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BAC304 Advanced Accounting Theory Paper Editing Service
Fair value accounting can be defined as the overall price / rate at which the asset can be transferred or purchased between the prospective buyer and seller, this characteristic is usually referred as “mark to market” accounting practices. (FASB, 2008). This characteristic is employed by banks, financial institutions and others in order to update the overall valuation of assets, marketable securities etc on a standard basis. Furthermore, Fair value accounting is stated as the price at which the seller tends to receive the money by selling the stated asset or enable in transmit of liability in a proper transaction among the market participants at a specified date. Therefore, from the definition it can be stated that fair value accounting mainly enables in considering more imaginary rates for valuing the assets and liabilities based on given circumstances and conditions. Many accountants, research scholars and business practitioners have stated that the adoption of fair value accounting principles and policies by leading firms has played an extensive role in contributing to the sub-prime crisis of 2007 – 2008. (Blankespoor, 2012). The subprime financial crisis has become a major financial chaotic situation around the world, due to poor lending practices and mortgage backed securities in many developed countries.
The financial crisis of 2007 – 2008, began with the easing of credit by issuing mortgage loans, these loans were then securitized using special purpose vehicles and it is sold in the market as mortgage backed securities. (Foster, 2010). From 2001 to early 2007, it was considered as one of the golden period in the US history were in a considerable economic prosperity was contributed to many individuals, the main source was identified as the poor lending practices implied by many banks & financial institutions and very loose regulatory requirements. In general parlance, accounting standards do not enable the banks and financial institutions to record overstated income which is mainly related to mortgage or home loans without a proper remedy from qualified analyst and financial controllers. When the FRB began to increase the interest rates from 4% in 2001 – 2002 to over 8% in 2007, the market began to crash and this has encouraged the crisis to pass on to the shareholders in the sector which has huge backlash in the market. (Simkovic, 2011). The main argument in the recent credit crisis is that the implementation of fair value accounting practices which has enabled the banks & financial institutions to increase the financial leverage during the boom period and this has made the financial system to be highly vulnerable to changes and increased the severity of financial crisis.
The following points is stated in detail to provide a overall understanding on the extent to which the fair value accounting practices has caused the global financial crisis. In order to reinstate , fair value is stated as the price at which the given asset is purchased and sold between the parties under the current transactions. In case of highly active market, fair value is considered as the current market price, however the market price should tend to reflect the real aspiration of prices as thought by the buyer and seller. (Turner, 2010). Researchers have claimed that fair value measure is not a accounting aspect but a mere measuring standards supporting the users.
Historical Cost Accounting does not have relationship to Current Market Value
The major components of the stated principle is that the use of historical cost of assets as stated in the balance sheet does not provide a real estimate which is in relation to the current market value. Under the historical accounting concept, the assets are usually stated at the purchase price or otherwise termed as the original value with little adjustments being provided for depreciation, for the usage of the assets. For example, a company which possess land and building in their asset side for many years, will eventually state the value of those assets at much lower price when compared with the market value of the assets. But it is noted that in historical accounting, the regulators has advised the business enterprises to factor in the changes in the market value of the asset. (Barth, 2010). The regulators have asked the publicly traded business enterprises to analyse the asset carefully for quarter on quarter and update their assets. In case if the business enterprise has identified that the overall value of any assets is low than the historical cost and the destruction is a permanent one, then the company should focus in reducing the value of the asset which forms part of the consolidated financial statements and must record the balance as loss in the p&l account of the company. Thus historical accounting has attempted to project the written down value of the asset only after careful though and analysis.
However, the use of fair value accounting has resulted in either exaggerating the asset or understating the asset based on the changes in the market price. Most bank executives were against such written downs in their asset as the impairment which is caused on the mortgage backed securities and other assets are for temporary basis and the prices may continue to increase after a initial slump. But, as the financial crisis gets worsen in the early 2008 the default rates on the mortgage backed assets and other structured finance securities began to increase, bankers and financial institutions were facing forceful demands from the external controllers to recognize the losses on the financial assets as permanent and need to write down the value of the assets as permanent, this has made the banks more vulnerable to risk. (Finnegan, 2012). In a general parlance, fair value accounting has defended the accounting fraud risk which the management tries to cover up the decrease in the market price with that of the cost price.
