Legend and truth of fair value in the financial crisis D.Gervasio, D.Montani, S.Somenzi

Paper Submission: 352

ISBN: 978 – 1- 922069 -03 -0

Fair value is a plus or a minus? The recent financial crisis have touched on accounting standard setting and the role in which accounting information contributed to the market turmoil. In this regard, fair value has been, more than ever in the spotlight, as many bankers, political figures, and commentators contending that it was a major contributing factor to the procyclical decline in the value of bank assets. In this context, we are looking for the role of fair value analyzing its legends and truths through the financial crisis. Because banks were at the center of this market turmoil, we focus our discussion and analysis on 46 European financial institutions with the largest influence and impact on both the economy and society in Europe. The analysis presented lead us to conclude that, contrary to what many of fair value contend, it played little or no role in the financial crisis; therefore, it could be blamed neither having caused nor having exacerbated the financial crisis. It is clear that the valuation of certain securities might be artificially low and could recover, though it is the duty of accounting reflecting the current situation and not necessarily a probable future.

Key words: fair value; financial crisis; procyclicality.

Legend and truth of fair value in the financial crisis

The Financial Crisis that began midway through 2007, resulted in the collapse of

numerous commercial and investment banks, including several high profile institutions.

Calls for action to prevent a repeat of the Financial Crisis have also touched on

accounting standard setting and the role in which accounting information contributed to

the financial crisis. In this regard, fair value accounting has been, more than ever in the

spotlight, as many bankers, political figures, and commentators contending that it was a

major contributing factor to the procyclical decline in the value of bank assets, when the

housing market bubble burst (Barth, Beaver, Landsman, 2001).

So called, the fair value accounting is defined, under IFRS, as “the amount for which an

asset could be exchanged, or a liability be settled, between knowledgeable, willing

parties, in an arm’s length, orderly transaction”(IFRS 7). The FASB's definition is

very similar, and 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” (FASB 159). This definition refers to the going concern principle so

as to distance fair value from the value at liquidation. Thus, the fair value is an estimate

of how much an asset or liability could be liquidated for in a transaction taking place

under market conditions (Pita, García-Gutiérrez, Inmaculada, 2006). Therefore, all

assets and liabilities have a fair value, although it will not always be easy to calculate.

In determining fair value, IFRS categorize assets and liabilities according to the level of

judgment (subjectivity) associated with the inputs to measure their fair value and three

levels must be considered (Magnan, 2009). At level 1, financial instruments are

measured and reported on a firm’s balance sheet and income statement at their market

value, which typically reflects the quoted prices for identical assets or liabilities in

active markets. It is assumed that the quoted price for an identical asset or liability in an

active market provides the most reliable fair value measurement because it is directly

observable to the market (mark-to-market). However, if valuation inputs are observable,

either directly or indirectly, but do not qualify as Level 1 inputs, the Level 2 fair value

assessment of a financial instrument will reflect a) quoted prices for similar financial

instruments in active markets, b) quoted prices for identical or similar financial

instruments in markets that are not active, c) inputs other than quoted prices but which

are observable or d) correlated prices. Finally, certain financial instruments which, for

example, are customized or have no market, will be valued by a reporting entity on the

basis of assumptions that presumably reflect market participants’ views and assessments

(e.g., private placement investments, unique derivative products, etc.). Such valuation is

deemed to be derived from Level 3 inputs and is commonly referred as “mark-to-

model” since it is often the outcome of a mathematical modelling exercise with various

assumptions about economic, market or firm-specific conditions (Magnan, M. 2009).

