Fair Value Accounting and Global Financial Crisis - Essay Example

Fair Value Accounting and Global Financial Crisis Name Date Course Executive Summary Global financial crisis that was witnessed in 2008 was attributed to various factors including the accounting principles. Fair value accounting contributed to the global financial crisis in various ways. Regulations in terms of the fair value accounting have weaknesses which led to the banking institutions adjusting their prices unlawfully. This contributed to the decline in the market and hence contributing to the global financial crisis. The public and private regulations also contributed to the problem due to its weaknesses and failure to monitor the situation in the market. The fair value accounting also has weaknesses in the banking sector and it led to the exploitation of the market by the bankers. The fall in the housing prices also affected other organizations that use the concepts of fair value accounting. This led to spill over to the market and hence affecting the housing and mortgage sector. Politics also contributed to the global financial crisis due to the taking of sides by the politicians and their failure to adopt some important recommendations. Introduction and Purpose Fair value accounting is a means that is usually used for the purposes of measuring the value of assets and liabilities in a company as it appears in the balance sheet (Penman, 2007). During the process of selling an asset, it is usually important to ensure that the principles of willing buyer and willing seller are upheld. This concepts also places emphasis on the method that should be used to establish the prices. The use of quoted prices in the active market as fair value is usually considered incase it is available. However, in instances when the prices are not available in the active market, valuation techniques and market information is usually put in place. The use of fair value is commonly used when dealing with the financial assets and liabilities (Ryan, 2008). It is also important for both parties to make the appropriate adjustments during the process. The fair value accounting has however, been blamed for contributing to the global financial crisis in 2008. The report supports the views and it discusses how it contributed to the global financial crisis in 2008 in response to the commissioning by the Chair of the Australian Accounting Standards Board. Discussion Public and private interest theories and fair value valuation According to the public and private interest theories, the regulations are aimed at preventing or correcting the undesirable results in the market (Siegers, 2003). The undesirable results include the global financial crisis that was witnessed in 2008. The regulation that governs the private and public firms always aims at rewarding the organizations that perform well. However this overlooks the impact that the performance may have on the economy. This is because the market process may have negative impacts on the growth and development of the economy. The public and private interest regulations also give powers to the government to prevent undesirable market outcomes by putting in place incentive measures. However, the public and private interest regulations have weakness which exposes the economy to undesirable effects. The regulations make assumptions that the government will fully ensure that the regulations are accounted for and that the market will be controlled. However, in most instances the markets usually self compensate incases of irregularities. The weaknesses in the public private interest theory greatly contributed to the global financial crisis in 2008. This is because companies are in a bid to outperform each other in order to be rewarded. The financial value accounting enabled the banks to increase their leverage in booms and hence leading to the vulnerability of the market. The public and private interest regulations did little to contain the situation as it did not intervene in the situation. The measures were also taken by the banks in a bid to self compensate the irregularities that were in the market and hence leading to the crisis (Persaud, 2008). Fair value accounting and the banking industry The principles of fair value accounting also promote the use of the market prices during the valuation of the products. This exposes most of the banks to financial risks and hence leading to the financial crisis in 2008. Since most of the banks rely on mortgages and the housing sector, the problem with the pricing contributed to the problem (Morris, 2008). This is because there was little market activities that was taking place in the housing sector and the mortgage sector. This led to the fall of the process of the houses and hence affecting the rates of the mortgages. On the other hand, since the existing market prices had to be used for the purposes of process it led to losses as the process in the active market were quite low. The regulator on the other hand failed to give a clear direction on the action that should have been taken due to the falling prices. This is an indication that the public and private interest regulations are rarely effected. The fair value accounting also promoted contagion in the market. This is because the banks that were dealing with assets for the purposes of generating profits had to sell the assets at a low price leading to forced sales. This has a direct