Question

During global financial crisis of 2008/9, it was claimed that IFRS fair value accounting techniques used in corporate reports had distorted financial reality and caused financial crisis.  Describe those alleged problematic fair value accounting techniques and standards, and state if you agree with the criticisms and why (300 words)

Answer 1

Fair value accounting involves reporting assets and liablities on the balnace sheet at fair value and recognising changes in fair value as gains and losses in the income statement.When market prices are used to determine fair value,fair value accounting is also called mark to market accounting.Critics argue that fair value accounting exacerbated the severity of the 2008 finacial crisis.The main allegation are that fair value accounting contributes to excessive leverage in boom periods and leads to excessive wtite down in busts.The main issue with fair value accounting was that companies are inflating their assets and thereby income by making financial assets at fair value only because there fair value had increased.

The critics are wrong,fair value acccounting is good accounting,and we should remain on track to implement IFRS.The alleged link between fair value accounting and the financial crisis is as follows.If some assets decrease in value,then mark to market accounting requires that the financial institutions holding it must mark it down to its market value and there by recognising a loss.The loss erodes its capital.

In order to shore up its capital it may have to sell those assets.This forced sale further depresses prices in the market,givin rise to the cycle all over again.The logic of the argument is wrong in the first place.Contrary to popular belief,accounting rules do not require companies to mark their assets to fire sale market prices.

IAS 39,the accounting standard on mark to market accounting for financial instruments,states that the fair value of an instruments is that which would have prevailed in an arms lenght exchange motivated by normal business consideration.Forced liquidation sale are not orderly transactions.

Even if accounting did require marking financial assets down to fire sale prices,two crisis in recent history remind us that the result is still likely to be far better than alternative.The saving and Loans crisis in the US during the 1980s and the japanese crisis of the 1990s prolonged for lack of fair value accounting.In both cases,many banks had become insolvent becuase market values of their assets had fallen below their liablities.