Fair Value Accounting Fact Or Fancy?

Abstract

Accounting methods had used historical costs prior to FAS 115 and FAS 157. For financial intermediaries in particular, fair value accounting (FVA) has replaced verifiable historical costs with market valuations that, for illiquid assets, rely on assumptions and are not a priori verifiable. The effect of using these relatively new financial accounting standards has been to convert the valuation basis from historical costs accounting to fair value accounting. The recent literature seems to indicate that the current guideline about fair value accounting may be appropriate in certain cases; but in many cases, it does not appear so. Nevertheless, the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) are, apparently, maintaining their current directives for accounting valuation. The Enron case clearly showed that FVA aided the firm in misstating income statements and balance sheets. Given the accounting literature on the subject, the use of FVA also appears to have contributed to the liquidity crisis of 2008 in a negative way in that (1) the use of FVA combined with mandatory capital adequacy requirement introduced a negative feedback mechanism which caused asset prices to fall more than they otherwise would have, and (2) the use of FVA seems to have caused a lack of confidence in valuations reported on banks’ financial reports. This paper will examine the problems inherent in the replacement of historical cost accounting with fair value accounting, with particular focus on the veracity and verifiability of FVA numbers. Our result indicates that accounting methods cannot possibly be responsible for various valuation models, particularly with respect to certain derivative contracts, such as energy swaps and credit default swaps which cannot be replicated in practice.