2008 global financial crisis & fair value accounting standards

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INTRODUCTION
Many believe that the financial crisis of 2008-2009 led to a close collapse of the US banking system (Bowen & Khan, 2014; Arnold, 2009, Bigman & Desmond, 2009)). Some argue that this disaster was due, in part, to fair value accounting. Is this the case? Should fair value accounting be scaled back or even scrapped? This paper will explore how and if fair value was part of the problem and whether it should be approached with caution going forward.

I will conclude that fair value accounting is an honest response to a real problem but not one without imperfections and controversy. It is possible, perhaps likely, that fair value accounting contributed or perhaps caused the 2008 global financial crisis. Regardless, the solution cannot be to throw out the baby out with the bath water. The abuses of fair value that occurred should be corrected but fair value accounting has an important place in informing capital markets. It is in the corruption of its use that troubles lie. In itself, fair value is a useful tool. What is more needed is better understanding of what is being reported (Mott & Deans, 2008; Pozen, 2009) and more attention to how to treat ill-liquid assets, the hardest ones to value because no exit price exists (FASB, 2014).

FAIR VALUE ACCOUNTING

Fair value accounting is the adjusting of historical transactions price to a market-driven price (FASB, 2014). Fair value is not specific to any firm, but is a treatment based on the asset or liabilities held by the firm. Financial assets or liabilities, securities with certain attributes, and assets arisen from mergers and acquisitions are typically the ones that are assessed or revalued based on market transactions. In some cases, when market transactions cannot be obtained or observed, alternative measures such as discounted cash flows are substituted for market pricing.

Fair value generally began with SFAS 157 where fair value was reported based on three "levels" of inputs (FASB, 2014). Level 1 was observable values for identical assets. Level 2 was observable values of comparable assets. Level 3 was unobserved variables and attributes presumed to impact values. So, level 1 might be the quote for Coke stock. Level 2 might be the quote for a note receivable based on similar credit risk and duration of another firm. Level 3 might be the value of a holding for which there is no market value (unique asset) and so the future cash flow is capitalized in a spreadsheet as the valuation. The quality of the valuation is lower as you rise in level. The level is reported and the method of valuation is discussed in the footnotes to assist the financial statement reader. The issuance of this new standards was just two years prior to the financial crisis so naturally the question rises: Did the standard help create or worsen the crisis (Trussell & Rose, 2009).

Fair value accounting is typically based on exit price (FASB, 2014). That is, what would you be able to get from selling it, net of transaction costs. This is highly problematic when there are market disruptions and it is not possible to sell the instrument. The potential ill-liquid holding would be classified (typically) as a level 3 input for valuation. But this can still be a difficult computation because the assumptions to use are unknown. During the financial crisis, the current performance of loans in a securitized portfolio may not be a good measure of the longer-term ability to perform. So, fair value, especially for level 3 instruments, can be complex and lead to over-correction (Kothari & Lester, 2012).

Fair value is justified over historical cost based on relevancy. There is a long tradition of favoring historical cost because it is verifiable and reliable. The prior transactions can be checked, audited and known for certain. This saves the preparer of the financial statement from criticism that they are trying to seduce investors with glowing reports that are based on someone's best guess about future market participants. However, while historical cost is neutral and verifiable, it is almost always wrong. That is, the true economic power of the asset or liability is not the original transaction price. For assets that are to be used or consumed in operations, like a building or truck, adjusting to market pricing is not relevant. However, for assets that are to be traded, or could be traded, the market pricing is ...