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8/7/2019 Article_potential

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Potential criticism on fair value accounting duringcredit crunch

ASSIGNMENT #

1

Submitted To:Prof. Salman Masood Sheikh

Submitted By:

Saqib MehmoodMS Commerce & Finance


2/11


Superior

University Lahore

Sr.No. Contents

1 TITLE OF THE ARTICLE

2 REFERENCE

3 MAIN AIM / PURPOSE

4 MAIN POINTS OF DISSCUSSION

5 FINDINGS / CONCLUSION


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7 LEARNING FROM THE ARTICLE

TITLE OF THE ARTICLE

Potential criticisms of fair value accounting during the credit

crunch.

REFRENCE

Dr. Omer Masood

MAIN AIM PURPOSE

The main aim of this study is to make an attempt to review an analysis regardingimplications of subprime crises for accounting & these implications depend upon the

interplay among attributes of subprime mortgages and other positions, the evaluation ofmarket prices & illiquidity during the crises and the requirements of the applicable

accounting standards.

Mainly this study provide us an over view about the institutional and market aspect of

subprime mortgages and other positions with the relevance of accounting and also show the

critical aspects of FAS 157s for fair value measurement. It also depicts the difficulties arisen

in applying the definition of subprime positions in the current illiquid market.Bottom line of whole discussion reveals the potential criticism of fair value accounting

during credit crunch.

MAIN POINTS OF DISSICUSSION OF THE ARTICLE

Fair value accounting

Credit crunch

Subprime crises- Subprime mortgages

Securitization


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Potential criticism on fair value accounting duringcredit crunch Fair value in the light of FAS 157

Bubble price

Unrealized gains & losses

Market illiquidity

FIAR VALUE ACCOUNTING

Mark-to-marketorfair value accounting, a term coined by Professor Matt Holden of UNLV, refers

to accounting for the value of an asset or liability based on the current market price of the asset or

liability, or for similar assets and liabilities, or based on another objectively assessed "fair" value.Fair value, also called fair price (in a commonplace conflation of the two distinct concepts), is a

concept used in accounting and economics, defined as a rational and unbiased estimate of the potential

market price of a good, service, or asset, taking into account such objective factors as:

acquisition/production/distribution costs, replacement costs, or costs of close substitutes

actual utility at a given level of development of social productive capability

supply vs. demand

and subjective factors such as

risk characteristics

cost of and return on capital individually perceived utility

In accounting, fair value is used as a certainty of the market value of an asset (or liability) for which

a market price can be determined (usually because there is no established market for the asset).

UnderUS GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in acurrent transaction between willing parties, or transferred to an equivalent party, other than in a

liquidation sale.

CREDIT CRUNCH

A credit crunch also known as a credit squeeze or credit crisis is a reduction in the general

availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loanfrom the banks. A credit crunch generally involves a reduction in the availability of credit

independent of a rise in official interest rates. In such situations, the relationship between credit

availability and interest rates has implicitly changed, such that either credit becomes less available atany given official interest rate, or there ceases to be a clear relationship between interest rates

SUBPRIME CRISES
http://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Accountancyhttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Estimatehttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Utilityhttp://en.wikipedia.org/wiki/Accountinghttp://en.wikipedia.org/wiki/US_GAAPhttp://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Accountancyhttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Estimatehttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Utilityhttp://en.wikipedia.org/wiki/Accountinghttp://en.wikipedia.org/wiki/US_GAAPhttp://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Interest_rate


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What does subprimemean?

A classification of borrowers with a tarnished or limited credit history. Lenders will use a creditscoring system to determine which loans a borrower may qualify for. Subprime loans carry more

credit risk, and as such, will carry higher interest rates as well. Approximately 25% of mortgageoriginations are classified as subprime.

Occasionally some borrowers might be classified as subprime despite having a good credithistory. The reason for this is because the borrowers have elected to not provide verification of

income or assets in the loan application process. The loans in this classification are called statedincome and/or stated asset (SISA) loans or even no income/no asset (NINA) loans.

