Examining Fair Value Accounting in the UK during the Financial Crisis

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Fair Value Accounting (FVA) has been accused as the main cause of the global financial crisis by many financial institutions. The main reason was the excessive injection of artificial volatility into the financial markets and which lead to a decrease in investors confidence about the solvency of the financial institutions. Financial Institutions argued that depressed market prices, which are acquired from inactive markets and subsequently used to measure banks financial instruments, cannot reflect a true and fair value of accounting publications. At the peak of the financial crisis, the IASB issued emergency amendments to IAS 39 and IFRS 7 in an attempt to relax fair value accounting. The amendments left commercial banks that report under IFRS with the decision to retroactively reclassify their financial assets that were once estimated at fair value into classes which necessitated measurement at amortized cost. This decision was however unparalleled to the IASB's general strategy for financial instrument reporting (IASB, 2008a) and its staunch preliminary position against reclassifications. The board, nonetheless, capitulated to the strong political pressures EU Commission and EU leaders who voiced concerns about the procyclicality that fair value accounting may introduce. The request was later made for the alignment of accounting rules for European banks to those of their US competitors since a similar reclassification option was already instituted under SFAS 115.

FVA's implementation has forced financial institutions to write down their assets to reflect distortions in market prices. These write-downs exacerbated volatility in earnings and contributed to market fragility. Scrutiny and reassessment of a wide range of financial products were performed which included derivatives, mortgage-backed and asset-backed securities and credit swaps A direct consequence was that information was no longer uniformed amongst investors that participated in these financial markets. This information asymmetry led to some investors, who were knowledgeable of pertinent market information, to profit at the expense of uninformed investors. Banks capitalized on the opportunity to forgo generous write-downs of financial assets that became illiquid or whose market prices significantly plummeted during 2008. For instance, the Deutsche Bank was able to raise its net income by 3.2 billion Euros in 2008 by simply reclassifying its illiquid assets which had a book value of 23 billion Euros.

The purpose of this dissertation is to empirically examine the role of fair value accounting in the 2008 global financial crisis with a central focus on fair value accounting's association with information asymmetry in the UK banking system. Although FVA has been used to evaluate assets and liabilities for many decades, this dissertation focuses primarily on fair value measurements as delineated under the accounting standard SFAS 157 Fair Value Measurements. This standard became effective in November 2007 and provided a definition of fair value as it related to financial reporting. It also outlined a three level measurement hierarchy that categorically ranks fair value inputs on the premise of their reliability. The standard seeks to categorize the most reliable inputs that are directly observable and obtainable from active markets as well as independent of the reporting body (Level 1) to the most unreliable inputs that are subjected to the estimations and assumptions of the reporting body when active markets are non-existent (level 3). The 2008 financial crisis provides a welcoming opportunity to analyse the relationship between information asymmetry and fair value measurements under SFAS 157 since there were widespread inactivity of many markets for assets and liabilities.

Problem Area

Proponents of FVA such as the U.S Security Exchange Commission, the International Accounting Standard Board and the Financial Accounting Standard Board argued FVA measurements can furnish investors real-time information that can enhance their comprehension of the economics values associated with various types of assets and liabilities as well as the assessment of suitable share prices. Fujioka et al. (2008) proposed that investors and decision makers are more inclined to use information based on fair value measurement over that historical cost measurements due to its overall perceived transparency and fairness. Ryan (2008: 1607) also noted that the evolution of the subprime crisis into a global financial meltdown can be attributed to poor operating, investment and financing decision making as well as inefficient risk management and fraudulent behaviour by householders, investors and firms. However, with the pervasive instances of inactivity amongst financial markets for assets and liabilities and the adjustments to the market valuations of assets and liabilities, information became imbalanced and uninformed amongst market participants. This inherently led to the existence of information asymmetry amongst investors such that some profited due to the key information made available to them. It is therefore the aim of this study to analyse the relationship between fair value accounting estimates, principally level 3 fair value estimates and information asymmetry.


