Did fair value accounting play a role in the current financial crisis? This appendix explores the issue. Fair value accounting implies that assets and liabilities get measured and reflected on a firm`s financial statements at their market value, or close substitutes. Extensive academic research done over the past 20 years shows that financial statements that reflect the market values of assets or liabilities provide information that is relevant to investors. In other context, fair value accounting is just a messenger carrying bad news. In contrast, there is also another research stream which is quite critical of the perceived merits of fair value accounting, and which worries about how it undermines what constitutes facebook cover http://www.facebookcover4u.com/ the core of financial reporting. More specifically, it is argued that fair value accounting is difficult to verify, may be based on unreliable assumptions or hypotheses and provides management with too much discretion into the preparation of financial statements. Hence, according to this view, fair value accounting is not necessarily a neutral or unbiased messenger. Moreover, fair value accounting creates a circular dynamic in financial reporting, with markets providing the input for the measurement of many assets, thus affecting reported earnings which are then used by analysts and investors to assess a firm’s market value. If markets become volatile, as has been the case in recent months, reported earnings also become more volatile, thus feeding investors apprehensions. Therefore, since fair value accounting is associated with more volatile and less conservative financial statements and, it may have allowed managers to delay the day of recognition as well as distorted investors and regulators’ perceptions of financial performance and stability at the end of the financial bubble. However, once the economic pendulum swung back, fair value accounting may have magnified their views as to the severity of the current financial crisis, hence accelerating some negative trends.
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Despite its almost universal adoption by accounting standard setters, the merits of fair value accounting continue to generate intense and passionate debates among academics, businesspeople, regulators or investors. A surprising element underlying these debates is the apparent irreconcilable positions adopted by participants in favour or against fair value accounting. However, the current financial crisis has significantly raised the level and stakes in that discussion, with fair value accounting increasingly being under attack. For instance, the U.S. Congress recently mandated the Securities and Exchange Commission to investigate and report on fair value accounting’s contribution to the financial crisis. In reaction, some standard setters such as the Canada’s Accounting Standards Board, the Financial Accounting Standard Board and the International Accounting Standard Board have recently introduced temporary provisions waiving some aspects of fair value accounting for financial institutions.
The purpose of the Appendix is to provide additional insights into the role played by fair value accounting in the financial crisis. Since the crisis is still ongoing, there is no direct or formal empirical evidence about such role, which may be perceived, actual or potential. However, by analyzing the conceptual and empirical foundations of fair value accounting, it may be possible to draw some inferences and to assess if and how fair value accounting underlies some of the recent turmoil in financial markets. In that regard, the Appendix aims to achieve the following objectives. First, I intend to provide a brief overview of fair value accounting, including its impact on financial statements. The overview includes a summary of the opposite viewpoints on the merits of fair value accounting. Second, I present and discuss the theoretical and empirical underpinnings of fair value accounting. Thirdly, I analyze the measurement and valuation challenges that arise from the use of fair value accounting. Finally, on the basis of the above analyses, I sketch a tentative framework to understand fair value accounting’s role and potential contribution to the financial crisis. While fair value accounting can conceptually apply to all aspects of a firm’s financial statements, I will purposefully focus on its application to financial instruments and financial institutions.2644