The accounting profession is responsible for delivering the information necessary to make correct decisions. To promote the dissemination of high quality information, accounting standard setters constantly struggle to keep standards up to date with the ever evolving markets. In light of the recent financial crisis, fair value accounting has come under scrutiny. Some critics go as far as to blame the whole crisis on fair value accounting. I assert that fair value increases a company’s transparency. Thus, through this principle, the responsibility of the accounting profession mentioned above is further accomplished: investors are getting necessary information on which to base their decisions.
Although fair value is blamed, the main problem does not lie in the standards, but rather, it lies in the fact that companies take measures to leave investors in the dark by not fully disclosing information. The officers that are responsible for financial reporting are not always concerned with delivering the needed information to the investors through their financial reporting. At the heart of it, third parties such as analysts, investors, standard setters and especially auditors may be responsible for encouraging and allowing such behavior to occur.
Fair value allows for certain assets to be valued at the amount for which they could be exchanged in an open market transaction. The problem with this arises when the market for an asset that a company values at fair value becomes illiquid. Without a market exchange to base the fair value off of, the value of the asset is determined through the use of complex models that the company must come up with (usually through the use of a specialist); these difficult to value assets are known as Level 3 assets.
During the financial crisis, prices for mortgage related securities fell significantly and markets for them became illiquid. The result was banks marking down their assets by significant amounts. Because of this, the banks had trouble meeting their capital requirements and the amounts they were allowed to lend were slashed by trillions of dollars. The critics argue that those trillions of dollars could have helped to stimulate the economy further but, instead, the banks sold the assets to attain cash which led to the continuance of assets getting marked down and the economic downturn became a seemingly never-ending cycle. This is the reason some critics argue that fair value accounting caused the financial crisis.
I think the argument against fair value accounting is wrong. The goal of accounting should always be to provide needed information to stakeholders. Fair value does just that. Instead, lack of full disclosure by management in their financial reporting is more to blame for the crisis.
Problems with Disclosure
Managed or faulty reporting practices are something that has been witnessed in the past. For example, there is evidence that managers are willing to take pretty big measures to meet benchmarks and earnings targets. Some managers even go as far as to destroy shareholder value through legal means in order to boost their numbers. There are many cases in which a firm misses an earnings target by even a cent per share and the stock price plummets as a result (Graham, Harvey and Rajgopal). With such pressure from the public, it is not a surprise that firms rarely, if ever, miss an earnings target by a penny (Brown and Caylor). This indicates that managers are willing to bend the accounting rules to make an extra cent of earnings per share in order to meet expectations.
Another, more recent, example of officers not fully disclosing information is the Repo 105 transactions that Lehman Brothers engaged in during its final years as a firm. The transaction consisted of the sale of billions of dollars in securities a few days before each quarter ended. They would report...