Accounting and the late 2000s financial crisis are the accounting methods that contributed to the 2008 financial crisis. There were many differing views on which parties were primarily responsible for the crisis. These include investment bankers, credit rating agencies, financial statement preparers, the US Federal Reserve, investors, loan originators, auditors, and borrowers among others. One of the parties identified was the role that accountants and specific accounting standards played in the crisis.
The Causes of the Great Recession and "History of Fair Value Issues"pbs.org "History of Fair Value Issues" provide more details of the specific causes. The key accounting issues were fair value accounting and the role of auditors.
Fair Value Accounting and its Role in the 2008 financial crisis The role of fair value accounting in the subprime mortgage crisis of 2008 is controversial. Fair value accounting was issued as US accounting standard SFAS 157 in 2006 by the privately run Financial Accounting Standards Board (FASB)—delegated by the SEC with the task of establishing financial reporting standards. This required that tradable assets such as mortgage securities be valued according to their current market value rather than their historic cost or some future expected value. When the market for such securities became volatile and collapsed, the resulting loss of value had a major financial effect upon the institutions holding them even if they had no immediate plans to sell them.
Financial Accounting Standard 157 In 2006 the Financial Accounting Standards (FASB) implemented FAS 157 in order to establish a generally accepted accounting definition of fair value, methods for measuring fair value, and to expand disclosures about fair value measurements in financial statements.http://www.fasb.org/summary/stsum157.shtml , "Summary of Statement No. 157" - FASB Pre-Codification Standards. The statement aimed to increase consistency, comparability and transparency among statements that incorporated fair-value measurements.http://www.honors.ufl.edu/apps/Thesis.aspx/Download/980 , "The Role of Auditors in the Current Financial Crisis" FAS 157 defines a hierarchy of three levels of inputs to obtain the fair value of an asset or liability.
These levels are classified as Level 1, Level 2 or Level 3. These levels differ in that Level 1 inputs have active markets, Level 2 inputs use models for similar assets, and Level 3 inputs are unobservable, relying on model assumptions. Since Level 2 and Level 3 inputs do not have active markets with identical assets, the discretion of management is required when determining the fair value of these assets. This provides room for managerial manipulation.
How Fair-Value Accounting Came into Being 1. Lessons from 1929 Stock Crash Under historical cost accounting, profits came to be calculated as the difference between the income accrued and costs incurred, according to revenue recognition and matching principal. This traditional measure of the profits did not prove adequate to value derivatives. In some cases, historical cost accounting didn't apply because there was little trading cost, (e.g. an interest-rate swap contract). And in other cases, because of the existence of fairly liquid markets and the wide use of valuation methodologies in financial markets to set asset prices, the relevance of historical cost accounting is largely undermined. In order to improve information transparency, and to better inform investors about the interest and credit risks reflected, FASB began take steps to extend the application of the fair value principle to an ever greater range of assets and liabilities.
2.The Expanding Use of Derivatives In the 1980s, derivatives underwent significant development as they came to be used to hedge against interest and exchange rate risks. Additionally, derivatives started to be used by credit institutions as a new source of business. The large-scale use of derivatives by large and medium-sized corporations, together with the ever growing importance of capital markets, has led to major changes in the traditional practices used to prepare financial statements.
US Savings and Loan Crisis and Fair-Value Accounting In the late 1980s and early 1990s, the Savings and Loan Crisis precipitated a collapse of the U.S. thrift industry. Investors demanded increased transparency, and historical cost accounting was blamed for creating rooms for banks to underestimate their losses. In 1991, the Government Accounting Office (GAO) issued a report that urged immediate adoption for both GAAP and regulatory reporting of mark-to-market accounting for all debt securities. It also suggested that a study be undertaken of the potential merits of a comprehensive market-value-based reporting system for banks. As fair value was increasingly viewed as an important tool for valuation, a clear guidance was needed for better application. In 2006, FASB issued FAS 157, which provided a uniform definition of “fair value” and guidance for application.
Fair Value Accounting in Practice Banks’ asset categories are mostly made up of loans and leases, available-for-sale and held-to-maturity securities, and trading assets. Loans and leases comprise the biggest and most important category for most banks. These assets are classified as either “held-for-investment,” or “held-for-sale”, accounted for at the lower of historical cost or fair value. Ultimately, most of the assets held by financial institutions were either not subject to fair value, or did not impact the income statement or balance sheet accounts. However, a large minority of the assets were “held-for-sale” or trading assets. The loans and securities in the held-for-sale classification are tested for impairment and, if impaired, written down to the present value of future cash flows. Loans are usually impaired because creditors will be unable to collect all amounts due but if classified as “held-for-sale” can also be deemed impaired under FAS157 if their market value falls for an extended period of time.http://www.fasb.org/summary/stsum157.shtml, “Summary of Statement No. 157” - FASB Pre-Codification Standards.
