THE CRISIS OF FAIR VALUE ACCOUNTING

Submitted by:
Rhea Srivastava
Division B (BBA LLB)
Roll No 11
Class 2016 of Symbiosis Law School, NOIDA
Symbiosis International University, PUNE
In
September 2011
Under the guidance of:
Dr. Pushpa Negi,
Course in Charge,
Accounting-1
Symbiosis Law School,
NOIDA 201301

DECLARATION

I Rhea Srivastava, student of BBA LLB Semester I of Symbiosis Law School,

Noida hereby declare that the Accounts research paper titled THE CRISIS OF
FAIR VALUE ACCOUNTING is submitted by me in the line of partial
fulfillment of course objectives for the BBA LLB degree.

I assure that this synopsis is the result of my own efforts and that any other institute
for the award of any degree or diploma has not submitted it.

C E R T I F I C AT E

The project entitled The Crisis of Fair Value Accounting submitted to the
Symbiosis Law School, NOIDA for Jurisprudence as part of internal assessment is
based on my original work carried out under the guidance of Dr. Pushpa Negi from
to 7th October 2011.
The research work has not been submitted elsewhere for award of any degree.
The material borrowed from other sources and incorporated in the thesis has been
duly acknowledged.

I understand that I myself could be held responsible and accountable for

plagiarism, if any, detected later on.

RHEA SRIVASTAVA

Date: 7th October 2011

ACKNOWLEDGEMENTS

With my deepest appreciation, I would like to thank Dr. Pushpa Negi for providing
me the opportunity to undertake a research work on The Crisis of Fair Value
Accounting
I would like to thank her for providing me all the necessary help in completing this
project. Without his help, it would be very difficult for me to complete the project
on time.
I would like to thank Symbiosis Law School, Noida for providing me an excellent
environment which helped in my project.
I would also like to thank all my classmates for helping me, in one way or the
other, for the success of this research paper.

INTRODUCTION

Fair Value is an accounting term, originally defined by the SEC.

Under GAAP, the fair value of an asset is the amount at which the asset could be bought or sold
in a current transaction between willing parties, other than in liquidation.
On the other side of the balance sheet, the fair value of a liability is the amount at which the
liability could be incurred or settled in a current transaction between willing parties, other than in
liquidation.
In todays dynamic and volatile markets, whether it is to buy or sell, what people want to know is
what an asset is worth today.
Accounting research h supports that assertion. The FASB, after extensive discussions, has
concluded that fair value is the most relevant measure for financial instruments. The FASB
revisited that issue and again renewed its commitment to eventually measuring all financial
instruments at fair value.
Fair value accounting provides more transparency than historical cost based measurements.
The goal of fair value measurement is for firms to estimate as best as possible the prices at which
the positions they currently hold would change hands in orderly transactions based on current
information and conditions. To meet this goal, firms must fully incorporate current information
about future cash flows and current risk-adjusted discount rates into their fair value
measurements.
Financial institutions have criticized fair value accounting. Those criticisms have included:

Reported losses are misleading because they are temporary and will reverse as markets
return to normal
Fair values are difficult to estimate and thus are unreliable
Reported losses have adversely affected market prices yielding further losses and
increasing the overall risk of the financial system.

Some of the key reasons why fair value accounting benefits investors include:

It requires or permits companies to report amounts that are more accurate, timely, and
comparable than the amounts that would be reported under existing alternative
accounting approaches, even during extreme market conditions
It requires or permits companies to report amounts that are updated on a regular and
ongoing basis

It limits companies ability to manipulate their net income because gains and losses on
assets and liabilities are reported in the period they occur, not when they are realized as
the result of a transaction
Gains and losses resulting from changes in fair value estimates indicate economic events
that companies and investors may find worthy of additional disclosures.

Potential Criticisms of Fair Value Accounting During the Credit Crunch

A. Unrealized Gains and Losses Reverse

Two distinct reasons why unrealized gains and losses may reverse with greater than 50%
probability. First, the market prices of positions may be bubble prices that deviate from
fundamental values. Second, these market prices may not correspond to the future cash flows
most likely to be received or paid because the distribution of future cash flows is skewed. For
example, the distribution of future cash flows on an asset may include some very low
probability but very high loss severity future outcomes that reduce the fair value of the asset.
1. Bubble Prices
The financial economics literature now contains considerable theory and empirical
evidence that markets sometimes exhibit bubble prices that either are inflated by
market optimism and excess liquidity or are depressed by market pessimism and
illiquidity compared to fundamental values. Bubble prices can result from rational short
horizon decisions by investors in dynamically efficient markets, not just from investor
irrationality or market imperfections.
2. Skewed Distributions of Future Cash Flows
Fair values should reflect the expected future cash flows based on current information as
well as current risk-adjusted discount rates for positions. When a position is more likely
to experience very unfavorable future cash flows than very favorable future cash flows,
or vice-versa statistically speaking, when it exhibits a skewed distribution of future cash
flowsthen the expected future cash flows differ from the most likely future cash flows.
This implies that over time the fair value of the position will be revised in the direction of
the most likely future cash flows with greater than 50% probability, possibly considerably
greater.