Assets of the financial institutions need to be “Marked to market”.
Most of the banks and financial institutions have made their assets to “marked to market”. The application of fair value system has critically decreased the overall ability of the financial institutions and banks to resist the overall risk. If the financial market is highly active, the products which are measured through fair value accounting system seem highly lucrative and portfolio managers tend to be optimistic to a very large extent. (Khan, 2010). But when the market is in a bearish mode and showing weaker signs, then the value of the assets will be undervalues. According to the financial standards, banks need to take steps to accrue the impairment based on the measurement attributes with respect to the assets or aim to reduce the capital which tends to affect the bottom line of the financial statements. Therefore, banks, at this juncture, in order to evade any adverse effect on their financial statement tend to sell their assets, which eventually results in decline in the value of the assets.
In the fair value accounting, the management of the business enterprise will divide their loans and securities on three broad categories, like : loans and securities which are held, loans and securities which are traded and loans and securities which are available for sale. If the management of the financial institutions possess the ability to hold such securities until maturity, then they may carry them at historical cost in their balance sheet. These loans which are held to maturity may be impaired in case if the value of such securities has come down permanently, however, by virtue of fair value accounting practices, the assets are always marked to market on each quarterly basis. Any decrease in the current market price of the traded assets will result in the reduction in the equity portion of the balance sheet and the income statement will be showing a loss for the business enterprise.
Also, the fair value accounting practices does not consider the bank credit risk, changes in the interest risk etc. furthermore, it also ignores the overall extreme risk which is confined to derivative instruments like forwards, swaps, options etc. Through the financial crisis, many has identified the ill effects of fair value accounting practices.
Assets should reflect the market price even in case of illiquid market
The other cause for the financial crisis is the adoption of fair value accounting which has suggested the assets should reflect the market price even in case of illiquid market. One of the straight forward characteristics of fair value accounting is the implementation of current market prices to the assets when the financial market is highly liquid, this is considered as Level 1 by FASB. So, whenever possible the assets should be valued as per Level 1 method. However, FASB has also recognize that the market prices are not always be there, in such circumstances, the management need to ascertain the value of the assets by using measurable market inputs, which is regarded as Level 2. (FASB, 2008). The inputs for ascertaining such values can be sourced based on the prices of similar securities or other related securities. Also, it is noted that there are cases when no such data or inputs are available, which is like making a investment in closely held private fund, in such cases the regulators has suggested to use Level 3, where in the assets are classified as illiquid assets. In this case, the financial advisors were allowed to value it by applying a “marking to model” approach rather than using “marking to market”. Under marking to model approach, the financial advisors are allowed to make assumptions in order to compute the fair market value of the assets. Thus the application of fair value accounting has induced the implementation of irrational behavior among the investors in the financial markets, during the crisis many financial institutions, credit agencies, have changed their ratings of business enterprises and securities in order to evade their responsibilities. This behavior has exaggerated the panic in the market and causes many negative effects.
In light of the recent statements by both FASB third level units, there is no doubt that it is clear to banks, less liquid bonds, marking model. It is noted that during the beginning of 2009, the valuation performed by 19 largest companies in US under the level 3 approach, has enhanced the asset value by over 14% when compared with the previous quarter results. That allowed the banks to provide a basis on reasonable assumptions own estimates of subprime income, mortgage-backed securities and other troubled assets for several years, the yield model is generally higher than for recent transactions d 'units like. (Blankespoor, 2012) Model Markup allows banks to paint a relatively optimistic picture of the economic situation. this is sure to meet the real skepticism by investors, banks Rating of precision troubled assets. He said Warren Buffett, trademarks degenerates into "myth brand." we can deal with this skepticism and maintain reliable estimates ? help investors understand how they reached a value for the property marked with the model, the Bank publishes an additional level of calendar lists three devices, and summarizes the key features. most important addition, the bank reported in sufficient detail includes the key assumptions in the models that allow investors to keep track of their calculations.