Subprime crisisBasically, lenders give money to people (loans, mortgages) who have poor credit ratings (who can't

possibly pay the interest rates charged), those people begin defaulting on the loans and the banks are

not getting their payments. This affects the whole country's economy...then has repercussions in theworld market and so on. It's basically a cycle...The current Subprime crisis is not really a crisis due

to over lending of banks, but situation created due to sub prime lending. Banks dont have enough

money to lend money. We will start with subprime lending.

What isSubprime Mortgage

A type of mortgage that is normally made out to borrowers with lower credit ratings. As a result ofthe borrower's lowered credit rating, a conventional mortgage is not offered because the lender views

the borrower as having a larger-than-average risk of defaulting on the loan. Lending

institutions often charge interest on subprime mortgages at a rate that is higher than a conventionalmortgage in order to compensate them for carrying more risk.

Borrowers with credit ratings below 600 often will be stuck with subprime mortgages and the higher

interest rates that go with those mortgages. Making late bill payments or declaring personalbankruptcy could very well land borrowers in a situation where they can only qualify for a subprime

mortgage. Therefore, it is often useful for people with low credit scores to wait for a period of time

and build up their scores before applying for mortgages to ensure they are eligible for a conventional

mortgage.

SECURTIZATION

The process through which an issuer creates a financial instrument by combining other financialassets and then marketing different tiers of the repackaged instruments to investors. The process can

encompass any type of financial asset and promotes liquidity in the marketplace.Securitization is the financial practice of pooling various types of contractual debt such as residential

mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said debt as

bonds, pass-through securities, orCollateralized mortgage obligation (CMOs), to various investors.The principal and interest on the debt, underlying the security, is paid back to the various investors

regularly. Securities backed by mortgage receivables are called mortgage-backed securities, while

those backed by other types of receivables are asset-backed securities..
http://en.wikipedia.org/wiki/Collateralized_mortgage_obligationhttp://en.wikipedia.org/wiki/Mortgage-backed_securitieshttp://en.wikipedia.org/wiki/Asset-backed_securitieshttp://en.wikipedia.org/wiki/Collateralized_mortgage_obligationhttp://en.wikipedia.org/wiki/Mortgage-backed_securitieshttp://en.wikipedia.org/wiki/Asset-backed_securities


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Potential criticism on fair value accounting duringcredit crunchBUBBLE PRICE

Bubble Price, an economic bubble (sometimes referred to as a speculative bubble, a market

bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is trade in high

volumes at prices that are considerably at variance with intrinsic values. It could also be described

as a trade in products or assets with inflated values.While some economists deny that bubbles occur,the cause of bubbles remains a challenge to those who are convinced that asset prices often deviate

strongly from intrinsic values. While many explanations have been suggested, it has been recently

shown that bubbles appear even without uncertainty, speculation, or bounded rationality.

UNREALIZED GAIN & LOSS

UNREALIZED GAIN

A profit that results from holding on to an asset rather than cashing it in and using the funds.

Let's say you own a stock that has doubled, but you haven't sold it yet. This is said to be anunrealized gain.

UNREALIZED LOSS

An unrealized loss occurs when a stock decreases after an investor buys it, but he or she has yet tosell it. If a large loss remains unrealized, the investor is probably hoping the stock's fortunes will turn

around and the stocks worth will increase past the price at which it was purchased. If the stock rose

back above the original price, then the investor would have an unrealized gainfor the time he or

she still holds onto the stock.

FAIR VALUE IN THE LIGHT OF FAS 157

On Sept. 15, 2006, the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards No. 157, Fair Value Measurement (FAS 157). The new standard applies

whenever other standards require (or permit) assets or liabilities to be measured at fair value. FASB

states FAS 157 does not expand the use of fair value in any new circumstances.

