Is It Fair to Blame Fair Value

Accounting for the Financial

Crisis ?

Prepared by :
Nitu Baral
Shreeza Tamrakar
Jeny Sherchan
 CONTENTS

Introduction

Myths about Accounting Methods

Recommendations for Realistic Reporting

Conclusion
 INTRODUCTION
Fair Value accounting, also called mark to market

accounting, is the practice of valuing an asset every

period based on its fair market value, not what was
paid for it.
A financial crisis can occur if institutions or assets

are over-valued, and it can be made worse by

irrational investors behaviour.
Mark-to-market accounting was “the principal

reason” that the U.S financial system melted down in

2008, Steve Forbes, Chairman of Forbes media and
sometime political candidate
Economist Brain Wesbury says:

 During the crash of 2008, value of any assets such as

corporate bonds and structured debts drop because

the market was frozen.
 This caused many banks to unload and sell assets at

fire-sale prices.
 This has lead to many European countries and US to

want to revert back to historical cost accounting

(valuing assets at purchase price).
According to Lisa Koonce, an accounting professor

at University of Texas:
 Fair value accounting is not the cause of the current

crisis
 The main reason of crash is subprime loan

 Shareholders group even argue that fair value accounting

is crucial in the decision making process for investors.

Fair Value and Historical Cost Accounting
Fair Value Accounting
Fair Value is the amount for which the
asset could be exchanged, or a liability
settled orderly among willing parties.
Focuses on the actual market values of
the asset.
More relevant to the intended users of
general purpose financial reports.
Contemporary and transparent.
Inaccurate when sharp, unpredictable
volatility in prices occurs.
Historical Cost Accounting
Historical Cost is based on the concept
that assets and liabilities are measured
and booked as per their original
acquisition price.
Focuses on the cost distribution of the
asset.
Doesn’t provide enough information
relevant to investors.
Conservative and easy to calculate.
Historical costs remain steady in the
long run.
The Myths:
Myth 1: Historical Cost Accounting Has No Connection

to Current Market Value

Myth 2: Most Assets of Financial Institutions Are Marked

to Market

Myth 3: Assets Must Be Values at Current Market Prices

Even If the Market for Them Is Illiquid

Myth 1: Historical Cost Accounting Has No
Connection to Current Market Value
Historical Cost Accounting records assets at their
purchase price or original value
Minor adjustments for depreciation and appreciation
Ultimately must be marked down to the current value
on the Balance Sheet and the result recorded in the
Income Statement
The only difference with respect to the Fair Value
Accounting is the duration and the amount in which
the market value can be reported
Myth 2: Most Assets of Financial Institutions
Are Marked to Market

Only 31% of bank assets were marked to market in the late

2008
Most bonds/loans were “held to maturity” subject to

historical accounting
The gains were reflected under “other comprehensive

income”
As a result, neither the net income nor the regulatory capital

were affected
Myth 3: Assets Must Be Valued at Current
Market Prices Even If the Market for Them Is
Illiquid
“How Liquid Is That Asset?”

Level 1 Level 2 Level 3

Most Liquidity Moderate Liquidity Least Liquidity
Liquidity
Standard

Valued at direct Valued using Valued using a

Valuation

market prices, based observable marketing financial model, such

Method

on active trading of inputs as a discounted cash

identical instruments flow model
Recommendation for Realistic
Reporting
Enhance the credibility of Marking to
Model

Delink Accounting and Capital

Requirements

Calculate EPS in both ways

Conclusion

No single best way to value assets.

Fair value accounting did not cause the

financial crisis.
Misperceptions about accounting

standards may have aggravated the crisis.

THANK
YOU