B. Market Illiquidity
Together, the orderly transaction and at the measurement date elements of fair value
definition reflect the semantics behind the fair in fair value.
Fair values are not necessarily the currently realizable values of positions; they are
hypothetical values that reflect fair transaction prices even if current conditions do not
support such transactions.
C. Adverse Feedback Effects and Systemic Risk
By recognizing unrealized gains and losses, fair value accounting moves the recognition
of income and loss forward in time compared to amortized cost accounting.
Unrealized gains and losses may be overstated and thus subsequently reverse if bubble
prices exist. If firms make economically suboptimal decisions or investors overreact
because of reported unrealized gains and losses, then fair value accounting may yield
adverse feedback effects that would not occur if amortized cost accounting were used
instead.

LI T E R AT U R E R E V I E W

Xin Lian (2008) examined that with the financial crisis escalating, some bankers, financial
professionals and legislators have started to question the Federal Accounting Standards (FAS).
They blame FAS 157 (on assuming fair value of financial assets) for an excess writedown when
the market dives and say the pricing mechanism does not work. It is claimed to have widened
losses and capital gap, driving financial institutions into panic sales, hence the self-reinforcing
process of lower prices, greater write downs, thinner capital, bigger headcust, and even lower
prices. 60 congressmen have endorsed a letter to the Securities Exchange Commission, asking to
give up the fair-value standard. They claim that the market is too messy for banks to mark their
holdings to. Therefore, the crisis may be defused if the mark-to-market standard is abolished

SEC 2008 Report to Congress - The SEC concluded that fair value was not the source of the
bank failures that occurred around the time of their report. However, these failures were
represented mostly by smaller banks. There was only one bank that was evaluated with assets
greater than $100 billion, and that bank was a thrift (Washington Mutual) with as little as 5% of
assets recorded at fair value.

The International Monetary Fund released a study of fair value accountings pro-cyclical
effects in the 2007 to 2008 period. - The paper analyzed a three tiered sample of banks
including traditional U.S. commercial banks, European banks and U.S. investment banks. The
analysis was based on 2006 financial results and utilized models to predict the impact of
particular economic shocks. The analysis concluded that fair value may magnify cyclical
volatility of capital. However, the studys results were based on hypothetical scenarios, given
that the real stress events of the recent crisis happened subsequent to when the study was written.

Landsman 2006 - International financial markets constantly demand unbiased, fair, reliable and
objective accounting systems which, under normal financial transactions and valuations, give a
fair value of any asset in focus. One popular valuation system constantly in use and adopted by
IASB(International Accounting Standards Board ) is fair value accounting. In its most basic
essence, fair value accounting encompasses determining the fair value of an asset or liability in a
current transaction. The key objective of fair value accounting is to give a value to an asset or
liability, without necessarily initiating a transaction. In essence then, fair value accounting
focuses on providing an objective valuation of an asset or liability without undue influence from
the concerned parties, without considering historical costs and basing the value of an asset on
mark- to- market accounting rules.

Gold et al 2007 - Firms have been forced to value their assets(mostly under-valuation) based on
deceptive market information which is misguided by the available information on the market
worth of such assets- a blame that squarely and objectively lie on fair value mode of evaluation.
Indeed, this aspect has been exacerbated by inactive markets, which, in relatively normal
financial conditions and transactions tend, on average, to devalue assets thus negating the
principal of 'fair value' so highly esteemed in fair value accounting methodology. However,
recent investigations into this aspect defend fair value accounting method from the financial
crises blame.

Emily Chasan (2008) - Fair value does provide a realistic view when price quotes are readily
available, but when there is no market, or a market disappears as it did in the credit crunch,
companies must use complex mathematical models to come up with values that can be just as
confusing to investors.
Accounting rule FAS 157, which for most companies takes effect this year, requires a specific
fair value framework to value most financial assets, but some believe fair value, and the early
adoption of that rule by most financial firms, has exaggerated write-downs tied to the credit
crunch.

Christian Laux and Christian Leuz (2010) - The main allegations are that fair-value
accounting contributes to excessive leverage in boom periods and leads to excessive write-downs
in busts. The write-downs due to falling market prices deplete bank capital and set off a
downward spiral, as banks are forced to sell assets at fifi re sale prices, which in turn can lead
to contagion as prices from asset fifi re sales of one bank become relevant for other banks. These
arguments are often taken at face value, but evidence on problems created by fair-value
accounting is rarely provided.
American Bankers Association (2009), fair-value ac

American Bankers Association (2009) Fair value accounting is appropriate for assets that
are held for trading purposes or if an entitys business model is based and managed on fair
value. However, for traditional commercial banks and for loans, leases, and securities that are
held to maturity, the argument goes, fair-value accounting can be inappropriate and misleading,
especially in a time of crisis and when markets are illiquid.
Liz Moyer (2008) explained n the wake of the Enron crisis, regulators pushed to make it easier
for investors to understand the value of a company's assets and lift the fog on the complexity of
structured finance.This "fair value accounting" was aimed at consistent reporting among

comparable firms. Assets would be labeled in one of three categories depending on their relative
liquidity, with the hardest-to-value assets put in "Level 3." But the rules, in the works for years
and put in place just as the credit crisis hit, didn't anticipate the amplifying effects of market
turmoil.

