IntroductionThe recent global economic crisis is a subject of much scrutiny. Whilst the culpability is place upon several diverse groups, the role of accounting in the financial crisis is regularly examined and censured. Whether or not accounting standards played any major role in causing global financial crisis is regularly debated by regulators, accountants and businesses. Even though it can be to some extent agreed that the major cause and the underlying drivers of financial crisis are financial institutions together with home mortgage financing scheme, the role that accounting standards played in the financial crisis isn’t as clear.
In its real form, fair value accounting entails reporting liabilities and assets on balance sheet at a fair value and indentifying shifts in fair value as losses and gains in income statement (Christian & Leuz, 2009). Some people are of the opinion that fair value accounting is essential for transparency and ultimate economic recovery, whilst others see fair value accounting as the partial cause of global financial crisis and a vice that should be gotten rid of. The major allegations that fair value accounting contributed aggravated the intensity of the global financial crisis is that it contributed to too much leverage in the boom periods and resulted to immense write downs in busts.
This paper looks at the role of accounting standards in global financial crisis and how accounting standard boards have responded to the crisis. Part ARole of accounting in global financial crisis (GCF)The generally recognized accounting description of fair value is based upon rule FAS 157, which was issued in 2006 by FASB. FAS 157 supported by FAS 115 describes fair value, develops a framework for gauging the formerly described fair value utilizing generally accepted accounting principles and boosts disclosures of fair value.
According to Christian and Leuz, (2009), fair value accounting records the worth of a liability or an assert based upon present market prices for that particular asset or in case of liabilities and assets without market price, the market cost for identical liabilities and assets. Fair value accounting can lead to enormous transformations in value on the financial statements of a company in a regularly changing market and can also make liabilities and assets to be incorrectly valued if the market prices swerve from the original fundamental value.
The pro-cyclical nature of market to market accounting has downward spiral and extension of global financial crisis. The interplay amid capital requirements and fair value may have pro-cyclical impact of the declining market values on capital structures and portfolios of regulated monetary institutions. Financial organizations may overcompensate and encourage moves such as premature liquidations, raising in ill-timed situations or taking too much risk. The pro-cyclical nature of fair value has majorly contributed to the way accounting has played a major role in protracting the global financial crisis (Christian & Leuz, 2009).
According to Andre et al. (2009), the pro-cyclical nature of market to market accounting was demonstrated within the mortgage backed security market since as the prices of houses turned down, mortgages went into default making the worth of mortgages associated assets to go down. Therefore, firms who were having these securities were needed to mark them down to the market resulting to an increase in their insolvency ratio.
Several firms then traded the mortgage supported securities as a result of the fear that prices would further go down. As a consequence, mortgage supported securities deluged the market and supply became higher than demand, making prices to go down. As a result of this second huge decline in cost, firms were again needed to mark down their securities. Therefore, this requirement of market to market accounting generated a pro-cyclical effect in mortgage supported security market.