8/7/2019 Potential Criticisms of Fair Value Accounting during the Credit Crunch

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Potential Criticisms of Fair

Value Accounting during

the Credit Crunch

PRESENTED BY:

SHOAIB AHMED

ROLL NO.E08MBA008

KHAWAR HAFEEZ

ROLL NO.E08MBA010

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Areas of Discussion

Credit Crises

Critical Aspects of FAS 157.s definitions and Guidance For 

Fair Value Measurements.

Conclusions regarding Potential Criticisms of Fair Value

Accounting during Credit Crunch

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Credit Crisis

A credit crunch (credit crisis) is a reduction in the general

availability of loans (credit) or a sudden tightening the conditions

required to obtain a loan from the banks.

A crisis that occurs when several financial institutions issue or are

sold high-risk loans that start to default.

The reasons of a credit crisis, banks either do not charge enough

interest on loans or pay too much for the securitized loan, or therating system does not rate the risk of the loans correctly.

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These are the main problems which caused the credit

crunch.

The banks and financial institutions issued subprime loans at floating

rate of interest, which at low rate initially and with the passage of 

time at high rate of interest.

These subprime loans were transformed into securities which can be

traded in the secondary markets.

The subprime loans started defaulting because of high rate of 

interest, the financial institutions also faced difficulties to pay the

interest against the securities.

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Fair Value

The price that would be received to sell an asset or paid to transfer a

liability in an orderly transaction between market participants at themeasurement date.

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Fair Value Accounting

It is a financial reporting approach in which companies are allowed

to measure and report on an ongoing basis certain assets and

liabilities at estimates of the prices they would receive if they were to

sell the assets or would pay if they were to be received of theliabilities.

Under fair value the companies report losses when the fair value of 

there assets decrease or liabilities increase. These losses reduce

companies reported equity and may also reduce companies reported

income.

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FAS 157

FAS 157 defines fair value as , The 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.

Critical Aspects of the Definition

The definition reflects an optimal ³exit value´ that is the highest values of assets and

the lowest values of the liabilities currently held by the firm. This value reflects the

solvency not the fair value of the entity in use.

At the measurement date means that fair value should reflect the conditions that exit

at the balance sheet date. If markets are illiquid and credit spreads are at historicallyhigh levels then the fair values would reflect the high values.

An ³orderly transaction´ is one that is unforced and unhurried. So the orderly

transaction may take a time of quarter or even more after the balance sheet date and at

that time the market conditions will differ from those existing at the balance sheet date

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Fair Value Hierarchy

Level 1

These are the unadjusted quoted market prices in active markets for 

identical items.

Level 2

These are directly or indirectly observable market data. They have

two broad subclasses.

(1) These are adjusted mark-to-market prices that are less than the

ideal but still pretty good.

(2) These are yield curves, exchange rates, empirical correlations

etc.

Level 3

These prices are based on historical data, historical data is used for 

fair valuation purposes and it is expected the future will be similar.

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Potential Criticism of Fair Value Accounting During the Credit Crunch

Unrealized Gain and Losses Reverse

The market prices may be bubble prices which deviate from

fundamental values and later on they may be reverse.

Future Cash Flows

Fair values reflect the expected cash based on current information as

well as current risk adjusted discount rates and the future

environment is uncertain and the financial instruments which contain

embedded options exhibit skewed distributions of future cash flows.

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