A thorough review of the accounting of the fair value on the brink of bankruptcy leading banks in the capital erosion. In the opinion of many banks, forced to decline to recognize the fair value recovered after the economic crisis is "artificial" value of the property. Investors, on the other hand, there is nothing like the man to preach to a fine for the value which no other prospective buyer is willing to buy the asset. (Lim, 2011) It cannot be combined with a variety of perspectives. And it can be met when the financial institutions has decided to disclose their results fully by enabling in recognizing the correct value of the asset and deduct the capital portion in case of loss. This will enable the business enterprises to possess the title to the assets and this will be made to be sold on the market - but the gain or loss on these obligations do not affect the solvency of the bank. The requirements for accounting and the money can be distributed to other areas until the banks showing a totally different methods. Gains and losses realized on a quarterly basis the bonds sales department, for example, can be accurately reflected in the balance sheet and accounts of the bank's results. But the average market value can be calculated for regulatory capital purposes based on these securities over the past two quarters. This combination makes it possible for investors to see the current values of these bonds, which reduces the volatility in quarterly regulatory capital banks. Even if legislators can extract more from the calculation of bank capital based on the recognition of the fair value of financial performance, the bankers continue to be concerned about the volatility of quarterly results. The bank, which has a total net revenues - commissions and net interest income - Total revenue was relatively stable horizon fluctuate significantly due to quarterly fluctuations in the value of securities and other market assets.
Recognition of fair value practices by the leading banks and organizations has lead to the cause of credit crisis, but this has enabled the management, researchers and accountants to look back and implement the accounting standards which will be more dynamic and stand the test of the time. Some investors mistakenly make the most of the bank's assets at market prices diving securities transactions. Other investors have realized that the securities fell sharply ad does not violate capital requirements for banks. If we know that the financial statements of these companies and investors complexity clearer responsibilities through thoughtful process and implementation of dynamic methods and accounting practices which will be equipped in a better manner so that it can react diligently based on the overall changes in the financial markets and government policies.
Barth, M. E., & Landsman, W. R. (2010). How did financial reporting contribute to the financial crisis? European Accounting Review, 19(3), 399-423. http://dx.doi.org/10.1080/09638180.2010.498619
Blankespoor, E., Linsmeier, T. J., Petroni, K., & Shakespeare, C. (2012). Fair value accounting for financial instruments: Does it improve the association between bank leverage and credit risk? The Accounting Review, 88(4), 1143-1177. http://dx.doi.org/10.2139/ssrn.1565653
FASB Financial Accounting Standards Board. (2008). Determining the fair value of a financial asset when the market for that asset is not active. FASB Staff Position, FSP FAS, pp. 157-3, October 10. Retrieved from http://www.fasb.org/pdf/fsp_fas157-3.pdf
Finnegan, P. (2012). IFRS9-Limited amendments, significant improvements. Retrieved from http://www.ifrs.org/Investor-resources/2012-perspectives/December-perspectives/Documents/Patrick-Finnegan-IFRS-9-Limited-Amendments-Significant-Improvements.pdf
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Khan, U. (2010). Does fair value accounting contribute to systemic risk in the banking industry? http://dx.doi.org/10.2139/ssrn.1327596
Lim, C. Y., Lee, E., Kausar, A., & Walker, M. (2011). Bank risk and the value relevance of fir value gains/losses. Research Collection School of Accountancy, pp. 1-42. Retrieved from http://ink.library.smu.edu.sg/soa_research/908
Simkovic, M. (2011). Competition and crisis in mortgage securitization. Indiana Law Journal, 88, 213-271.
Song, C. J., Thomas, W. B., & Yi, H. (2010). Value relevance of FAS No. 157 fair value hierarchy information and the impact of corporate governance mechanisms. The Accounting Review, 85(4), 1375-1410.
Turner, A. (2010). Banks are different: should accounting reflect that fact?. Speech given to the Institute of Chartered Accountants in England and Wales (ICAEW), London, UK, January 21. Retrieved from http://www.fsa.gov.uk/pages and library/Communication/Speeches/