SUPERIOR UNIVERSITY

Corporate Finance
MBA -1 Year (Evening)
Session 2010-11

Article Title: Potential Criticism of fair value accounting during the credit
crunch

Submitted To: Prof.Salman Masood Sheikh

Submitted By: M.Salman Nisar (MBA-1 Year)

Potential Criticism of Fair Value Accounting During the
Credit Crunch

FAIR VALUE:

Fair value is used as a certainty of the market value of an asset (or liability) for which a
market price can be determined (usually because there is no established market for the asset).
Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or
sold in a current transaction between willing parties, or transferred to an equivalent party,
other than in a liquidation sale

CREDIT CRUNCH:

A credit crunch (also known as a credit squeeze or credit crisis) is a reduction in the
general availability of loans (or credit) or a sudden tightening of the conditions required to
obtain a loan from the banks. A credit crunch generally involves a reduction in the
availability of credit independent of a rise in official interest rates

AIM/PURPOSE OF ARTICLE:

The main purpose of this article is to critically analyze the relationship of fair value
accounting and Credit Crunch. It also identifies various aspects which resulted in credit
crunch and how the fair value accounting played its role in this issue.

POINTS OF DISCUSSION

1. Did fair-value accounting contribute to the problems of investment funds that invested in
mortgage-backed securities, and thus contributed to the demise of financial institutions
like investment banks that issued those funds?
2. Did fair-value accounting weaken bank holding companies or investment banks in other
ways?
3. Is there evidence that banks made use of the safeguards and discretion in fair-value
accounting rules and deviated from potentially distorted market prices?
4. Is there evidence that fair-value accounting led to excessive write-downs of financial
assets?
5. Does fair value accounting provide more useful information to market participants
than the alternative accounting measurement approaches (generally some form of
amortized cost accounting)?
 6. Can the FASB improve FAS 157's guidance regarding fair value measurement to
cope better with illiquid or otherwise disorderly markets?

CONCLUSION

Based on article analysis and the available evidence, it is unlikely that fair-value accounting
added to the severity of the financial crisis. The crisis started when housing prices declined and
delinquency and default rates increased. Uncertainty and information asymmetry dried up the
refinancing and repo markets, which were crucial for investment funds, investment banks, and
several large bank holding companies. Clearly, these events and the severe illiquidity of many
markets posed serious challenges in determining fair values of financial assets. But while there
likely have been downward spirals and asset-fire sales, there is little evidence that spirals or fire
sales occurred as a direct result of fair-value accounting or that fair-value accounting led to
widespread contagion.

1. Policymakers should support existing fair value accounting requirements and their
extension to all financial instruments. The FASB should provide additional guidance
about
a. when market illiquidity is so great that firms may estimate fair values using
internal models instead of observable but low quality market information and
b. how to measure illiquidity risk premia.
c.
2. The FASB and SEC should require firms to make additional mandatory disclosures
and strongly encourage them to make additional voluntary disclosures about their
unrealized fair value gains and losses and how they have resulted from market
illiquidity.

LEARNING:

I personally feel that fair value accounting might be a factor that triggered up the financial
crunch but alone its not the reason of it . in fact practically from accounting point of view fair
value of accounting is the right way to go with certain modifications

There are few who would argue that fair value is inappropriate for measuring investments
held for trading purposes where deep and active markets exist. Knowing the spot price is
critical for managing a short term trading portfolio. Many derivatives have no initial cost, and
fair value is the only sensible way to measure and record them. Mortgage servicing rights are
non-financial assets and are not directly impacted by falling investment prices.
REFERENCES:

• The Truth about the Golobal Financial Crisis (Omar Masood)

• Fair Value Accounting & Financial Crisis’s (www.wikipedia.com)

Fair Value Accounting: Policy Issues Raised by the Credit Crunch

(http://whitepapers.stern.nyu.edu/summaries/ch09.html)

Did Fair-Value Accounting Contribute to the Financial Crisis?

(www.eu-financial-system.org/
fileadmin/content/Dokumente_Events/12th_conference_Rome/Papers/Laux_Leuz.pdf
)

Fair Value Accounting: Villain or Innocent Victim

(www.bos.frb.org/bankinfo/qau/wp/2010/qau1001.pdf)