How FAS 157 Changes Current Practice

FAS 157 will change current practice by:

o Defining fair value: Fair value is 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.

o Requiring certain methods to be used to measure fair value: measured as a market-based

measurement, not an entity-specific measurement, based on assumptions market participants
http://en.wikipedia.org/wiki/Intrinsic_value_(finance)http://en.wikipedia.org/wiki/Uncertaintyhttp://en.wikipedia.org/wiki/Speculationhttp://www.investopedia.com/terms/u/unrealizedloss.asphttp://www.investopedia.com/terms/u/unrealizedgain.asphttp://en.wikipedia.org/wiki/Intrinsic_value_(finance)http://en.wikipedia.org/wiki/Uncertaintyhttp://en.wikipedia.org/wiki/Speculationhttp://www.investopedia.com/terms/u/unrealizedloss.asphttp://www.investopedia.com/terms/u/unrealizedgain.asp


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would make in pricing the asset or liability. FAS 157 establish a three level hierarchy formeasuring fair value, described further below.

o Expanding disclosures about fair value measurements

Three Level Hierarchy

Entities are to use inputs for measuring fair value according to the three level hierarchy established

in FAS 157, using the highest level possible (e.g., Level 1) if such inputs are available, and if not,going to the next lower level. The three levels for measuring fair value are:

Level 1o Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or

liabilities that the reporting entity has the ability to access at the measurement date.

Level 2o Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable

for the asset or liability, either directly or indirectly. Level 2 inputs include:a. Quoted prices for similar assets or liabilities in active markets;b. Quoted prices for identical or similar assets or liabilities in markets that are notactive, that is, markets in which there are few transactions for the asset or liability, the

prices are not current, or price quotations vary substantially either over time or among

market makers (for example, some brokered markets), or in which little information isreleased publicly (for example, a principal-to principal market);

c. Inputs other than quoted prices that are observable for the asset or liability (for

example, interest rates and yield curves observable at commonly quoted intervals,

volatilities, prepayment speeds, loss severities, credit risks, and default rates);

d. Inputs that are derived principally from or corroborated by observable market databy correlation or other means (market-corroborated inputs).

Level 3o Level 3 inputs are unobservable inputs for the asset or liability.

o Unobservable inputs shall be used to measure fair value to the extent that observable

inputs are not available, thereby allowing for situations in which there is little, if any,market activity for the asset or liability at the measurement date.

o However, the fair value measurement objective remains the same, that is, an exit price

from the perspective of a market participant that holds the asset or owes the liability.o Therefore, unobservable inputs shall reflect the reporting entitys own assumptions

about the assumptions that market participants would use in pricing the asset or

liability (including assumptions about risk).o Unobservable inputs shall be developed based on the best information available in the

circumstances, which might include the reporting entitys own data.

o In developing unobservable inputs, the reporting entity need not undertake all

possible efforts to obtain information about market participant assumptions.

o However, the reporting entity shall not ignore information about market participant

assumptions that is reasonably available without undue cost and effort. Therefore, thereporting entitys own data used to develop unobservable inputs shall be adjusted if

information is reasonably available without undue cost and effort that indicates that

market participants would use different assumptions.


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MARKET ILLIQUIDITY

The state of a security or other asset that cannot easily be sold or exchanged for cash without a

substantial loss in value. Illiquid assets also cannot be sold quickly because of a lack of ready and

willing investors or speculators to purchase the asset. The lack of ready buyers also leads to largerdiscrepancies between the asking price (from the seller) and the bidding price (from a buyer) than

would be found in an orderly market with daily trading activity.Some examples of illiquid assets include: real estate, huge blocks of stock, antiques, and

collectibles.

FINDING / CONCLUSION

There are two main areas which effect the fair value and it intrupt the calculation of fairvalue that are bubble price and future value of cash flows.

Bubble Price, an economic bubble, a market bubble, a price bubble, a financial bubble, a

speculative mania or a balloon istrade in high volumes at prices that are considerably at

variance with intrinsic values. It could also be described as a trade in products or assets

with inflated values.Second is future cash flows,this concept argues that the market price may not correspond to

the future cash flows most likely to be recived or paid becouse the distribution of cash flows

is skewed.

