Global Financial crisis is one of the biggest crisis that happened in the year 2008-09. Fair value accounting was blamed for the crisis. The techniques were questioned. Thus, shifting the Focus on Fair value accounting. The following paragraph reads about the problems and the changes in Fair Value techniques.
Fair value accounting has been criticized for not being able to provide a transparent view of the situation in the global crisis. Fair value techniques require that the assets and liabilities are presented at market value in the balance sheet. The main allegations were that fair value provided excessive leverage in the time of boom while leads to excessive write-downs in the depressions (De Jager, 2014). This is what happened in The Global Crisis. Once the economy started going down due to the bust of the housing bubble and sub-prime crisis, people stop taking debt and the spending and investments were reduced.
Banks were making losses as prices started falling and debts were not being paid. This activated a downward cycle in the economy. There were various bonds, mortgages, and structured debts that were performing, yet due to falling in prices banks have to reduce their value and market pushed banks to sell their assets at fair value in the market that was quite low at that time (Shaffer, 2010). In fair value accounting techniques, even if the prices decline for a short period, banks are required to reduce their prices and this leads to insolvency. This chain of fair value representation led to a Global crisis in the year 2008-09.
I don't agree that the Fair value technique led to the Global financial crisis. According to a study conducted by SEC in the year 2008, it was shown that only 31% of the banks were using the technique of Fair value accounting. Other than that, in the standard of Fair value accounting, there are 3 levels at which assets are priced. Level 1 is the market price. Level 2 is when the market prices are not available, inputs are used. Level 3 defines the prices in an illiquid market where executives are allowed to value the assets at their assumptions and when the market froze in 2008, executives were required to make their assumptions and create a prices chain for assets. The problem was the loans that were provided on the collateral security which were huge and many financial institutions taking the risk recklessly (Haswell & Evans, 2018). Even if the assets were marked at historical cost, there is no such evidence present that might have solved the problem and stopped the lending. Fair value provides a transparent value to customers, and should not be used as a convenient measure to outgrow the faults that have been conducted.
From the year 2009-2020, various changes have been brought in Fair value standard. Various aspects were added while certain were removed and some were modified. Certain disclosure requirements were removed for the nonpublic entities that include the changes in unrealized gains and losses. The valuation process for the measurement of Assets at level 3 for non-public entities has been removed, however, they are required to provide the quantitative information of unobservable inputs.
For public entities, additional disclosure for level 3 fair value calculation was added. It will show how the entity has calculated the weighted average of the assets. Also median and average are to be disclosed. With those changes that have happened in unrealized gains are also to be depicted at the end of each reporting period. The phrase 'at a minimum' is deleted to get an appropriate consideration of the value (Defond et al., 2019). It has also been clarified that uncertainty of measurement is supposed to be communicated on the reporting date rather than sensitivity for changes in the future of fair value.
I agree that the changes that have been brought in by the authorities will provide more clarification on the value as of the reporting date. The method for calculation will depict whether the entity is estimating the value appropriately or not. Also, the entities will be required to present value as they are and not on the minimum side. These changes have improved the Fair value standard.
I agree that the assets will be measured more appropriately than they were being measured at the time of the Global financial crisis. At that time, companies were not required to show the method of calculation for weighted average and how they have valued the assets but the changes that have been brought require the entities to present these values. Also, with the introduction of IFRS 9 that measures expected losses of the entities before they have happened at the fair value. This will help the banks and other financial institutions to have a check on the value of losses and expected losses that can occur. Also, the value of the assets at level 3 when the economy is suffering or at losses was presented at the minimum. However by removal of that phrase, the amount will depict its accurate value and provide a better position in the market.
Public entities will have to show the value of unobservable items that are being taken into consideration and also the changes that are happening will be shown as per the reporting date and not based on any future value. So, the exact value as on that date can be checked.
Thus, these changes will help in depicting a better situation of the entities at the time of the economic downturn that might happen in the future. This will project a better picture and fair value measurement will have an appropriate effect on the measurement of assets and liabilities.
Fair value accounting has little role to play in financial crisis. Yet the improvements made in the standard like removal of word minimum and introduction of IFRS 9 on fair value will improve the Fair value accounting techniques.
de Jager, P. (2014). Fair value accounting, fragile bank balance sheets, and crisis: A model. Accounting, Organizations and Society, 39(2), 97-116.
DeFond, M. L., Hu, J., Hung, M., & Li, S. (2019). The effect of fair value accounting on the performance evaluation role of earnings. Available at SSRN 3466021. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3466021
Haswell, S., & Evans, E. (2018). Enron, fair value accounting, and financial crises: a concise history. Accounting, Auditing & Accountability Journal. Retrieved from: emerald.com/insight/content/doi/10.1108/AAAJ-04-2016-2525/full/html
Shaffer, S. (2010). Fair value accounting: villain or innocent victim-exploring the links between fair value accounting, bank regulatory capital, and the recent financial crisis. FRB of Boston Quantitative Analysis Unit Working Paper, (10-01).
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