Accounting and Financial Crisis

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June 2010, Vol.6, No.6 (Serial No.61)

Journal of Modern Accounting and Auditing, ISSN 1548-6583, USA

Fair value accounting under financial crisis
HE Cai-xia1, ZHANG Chi2
(1. School of Accounting, Zhongnan University of Economics and Law, Wuhan 430073, China; 2. School of Management, Huazhong University of Science and Technology, Wuhan 430073, China)

Abstract: The recent financial crisis has led to a vigorous debate about the pros and cons of fair-value accounting (FVA). This debate presents a major challenge for FVA going forward and standard setters’ push to extend FVA into other areas. In this article, we highlight three important issues as an attempt to make sense of the debate. First, much of the controversy results from confusion about what is new and different about FVA. Second, while there are legitimate concerns about marking to market (or pure FVA) in times of financial crisis, it is less clear that these problems apply to FVA as stipulated by the accounting standards, be it IFRS or U.S. GAAP. Third, historical cost accounting (HCA) is unlikely to be the remedy. There are a number of concerns about HCA as well and these problems could be larger than those with FVA. Key words: fair value accounting; historical cost accounting; financial crisis

1. Introduction
The recent financial crisis has turned the spotlight on fair-value accounting (FVA) and led to a major policy debate involving among others the U.S. Congress, the European Commission as well banking and accounting regulators around the world. Critics argue that FVA, often are also called mark-to-market accounting (MTM), has significantly contributed to the financial crisis and exacerbated its severity for financial institutions in the U.S. and around the world. On the other extreme, proponents of FVA argue that it merely played the role of the proverbial messenger that is now being shot. In our view, there are problems with both positions. FVA is neither responsible for the crisis nor is it merely a measurement system that reports asset values without having economic effects of its own. In this article, we attempt to make sense of the current fair-value debate and discuss whether fair value accounting contributes to financial crisis. We come to the following four conclusions. First, much of the controversy about FVA results from confusion about what is new and different about FVA as well as different views about the purpose of FVA. Second, there are legitimate concerns about marking asset values to market prices in times of financial crisis once we recognize that there are ties to contracts and regulation or that managers and investors may care about market reactions over the short term. However, it is not obvious that these problems are best addressed with changes to the accounting system. As our third conclusion highlights, there could be implementation problems in practice. It is important to recognize that accounting rules interact with other elements of the institutional framework, which could give rise to unintended consequences. At the same time, it is important to recognize that giving management more flexibility to deal with potential problems of FVA also opens the door for manipulation. Thus, standard setters and enforcement agencies face a delicate trade-off. Fourth, we emphasize that a return to historical cost accounting (HCA) is unlikely to be a remedy to the problems with FVA. HCA has a set of problems as HE Cai-xia, School of Accounting, Zhongnan University of Economics and Law; research fields: accounting and financial crisis. ZHANG Chi, School of Management, Huazhong University of Science and Technology; research fields: accounting and financial crisis. 59

Fair value accounting under financial crisis

well and it is possible that for certain assets they are as severe, or even worse, than the problems with FVA. Based on extant empirical evidence, it is difficult to evaluate the role of FVA in the current crisis. In...
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