In today's dynamic and volatile markets, whether it is to buy or sell, what people want

to know is what an asset is worth today. However, the introduction of the concept of fair

value has meant a change from the classic principles of the accounting system based, for

a long time, on historical cost whose persintence is justified by its conformance to the

“matching concept” which prescribes that costs of resources recognized in the income

statement should be matched with corresponding revenues reported in income. This

principle allows greater evaluation of actual profitability and performance as it

correlates, although imperfect, expenditure with earned revenue. Furthermore, the

presence of an actual as opposed to a hypothetical transaction, and lesser likelihood of

measurement error are other historical cost’s traditional strengths. On the other hand,

this method, does not reflect the true economic value of financial instruments and the

aligning of the accounting value of an asset or liability with its market price takes place

only in certain situations, primarily when the company can demonstrate that the value of

the asset or liability has been altered permanently. With the passage of time, historical

prices become irrelevant in assessing an entity’s current financial position since they

provide low information content for investors; consequently, making an accurate

assessment of the health of enterprises or banks and formulating the appropriate

regulatory response, becomes increasingly difficult (Penman, 2007).

In a context in which the central aim of financial reporting is to portray the underlying

economic position of the company and to faithfully reflect the genuine economic

fluctuation of the business cycle, the concept of fair value gained much more

prominence than the historical cost as it provides up-to-date information consistent with

market, thereby increasing transparency and encouraging prompt corrective actions; in

addiction, consistent empirical research evidence has shown that assets or liabilities

valued at market value provide more relevant information to users of financial

statements (i.e. investors, regulators) as their market values are considered to be more

strongly associated with stock prices than when valued at historical costs (Barth,

Beaver, Landsman, 2001).

Fair value accounting is seen to better align itself with investor needs than historical

cost as it allows for financial statements to be more relevant and more easily

comparable across different companies and periods. For instance, under fair value

accounting, the value of financial assets acquired by two different firms at different

points in time may be easily comparable whereas under historic measurement, the

accounting value of these assets will more likely be recorded differently in the balance

sheets of the two firms (Lefebvre, Simonova, Scarlat, 2009).

Despite the many tangible or perceived benefits of fair value accounting, since the

anticipation of the (current) financial crisis, it has been subject to severe criticism as

noted in the report on global financial stability by the International Monetary Fund

(2008): “Since the 2007 market turmoil surrounding complex structured market

products, fair value accounting and its application through the business cycle has been

a topic of considerable debate” (IMF, 2008).

Under stressed liquidity conditions, financial institutions made wider use of

unobservable inputs in their valuations, increasing uncertainty among financial

institutions, supervisors and investors regarding the valuation of financial products

under such conditions. Questions arose whether market value of financial instruments

still reflected their underlying cash flows or the price at which instruments could

eventually be sold (their theoretical or fundamental value).

The reason for this debate and severe criticism on fair value accounting lies in the

difficulties of its estimations under illiquid and disorderly conditions, as well as the

alleged pro-cyclical effect that it could introduces in firms’ financial statements.

With markets increasingly becoming more volatile and illiquid (mid-2007), the

valuations of complex financial instruments became more vulnerable and inaccurate.

Since most financial instruments were valued at fair value (IMF, 2008), also the firm’s

value on the balance sheet and reported earnings were subject to growing volatility,

therefore distorting investors’ view on financial performance and stability (Magnan,

2009). The general tenor of the fair value criticisms is that fair value information,

particularly in the context of the Financial Crisis, lacks sufficient quality to be

informative to investors and other financial statement users (Barth, Landsman, Wayne,

2010).

In addition, critics claim that if prices from active markets are available, fair- value

accounting provides little room for manipulation and generally provides reliable

information. However, if there are no observable prices on which to base fair value

estimates (level 3 inputs), management has considerable discretion. Historical-cost

accounting offers little room for manipulation as long as original purchase prices or

amortized costs are used, but this information is often criticized for not being relevant

(Laux, Leuz, 2010).

