GFC and Fair Value Accounting
During the 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 the crisis.
(a) Describe those alleged problematic fair value accounting techniques and standards, and state if you agree with the criticisms and why (10 marks).
(b) In the period 2009-2020 do you think IFRS fair value standards have improved? State your reasons and evidence (10 marks).
(c) In the event of a major economic downturn in 2020 or later do you think assets will be appropriately measured by IFRS fair value accounting standards? Explain (10 marks).
Part One: Fair-Value Accounting and GFC
The Global Financial Crisis of 2008/9 triggered an intense debate on fair-value accounting as the critics argued that fair-value accounting contributed considerably to the crisis or aggravated its severity. In its basic form, fair-value accounting entails reporting the assets and liabilities on an entity’s balance sheet at their fair value and then recognizing any changes in the fair value as losses and gains in the income statement. A key component of fair value accounting is the marking to market practice that does not allow for outdated and wishful-thinking valuations. The practice revalues and updates asset valuations periodically according to the price that would be fetched if sold on an open market, irrespective of their original price (Masoud & Daas, 2014). However, it is at the center of the hottest debate in years.
Most bankers derided fair value accounting when the abrupt seize-up of the global credit markets pushed the clearing prices for their institutional assets to record lows in the fall of 2008. The rules of mark-to-market accounting converted a big problem into an enormous one. The majority of structured debt, mortgages, and corporate bonds were still performing, but their underlying assets plunged below their actual values since the market was frozen. Consequently, the banks were driven to insolvency and forced to offload these assets at fire-sale prices, triggering a further decline in values due to marking to market. Thus, the main argument is that fair-value accounting contributed to excessive financial leverage during the boom period and unwarranted write-downs during busts (Laux & Leuz, 2010). The write-downs depleted the bank capital and triggered a downward spiral since most of the banks were forced to sell the assets at the fire-sale prices leading to a contagion because the prices from asset fire sales proceeds were relevant for the other banks.
One can conclude that fair value accounting is not one of the causes of the GFC. Instead, it communicated and relayed the impact of bankers’ bad decisions, such as the issuance of credit default swaps and subprime loans. The other option was reporting these loans on the accounting books at their initial amounts, which is akin to disregarding reality (Pozen, 2009). Likewise, establishing fair values for illiquid assets during a crisis is hard. However, reporting illiquid assets’ values did not worsen the crisis since the market would not have reacted if banks did not report losses or used historical-cost accounting. Besides, fair value information must be availed to providers of capital along with other users in market turmoil and liquidity crunches. Assuming that the banks did not mark existing bonds to market, the stockholders would be uncertain about the values of assets. They would be reluctant to aid in the recapitalization of the troubled institutions. Overall, based on these arguments is unlikely that fair-value accounting contributed or aggravated the severity of the financial crisis.
Part Two: Fair-Value Accounting and GFC
In the period between 2009 and 2020, the IFRS fair value standards have improved considerably. One of the core issues arises when the market-based measurements do not reflect the true value of an underlying asset accurately. This could occur when an entity is forced to compute the selling prices of its assets and liabilities in volatile and unfavorable periods during the 2008 global financial crisis. In a bid to counter this, the Financial Accounting Standards Board voted and sanctioned new accounting guidelines in 2009. The approved allowed for valuations based on prices received in orderly markets instead of forced liquidations. In 2011, IFRS 13 was implemented by the International Accounting Standards Board and provided guidance performing fair value measurement. A company uses assumptions that the participants in the financial markets would use in pricing assets under the present market conditions, comprising risk assumptions when measuring fair value (International Accounting Standards Board, 2011). Therefore, IFRS 13 necessitates entities to take into consideration the effect of credit risk in the determination of fair value measurement.
Another improvement is when employing the fair value method under IAS 16, an entity should post any of the gains to the Other Comprehensive Income statement. The entity can report gains to net income only to the extent of losses on past revaluation on the same asset. As a result, under IAS 16, firms cannot exaggerate their net income owing to the revaluation election (Ball, 2016). IFRS also offers choices amongst alternative accounting techniques. For instance, IAS 38 and IAS 16 offer choices between reporting some long-lived assets at either cost or fair value. Even though the options are constrained, they offer an additional discretion layer to managers.Part Three: In the event of a major economic downturn in 2020 or later do you think assets will be appropriately measured by IFRS fair value accounting standards?
If there is a downturn, assets will be suitably measured using the IFRS fair value standards. Fair value accounting leads to accurate asset valuation continuingly to users. When the prices of assets increase or are expected to rise, an entity marks the asset value to its present market price to replicate what would be received if it is sold. Conversely, if there is a downturn, an entity then marks down the asset value to reflect a reduction in the current market prices. Thus, fair value yields applicable information for users regarding the assets in the financial reports as opposed to cost-based accounting measures (Ashford, 2011). Furthermore, the adoption of fair value accounting is important during a crisis as it limits the ability of companies to manipulate or alter the reported net income, possibly (Abdullahi & Ma’aji, 2016). From time to time, the management could deliberately arrange some asset sales to use losses or gains from these sales to decrease or increase their net income as reported in the books at their desired periods. The implementation of the IFRS fair value accounting standards ensures that gains or losses from changes in prices for an asset are reported in the fiscal period that they occurred. The rise in asset value increases the annual net income, while a reduction in asset value decreases the net income.
References
Abdullahi, S.R & Ma’aji, M.M. (April 2016). A Critical Evaluation of the Measurement and Effects of Fair Value in Financial Statements. International Journal of Innovative Research in Social Sciences and Strategic Management Techniques. 3,1, 2467-8155 Retrieved from https://www.researchgate.net/publication/313179049_A_Critical_Evaluation_of_the_Measurement_and_Effects_of_Fair_Value_in_Financial_Statements
Ashford, C (2011). Fair Value Accounting: Its Impact on Financial Reporting and how it can be Enhanced to Provide More Clarity and Reliability of Information for Users of Financial Statements. International Journal of Business and Social Science, 2, 20, 12-19. Retrieved from https://ijbssnet.com/journals/Vol_2_No_20_November_2011/3.pdf
Ball, R. (January 01, 2016). IFRS – 10 years later. Accounting and Business Research, 46, 5, 545-571. Retrieved from https://www.tandfonline.com/doi/full/10.1080/00014788.2016.1182710
International Accounting Standards Board., & IFRS Foundation. (2011). IFRS 13 Fair value measurement. London: International Accounting Standards Board. Retrieved from https://www.ifrs.org/issued-standards/list-of-standards/ifrs-13-fair-value-measurement/
Laux, C., & Leuz, C. (2010). Did fair-value accounting contribute to the financial crisis?. Cambridge, MA: National Bureau of Economic Research. Retrieved from https://www.nber.org/papers/w15515
Masoud, N., & Daas, A. (September 30, 2014). Fair-Value Accounting’s Role in the Global Financial Crisis?: Lessons for the Future. International Journal of Marketing Studies, 6, 5.) Retrieved from http://www.ccsenet.org/journal/index.php/ijms/article/view/40902
Pozen, R. C. (November 01, 2009). Is it fair to blame fair value accounting for the financial crisis?. Harvard Business Review, 87, 11.) Retrieved from https://hbr.org/2009/11/is-it-fair-to-blame-fair-value-accounting-for-the-financial-crisis