Fair value in accounting and its various applications has been debated and criticized by various critics as having a hand in the financial crisis. This paper is a presentation of arguments on how the use of fair value led to financial crisis. The collapse of various financial institutions and commodity market will be investigated. This will include a focus on credit crouch and Lehman brothers.
Thesis statement: Fair value accounting has contributed to the current financial crisis in the states of America. This is a statement derived from financial institutions which were affected by the fair value accounting. These institutions include the Lehman brothers’ company, AIG, and the credit crunch after the use of a mortgage-backed security.
Fair value accounting
Fair value accounting represents the value an entity would gain if it sold stock or rather the payment made to settle liabilities. Generally Accepted Accounting Principle states that fair value is the exchange price for an asset or liability given the existing market conditions (Krugman, 2009). To achieve this condition, both buyer and seller must be willing parties. Price level is determined by availability of enough information in the market. To estimate fair values, valuation model is employed. The model considers such data as: condition of an economy, prices of competing products, information flow and government regulations (Colin, 2000). A strong internal in for of counterchecking transactions ensures that accuracy is maintained in recording. It is appropriate to continuously appraise this model to cater for frequent changes in the market.
FASB and IASB provide a guide on accounting with fair values. FVA and its application through the business phases have been a theme to debate over the years. The focus was that FVA aggravates swings in financial markets and can ultimately lead to a negative change in the financial markets (Clarke, 2007). There have been opinions on the contributions made by fair value accounting to the current financial crisis. Critics argue that FVA and asset write ups allows bank to increase their leverage in booms which in turn makes the financial structure weak and financial crisis more intense (Laux, 2009). The argument did not consider the fact that FVA provides early warning for an impending danger thus prompting banking institution to use appropriate measures. Another argument on fair value accounting is its ability to promote pollution in financial market. This situation is evident where banks must sell their assets below the fundamental point and that price is subsequently used by other banks to mark their prices to market (Colin, 2000). Researchers have considered differentiating approaches used in measuring assets and liabilities. Utilization of both historical and present value valuation approaches is an absolute way of arriving at a good measurement criterion.
The current financial crisis is partly because of advice from government, complexity of financial instruments and timing in the market. The federal government using administrative powers manipulates the Federal Reserve Bank to lower their lending standards to banks (Drever, 2007). The low lending rate acted as an incentive for people to borrow funds to invest in various prospective areas. The value of securities reduced because of the fall in the housing sector. Fair value structure was used as a valuation criterion for marketable securities.
The benefit attached to the use of fair value is its ability to provide information on financial assets and liabilities contrary to the historical cost approach. Fair value system also provides comparability of assets bought or sold at different time period since it reflects the condition of the market at the present time. Investors also are more concerned with details of the balance sheet and other financial statements. For this reason, its preparation and disclosure will go along in supplementing on the information they have before a critical step of choosing an investment.
Intricacy and methods of measurement
Measurement in accounting entails determination of the value of an asset or liability for the use by other parties. Financial Accounting and Standard Board establish that present value (PV) procedure can be used to determine fair value. Use of the technical terms such like ‘expected fair value’ and ‘estimated future cash flows’ shows uncertainty this questioning reliability of data (Krugman, 2009). One of the points to make a note of is the projection made by management on the cash flows expected in the future from a specific asset group. Time factor would be important in determination of cash flows projections. When goodwill is involved in calculating fair value it becomes extremely complicated because management must exercise judgment in the estimation process. Financial Accounting Standard Board (FASB) recognizes the complexity of measuring risk by advising on the use of risk premium in calculating the present value (Copeland, 2000). The uncertainty in measuring risk for example in Mortgage-backed securities and collateralized debt obligations even though cash flows are expected in the future shows the difficult of making accurate forecast to be used in determining the fair value.
Discounted cash flows method of measuring fair value necessitates grouping of assets. The difficult nature of this approach is the allocation of asset’s fair value to the different assets within the group. In circumstances where there is plant, property, intangible assets and equipment, possibility of measuring fair values is less. Market values for intangible assets are not always obtainable. This calls for the use of DCF method. One of the disadvantages of fair value measurement is the possibility of dishonest managers manipulating the prediction criteria to reflect magnified figures so that they achieve their selfish ambitions (Forster, 2010).