Furthermore, all derivatives are treated as trading assets and are marked to market. However, as the crisis evolved and liquidity deteriorated, fair value assets held by banks increasingly became Level 3 inputs because their market prices became unobservable.
As mentioned in the 2010 article written by Laux and Leuz, linking banking capital regulation and fair value accounting is the most plausible way fair value accounting could have contributed to the crisis: Asset prices deviate from their fundamental values, which causes a bank to write down its assets and, in turn, depletes its capital. Consequently, the asset write-downs may force the bank to sell such assets at fire sale prices and start a downward spiral. This causes a contagion problem and forces other banks to take similar write-downs. However, according to Laux and Leuz, this is not what typically happens in banks’ practices.
The Link between Fair Value and Crises As mentioned in the article written by Laux and Leuz, linking banking capital regulation and fair value accounting is the most plausible way fair value accounting could have contributed to the crisis. The explanation that links the two subjects is that asset values deviate from their fundamental market prices, which causes a bank to write down its assets and, in turn, deplete its capital. Consequently, the asset write-downs may force the bank to sell such assets at fire sale prices and start a downward spiral. This causes a contagion problem and forces other banks to take similar write-downs. However, according to Laux and Leuz, this is not what typically happens in banks' practices.
Fair Value Accounting in Practice In practice, Banks' asset categories include loans and leases, available-for-sale and held-to-maturity securities, and trading assets. Loans and leases, however, comprise the biggest and most important category for banks. These assets are classified as either "held-for-investment," which is typically a small percent of the loans, or "held-for-sale", accounted for at the lower of historical cost or fair value. The loans and leases in the held-for-sale classification are tested for impairment and, if impaired, written down to the present value of future cash flows. Loans are usually impaired because creditors will be unable to collect all amounts due.
This was a reoccurring problem in the 2008 financial crisis. Since the crisis unfolded, fair value assets held by banks increasingly became Level 3 inputs (unobservable). Ultimately, most of the assets held by financial institutions were either not subject to fair value, or did not impact the income statement or balance sheet accounts.
Fair value as a Contributor There has been debate on whether fair value accounting contributed to the crisis or simply was the messenger of the crisis. The opponents of fair value believe it is the contributor to the crisis. Opponents, such as FDIC chairman William Isaac and House Speaker Newt Gingrich, lobbied and urged for the suspension of mark-to-market accounting. Clearly, the lobbying has been an issue of debate as well – one that proponents are not pleased with, as lobbying the FASB presents an issue of its independence. These people believe fair value accounting is not the most relevant method of measuring financial instruments.Forbes.com Cindy Fornelli, "The Great Fair-Value Debate"
Steve Forbes is another opponent who believes fair value accounting was the "principal reason" for the 2008 financial crisis. One argument is that a majority of structured debt, corporate bonds and mortgages were still performing, but their prices had fallen below their true value due to frozen markets (contagion explained above). Opponents also state that fair value accounting undermines critical foundations of financial reporting, including verifiability, reliability and conservatism. It is argued that fair value accounting lacks all three attributes. Some opponents may even suggest that historical cost accounting is more accurate by arguing that financial institutions are forced to record any permanent impairment in the market value of their assets.
Brian Wesbury, Chief Economist, and Robert Stein, Senior Economist at First Trust Advisors in their “Economic Commentary” claimed that “It is true that the root of this crisis is bad mortgage loans, but probably 70% of the real crisis that we face today is caused by mark-to-market accounting in an illiquid market".
Fair Value as a Messenger On the other hand, proponents for fair value accounting believe that fair value was not the cause of the crisis. Instead, they suggest fair value only communicated the effects of poor decisions, such as subprime loans. Proponents also believe that fair value accounting provides investors with critical transparency of companies. There are empirical foundations that prove fair value accounting to be the better indicator of value when compared to historical cost. The lack of transparency by using historical cost accounting may make matter worse. It is possible the market reacts more extremely if the fair-value or current market prices are not disclosed. There is no empirical evidence that using historical cost accounting will calm the investors.
As with any standard setting body, the FASB was faced with tradeoffs when it made the decision to implement this new standard. Since this is an imperfect world with information problems, it is difficult to know what the absolute best option is. This is why it is important that the FASB, along with all other participants in the financial environment, become knowledgeable in their fields, and assess how their decisions and performance may affect others. This stands true for auditors and their role in the financial markets and crisis.