This study focuses on the information asymmetry dilemma among equity investors that was instigated by fair value estimates. Key emphasis is on the UK banking industry during the 2008 global financial crisis. The motivation for this study stems from the following reasons:

Information asymmetry typically among investors has been a critical empirical theme in the field of finance and accounting. Information asymmetry among investors, where by some investors gain from information advantage over others, has been extensively accepted (Copeland and Galai, 1983). This is because informed investors may have access to unrevealed information or possess vast experience or knowledge to proficiently evaluate complex information compared to their uninformed counterparts (Mohd, 2005).

Literature has should there are several consequences that may ensue from information asymmetry. Easley and OHara (2004) have shown that it can have an impact on the cost of capital of firm. Myers and Majluf (1985) pointed out that it can affect a firm's investment and financial decision making and capital markets efficiency. Glosten and Milgrom (1985) noted that high information asymmetry results in low market liquidity, lower social benefits from trading activity and even lead to market failure.

Literature and other empirical studies have highlighted that information on bank assets such as fixed assets, loans, assets held in trading accounts is opaque. Consequently, due to their complexity, many investors from the outside encounter difficulty to value them and determine their potential levels of risk (Morgan, 2002). This information asymmetry presents opportunities for informed investors to profit over other uninformed investors. These investors will not invest when the information quality is poor since this has an unfavourable effect on the stock prices. In the heat of the financial crisis upturns in mortgage defaults have significantly reduced the market rate and liquidity of banks mortgages and underlying securities backed by these assets. Because the measurements obtained from inactive asset markets was deemed unreliable, the employment of fair value accounting, specifically level 2 and level 3, has been subjected to extremely harsh criticism. The measurement of these assets was considered by equity investors as distorted, informational opaque and risky. Hence studying the information asymmetry chiefly for level 2 and level 3 fair value measurements is paramount since they involve a large proportion of managerial intuition, discretions and assumptions.

Motivation also stems for literature on accounting disclosure. According to Ertinur (2004), tenets of the Economic Theory proposes that increased levels of accounting disclosure can potentially reduce the private benefits associated with information gathering and by extension reduce the information asymmetry among equity investors. Uninformed investors may seek to widen the bid-ask spread in response to the informed trading advantage that some informed investors enjoy (Bagehot, 1971). Nonetheless, ample accounting disclosures can close the gap between information advantaged traders and uninformed traders and at the same time narrow the bid-ask spread (Glosten and Milgrom, 1985). The reduction in the bid-ask spread can increase the security's liquidity resulting in increased trading volume and stock prices (Boone, 1998). The FASB indicated that SFAS 157 can provide enhanced information to financial statement users on matters relating to reliability, relevance, risks associated with assets and liabilities reported at fair value. The board also believes that such accounting disclosures can potentially provide equity investors with improved information on how fair value is employed to measure assets and liabilities, inputs employed to develop the measurements and the effects of those earnings (FASB, 2006). It is the ambition of this dissertation to examine whether the objective of proliferating fair value disclosures under SFAS 157 have been attained by centring on the information asymmetry concern.

Research Question

This study examines the relationship between information asymmetry and fair value measurements in the European banks. The accounting standard SFAS 157 has outlined the manner in which fair value evaluations are to be applied to Level 1, Level 2 and Level 3 of financial assets. Hence, the research question examines the nature of information asymmetry in all of these three levels of accounting data.

RQ: Does an association between information asymmetry and UK banks financial assets and liabilities exist? If so, are there distinct variances in information asymmetry in level 1, level 2 and level 3 fair value evaluations?

In order to comprehensibly answer this question, quarterly data of the FY 2008 for European banks will be used. In addition, bid-ask spread will be utilized as the proxy for information asymmetry since it is well established and have been widely used in finance and accounting literature as a suitable proxy for information asymmetry. According to Glosten and Milgrom (1995), knowledgeable investors can exploit information advantages at the expense of uninformed investors when information asymmetry among equity investors is high. In an attempt to safeguard themselves against looming trade losses, these uninformed investors would choose to increase the bid-ask spread. Hence, a positive correlation between information asymmetry and the bid-ask spread can be directly observed.


