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With the recent financial crisis prevailing around the word and centered in the US, the use of accounting especially the fair value accounting has created a great concern about this attribution to this financial crisis. Many of them pointed out that the fair value accounting has exacerbated but not initiate this crisis. (See Laux & Leuz 2009, and Badertscher, Burks, Easton 2010) As accounting its own has The first part of the essay will concentrate on analysing the role of accounting during this financial crisis, in particular discussing whether fair value accounting has worsened the financial crisis. The second part involves the analysis on accounting being a remedy for the financial crisis.
The fair value accounting, which could provide inappropriate value and unreliable prediction for financial instruments, leads losses to banks and accelerated the financial crisis as a whole. Huian (2009) pointed out that under the FAS (Financial Accounting Standards) No 157; it is required to estimates the value even if there has no active market exists, and he suggested that the CDS (Credit Default Swap) and other financial instruments are measured at the fair value which resulted in a far less credible results. Furthermore, Laux & Leuz (2009) illustrates that banks may have to sell all these securities with a fairly low price because of the fair value accounting, and which triggers the contagion in the financial markets. As the financial instruments are not measured accurately and reliably under the fair value accounting, banks have to make a loss under the accounting rules. Similar to a chain reaction, banks continue to make losses by selling assets at a low value determined by fair value accounting, the whole financial markets is worsen off. However, it could also be that banks have spent a huge amount of resources trying to acquire the market price in accordance with the fair value accounting rules; these amounts of capital the banks spent eventually became a burden and later a loss.
On the other hand, the fair value accounting actually contributes little to the banks' losses because the actual losses are made on their loans to low less credible borrowers, and hence has little negative effect on the economy. "Credit loss provisions had a greater impact on banks' financial position than the impact of mark-to-market losses." Huian (2009) It interprets that there is a possibility that banks might had not valued many of their financial products under the fair value accounting, but they still made a loss. There has incurred a loss because their debtors of loans are not able to pay back. Badertscher, Burks, Easton (2010) has also found no evidence that the fair value accounting made the banks sell securities at losses during the crisis. Thus, it is apposite to speculate that the losses made by the bank are not due to the fair value accounting. Furthermore, Shaffer (2010) researched the relation between the banks' capital and fair value accounting, concluding that the loan losses had a much greater impact on the banks rather than the fair value impacts. (See Shaffer 2010 table 4 Pg. 18) Given by the evidences in the literature and the analysis above, it is reasonable to conclude that the fair value accounting has no significant effect contributing to the financial crisis, but it does have an impact on the financial institutions as discussed in the second paragraph.
The role of accounting in the recovery from the crisis
In terms of recovering from the crisis, Huian (2010) suggests that setting the standard to use full scaled fair value accounting could be a solution, because the combined method including fair value accounting and historic cost accounting creates confusion among the investors. It is beneficial for recovering from the crisis, because a unified accounting rule will provide the investors more comparability and clear vision on the asset values, and certainly will boost the investment confidence. However, it turns back the problem that Laux & Leuz (2009) raised about the absent of the market prices. If prices of assets in the markets are hard to impossible to determine, only by estimation could result in biased prices and resources wasted in determining the prices.
It was criticized by Huian (2010) that the FAS no 157 impose the rule to use fair value accounting even when active markets are available. Thus, changing the accounting rule to a more flexible condition might help recovering from the crisis. For example, allowing the financial institutions to use different method of accounting when active markets do not exist. As Laux & Leuz (2009) illustrates that historic cost accounting gives the banks more flexibility to choose at which price to sell the assets, this ensures that banks will not make a loss due to inappropriate estimation of the prices. However, it is also suggested by Laux & Leuz (2009) that more flexibility and relaxing the rules could provide the space for manipulation and impair the reliability of accounting information.
In conclusion, just as Laux and Leuz (2009) pointed that accounting should not be responsible for creating this financial crisis as reporting asset values did not trigger the crisis, but fair value accounting do have an impact on the crisis. Therefore, accounting is not a root cause of the financial crisis. In addition, it is possible that accounting can contribute to the recovery from the financial crisis. For instance, setting full standards could promote investment confidence, and reshaping accounting standard rules gave banks more options to resist losses. However, to what extent will these approaches be effective are to be analysed. Furthermore, to what extent has fair value accounting affected (or worsened) the financial markets during the crisis remain unknown.