Y&A

1. Introduction

Fair-value accounting is a type of accounting wherein companies appraise and account specific assets and liabilities at fair-value-equivalent prices. This method is intended to create realistic financial statements as fair-value signifies that assets are accounted for at the price that would be received by the company if it were to sell them, and liabilities are reported at the value the company would receive if they were relieved of them. The role of fair-value accounting in financial crises is profoundly contested and divisive. The actual point of disagreement is the use of fair values in financial reports. A few people maintain that fair-value accounting resulted in the financial crisis, while others set all such assertions aside and affirm that the only role of accounting was to provide and showcase the factual values of company assets. In this paper, I intend to examine the positive and negative sides of the use of fair-value accounting in an economy, and its contribution, if any, to the financial crisis. I shall further discuss the accounting regulations’ extent in fair-value accounting theory, and the investigative substantiation that escalating price instability during the crisis caused more companies to adhere to the requirements of hedge accounting.

‘Fair-value accounting has significantly contributed to the financial crisis or, at least, aggravated its severity’.

Generally denoted as ‘mark to market’, fair-value measurement has been in widespread use for a number of decades in the United States’ Generally Accepted Accounting Principles (GAAP) as a method for calculating liabilities and assets. To cite examples, fair-value accounting was used in the early years in US theories such as Employers' Accounting for Pensions (Issued 12/85), Accounting by Debtors and Creditors for Troubled Debt Restructurings (Issued 6/77), Generally Accepted Accounting Standards No. 15, Accounting for Certain Mortgage Banking Activities and Accounting for Impairment or Disposal of Long-lived Assets (Issued 9/82).

Fair-value advocates, including the chief affiliates of the SEC, IASB and FASB, dispute that it is the most applicable measure for fiscal instruments that provide investors with precise, clear and well-timed information. They are of the view that it adds to market regulation and results in more competent and resourceful markets, and that the substitute models of measurement delay or hide the revelation of vital information and generate incompetent market decisions. However, its positive effects are overpowered by the negative ones; it was fair-value accounting that aggravated the severity of the financial crisis to a great extent.

According to the American Bankers Association (2009), fair-value accounting is suitable for assets held for the purpose of trading or is apposite if an individual’s model of business is based and administered on fair-value (Stojilković, 2011). Nonetheless, for securities, leases and loans held to maturity, and for conventional commercial banks, it is disputed that fair-value accounting may prove to be unsuitable and deceptive, particularly when markets are illiquid as well, as during the crisis.

Banks that are focused on conventional lending business are in a position to evade the fair-value accounting effects on their income statement or balance sheet by categorizing their loans as ‘held-for-investment’. Correspondingly, fair-value accounting is not a requisite for securities that are ‘held-to-maturity’ (Stojilković, 2011). For the 31 bank-holding firms that were unsuccessful and were detained by U.S. bank regulators during the period 2007 to2009, no fundamental role was played by the trading of assets, and loans comprised about three-quarters of their respective balance sheets (Stojilković, 2011).

Even though fair-value derivation is extremely multifaceted in times of crisis and in illiquid markets, it is theoretically complex to dispute that the revelation of fair-value information, as such, increased the level of indecision and ambiguity, and worsened the economic crisis (Stojilković, 2011). With the problems identified in the subprime lending markets and housing, it is improbable that investors would not have been alarmed and worried about bank holding companies if they would not have revealed the fair-value information (Stojilković, 2011). It is in fact more conceivable that less information on fair-value would have augmented unfavourable selection worries and investor indecision.

Therefore, even for the leading position documented at fair-value, that is obtainable for securities, the regulatory capital and income statement were protected from changes in fair-value in specific cases where banks disputed during the time of crisis that fair-value accounting was not apposite and undecided; when the market prices declined, and liquidity dropped, when the risk premium increased, or when the bank had the intention and capability of clinging to assets, it was considered provisional (Plantin et al., 2008).

To examine the relationship between the financial crisis and fair-value, this investigation considers the largest banking institutions. In relation to smaller ones, large institutions use a larger percentage of fair values in their respective balance sheets. Additionally, smaller institutions do not usually spend in the type of illiquid or compound securities that are deemed the chief sources of decline in pro-cyclical asset prices since they do not usually have the domestic proficiency to administer the risks linked with such different investment products. Hence, as far as fair value’s noteworthy effect on endorsed asset sales and bank capital is concerned, it stands to reason that this effect/result would be most distinct at the leading banks as regards the financial crisis (Jarolim & Öppinger, 2012).