It is goal of this dissertation to provide supplementary understanding into role played by fair value accounting in the recent financial crisis with a central focus on information asymmetry in the UK banking system. However, because the crisis is not fully abated, there is still a meagre quantity of available literature to lend substantive support to its absolute role in the crisis in the UK. Nonetheless, by alluding to and analysing the conceptual and empirical fundamentals of fair value accounting in the U.S., it may be possible to draw inferences and make assessments on the ways in which fair value accounting impacted on the recent financial turmoil.


This study makes contributions to the on-going debate on fair value accounting by presenting a cross-sectional analysis of information asymmetry of fair value estimates. In so doing it lends support to existing literature which makes connections with the quality of accounting information to capital cost and liquidity of equity markets (Leuz, 2010). The study may also provide interest to accounting standard setters, bank regulators, accounting academia and equity investors.


The rest of the dissertation is organized in the following fashion. Chapter 2 provides a literature review on fair value measurements and summarizes the hypotheses based on the research question examined in the study. Chapter 3 discusses the research methodology as well as sample selection process. The findings of principal tests are presented in Chapter 4. The final chapter comprises of the conclusions of the study.

Chapter 2 Fair Value Accounting

This chapter outlines the definition of fair value with respect to U.K. accounting standards specific to the banking industry. After a review of empirical studies and literature on fair value accounting, hypotheses are developed based on the research question of this dissertation.

Definition of Fair Value Accounting

Fair Value Accounting is not a novel concept. In fact, the implementation of fair value measurements can be dated back to the early twentieth century (SEC, 2008). During the early 1930s, banks and other financial institutions were required, for the purpose of administrative reasons, to estimate their portfolios at market value. From then, there were many pronouncements on the use of fair value. Nevertheless, these basic standards simply outlined what to measure at the fair value but did not indicate how to measure. In addition, these pronouncements were contained many inconsistent and ambiguous definitions of fair value. For example, SFAS 107 Disclosure on Fair Value of Financial Instruments provided a definition for fair value to mirror procedure and measurements for utilizing unadjusted quoted market prices derived from an active market (FASB, 1991). Accordingly it declared thatfair value is the amount at which the instrument can be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale (SFAS 107: paragraph 5). This definition is, however, deemed very ambiguous and narrow. According to Whittington (2007), it is vague whether the use of the word amount instead of price reflects the gross selling price or the net realizable value that sellers would achieve after making deductions for transaction costs. In addition there is no general constituent for fair value accounting such that it was indistinguishable as an entry value, an exit value or a value in use . In the instance of active and liquid markets, assets and liabilities measurement at these values would not present any complications. The concerns and application difficulty surface in cases of illiquid markets. This is because the exchange values may not completely reflect the essential assets and liabilities values and the three components of fair value ( entry value, exit value and value-in-use) are intrinsically dissimilar from each other, thus resulting in abject confusion and inconsistency in financial reporting (Barth and Landsman, 1995).

Consequently, the FASB has provided a clear definition of fair value as an exit value and has also outlined consistent regulation on the application of fair value in the revised standard SFAS 157 Fair Value Measurements (FASB, 2006). This new standard aimed at enhancing homogeneity and comparability in the application of fair value. It defines fair value as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date (SFAS 157: paragraph 5). This definition underscores four essential structures of fair value that have not been identified in earlier pronouncements. Firstly, fair value is plainly recognized as an exit value that an organization will acquire for sale of an asset or transfer of a liability; and not an entry value or a value-in-use. Secondly, as noted by Whittington (2007), the word price is used in the stead of amount which denotes that transaction cost is not considered in fair value. Thirdly, the sale of an asset or transfer of a liability is considered as a hypothetical transaction by the measurement date, instead of the notion of real market transaction simply because of the use of the term would (Benston, 2008). Finally, the expression market participants connotes that fair value reflect the perspective of the market more willingly than that of a singular entity. This fundamentally suggests that fair value to be measured according to the assumptions that market participants would like to apply in order to value the asset or liability (SFAS 157: paragraph 11).

