Exploring the effect that fair value have had on the recent financial crisis

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How far do you think the financial reporting standards relating to fair value have contributed to the recent financial crisis? Should standard-setters consider the possible economic effects of their requirements when developing new accounting standards?

"Fair value is the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parities in an arms length transaction- in effect a market price in a theoretically perfect market".

Fair value is defined as a rational and unbiased estimate of the potential market price of a good, service or asset taking into account such objective factors as acquisition/ production/ distribution cost, replacement cost or cost of close substitutes. In accounting it is used to estimate a price of an asset or a liability where a market price cannot be determined, as in many cases there may not be an active market of it. In other phases, the historical cost accounting had some cons like the net asset would increase over the time which wasn't shown in historic cost while in fair value it was possible to do so.

The contribution of fair value to the present financial and economic crisis is under dilemma. Even though there have been several evidences in the past which support the contribution towards it. The bursting of the Japanese bubble caused by the reverberation effect due to the low financial fragility and on the other hand the credit bubble in the real estate businesses proves the stated. The bubble created by over valuing leads to debt and lesser credit fragility. Therefore reverberates between the stock market, real estate, credit and productive capital.

Even in the banking system, which in the present recession has gone worse from bad, fair value had its own pros and cons. Fair value is built upon the hypothesis in order to develop credibility and generate stability. Revaluation on a regular basis acts as a simulator for new strategies to survive and helps the banks to be more impulsive and generate higher returns. But the adoption of fair value puts the flexibility of the banks at stake where economic and financial interface is required.

Andrew Smithers describes fair value as the level prices would be at "if markets were perfectly efficient- ft.com

As Andrew Smithers states that the fair value prices would be equal to the actual value if we operated in a perfect manner, while in the real world there is no perfect market and hence forth misuse of fair value is being done. This may imply into generation of profits through exploitation of use of fair value in the real world

It has been argued that fair value has contributed to this financial crisis and managers are to blame for this crisis, this is due to managers over valuing the assets an undervaluing the liability. This has helped managers getting a bonus as they are the one who set out the fair value, as managers themselves usually determine the fair value; it is natural for them to show it in a positive way to make them look favourable, this is supported in various governments indirectly, for example in the tax law of the USA the bucket three is given to the unobservable inputs which price estimation is left under the hands of the managers itself.

However some analysts argue that fair value accounting has been made a scapegoat in this financial crisis and fair value doesn't have much to do with this. Nicolas Veron talks about the two criticism of fair value accounting centring with illiquidity and procyclicallty.

Illiquidity caused by banks needing to record a drop in value which is unjustified by economic fundamentals with corresponding reduction in shareholder equity, therefore required to raise more capital to maintain solvency ratio from depressed valuation condition from current shareholder or to reduce lending.

Procyclicality is the other criticism of fair value accounting, as it is argued this creates a boost for firm's balance sheet during economic boom and it equally reduces the balance sheet values in a bust.

It's a cycle which helps firms in a economic boost by showing an increased book value for assets and reduced liability through fair value, which reflects positively in their balance sheet. This increases the investor confidence and therefore more investment at a higher share value is benefited by the firm. And the opposite happens during a bust where the balance sheet looks worse due to fair value used for assets and liabilities are adversely affected, and therefore investor confidence goes down and a lower price is set for the firm's shares.

Critics of fair value have referred to market research where it has shown that the market is imperfect even in normal condition, and even more when there is a speculative bubble or a collective panic especially because of information asymmetries and difference among market participants in terms of beliefs and behaviour. Therefore by granting to much relevance to markets, accounting standards would be a culprit in accentuating both boom and bust.

Nicolas Veron does recognise some difficulties with the fair value accounting but does not think there is any need for it to be permanently amended or scraped, as without the fair value accounting there will not be any viable alternative. And she argues that there may be problems with is, but no one has come up with an alternative solution to this problem, so without the use of fair value accounting we would be left to use historical data.

Historical data has a value to certain extent however it may not reflect the current position of a firm as, an asset purchased 5 years ago would possible have increase and this increased asset could not be shown through increased share value, therefore historical data is still used in accounting but it cannot alone reflect a firms correct balance sheet.

By scraping fair value we will be depriving ourselves of a reflection of the current market and be in loss of data which would help us, if however we were to only have historical cost this will not be a true reflection of the current market and therefore may mislead us more. So there may be a problem with fair value accounting but it is not so as there is a better option out there then this, and this is currently the most accurate method out there.

Critics are at loss to accompany their argument with credible counter proposal, while it is easy to point out the problems with fair value it is less easy to identify an alternative method that would better fulfil the features.

Supporters of fair value claim markets do not appear to be blinded by the 'artificial' features of accounting data and the problem is real and relate to the dysfunction of market itself and not because of the accounting method used to report it.

This is backed up by the $19billion write down in the first quarter of 2008 by UBS led to an upsurge of around 15% in the share prices compared to closing price the previous day.

However writers like Prem Sikka would probably disagree to that, as he talks about how Accounting rules and auditors have allowed banks to show toxic assets at inflated values and keep more than $5,000billion of liabilities off their balance sheets. This has helped fuel the economic crisis, as bank were overvaluing their assets and under-valuing their liability, which lead to banks giving out more loans then they could afford to do so. Such as Lehman Brothers who had leverage of more than 30 to 1. With this leverage, a mere 3.3% drop in the value of assets wipes out the entire value of equity and makes the company insolvent". Major banks have reported leverage ratios of between 11:1 and 83:1. Yet accounting rule makers did not consider the likely consequences of their policies.

Looking at the evidence and recent financial crisis I do believe that fair value account did play a major part in fuelling this, because the balance sheet was looking much more favourable for the banks the boom and created an upward spiral. And they were lending our money based what they may have but in reality it wasn't there. Fair value accounting may not have been the cause of it but it was the method used by managers for them to manipulate and increase the company profits as well as for them to achieve a bigger bonus.

It is said that fair value can be like knife which can be used for useful purpose as well as it can be quite painful if you are holding the wrong side of it.

Fair value gives a relevant liquidation value at each instant but it can obscure the value creation process by mixing the present profit with unrealized capital gains and losses, where as historical cost show the actual cost and actually value creation but do not deliver the liquidation value of a firm.

Standard-setters consider the possible economic effects of their requirements when developing new accounting standards, as it is not longer just about a firm rather it affects the entire economy when it is used by financial institutions like banks and insurance companies. Therefore we may need to come up with a new system which is more reliable in this age, where information has become one of the most valuable assets, and to have an accounting system where this information is misrepresented will lead to more economic crisis such as the ones we are currently facing.

They should look to how to ease the procyclical affect as is has frozen the economies at the moment and that this does not keep getting worse, so that the negative spiral does not go too far where investors do not have any confidence to put up more money.

It should be also looked at how the valuation can be carried out by external independent auditors, rather then for managers themselves to come to it. This may reduce the chance of managers trying to increase the value of their investment for them to look better and a bigger bonus. I also believe if fair value accounting was performed in the correct manor without the manager's bias, would not have caused this crisis.

To sum it up there is a lot of critics of fair value which I think is fair to criticize as there has been short falling of this system; however there hasn't been any other system put forward by anyone for us to move away from fair value.

Therefore I believe this system is the best one to reflect the true worth of a firm's asset or liability at this point of time however it is open to a lot of manipulation which has lead to us now blaming the fair value accounting method.

If we were in a perfect market this would not be the case, but in the real market that is not possible; I think the problem lies with the manipulation of fair value, so standard setters should evolve fair value method in a way where manipulation of it could be reduced.