Academic journal article International Journal of Business

Role of Accountants and Fair Value Accounting Leading towards the Global Financial Crisis

Academic journal article International Journal of Business

Role of Accountants and Fair Value Accounting Leading towards the Global Financial Crisis

Article excerpt

I. INTRODUCTION

Fair value accounting is a financial reporting approach in which companies are required or permitted to measure and report on an ongoing basis certain assets and liabilities (generally financial instruments) at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities. Under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. Those losses reduce companies' reported equity and may also reduce companies' reported net income. Some parties have strong opinion that fair value accounting has a major contribution in strengthen credit crises, specially pointing to the obvious difficulties of measuring the fair values of subprime positions in the current illiquid markets and the feedback effects noted above. This is untenable. The subprime crisis was caused by firms and households making bad operating, investing, and financing decisions, managing risks poorly, and in some instances committing fraud. The best way to stem the credit crunch and damage caused by these actions is to speed the price adjustment process by providing market participants with the most accurate and complete information about subprime positions. While imperfect, fair value accounting provides better information about these positions and is a better platform for mandatory and voluntary disclosure than alternative measurement attributes, including any form of cost-based accounting.

This is not to say that guidance for the measurement of fair values in illiquid markets cannot be improved. While FAS 157 provides a clearer definition of fair value and considerably expanded guidance specifying how fair value should be measured than prior GAAP, the current market illiquidity has raised significant challenges for the interpretability of this definition and guidance. FAS 157's definition of fair value reflects the idea that there can be "orderly" transactions based on the conditions that exist at the "measurement date." During the subprime crisis, this idea has become increasingly difficult to sustain even in thought experiments and, more importantly, practically useless as a guide to preparers' estimation of fair values. FAS 157's fair value measurement guidance includes a hierarchy of inputs that favours observable market inputs over unobservable firm-supplied inputs, but that ultimately requires preparers to employ "the assumptions that market participants would use in pricing the asset or liability." This hierarchy provides little help to preparers who have to decide whether to base their fair valuations on the poor quality signals currently being generated by markets versus highly judgmental firm-supplied inputs such as forecasts of house price depreciation. For the duration of the crisis, preparers will need to exercise considerably more than the usual professional judgment to apply FAS 157's language to their specific circumstances.

As the successive waves of the subprime crisis have hit, firms have repeatedly and sharply revised upward their estimates of credit losses. These revisions are inevitable consequences of how the subprime crisis evolved, and they do not imply there have been any problems either with accounting standards or how preparers have applied them. However, these revisions and the high potential for further upward revisions have contributed to the aforementioned feedback effects between reported losses and market illiquidity. Needless to say, this market illiquidity is damaging our real estate and credit markets and overall economy, and it needs to be cured through means that do not simply push the problem into the future. As always, essential components of such a cure are for firms to provide relevant, reliable, and understandable financial report information and for users to conduct careful and dispassionate analysis of that information.

The remainder of the essay is structured as follows. …

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