Question

By reading the case of Subprime crisis and Fair-value Accounting,

1. What are the critics of fair-value accounting concerned about with respect to the recent subprime crisis in the US ?

2. What are the arguments of those supporting fair value accounting ?

3. What could be the potential drawbacks of using only historical costs ?

Answer 1

1.The role of fair value accounting in the sub prime crisis is debatable. SFAS 157 required that tradeability assets be valued at their current market value rather than their historic cost.There was no mechanism to value actively trading securities in a non active market.The critic is that fair value accounting led to a meltdown of the US economy as it there was no mechanism to adjust to frozen markets and the prices of the mortgage backed securities fell to an unprecented low.

2) The arguments of those supporting fair value accounting is that it was not the cause of the current crisis.They blame granting subprime loans and writing credit default swaps citing them as bad economic decisions.The alternative is to keep loans at their original amount which is akin to ignoring reality.

C) Accuracy in reporting is one of the biggest drawbacks of using only historical cost as it does not represent the current market scenario.Users of financial statements will not be able to predict future cash flows related to those assets.