Fair Value Accounting Standards

Demerits of Fair Value Accounting

Financial Accounting Standard’s Boards (FASB) proposed amendments to be made on accounting standards which are expected to be adopted once the draft is approved by my committee members. The new standard requires financial institutions to account for their assets and liabilities at current market values and prescribes different accounting treatments for each. These amendments may ultimately result in additional pressure to the already distressed economy since the proposed model involves no cash flows and businesses will be forced to undervalue their assets resulting in huge losses. The basic findings continue to hold that the magnified changes inherent within the process would increase the volatility of massive collateralized securities that markets hold.

Moreover, since robustness about disclosures causes uncertainties, investors and the public will therefore be unable to identify the valuation method a bank uses, underlying risks, and estimates used in valuing assets. Mark-to-market accounting has received considerable criticism and its significant number of deregulations in the banking industry, which brings us to the question, how do we address the absence of variables to control for the efficient structure in the markets? Here we do argue, however, that policymakers should examine in context the shortcomings of the proposed accounting standard and consider in the future whether to undertake a project that would eliminate the differences that exist between the two accounting standards.

Effects of Fair Value Accounting on the Current Economic Crisis

The proposed amendments prove impractical because the rules delivered under FASB are unique in determining the appropriate accounting requirement which does not relate to the changes in economic welfare. As a general, conceptual matter, market-to-market accounting under IFRS is tied to the economic welfare of a country, and its irregularities may have adverse effects on banking markets. FASB though still in its early stages of deliberation, we can see that its adoption would have negative implications on the balance sheet since banks will be forced to write down assets are relatively low prices leading to losses. To support this analysis, we employ a number of observations to bolster this argument, first, S&P (2008, p.1) and Hansen (2009) find that when mortgage-backed securities that harbor trillions of dollars worth of assets are forced to value their securities at mark-to-market values, they undergo huge losses since they are forced to underbid the prices thereby unable to meet their liabilities. Secondly, the mortgage may be more than 50% of their face values and since the proposed model requires them to mark their assets at the current market price, the bank will be forced to sell the securities at much lower prices than what they actually sustained.

Moreover, Moody Investors Services argue that credit default swaps applied in mark-to-market accounting may not accurately indicate the nature of credit deterioration. If true, then policymakers of FASB should propose amendments that accommodate these credit facilities.

He further provides two bond insurers; MBIA and Ambac as examples of failed markets for more investigative analysis. He argues that the two investors who had invested heavily in CDS markets suffered huge losses after its collapse since they had valued their assets using the diminished market prices (Rappeport, 2008).

Amid the crisis, the proposed accounting standard has already exposed certain weaknesses, which, in part, with the current accounting standards will contribute to massive infusion and deceit to investors and the public. Banks being the most vulnerable institutions, Calabresi (2009) posits that “At the moment, there are few buyers for the toxic assets that are poisoning Citigroup, Bank of America and other major financial players. The unsellable loans sit on the banks’ balance sheets at a huge loss, priced from zero to an optimistic 60% of what they might have sold for before the crash” (online).

Pricing

Since banks use financial models, ABX (price index), or credit default swaps to determine prices for their assets, FASB should consider the infrastructures of some companies with regard to pricing models before implementing the new accounting standards. We see that gauging prices may unnecessarily understate the risks of insolvency and by the time banks predict their forecasts, toxic assets will have already found their way into the markets and also, the suggested financial models may understate the value of asset driving banks to huge losses. For example, before the credit crunch in 2007, ABX indexes for subprime mortgage bonds were priced at 27% which has risen over the years, and valuing mortgages at mark-to-market prices would lower their values dangerously forcing them to collapse. Also, even though many loans that support bonds are yet to default, or may never will, the losses will be so great that even large financial institutions will be forced to wipe out their capital (Calabresi, 2009: Hiltzik, 2009; Sorkin, 2009).

American Bankers Association replicates the analysis by arguing that mark-to-market accounting would increase pro-cyclicality thereby disrupting the goal convergence of accounting standards. Since securities keep fluctuating in price, Hamilton (2009) argues that the model would force banks to value their assets based on the volatility of the marketplace rather than the cash flow it receives causing massive disruption to the banks and economy. Another alternative explanation suggests that the proposed model would discern investors and regulators since it provides misleading information making it difficult to understand the business of banking. The G-20 recommendations require accounting setters to improve accounting standards in the valuation of financial instruments, contrary to what the mark-to-market approach provides. Another shortcoming of this proposal is that it does not meet Basel’s Committee principles which require accounting standards to reflect transparency in their banking transactions.

Since FASB proposes to increase the use of mark-to-market accounting, industry lobbyist believes the rule will diminish the value of assets contrary to G-20 recommendations that require accounting standards to be less pro-cyclical. Another shortcoming of this model is that it does not conform to the Treasury principle that requires regulatory capital and accounting frameworks to be modified to avoid unnecessary overstating of the risks of insolvency (Hamilton, 2009).

Moreover, market fluctuations will be intensified since financial assets will only reflect the price of the current markets ultimately increasing volatility in returns through the profit and loss account. We should also note that markets will be distressed when they hold massive collateralized securities that would have otherwise been sold for profits. Since losses are only recorded in accounting books, a pro-cyclical view distorts the investors’ confidence and subsequently intensifies price fluctuations in the already distressed economy. Hamilton (2009) argues that “maintaining amortized cost valuations for loans and securities in the traditional banking segment gives investors a simple and accurate way to view how the organization manages its portfolio. The investor can easily see what amounts are due to the bank, how much is expected to actually be collected, and what level of yields are being earned”( online), contrary to the proposed mark-to-market accounting. In addition, the endorsed reforms show inconsistency in their banking models resulting in a widened gap between the U.S. accounting standards and the world.

Conclusion

Market to market accounting has received considerable criticism and its significant number of deregulations in the banking industry, which brings us to the question, how do we address the absence of variables to control for the efficient structure in the markets? Here we do argue, however, that policymakers should examine in context the shortcomings of the proposed accounting standard and consider in the future whether to undertake a project that would eliminate the differences that exist between the two accounting standards. The amendments should acknowledge the existing gap between the current accounting standards and the proposed draft that would accommodate the banks’ profitability and the economy as a whole.

References

Calabresi, M. (2009). Will a Mark-to-Market Fix Save The Banks?. TIME cnn. Web.

Hamilton, J. (2009). Banking Industry Says Proposed Changes to Fair Value Accounting Would Contravene G-20 goals by Disrupting Convergence and Increasing Procyclicality. CCH Financial Crisis News Center. Web.

Hansen, S.W. (2009). Understanding How Mark to Market Rules are Fueling the Credit Crisis. Learning Markets. Web.

Hiltzik, M. (2009).Mark-to-Market ‘ a stiff standard for banks’ accounting. Los Angels. Web.

Rappeport, A. (2008). Should Monolines Balme Mark-to-market?. CFO. Web.

S&P. (2008). Fair Value Accounting Works Well, but Is Not Perfect. The CPA Journal. Web.

Sorkin, A. S. (2009). Suspending Mark-to-Market: Bad Policy, Bad Time. The New Yolk Times. Web.