Fair Value Accounting and current Financial Crises

Fair value accounting is used to to an estimation of the market value of an asset or liabilities for which a market price can not established or determined, usually because there is no established market for the asset. Fair value accounting, mandated by Financial Accounting Standard Board in its statement 157, is effective for financial statements issued for fiscal year beginning after November 15, 2007. Fair value accounting has been credited with many things from promoting transparency in the financial accounting, contributing to the 2007-08 financial crises.

Many banks, industry organizations and other financial institution have blamed this accounting practice for the downward economic spiral, as it forces businesses to assign a low value to asset as they would trade today, even if the company does not intend to sell them. Critics have also charged that it is impossible to determine fair market value in an illiquid market, such as the one that began to materialize after the risky trading of mortgage backed securities reversed course.

So this was, in part, the result of the massive de-leveraging of balance-sheets by market participants and reduced appetite for the risk as the marginal calls increased, putting enormous pressure on asset prices a downward spiral of lower prices, forced sales and higher volatility etc.The trust and confidence that counter parties require in one another in order to lend, trade or involvement in similar risk based transactions dissolved to varying degrees for each firm very quickly.

So finally it can be concluded that rather than a crises precipitated by fair value accounting the crises was a "run on the bank" at certain institutions manifesting itself as in counter parties eliminating various credit risk exposures that they had to each firm. Fair value accounting was not the culprit of the financial meltdown that has brought down the biggest financial institution in the world.

Comments are WELCOME