The recent financial crisis has led to a major debate about fair-value accounting. Many critics have argued that fair-value accounting, often also called mark-to-market accounting, has significantly contributed to the financial crisis or, at least, exacerbated its severity. In this paper, we examine the role of fair-value accounting in the financial crisis. This essay will be structured as followings. Firstly, this essay will discuss the goal, and the main features and the hierarchy fair value view. Following this, the essays will mainly focus on demonstrating the benefits and drawbacks of fair value in the contest of financial crisis.
Ryan (2008) explains that the goal of fair value accounting is for firms to estimate as best as possible the price at which the position they currently hold would change hands in orderly transactions base on current information and conditions. Thus, firms must fully incorporate current information about future cash flows and current risk-adjusted discount rates into their fair value measurements.
The first main feature of fair value view is that accounting information needs ideally to reflect the future, not the past, so past transactions and events are only peripherally relevant. This is to say that cost is an in appropriate measurement basis because it relates to a past event whereas future cash flow will result from future exit, measured by fair value. Then, the second feature states that market prices should give an informed, nonentity specific estimated of cash flow potential, and market are generally sufficiently complete and efficient to provide evidence for representationally faithfully measurement on this basis.
Furthermore, according to SFAS 157, there are three levels of fair value measurement inputs. The level 1 state that inputs are unadjusted quoted market prices in active markets for identical items. Level2 describe that inputs are other directly or indirectly observable market data such as quoted market price, yield carves, interest rates or exchanges rates. Then, level 3 say that inputs are unobservable, firm-supplied estimates, such as forecast of home price depreciation and the resulting credit loss severity in mortgage-related positions.
In the context of financial crisis, fair value has a number of benefits. Firstly, it provides accurate asset and liability valuation on an ongoing basis to users of a company’s reported financial information. When the price of an asset or liability has increased or is expected to increase, the company marks up the value of the asset or liability to its current market price to reflect what it would receive if it sold the asset or would have to pay to relieve itself from the liability. Conversely, the company marks down the value of an asset or liability to reflect any decrease in the market price. Thus, even if markets exhibit bubble prices, fair values are more accurate, timely, and comparable across different firms and positions than are alternative measurement attributes.
Secondly, Fair value accounting limits a company’s ability to potentially manipulate its reported net income. Sometimes management may purposely arrange certain asset sales, for example, to use gains or losses from the sales to increase or decrease net income as reported at its desired time. Using fair value accounting, gains or losses from any price change for an asset or liability are reported in the period in which they occur.
Thirdly, Moreover, while the credit crunch raises issues for fair value measurements, under FAS 157, fair values need not reflect fire sale values. When level 2 inputs are driven by fire sales, firms can make the argument that level 3 model-based fair values are allowed under FAS 157. Requiring firms to make this argument provides important discipline on the accounting process. However, this requires substantial changes in accounting…