The subprime crisis is an ongoing financial issue and a real estate problem for the United States economy. The increasing numbers of foreclosures and falling housing prices started back in 2007. Subprime crisis has adversely affected financial institutions and financial markets. Majority of subprime lenders filed for bankruptcy and announced losses (Healy, Palepu & Serafeim, 2009). The factors that contributed to subprime crisis is still debatable. According to financial analysts and economists, borrowers who sought credit beyond their reach and investors who sought high returns contributed to the crisis. In addition, there are claims that accounting standards worsened the crisis. These claims raised important questions about fair-value accounting. This paper will answer the research question, did the fair-value accounting method provide early warning signals of the financial problems at financial institutions?
Early accounting standards were based on income/expense approach. So, income statement was the main financial statement. An income statement shows the financial performance of a company in terms of net profit or loss over a specified period of time. Income refers to what a company has earned over a given period of time while expense refers to costs incurred by a company over a given period of time. By deducting expenses from income, net profit or loss of the company is obtained.
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In the 1980s, with the introduction of new financial instruments; the financial market become more complex. Historical cost turned out to be a poor measurement approach because financial products such as derivatives could not be measured accurately. These prompted the Financial Accounting Standards Board (FASB) to shift from income/expense approach to fair value measurement approach. According to U.S Generally Accepted Accounting Principles (U.S GAAP), fair value is defined as an ‘exit price’. On the other hand, fair-value accounting is a valuation principle proposed by FASB and it advocates for regular updates to be done on specific financial instruments. It further advocates for current prices of similar financial instruments to be determined in the context of a liquid market. The principle has existed since the early 1990s and banks involved crisis implemented it. However, it was amended in 2006 by FASB after claims that it contributed to the subprime crisis. The new guidelines provide a clear standard method of calculating financial instruments fair value.
A three-level hierarchy of inputs is used to classify fair value measurements methods from the most to least reliable. The three levels answer the research question as it indicates what needs to be known, assumed and estimated in fair-value accounting method. Level 1 inputs are the observable market prices in active markets for similar financial instruments. FAS 157 requires financial institutions to measure fair values using level 1 inputs if market prices are available. Fair value estimates in level 2 is measured using observable market prices for identical financial instruments or mark-to-models that use observable inputs. The inputs used in the model is reliable but the reliability of the estimates depend on the model used. Level 3 inputs are unobservable and do not have any relevant market base that can be used to value financial instruments. So, level 3 estimates depend on basic accounting principles for recording revenues and expenses earned and incurred by a firm respectively.
In recent years, the use of fair value measurement approach has expanded significantly. The original FASB guidelines on fair value measurements were issued as stand-alone statements. In 2009, the stand-alone statements were codified hence the current Accounting Codification Standards. Most bank leaders are in agreement that the mixed measurement approach is the best method to be used in estimating financial instruments fair value. Also, updates on “Accounting for Financial Instruments and Revisions to Accounting for Derivative Instruments and Hedging Activities” proposed on the use of mixed measurement approach. The proposal was drafted in 2010 by FASB in conjunction with United States financial institutions. Proponents of fair value have argued that fair value incorporates information that is not factored in by historical cost measurement such as price risks inherent in financial instruments and time value for money. Therefore, the claims that accounting standards worsened subprime crisis is not correct since the fair-value accounting method is the best method compared to historical cost measurement.
I highly recommend the fair-value accounting method to banks because fair value measures the value of financial instruments in a meaningful way. To increase the trustworthiness of level 3 asset values, bank leaders are encouraged to disclose how they make level 3 fair value estimates. Fair value disclosures by bank management will reduce the level of controversy associated with the fair-value accounting method. Also, it helps the capital market to asses more accurately the economic value of level 3 estimates. To make financial statements more informative, banks are encouraged to disclose level 2 fair value estimation process. Disclosures of models and assumptions adopted when estimating level 2 fair value help reduce investors' concerns.
In conclusion, the claims that fair-value accounting method worsened subprime crisis is not accurate. The new proposals fronted by FASB on fair value measurements should be implemented by financial institutions. By doing so, financial institutions will be alerted on economic problems in a timely manner.
References
Healy, Palepu, & Serafeim (2009). Subprime Crisis and Fair-Value Accounting. Harvard Business School .
Chung, S.G., Lee, C., & Mitra, S. (2016). Fair Value Accounting and Reliability. The CPA Journal .
Financial Accounting Standards Board (2010). Proposed Accounting Standards Update. Retrieved from U.S. Department of Labor, Bureau of Labor Statistics. (2008). Police and detectives.
Chea, C.A. (2011). Fair Value Accounting. International Journal of Business and Social Science , vol .2 No.20.