Fair Value Accounting and the three-level hierarchy

SFAS 157 has established a three-level hierarchy aimed at ranking the inputs to valuation methods used to measure fair value on the premise of their reliability. Alluding to paragraph 24 of SFAS 157, unjustified quoted prices derived from active financial markets for identical assets and liabilities are classified under Level 1 inputs. These inputs can be directly observed in liquid asset markets and are also publicly accessible with managements controls. These inputs are deemed the most reliable indication of fair value. The FASB is cognizant that certain assets and liabilities do not always have active markets in existence and even if markets do exists, they are not dependable to provide reliable and relevant information to measure fair value due to their illiquidity.

In an effort to solve this difficulty, the FASB has introduced Level 2 inputs which are essentially are inputs that are directly and indirectly observable for assets and liabilities, other than quoted prices incorporated in Level 1. Level 2 inputs can be subcategorized into three classes: quoted market prices for corresponding assets and liabilities in active markets; quoted market prices for corresponding assets and liabilities in inactive markets and lastly, prices validated by market-based measures which are satisfactory to permit the fair values to be estimated (SFAS 157, paragraph 28).

Level 3 inputs are unobservable and are calculated by using discounted cash flow methods, price models or other approaches which reflect the reporting entity's personal assumptions and deductions (SFAS 157: paragraph 30). These inputs are less accurate, heavily subjected to administrations manipulations and incorporate more information risks. Subsequently, the FASB has restricted the use of Level 3 inputs to only circumstances when Level 1 and Level 2 inputs are unavailable.

Fair Value Vs. Historical Cost Accounting

Historical cost accounting was at the core financial reporting during the early 20th century. A company then stated the price at which an asset was acquired and not its selling price in the current or future market. The same rule was applicable to accounting for liabilities (Plantin et al., 2008).

Arguably, while historical cost accounting could have potentially safeguarded banks and financial institutions from the considerable write offs of their financial assets values, it also possessed inherent shortcomings. For instance, historical cost accounting did not grant equity investors and other users of financial statements access to pertinent information on the institution's asset values. This meant that in the event of business liquidation, the assets would ultimately require revaluation and if assets were to be sold, their sale value would not be identical to their stated value at cost (Ryan, 2008).

Bernard (2009) contended that valuation procedures in accounting that underscores the significance of marking to market simply reflect the market's volatility and is not a contributory factor. Financial assets owned by banks and other institutions experienced losses on their value primarily because of the increase in inactive markets for the securities. Fair value accounting procedures forces establishments to show impairment losses and write-downs of the asset and liabilities values. Since selling the assets can result in banks suffering losses, financial assets were retained and investors were duly informed through their issued financial statements about the changes in the prevailing market value of these assets. By comparison, under historical cost accounting methodology, the opportunity for transparency in reporting would have been eliminated resulting in equity investors unawareness of the level of financial risks associated with these assets (Bernard, 2009).

Nonetheless, Magnan (2009) reasoned that fair value accounting is not, in itself a flawless methodology for financial reporting and has the potential to accomplish more than just mirror the existing market information.

Arguments For and Against Fair Value Accounting

Associated with the implementation of fair value accounting procedures, is a continuing debate on the advantages and disadvantages of fair value accounting amidst the business community, financial regulators and academics. This subsection highlights some of the main tenets of this debate both in favour and disfavour of fair value accounting.

Arguments for FVA

There is a shared view amongst the FASB, accounting academics and investor associations that fair value accounting is preferred over other methods of measurement attributes such as historical cost accounting for four main reasons.