According to Alex J. Pollock (2008) - "Fair-value" accounting is obviously appropriate

for you if you are a securities broker. But should everybody else in the world be accounted for as
if they were securities brokers? That is hardly obvious; indeed, highly dubious.
From the proponents of this dubious proposition we constantly hear that they are only insisting
on "the facts" of market prices. Of course, they admit that in many cases there is no active
market or no market at all, but then we need estimates--as is true in many other areas of
accounting. They also admit that markets can be panicked and reach fire-sale prices that will be
judged by later observers as irrational, but they say that, nonetheless, this is "the fact" of the
market price now. Also, a lot of prices are probably not what most people would feel are fair and
appropriate in normal circumstances. But that's still what the market price is."

Nicolas Vron (2008) - The ongoing financial crisis has spurred much finger-pointing at fair
value accounting for financial instruments, as set out in both leading sets of accounting standards
used by listed companies around the world, namely US Generally Accepted Accounting
Principles (US GAAP) and International Financial Reporting Standards (IFRS). Prominent
financial leaders such as Martin Sullivan, CEO of AIG, and Henri de Castries, CEO of AXA,
have singled out fair value and the related wide use of mark-to-market accounting as a major
factor in the crisis. Echoing these views, European Commissioner Charlie McCreevy expressed
his concern on 1 April this year about the impact of mark to market valuation when markets
generally become illiquid and irrational.

CONCLUSION

FVA is full of arguments that do not hold up to further scrutiny and need more economic
analysis. Moreover, it is important to recognize that standard setters face tradeoffs, and in this
regard FVA is no exception. One example is the tradeoff between relevance and reliability, which
is at the heart of the debate of when to deviate from market prices in determining fair values.
Another example is that FVA recognizes losses early thereby forcing banks to take appropriate
measures early and making it more difficult to hide potential problems that only grow larger and
would make crises more severe. But this benefit gives rise to another set of tradeoffs. First, FVA
introduces volatility in the financial statement in normal times (when prompt action is not
needed). Second, full FVA can give rise to contagion effects in times of crisis, which need to be
addressed be it in the accounting system or with prudential regulation. It may be better to
design prudential regulation that accepts FVA as a starting point but sets explicit counter-cyclical
capital requirements than to implicitly address the issue of financial stability in the accounting
system by using historical costs. It is an illusion to believe that ignoring market prices or current
information provides a foundation for a more solid banking system.

REFERENCES

American Accounting Association Financial Accounting Standards Committee. 2000.

Response to the FASB Preliminary Views: Reporting Financial Instruments and
Certain Related Assets and Liabilities at Fair Value. Accounting Horizons,
December, pp. 501-508.
American Institute of Certified Public Accountants. 2001. Accounting by Certain Entities
(Including Entities with Trade Receivables) that Lend or Finance the Activities of Others.
Statement of Position 01-6. New York, NY: AICPA.
Bank of England. 2008. Financial Stability Report. Issue No. 23. April.
Barlevy, G. 2007. Economic Theory and Asset Bubbles. Economic Perspectives, Third Quarter,
44-59.
Bies, S. 2008. Fair Value Accounting. Speech to the International Association of Credit Portfolio
Managers General Meeting, New York, New York, November 18.
CFA Institute. 2005. A Comprehensive Business Reporting Model: Financial Reporting for
Investors. Center for Financial Market Integrity. October.
Financial Accounting Standards Board (FASB). 1975. Accounting for Contingencies.
Statement of Financial Accounting Standards No. 5. Norwalk, CT: FASB.
Accounting for Certain Mortgage Banking Activities. Statement of Financial Accounting
Standards No. 65. Norwalk, CT: FASB.
Disclosures about Fair Value of Financial Instruments. Statement of Financial Accounting
Standards No. 107. Norwalk, CT: FASB.
Accounting for Certain Investments in Debt and Equity Securities. Statement of Financial
Accounting Standards No. 115. Norwalk, CT: FASB.
Accounting for Derivative Instruments and Hedging Activities. Statement of Financial
Accounting Standards No. 133. Norwalk, CT: FASB.
Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.
Statement of Financial Accounting Standards No. 140.

Did Fair-Value Accounting Contribute to the Financial Crisis? By Christian Laux and Christian
Leuz - http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.24.1.93

Fair Value Accounting is the Wrong scape Goat for this crisis by Nicolas Veron
- http://www.sec.gov/comments/4-560/4560-3.pdf
Fair Value Accounting: Villain or Innocent Victim by Sanders Shaffer http://www.bos.frb.org/bankinfo/qau/wp/2010/qau1001.pdf