When the fair value is to be calculated on the basis of bubble price then it could not be the

true representative of the actual price prevailing in the market becouse the bubble price is the

artificially created value or overinflated value that misrepresent the fair value calculations

and when the future value of cash flows are to be calculated on the basis of that type of fake

price then definatly thes future value of the cash flows also dipict not true and faire values.

The best way to stem the credit crunch and the damages caused by these actions is to speed

up the price adjustment process by providing market participents with the most accurate and

complete information about the subprime postions.

Actully the credit crunch also known as a credit squeeze orcredit crisis is a reduction inthe general availability ofloans (orcredit) or a sudden tightening of the conditions required

to obtain a loan from the banks. A credit crunch generally involves a reduction in the

availability ofcredit independent of a rise in official interest rates.

In such situations, the relationship between credit availability and interest rates has implicitly

changed, such that either credit becomes less available at any given official interest rate, orthere ceases to be a clear relationship between interest rates and credit availability credit

rationing occurs. Many times, a credit crunch is accompanied by a flight to quality by

lenders and investors, as they seek less risky investments (often at the expense of small to
http://en.wikipedia.org/wiki/Intrinsic_value_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Intrinsic_value_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Flight_to_quality


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Potential criticism on fair value accounting duringcredit crunchmedium size enterprises). A credit crunch is often caused by a sustained period of careless

and inappropriate lending which results in losses for lending institutions and investors in

debt when the loans turn sour and the full extent ofbad debts becomes known. These

institutions may then reduce the availability of credit, and increase the cost of accessing

credit by raising interest rates. In some cases lenders may be unable to lend further, even ifthey wish, as a result of earlier losses.The crunch is generally caused by a reduction in the

market prices of previously "overinflated" assets and refers to the financial crisis that results

from the price collapse.

The states of a security or other asset that cannot easily be sold or exchanged for cash

without a substantial loss in value, that concept reflect the illiquidity of the market.

Illiquid assets also cannot be sold quickly because of a lack of ready and willing investors or

speculators to purchase the asset. This is not to say that guidance for the measurement of fairvalues in illiquid markets cannot be improved, FAS 157 provides the clearer definition aboutthat but illiquidity of the market raise some challenges for the measurement of the fair value.

Fair values are not necessarily the current realizable value of positions; they are hypothetical

values that reflect fair transaction price if current conditions do not support such transactions.

When markets are severely illiquid, as they have been during the credit crunch, the notion

yield significant practical difficulties for prepares of firms financial statements.

FAS 157 providess the clearer defination of fair value and considerably expended guidence

specifying how fair value should should be measured than prior GAAP, but the current

market illiquidity has raised significant challenges for the interpretability of this definationand guidence.

FAS 157 creates a hirarchy of inputs into fair value measurements, it provides levels for

some required disclosure; first FAS157 require disclosure by the level of hirarchy, second

SOP 94-6 disclosure of certain risk and uncertanities, third SAS 1 require disclosure of type

2 subsequent events (events that occure between the balance sheet date and the financialreport filling date).

However it is absolutly clear that the subprime crises that gave rise to the credit crunch was

primarily caused by firms, investors and household making bad operating, investing and

financing decisions, managing risk poorly and in some instances commiting farud, not by

accounting.Econmoic policy, bank regulations, corporate governance, financial reporting, common

sense, fear of debt and bankruptcy, and all of our other protective mechanisms were

insufficient to crub these behaviours.