Fair-value application to investment portfolios remains to be examined. The critics maintain that fair-value controls behaviour and alters the financial picture when it is applied to assets serving as long term investments, such as equity or debt securities (Plantin et al., 2008). It is further maintained that this alteration is augmented when de-leveraging comes to the fore, when investments are exchanged in illiquid marketplaces, where the management and auditors are excessively traditional owing to litigation risk, and when investors behave unreasonably (Laux & Leuz, 2010). Such elements subsisted in the year 2008. Moreover, with the collapse of market liquidity and with an increase in distressed transactions, the rules of fair-value materialized to produce accounting for particular classes of assets that deviated from the basic economic value that is expected on the basis of estimated cash flow (Stojilković, 2011).

This exerted a vast effect on the regulatory capital of banks as at the beginning of 2008. These institutions held a considerable proportion (12% of total assets) of long-term security investments in their ‘held-to-maturity’ and ‘available-for-sale’ portfolios (Plantin et al., 2008). Based on their pattern of classification, fair-value pertains to investment securities. In each reporting period, the ‘available-for-sale’ investment securities are measured at fair-value, and the resultant adjustments are called unrealized losses or gains (Scott, 2010). The adjustments undertaken are documented in the ‘Accumulated Other Comprehensive Income’ equity account. It is important to note that fair-value adjustments related to unrealized gains on equity securities and debt securities are barred when calculating the regulatory capital of Tier 1, and that the unrealized losses on equity securities are counted in Tier 1 (Plantin et al., 2008). Nevertheless, equity securities characteristically compose a much lesser fraction of the investment portfolio of banks (Plantin et al., 2008). As can be seen in the sample banks, the unrealized losses on equity securities stand irrelevant (Enria, 2004).

It can, therefore, be concluded that in the majority of banks, fair-value adjustments showed only a minor impact on regulatory capital. This does not explicate the relation between capital obliteration and fair-value. It should also be considered that OTTI (Other than temporary impairment) losses take into account the effects of illiquid and distressed markets and the impact of plausible credit losses (Benjamin et al., 2012). There is not much evidence to support that capital is not affected by plausible credit losses. Fair-value concerns deal with the other pricing ‘noise’ augmented by the crisis and the effect of market disturbance (Benjamin et al., 2012). Therefore, if credit loss is eliminated, the impact of fair-value owing to pricing ‘noise’ is expected to fall to an even lesser amount.

Investors benefit greatly from fair-value accounting. Financial statements mirror a more lucid image of an organization’s health as the fair-value theory registers assets and liabilities as per their real values (Wallison, 2009). This, in turn, permits investors to make prudent decisions regarding their investment options within the organization (Wallison, 2009). The necessary footnote disclosures provide investors with a suitable method of investigating the effects of statement variations because of the fair values of assets and liabilities (Wallison, 2009).

3.1.2 Financial Statements in Pragmatic Format

3.1.3 Reduced Net Income

When using the fair-value accounting method, the calculated net income of a company decreases with a decrease in the assets’ values. Similarly, the calculated net income of a company decreases with an increase in its liability values (Penman, 2007). The end result of a company’s income statement is net income; this sum reveals the amount on which the company pays taxes (Penman, 2007). The company is at an advantage here as lower net income results in lower taxes. This consequently brings about a reduction in the company’s equity, which leads to fewer employee bonuses (Penman, 2007). Ultimately, the company benefits here as well as more money go into the company’s pocket (Penman, 2007).

In markets that are unpredictable, the value of an item changes quite often. This results in vast disparities in the earnings and value of a company (Bischof et al., 2010). Losses on items against the earnings of a company are usually disregarded by accountants (Benjamin et al., 2012). Publicly held companies find it difficult, as investors, to appraise a company with such primed fluctuations. In addition, the potential for imprecise assessments could result in audit problems.

Businesses engaged in specific investment packages or assets find it difficult to evaluate items in the marketplace (Benjamin et al., 2012). In the absence of market information, accountants ought to take an expert decision on the value of an item. Accountants ought also to ensure that all methods of valuation used are feasible and take into account all procedural aspects of the same. Fundamentally, companies ought to have apt reasons for valuing investments and assets (Benjamin et al., 2012).

