008 was the first global crisis in which accounting system took the fair value technique at the global scale, heightening the interest in the financial market. The main concerns about this system are that it gives room for valuation of the illiquid financial instruments as well as induced artificial pro-cyclicality and volatility. Interestingly, I am not in favour of the move to pure fair valuation since fair value permits for specific assets to be prized at a quantity where they would be swapped in the open market. The issue with this was that whenever marketplace for the asset that an organization price at the fair value became illiquid. In essence, fair value accounting is said to contribute greatly to the global recession as it attributed to extreme leverage in flourishing time and resulted in extreme write-downs in the arrests. Further, it can be concluded that FVA attributed to 2007/2008 global recession since it resulted in a lot of distress in securities, disrupted or illiquid markets could be accounted for were issued by FASB while others failed to properly assess estimates used by the management in valuing liabilities and assets. It also brings about some artificial volatility in the monetary reports, and in the monetary markets. Further, it is evident that contribute to latest global recession since it the system is said that it does not correctly reflect the manner in which it manage their main operations, focused particularly on the long-run decision and are less concerned with the short-run variations.
It is also evident that fair value accounting had significant influence in the 2007/2008 global recession in that it introduced some bias into the asset valuation against the long-run illiquid assets. Such bias resulted in some difficulties that might arise while establishing the market prices for the assets using private information, one of the well-established feature of the financial institutions operations, requiring particular expertise and information. Further, it can be concluded that fair value accounting attributed to the global financial crisis since it resulted in inconsistent application across different nations. This discrepancy did not just distresses dependability of the FVA, but it also affected efficiency of the Basel II regulations which in turn resulted to global financial crisis. Therefore, on overall I am not in favour of the move to pure fair valuation since the FVA can be said to have attributed greatly to the 2007/2008 financial crisis; hence, there is need to review this accounting practice to curb such occurrence from occurring again. With these considerations, I am not in favour of the pure fair valuation since it is believed to attribute to the recent global recession.
André, P, Cazavan-Jeny, A, Dick, W, Richard, C, & Walton, P 2009, ‘Fair value accounting and the banking crisis in 2008: Shooting the messenger,’ Accounting in Europe, 6(1), 3-24.
Badertscher, BA, Burks, JJ & Easton, PD 2011, ‘A convenient scapegoat: Fair value accounting by commercial banks during the financial crisis,’ The Accounting Review, 87(1), 59-90.
Badertscher, BA, Burks, JJ, & Easton, PD 2010, ‘Fair Value Accounting, Other-Than-Temporary-Impairments, and the Financial Crisis,’ The Acccounting Review, 87(1), 59-90.
Barth, ME, & Landsman, WR 2010, ‘How did financial reporting contribute to the financial crisis?’ European accounting review, 19(3), 399-423.
Bignon, V, Biondi, Y, & Ragot, X 2009, An economic analysis of fair value: Accounting as a vector of crisis.
Glavan, S 2010, Fair value accounting in banks and the recent financial crisis,’ Estabilidad financiera, (19), 53-69.
Katz, D 2008, ‘Former FDIC chief: Fair value caused the crisis,’ CFO. com, 29.
Khan, U 2010, ‘Does fair value accounting contribute to systemic risk in the banking industry?.
Kothari, SP & Lester, R 2012, ‘The role of accounting in the financial crisis: Lessons for the future,’ Accounting Horizons, 26(2), 335-351.
Landsman, W. R. (2007). Is fair value accounting information relevant and reliable? Evidence from capital market research. Accounting and Business Research, 37(sup1), 19-30.
Laux, C & Leuz, C 2009, ‘The crisis of fair-value accounting: Making sense of the recent debate,’ Accounting, organizations and society, 34(6), 826-834.
Laux, C & Leuz, C 2010, ‘Did fair-value accounting contribute to the financial crisis?,’ The Journal of Economic Perspectives, 24(1), 93-118.
Magnan, ML 2009, ‘Fair value accounting and the financial crisis: messenger or contributor?,’ Accounting Perspectives, 8(3), 189-213.
Masoud, N, & Daas, A 2014, ‘Fair-Value Accounting’s Role in the Global Financial Crisis?: Lessons for the Future,’ International Journal of Marketing Studies, 6(5), 161.
Pinnuck, M 2012, ‘A review of the role of financial reporting in the global financial crisis,’ Australian accounting review, 22(1), 1-14.
Pozen, RC 2009, Is It Fair to Blame Fair Value Accounting for the Financial Crisis?(Digest Summary),’ Harvard Business Review, 87(11), 85-92.
Shaffer, S 2010, Fair value accounting: villain or innocent victim-exploring the links between fair value accounting, bank regulatory capital and the recent financial crisis.
Veron, N 2008, ‘Fair value accounting is the wrong scapegoat for this crisis,’ Accounting in Europe, 5(2), 63-69.