Firstly, fair value accounting can deliver precise and transparent information to enable investors to comprehend the economic value of assets and liabilities. While managers may possess superior knowledge about the financial performance of the organizations, such information may not necessarily be disclosed to capital market investors. The implementation of fair value accounting has the ability to condense the information asymmetry that is existent between management and investors. The underlying reason is that fair value estimation inputs are directly quoted from the asset markets. They are therefore publicly accessible and managements manipulations are significantly less. Because there is added market discipline with fair value accounting, debatably, it is more relevant and reliable to investors.

Secondly, fair value accounting affords investors the latest information which can be pertinent to their decision making. This accomplishes this by capturing information associated with market prices at all moments in time. Due to this timelessness feature and the inability of banks to modulate prospective problems, information based on fair value is dubbed as better preferred to the historical cost accounting measurement of information. This is because fair value reflects a true and steadfastly truer reflection of prevailing market information rather than providing a misleading imagery of better appearance (Laux and Leuz, 2009; Muller et al., 2008).

Thirdly, the implementation of fair value accounting can potentially prevent the notion of gains trading which can occur under historical cost accounting (Laux and Leuz, 2009). The use of historical cost accounting to estimate assets and liabilities can generate incentives for banks to participate in inefficient asset sale ventures in an effort to realize premature earnings (Plantin et al., 2008; Laux and Leuz, 2009). This is referred to as gains trading. Thus the introduction of fair value can be associated with the motive to avoid gains trading(Schulz and Hollister, 2003).

Fourthly, in some instances, a mixed accounting model is used to financial instruments measurements. According to Barth (2004), a mixed-accounting model is the principal source of extra volatility in financial statements. Many of the ordinary financial instruments such as deposits, debt and held-to-maturity securities are reported under historical cost accounting are prone to potential inefficiency write-downs for every accounting period. Contrariwise, other financial instruments under SFAS 115 such as available-for-sale and trading securities; fair value hedge derivatives reported under SFAS 133; and fair value options reported under SFAS 159, are all reported on the balance sheet at fair value. Additionally, unrealized losses and gains resulting from fair value changes may or may not have an impact on reported income, conditional to their classification.

Empirical studies on the Fair Value Accounting in Global Financial Crisis

Chapter 3 Sample Selection and Research Design

This chapter examines the research methodology and the data sample that will be used to answer the research question and hypotheses described in Chapter 1. The researcher will employ a sequence of pooled time-series cross-sectional Ordinary Least Squares regression analyses to investigate the information asymmetry issue of fair value estimates in the U.K. banking industry in 2008.

3.1 Data and Sample Selection

The BvD Bankscope Database serves as the primary source and starting point for this study's sample selection. The study examines the association of fair value estimates and information asymmetry by employing banks quarterly accounting

3.1 Information Asymmetry and Bid-Ask Spread Proxy

Many types of variables are used as proxies since information asymmetry among investors cannot be directly observed in equity markets. Clarke and Shastri (2000) noted that there are three categories of information asymmetry measurements namely:

1. Investment opportunity set measures

2. Analysts forecast measures

3. Market microstructure measures

However, a popular proxy used in market microstructure literature is the bid-ask spread. This is mainly because the bid-ask spread tackles the adverse selection dilemma that stems from firm shares transactions in the presence of informed and uninformed investors alike. According to Leuz and Verrecchia (2000) the less adverse selection is brought out by less information asymmetry, which in turn suggests a smaller bid-ask spread. Hence, in this study the bid-ask spread will be used as the underlying proxy for information asymmetry due to its sound technical development and widespread use as a proxy for information asymmetry in many finance and accounting literature (Bhat and Jayaraman, 2009).

The bid price is the fundamentally the accepted buying price from dealers and the ask price is their accepted selling price. The difference is the bid-ask spread. Bagehot (1971) was first to make a correlation with information asymmetry and the bid-ask spread based on the work of Demsetz (1968) who presented empirical literature on the theory of securities transaction costs. It was later