The role of fair value accounting in the subprime mortgage crisis of 2008 is controversial. Fair value accounting was issued as US accounting standard SFAS 157 in 2006 by the privately run Financial Accounting Standards Board (FASB)—delegated by the SEC with the task of establishing financial reporting standards. This required that tradable assets such as mortgage securities be valued according to their current market value rather than their historic cost or some future expected value. When the market for such securities became volatile and collapsed, the resulting loss of value had a major financial effect upon the institutions holding them even if they had no immediate plans to sell them.
Fair value accounting
Definition of fair value accounting
In 2006, the Financial Accounting Standards Board (FASB) implemented SFAS 157 in order to expand disclosures about fair value measurements in financial statements. Fair-value accounting or "Mark-to-Market" is defined by FAS 157 as "a price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date". The definition is accompanied by a framework which categorize different types of assets and liabilities into 3 levels, and their measurement varied accordingly. The hierarchy of fair value is: (1) Assets or liabilities whose values could be observed on an active market of identical assets or liabilities. (2) Assets or liabilities whose value could be quoted from an inactive market, or based on internal-developed models, with input data from observable markets of similar items. (3) Financial assets and liabilities whose values couldn't be quoted from an observable market but instead based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. This requires management estimation that may lead to manipulation.
How Fair-Value Accounting Came into Being
1. Lessons from 1929 Stock Crash Under historical cost accounting, profits came to be calculated as the difference between the income accrued and costs incurred, according to revenue recognition and matching principal. This traditional measure of the profits did not prove adequate to value derivatives. In some cases, historical cost accounting didn't apply because there was little trading cost, (e.g. an interest-rate swap contract). And in other cases, because of the existence of fairly liquid markets and the wide use of valuation methodologies in financial markets to set asset prices, the relevance of historical cost accounting is largely undermined. In order to improve information transparency, and to better inform investors about the interest and credit risks reflected, FASB began take steps to extend the application of the fair value principle to an ever greater range of assets and liabilities.
2.The Expanding Use of Derivatives In the 1980s, derivatives underwent significant development as they came to be used to hedge against interest and exchange rate risks. Additionally, derivatives started to be used by credit institutions as a new source of business. The large-scale use of derivatives by large and medium-sized corporations, together with the ever growing importance of capital markets, has led to major changes in the traditional practices used to prepare financial statements.
US Savings and Loan Crisis and Fair-Value Accounting
In the late 1980s and early 1990s, the Savings and Loan Crisis precipitated a collapse of the U.S. thrift industry. Investors demanded increased transparency, and historical cost accounting was blamed for creating rooms for banks to underestimate their losses. In 1991, the Government Accounting Office (GAO) issued a report that urged immediate adoption for both GAAP and regulatory reporting of mark-to-market accounting for all debt securities. It also suggested that a study be undertaken of the potential merits of a comprehensive market-value-based reporting system for banks. As fair value was increasingly viewed as an important tool for valuation, a clear guidance was needed for better application. In 2006, FASB issued FAS 157, which provided a uniform definition of “fair value” and guidance for application.