Is Fair Value Accounting Fair?

1. Background on Fair Value Accounting

Fair value accounting was introduced into the U.S in 1994 to address the accounting issues for financial instruments. During this period of time, there was a sharp increase in the use of derivatives and other complex financial instruments for investments. As a result, fair value accounting was developed to enhance the decision usefulness and relevance of financial reporting. Comparability amongst firms with exposures to similar financial instruments was also one of the main reasons why fair value accounting was introduced.

2. Major Criticisms of Fair Value Accounting

One of the major criticisms of fair value accounting would be the application of fair value accounting in illiquid or volatile markets such as the recent subprime meltdown where prices are not reflective of true asset values. In addition, a fair amount of judgment is needed to determine fair value, making the value subjective and not as reliable.

2.1 Volatile and Illiquid Markets

Fair value accounting receives no complaints when markets are performing well and assets are generally rising in value. This is because huge trading volumes are done daily and the price is reflective of the true fair value of the underlying. However, in volatile times coupled with scarce credit and liquidity, daily mark-to-market valuation creates large impacts on a company's financials. This can be easily observed when one looks at the predicament of investment firms such as Merrill Lynch and Citigroup.

The underlying problem is due to the crippling of the market's ability to price assets correctly in times of turmoil. As behavioural finance dictates, panic and fear takes over during market downturns. Market forces are no longer driven by a group of rational investors. As a result, assets that are perceived to be risky often have their prices pushed down lower than its actual value. Market fear kicks in and pushes the prices of these assets even lower as panicking investors and...