It is not to say that fair value accounting and other aspects of GAAP have worked perfectly

during the subprime crises. The crises had made clearer that financial statements preparer

need additional guidence regarding how to calculate fair values in the illiquid market.
http://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Bad_debthttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Financial_crisishttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Bad_debthttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Financial_crisis


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LEARNING FROM THE ARTICLE

My own leaning from the aricle potentialcritscm of fair value accounting during creditcrunch written by Dr. Omer Masood ,regarding the areas which the writer consider during

his research. It is not eaisy to understand the idea and the concepts of the article firsthand; so

I take help from search engines and also from some professionals which have some idea

regarding these concepts which the writer bring under consideration.

As the mark-to-market or fair value accountingis concerned, it refers to accounting for the

value of an asset or liability based on the current market price of the asset or liability, or for

similar assets and liabilities, or based on another objectively assessed "fair" value.

Fair value, also called fair price or a commonplace conflation of the two distinct concepts; is

a concept used in accounting and economics, defined as a rational and unbiased estimate of

the potential market price of a good, service, or asset.There critical aspect of fair value defination reflects three conspets about the fair value:

Exit price;proceeds that would be recived if an asset were sold or the liability is to beterminated, it may be expressed in terms of net realizable value, current selling price or the

present value.

Entry Value; replacement cost, it is current estimated fair market price or cost of acquiring

an asset.

Value in Use; the entity specific value to the current holder of an item.

The critical aspect of fair value defination required disclosures; first FAS157 requiredisclosure by the level of hirarchy, second SOP 94-6 disclosure of certain risk and

uncertanities, third SAS 1 require disclosure of type 2 subsequent events (events that occurebetween the balance sheet date and the financial report filling date).

Subprime crises is basically a cycle which starts when lenders give loan to people who have

poor credit ratings; who can't possibly pay the interest rates charged, those people begin

defaulting on the loans and the banks are not getting their payments. This affects the whole

country's economy and then has repercussions in the world market and so on.The states of a security or other asset that cannot easily be sold or exchanged for cash

without a substantial loss in value, that concept reflect the illiquidity of the market.
http://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Accountancyhttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Estimatehttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Accountancyhttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Estimatehttp://en.wikipedia.org/wiki/Market_price


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Potential criticism on fair value accounting duringcredit crunchIlliquid assets also cannot be sold quickly because of a lack of ready and willing investors or

speculators to purchase the asset. This is not to say that guidance for the measurement of fair

values in illiquid markets cannot be improved, FAS 157 provides the clearer definition about

that but illiquidity of the market raise some challenges for the measurement of the fair value.

Fair values are not necessarily the current realizable value of positions; they are hypotheticalvalues that reflect fair transaction price if current conditions do not support such transactions.

When markets are severely illiquid, as they have been during the credit crunch, the notion

yield significant practical difficulties for prepares of firms financial statements.

A credit crunch also known as a credit squeeze orcredit crisis is a reduction in the general

availability ofloans (orcredit) or a sudden tightening of the conditions required to obtain a

loan from the banks. A credit crunch generally involves a reduction in the availability of

credit independent of a rise in official interest rates.

As the illiquidity crises intensifies, areas that are not directly related to the subprimemortgage sector are starting to suffer loss such as auction rate, securties etc. the value of

asset backed securties backed by the subprime products has fallen the performance of

subprime loans has continued to be worsan.

Potential criticism of fair value accounting during credit crunch is due to some situtions or

reasons which may influence the fair value and its calculation.

The unrealized gain and losses affect the calculation of fair value. There are two main

reasons that may deviate the fair price from actual, first is bubble price;bubble Price, an

economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price

bubble, a financial bubble, a speculative mania or a balloon) is trade in high volumes atprices that are considerably at variance with intrinsic values. It could also be described as

a trade in products or assets with inflated values.

Second is future cash flows, this concept argues that the market price may not correspond

to the future cash flows most likely to be recived or paid becouse the distribution of cash

flows is skewed.

However it is absolutly clear that the subprime crises that gave rise to the credit crunch was

primarily caused by firms, investors and household making bad operating, investing and

financing decisions, managing risk poorly and in some instances commiting farud, not by

accounting.
http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Intrinsic_value_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Intrinsic_value_(finance)

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