Fair Value Accounting And Global Financial Crisis

Executive Summary:

The report has focused on analysing the contribution of the fair value accounting system in the global financial crisis. The studies suggest that there were many aspects in the accounting process that led the banks to initiate fire-sale for their assets which brought liquidity in the market. However, further analysis of the market status and the valuation process of the banks reflected that the fair value accounting system was used only for the trading valuation while the real assets were valued in historical cost method which created a gap in the valuation. The study also evaluated that most of the banks suffered in the crisis not because of undervaluation but over valuation of the assets that nullified the investors in the market. The connection between the FVA and GFC has been analysed and illustrated in the report.

Introduction and Purpose:

Fair Value Accounting has been defined in many terms and aspects based on its nature of accounting policies. The International Accounting Standards Board stated that the process of estimation of an asset that could be dealt with appropriate parties is called a fair value accounting (Gassen and Schwedler, 2008). The main purpose of the fair value accounting system is to identify the changes in the value of the assets and liabilities and formulate a balance sheet that derives the current value of the assets and liabilities (French, 2005). However, Fair value accounting has been considered as one of the causes of the recent global financial crisis. This is one of the most hyped discussions in the financial sector.

This report will analyse the facts and data that suggests fair value accounting as one of foremost causes of the global financial crisis. The researcher will try to understand the factors that led to the happening of the global financial crisis and evaluate the contribution of the fair value accounting system in the process. 

Global Financial Crisis:

The initiation of the financial crisis started in the middle of the year 2007 when American firm Bear Stearns announced problems with funds relating to sub-prime mortgages (Citadel, 2009). Sub-prime mortgage offerings were then considered as the primary source of the ongoing market fluctuations. By the end of year, the equity market was affected as the credit markets rose and some parts of it started to breakdown and the share prices of the banks also started coming down. By the end of 2008, US economy was trembling as Lehman Brothers went bankrupt and the US Government had to support many mortgage and insurance agencies (Benmelech and Dlugosz, 2009). The collapse of Lehman Brothers increased the fear in the market operations and the financial operations in the global market came to a near halt. The Governments of the nations started reducing the interest rates of the policies and started overtaking financial firms that were stuck in the situation (de France, 2008).                

The effect of the global financial meltdown in Australia was much diminutive in comparison to other developing countries. The financial sector of the country remained in a profitable position and did not require any kind of support from the Government of the nation (Alles, 2009). However, the financial sector nevertheless took a hit as the economic growth slowed by .5% and the rate of unemployment rose to 5.75 by the end of 2009 (Alles, 2009). The most affected sector was the Australian citizens with the fall in the equity prices (Citadel, 2009). The overall impact was a 10% reduction in the wealth of the Australian people. The Australian economy made a quick recovery and by the end of 2009 had covered half of its wealth reduction (Gassen and Schwedler, 2008).

As the Lehman Brother closed down, the currency of Australia started to decline and it went down by almost 30%. This made the market rigid and the Australian Reserve Bank had to get involved for increasing the liquidity in the market (Citadel, 2009). The re-growth of the Australian economy was fast which aided in reducing its losses for the global financial recession. The money markets and the credit markets of the country reflected buoyancy and the healthy nature of the Australian economy.

Global Financial Crisis and Fair Value Accounting:

Fair value accounting has been a hot topic in the aftermath of the recession and is considered as the factor behind the global financial crisis. The blame game is still going and the primary question is whether the fair value accounting process has accelerated the financial crisis and made the market more unstable (Benmelech and Dlugosz, 2009). Fair Value accounting is the process of assessing the price of an asset or a liability by using the market information. The key concept of the theory is that use of the current market information for identifying the value of assets and liabilities and deriving the current economic status of the economy. The fair value accounting is being blamed as most of assessments are being made on estimations and judgement of the market position (Plantin et al. 2008). On the other hand, Laux and Leuz (2009) stated that historical cost accounting system would have been a better choice as its assessments are based on actual dealings and transactions and the aspects of estimation are less. Thus, the results are more accurate in comparison to the fair value accounting system. Laopodis (2009) added that fair value accounting has not been able to maintain a transparent scenario in the financial reporting system and thus gave rise to many speculations that enhanced the market volatility. The support of the detractors of the fair value accounting system is that fair value accounting system forces the banks to sell their distressed assets and securities at fire-sale prices. This hampers the capital growth of the firms and also has a negative impact of the investors of the banks.