Collapse of major financial institution
The beginning of the crisis was a very simple pointer in the financial market. It was triggered by a housing plan whereby credit was given to people to buy houses whereas they could not afford (Barry, 2007). Since they didn’t have enough savings, the only option was to go for mortgage from financial institution. The long run effect was a failure in paying back their debts and a subsequent collapse of major banking institutions. Statistics shows that there was an estimate of 6 trillion US dollars mortgage debt in 1999 which translated to 12 trillion US dollars in 2007 and a further higher level in later years (Colin, 2000). If these figures are compared with annual value of gross domestic product of approximately 11.5 trillion US dollars with a debt of 9 trillion US dollars, then it was not possible to pay the losses. This acted as the beginning of the present predicament of never-ending financial crisis. Although expansionary fiscal policy has been used to counter the effects of financial crisis, there were minimum positive results.
Unpredictable financial results
Research in the past indicates that when fair value is adopted, it results to unpredictable earnings. In the past two years, banks and other financial institutions have been unstable such that the fair value accounting has magnified the perception of investors, government, and regulators that the marker is in real financial crisis (Chen, 2008). A drop in earnings compared with the past years is a clear indication of the effects of fair value accounting. The insufficiency of measurement under the current conditions in the market must be rectified by provision of relevant information in form of disclosure (Cummings, 2008). The action would prompt the users of financial information to consider notes on the accounts when the situation in the market is not predictable. The quality and consistency of international financial reporting standards is critical for the stability of financial market. It can be highlighted that accounting information including disclosures stated in the standards of reporting is among the parts provide by the companies offering financial services (Cummings, 2008). Furthermore a clear distinction must be made between financial accounting requirements as applied to listed companies and the prudential concept brought about by supervisors of financial firms. Prudential framework corrects cycles in years thus applicable to analyzing financial information.
The credit crunches
The value of stocks in the stock market depends entirely on investor’s evaluation. The level of exposure of the values matters most before the investors decides on the subprime loans. Information on valuation presented by the financial institutions influences the frame of mind of the investors because of the most recent quotations. This forms part of the reason for the release of earnings in 2007 by credit Suisse (Laux, 2009). Beginning of February 2008, credit Suisse made approximately 8.5 billion Swiss francs then a week later it announced an adjustment of some asset-backed positions following a new structure in its credit trading business (Copeland, 2000). The value was reduced by an estimate of 2.85 billion US dollars. In 2008, operating income for credit Suisse was cut by 10% thus illustrating the difficulty of deducing the fair value when in real terms, assumptions about the future changes frequently.
Before the Lehman brothers company ran out of finance, it had a loss of 4.8 billion US dollars for the year ended 2008. This amount of loss was due to a fall of revenues for principal transactions including earnings from financial instruments and other assets owned by the company. The downward trend in transactions can be detailed by unrealized losses of US dollars 1.6 billion in the year 2008 with unrealized gains of 200 million US dollars in 2007 (Laux, 2009). Fair value therefore expanded the accounts of Lehman brothers in a negative direction.
An important point to note is the reduction in value of assets in financial institutions after using the fair value accounting. The effect is a contraction of capital ratios thus forcing the financial institution to sell its assets at a distressed price. Application of fair value accounting sends information that a company’s solvency is deeply undermined by strategies in financial institutions or rather their practices of lending and depositing fund but it is the duty of the regulators to specify the information to use when deciding on the market prices.
Critics argue that fair value accounting values distracts attention from the main issue. The main concern is the quality of the associated disclosure. Former governor of Federal Reserve Bank held that the main focus should be on disclosure so that investors and other beneficiaries of financial statement comprehend the drivers behind fair values (Forster, 2010). Fair value estimate failed to elaborate on the extent of risk credit Suisse and Lehman brothers faced if events did not turn as expected. AIG faced adverse risk because of exposure to credit evasion swaps. If the balance sheet of the mentioned financial institution is evaluated before the crisis, it would have been difficult to investigate the amount of losses following the risks.
As specified in this paper, fair value accounting is the price charged or received by a firm in a given time period if it were to sell an asset or pay a liability. Valuation model is used to arrive at fair values of assets and liabilities. The model captures the situation in the market at a given time period. Demands initiated by government on Federal Reserve banks to reduce their lending standards by using mortgage-backed securities affected value and investors confidence. The paper offered an explicit illustration of: AIG, credit Suisse and Lehman brothers who were affected by the crisis.
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