According to the CPA journal in 209, the use of fair value accounting has been expanding in reporting standards under generally accepted accounting principles (GAAP) in recent years. SFAS157 defines fair value, establishes a framework to measure fair value and requires for disclosing fair value measurements. Definition of fair value under SFAS is "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date" (CPA Journal, 2009).
In fair value accounting, assets are valued at a calculated current market price. Companies report losses or gains on the assets even when they haven't sold them (Triangle Business Journal, 2008).
Fair value accounting, or mark-to-market accounting has been blamed for contributing significantly to the current financial crisis (Christian Leuz, 2010). According to Christian Leuz, professor of the University of Chicago Booth School of Business, and Christian Laux, professor of Goethe-University Frankfurt, fair value accounting is neither responsible for the crisis nor it is merely a measurement system that report asset values without having economic effect of its own. Critics argue the fair value accounting or mark-to-market accounting has significantly contributed to the financial crisis and exacerbated its severity for financial institutions in the U.S. and around the world. On the other extreme, proponents of fair value accounting argue that it merely played the role of the proverbial messenger that is now being shot (Christian Laux and Christian Leuz, 2008).
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Fair value accounting was not the cause of the financial meltdown that has brought down the biggest financial institutions in the country, said by the U.S. Securities and Exchange Commission or SEC.
The main arguments against fair value accounting are that it contributes to excessive leverage in boom periods and leads to excessive write-downs in busts (Christian Leuz, 2008). Many banks and industry organizations have blamed fair value accounting for the downward economic spiral, saying that many organizations became in viable based only on paper losses. Critics have also charged that it is impossible to determine fair market value in an illiquid market, such as the one that began to materialize after the risky trading of mortgage-backed securities reserved course (Triangle Business Journal, 2008). A major problem in the crisis was that banks were highly levered during the boom and relied heavily on collateralized repurchase agreements (Christian Leuz, 2008).
Christian Laux and Christian Leuz said that it was unlikely the fair value according contributed to bank leverage prior to the crisis. They explained that the amount of debt that can be obtained by collateral. Investors were concerned about banks with substantial mortgage exposure once the problems in the mortgage market were apparent. Thus, financial institutions that relied heavily on short-term borrowing and had substantial subprime exposures would have forced major difficulties regardless of the accounting rules. In fact, problems could be worsening if there is less transparency about losses and exposures. The SEC reported said, "Rather than a crisis precipitated by fair value accounting, the crisis was a 'run on the bank' at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm (Triangle Business Journal, 2008).
The partner at Mayer Brown LLP law firm, Stanley Parzen said, fair value accounting actually helps freeze the market during the crisis. He said, to look at market transactions and similar transaction is the most technical method to value a financial instrument under fair value accounting. "By selling into a market without many transactions, you may be establishing a market value which is going to require you to take a loss."
An article from Bank Accounting & Finance asked a question: what is the root cause of our current economic problems, and is fair value accounting capable of capturing these problems accurately? The authors Wallace and Marsha disagree that fair value accounting is the root of our current economic crisis. Instead, fair value accounting is merely the messenger rather than contributor. And in fact, the situation might be worse without fair value accounting, since the magnitude of the problems would not have been recognized as soon under traditional accounting methods. If we had instituted fair value accounting earlier, we might have avoided the situation that we are in today (Wallace and Marsha, 2008).
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Christian Laux and Christian Leuz also pointed out some reasons that fair value accounting did not play a major role in this financial crisis. First, the fair value accounting and asset write-ups allow banks to increase their leverage in booms, therefore makes the financial system more vulnerable and financial arises more severe. However, this argument ignores that fair value accounting provides early warning signals for measure earlier. Thereby, fair value accounting may actually reduce the severity of the crisis (Christian Laux and Christian Leuz, 2010). Also, for U.S. bank holding companies, the impact of fair value changes on the bank income and regulatory capital is much more limited than the vigorous public debate might suggest that are carried at fair value, not all fair value changes affect banks' net income or enter the computation of the banks' regulatory capital (Christian Leuz, 2008).
Furthermore, the treatment of financial assets under U.S. GAAP is moe flexible. Leuz and Laux emphasize that the accounting rules allow reported values to deviate from market prices under important circumstances. For instance, fire-sale prices are not supposed to e used in determining fair value (Christian Leuz, 2008).
Using U.S. banks' financial statements, Laux and Leuz provide evidence that, as the crisis worsen, banks made enough use of the flexibility built into the rules. For instance, they moved assets that had been valued using quoted price in active market (Level 1 assets), or that had been valued using observable inputs from similar assets (Level 2 assets), to Level 3 valuing them with models (Christian Leuz, 2008).
There are also little evidence of excessive write-downs, or that fair value reported y banks were systematically too low. Laux and Leuz believed that , far from being a main contributor to the crisis, fair value accounting rules actually allowed banks to use discretion to keep fair values high (Christian Leuz, 2008).
According to a journal from Bloomberg Business week, critics had argued that the accounting rules made the current financial crisis worse by forcing banks to sharply reduce the value of assets such as mortgage-backed securities that were severely depressed by market conditions. The journal said the value of mortgage-backed securities, which are bonds backed by home loans, and other risky investment products fell sharply at the beginning of 2007. Because of the accounting rules, banks were required to record hundreds of billions of dollars in non cash charges to reflect the reduced value of those investments. As their value fell, banks became more unwilling to sell the assets as loss, only further weakening the prices and leading to more write-downs (Stephen Bernard, 2009).
According to the CPA journal, fair value accounting stands in contrast to historical cost accounting, which reports assets at the original price paid and with costs allocated over time used. The debate between fair value accounting and historical cost accounting method is usually framed by the issue of relevance versus reliability (CPA Journal, 2009)
Those who support the use of fair value accounting believe that reporting financial assets and liabilities at fair value is more relevant than historical cost. Fair value reflects the amount at which an asset can be bought or sold and provided better insights to current risk. As a result, investors and other decision-makers can exercise better market discipline and corrective acting regarding a company's decision (CPA Journal, 2009).
Prior to the crisis, the market for securitized loans was reasonably liquid and gave banks an opportunity to recognize significant gains from loan organization. Thus, those who critic fair value accounting and call for a return to historical cost accounting have to be careful: historical cost accounting for loans coupled with banks' short term incentives may in fact have been an important factor in the recent surge of securitizations (Allen, F. and Carlettie, E., 2008).