Plantin et al. (2008) noted that while the causes of the GFC were not the accounting theories and principles but they have contributed in accelerating the process. Laux and Leuz (2009) opined that while fair value accounting is being blamed, the experts must acknowledge that the switching of the accounting standards is not complete. Laux and Leuz (2009) also stated that the most of the firms are using the fair-value accounting systems for the trading operations only whereas the assets and liabilities are valued with the help of historical cost accounting system. This builds a gap in the process of estimation and forecasts and ultimately resulted in the fall of the equity markets.

The debate regarding the contribution of FVA started when President of US George Bush signed the Emergency Economic Act 2008 and gave the Securities and Exchange Commission the power to stop the use of fair value accounting process under the section 132 of the Act (Citadel, 2009).  The act was signed with a view of protecting the interests of the public and the investors of the nation.

Contribution of FVA’s in the GFC:

Based on the system of the Fair value accounting system, it is very improbable that the FAV has contributed in speeding up the global financial crisis. The crisis mainly started with the fall of the real estate prices and as the defaults rates usage increased in the US market (Landsman, 2007). The sub-prime mortgages provided by the US government became a tool for the public to acquire their American Dream (Alles, 2009). However, the consequences were not thought of as the price of the real estate products were being valued at the historical cost accounting system. Moreover, as the repo markets started drying because of uncertainty in the estimation process, the investment banks and funds started to collapse which initiated the economic crunch (Benmelech and Dlugosz, 2009). This also led to the development of many complexities in the valuation of the financial assets through fair value accounting system. These facts also suggests that the fire-sale of the assets were not contributed by the fair value accounting process, rather it was a gradual process of asymmetry in information collection that led to the global financial crisis.

In case of the bank holding companies, most of them were heavily relying on cash-flow based models for valuing their assets and liabilities. This again brought a gap in the process of estimation and valuation. It should also be noted that most of the banks did not report that their misprocess was a result of undervaluation (Alles, 2009). On the other hand, in most cases the problem raised because of over valuation of the assets that led to the fall of the assets prices and generated an economic instability. The issue created as a result of overvaluation of the assets was that the value of the assets was set so high that the banks were not able to sell them. Thus, the fire-sale process gained speed and led to financial crisis in the banking sector. The example of Merrill Lynch is appropriate in this scenario; they sold $30.6 billion worth of collateralized debt obligations with 22 cents on dollar backing. This reflected as a loss of $4.4 billion. However, during the period of the loss the asset value was set 65% higher than that of the market exit price (Benmelech and Dlugosz, 2009). This suggests that while fair value accounting may be a part of the GFC but the process of acceleration of the market volatility was not only because of fair value accounting system.    

Conclusion:

The above study reflects the debate among the market and financial experts regarding the contribution of the fair value accounting system in the speeding up of the global financial crisis. The growth of the financial instability in the market was a result of misalignment of the accounting standards followed by the financial in situations. The process of switching to the fair value accounting process was not implemented to optimum usage that created discrepancies in the valuation of the assets and liabilities and resulted in the global financial meltdown.

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References:

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De France, B. (2008). “Valuation and Financial Stability.” Financial Stability Review, Vol.12

Benmelech, E. and Dlugosz, J. (2009). “The Credit Rating Crisis.” NBER Working Paper No. 15045

Citadel. (2009). “Capital Adequacy of the U.S. Banking System,” Fixed Income Newsletter, March

French, N. (2005), “The valuation of specialised property: A review of valuation methods”, Working Paper, The University of Reading, England,

Gassen, J., and Schwedler, K. (2008), “Attitudes towards fair value and other measurement concepts: An evaluation of their decision-usefulness”, Survey: The View of European Professional Investors and their Advisors

Landsman, W. R. (2007). “Is fair value accounting information relevant and reliable? Evidence from capital market research,” Accounting and Business Research, Special Issue: International Accounting Policy Forum: 19–30.

Laopodis, N., (2009), “REITS, the stock market and economic activity”, Journal of Property, Investment & Finance, Vol. 27. no. 6. pp. 563-578.

Laux, C., and Leuz, C., (2009), “The crisis of fair accounting: Making sense of the recent debate”, Accounting, Organisation and Society, 34 (6):pp. 826-834.

Plantin, G, Haresh S, and Shin, H.S. (2008). “Marking-to-Market: Panacea or Pandora’s Box?” Journal of Accounting Research, Vol. 46. no.2. pp. 435–460.