impact on the other organizations that rely on the fair value accounting in order to make their prices in the market. Since the prices were low due to the action of the banks the fair value accounting principles meant that the prices should also be used by all the organization (Leuz, et al, 2010). This directly contributed to the global financial crisis in 2008. The public and private interest regulations is for the purposes of ensuring that spillovers are not witnessed in the market due to the failure of banks and other financial institutions. This is also for the purposes of protecting the consumers and the entire market. The regulations therefore allows for deviations to be used when using the fair value accounting principles in some instances (Arispe, 2013). Due to the difficulties in determining the time to carry out the deviations, the managers in some of the banking sector took advantage of these principles. The prices were thus deviated leading to disharmony in the market which affected the mortgages and hence contributing to the global financial crisis. On the other hand, the weaknesses of the fair value accounting led to the managers to increase their rates in order to recover from the losses that they were experiencing. This had a direct impact on the rise of the global financial crisis. The lack of restrictive guidance when using the fair value accounting principles is also a factor that immensely contributed to global financial crisis (Wallison, 2008). Putting in place the regulations that ensure that gaming is not done when using the fair value accounting is also difficult. This is because the banks have more information and advantage over the regulators and hence making it difficult for the regulators to fully implement changes. This weakness also contributed to the global financial crisis as the regulators were unable to regulate the conduct of the banking institutions. Fair value accounting principles are not relevant to the investors and do not suit the business models for most of the banks (Laux, et al, 2009). On the other hand, it has a negative impact on the assets that are held to maturity. The combination of these weaknesses led to the banks showing higher valuations which had a negative impact on the market and hence contributing to the global financial crisis in 2008. On the other hand politics was also responsible for contributing to the global financial crisis in 2008. Fair value accounting and politics Accounting discrepancies through the use of the fair value accounting had been uncovered in the United States of America by the Office of the Federal Housing Enterprise Oversight. However due to politics, the new measured that had been proposed were not put in place. Most of the politicians who scrutinized the report were against it with some arguing that the regulation was an attempt by the Authority to influence the prices in the housing sector. Failure to implement new laws led to irregularities and hence contributing to the global financial crisis (Scoles, 2008). On the other hand the lowering of the interest rates due to the terrorist attacks in 2001 also contributed to the global financial crisis in 2008. The government through the legislators approved the lowering of the lending rates and hence contributing to the problem. It is thus evident that the decisions that were politically motivated also contributed to the global financial crisis in 2008. Conclusion In conclusion, the fair value accounting is aimed at ensuring that prices used while dealing with assets and liabilities in the company conforms to the prices in the active market. The fair value accounting also contributed to the global financial crisis in 2008.This is attributed to the failures of the regulations which are governed by the public and private regulations. It is also evident that the weaknesses of the fair value accounting greatly contributed both directly and in directly to the global financial crisis. Politics also had a role as it prevented some of the legislations from being implemented and hence leading to the global financial crisis. List of References Laux, C, et al, 2009, The crisis of fair-value accounting: Making sense of the recent debate, Accounting, Organizations and Society 34, 826–834. Siegers, J, 2003, Public and private interests in regulation, Essays in law and economic regulations. Leuz, C, et al, 2010, Did Fair-Value Accounting Contribute to the Financial Crisis? Journal of Economic Perspectives—Volume 24, Number 1—Winter 2010—Pages 93–118 Arispe, F, et al, 2013, Fair Value Accounting and the Global Financial Crisis, European Journal of Banking and Finance, Vol.11. Penman, S, 2007, Financial reporting quality: Is fair value a plus or a minus? Accounting and Business Research Special Issue: International Accounting Policy Forum, 33, 44. Persaud, A, 2008, Regulation, valuation and systemic liquidity, Banque de France, financial stability review – Special issue on valuation, no. 12. Morris, S, 2008, “Financial Regulation in a System Context.” Brooking Papers on Economic Activity, Fall, pp. 229–61. Wallison, J, 2008, Fair Value Accounting: A Critique, American research institute for public policy research. Ryan, G, 2008, “Accounting in and for the Subprime Crisis,” The Accounting Review, 83(6): 1605–38. Scoles, M, 2008, “What Is Fair Value Accounting and Why Are People Concerned about It?” American Enterprise Institute, Washington. Read More