As against the historical costs, fair-value accounting may be considered less reliable by accountants. For instance, accountants characteristically check the entire market when looking for a new value for investments or assets (Benjamin et al., 2012). Nonetheless, accountants should make a judgment call for the valuation of items in the books if the item is sold at different values in different areas (Benjamin et al., 2012). Owing to the valuation method of the accountant, issues may arise if a company with analogous investments or assets values items differently against another who may not (Magnan, 2009).

The book value of a company is the sum of all the owned assets. Traditionally, value is altered when the company disposes of old assets and/or procures new assets (Wallison, 2009). Currently, however, fair-value accounting also alters the book value of a company for apparently subjective concerns (Wallison, 2009). For instance, a company may be required to make accounting amendments if an investment or asset witnesses a major fall in value for a short period of time. However, if the value returns, the amendment only reduces the book value of the company for that short period of time (Benjamin et al., 2012).

Asset-markets exhibit a cyclical pattern, wherein the risk is over-estimated during slow-downs and is under-estimated during booms. This cyclical pattern in the case of banks is familiar to all. Banks cautiously evaluate default risk while determining the interest charged to companies directly after a serious financial crisis and the associated firm’s bankruptcy (Benjamin et al., 2012). However, when the boom linked with a low rate of interest continues for a considerable time, numerous statistical studies confirm that the estimated default probability is likely to be reduced to zero. This, in turn, offers credit to rather uncertain ventures. The incongruity between the actual economic return rate and the expected returns is at the source of a recession, all through which the estimated default probability is radically raised, consequently calling for a financial slump (Benjamin et al., 2012). Short-term recessions may be worsened by several psychological reasons of behavioural finance, such as blindness to hindering crisis, over-assurance in one’s own aptitude, mimetism and/or memory loss (Benjamin et al., 2012).

Benjamin, S.J., Niskkalan, A., & Marathamuthu, M., 2012. Fair value accounting and the global financial crisis: The Malaysian experience. JAMAR, 10(1), pp.53-68.

Bischof, J., Brüggemann, U., & Daske, H., 2010. Relaxation of fair value rules in times of crisis: An analysis of economic benefits and costs of the amendment to IAS 39. [Online] Available at: <http://areas.kenan-flagler.unc.edu/accounting/documents/daske-bbd_gia.pdf>. Accessed 4th April 2014.

Enria, A., 2004. Fair value accounting and financial stability. Occasional Paper Series, 13(1), pp.1-45.

Jarolim, N. & Öppinger, C., 2012. Fair value accounting in times of financial crisis. ACRN Journal of Finance and Risk Perspectives, 1(1), pp.67-90.

Khan, U., 2010. Does fair value accounting contribute to systemic risk in the banking industry? Columbia Business School Research Paper Series.

Laux, C. & Leuz, C., 2010. Did fair-value accounting contribute to the financial crisis? Journal of Economic Perspectives, 24(1), pp.93–118.

Lauxa, C. & Leuz, C., 2009. The crisis of fair-value accounting: Making sense of the recent debate. Accounting, Organizations and Society, 34, pp.826–834.

Magnan, M.L., 2009. Fair value accounting and the financial crisis: Messenger or contributor? Accounting Perspectives, 8(3), pp.189-213.

Noyer, C., 2008. Valuation challenges in a changing environment. Financial Stability Review, 12, pp.1-7.

Penman, S.H., 2007. Financial reporting quality: Is fair value a plus or a minus? Accounting and Business Research Special Issue: International Accounting Policy Forum, pp.33-44.

Plantin, G., Sapra, H., & Shin, H., 2008. Fair value accounting and financial stability. Financial Stability Review, 12, pp.85-93.

Pozen, R.C., 2009. Is it fair to blame fair value accounting for the financial crisis? Harvard Business Review, pp.1-10.

Scott, I.E., 2010. Fair value accounting: Friend or foe? William & Mary Business Law Review, 1(2), pp.489-542.

Stojilković, M., 2011. Towards a criticism of fair value accounting. Economics and Organization, 8(1), pp.91-109.

Wallison, P.J., 2009.Fixing fair value accounting.OECD Journal on Budgeting, 2, pp.1-7.

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