Within a context in which it is no longer possible to use a market price to value

financial instruments, it becomes necessary to resort to internal valuation models based

on inputs not directly observable in the market and which, in turn, implies that a firm’s

economic lifecycle increases in amplitude, both in times of economic growth and

economic downturn (Magnan, 2009). The main point is that changes in the prices of

financial assets recorded at FV are reflected immediately in banks’ balance sheets

(HFT, FVO and AFS categories) and profit and loss accounts (only the first two

categories), regardless of whether or not they are realized. Since asset prices are pro-

cyclical, the expansion of balance sheets during booms and their contraction in

downturns are sharper than under historical cost accounting. The current crisis shows

how this mechanism works in reverse in a downturn: the immediate recording of fair

value reduction on assets reduces banks’ capital base, hence their lending and their

demand for securities; and this in turn feeds back onto economic activity. FVA may

also prompt pro-cyclical behaviour of balance sheets indirectly, through its effect on the

demand for assets. Plantin, et al. (2008)90, point out that mark-to-market strengthens

this effect: a bank manager with short-term incentives will be tempted to pre-empt the

fall in price by selling the asset itself, amplifying the price fall; and conversely during

upswings. In this way, a negative dynamic arises and intensifies the problems as a result

of the reaction of investors and bank managers, who act to limit losses.

Volatility and procyclicality of FVA

Companies activities during the reporting period will naturally be reflected through the

changes reported in financial statements. However, Barth (1994 and 2004) makes the

observation that there are other three primary sources of “extra” volatility associated

with fair value-based accounting amounts relative to those determined using modified

historical cost. The first is the inherent volatility which is driven by the change in

underlying economic conditions and is reflective of the changes in the value itself. The

second is the volatility produced by measurement errors and/or changing views

regarding economic prospects throughout the business cycle. The third type is

introduced through the mixed-model volatility. It manifests itself because some assets

and liabilities are measured at fair value whereas others may be at historical cost, while

some others could be at current value.

Another conceptual research which undertakes to study how fair value accounting

possibly led to increased volatility and a negative amplification of some financial

institutions’ business cycles during the financial crisis is presented by Magnan. More

specifically, Magnan, in his study, argues that fair value accounting creates a circular

dynamic in financial reporting, with markets providing the input for the measurement of

many assets, thus affecting reported earnings which are then used by analysts and

investors to assess a firm’s market value. Therefore, since fair value accounting is

associated with more volatile and less conservative financial statements and, it may

have allowed managers to delay the day of recognition as well as distorted investors and

regulators’ perceptions of financial performance and stability at the end of the financial

bubble. However, once the economic pendulum swung back, fair value accounting may

have magnified their views as to the severity of the current financial crisis, hence

accelerating some negative trends. Magnan’s main argument is that fair value

accounting created incentives for management to engage risk-full investments. The

unrealized gains of these investments were recognized and have amplified economic

growth, but led to amplification of negative growth in times of economic downturn,

when these unrealized gains turned into losses. Furthermore, Magnan expects future

empirical evidence will indicate overstatements and purposely shifts to level 2 and level 3

valuations, which covered-up developing losses and provided unrealized gains, but caused

significant losses when the crisis began.

Thence, the increased volatility of information presented in financial statements may

erode relevance and reliability of information for investors. More specifically, the

volatility may negatively affect investors’ ability to confirm or to correct expectations

and to form an understanding of past and present events. Moreover, the use of

unobservable and estimated inputs for fair value measurement may affect reliability of

information as it reduces verifiability. As such, the use of fair value accounting may

diminish the investor’s ability to assess economic risk of company operations

(Lefebvre, Simonova, Scarlat, 2009). Nevertheless, higher FV volatility, per se, would

not necessarily be a problem if market participants are well informed and could

correctly interpret the information provided in the financial statements. In this sense,

increased volatility may be thought of as part of the process of fair valuing financial

instruments, and a reflection of genuine economic volatility, not as a cause itself of

procyclicality (Sole, Novoa, Jodi, 2009).

Obviously, another unintended consequence of fair value accounting is the procyclical

effect introduced in firms’ balance sheets, generally understood as amplification of

otherwise normal cyclical business fluctuations, both in booms and in busts, that creates

preconditions for increasing instability and vulnerability of the financial system

(Lefebvre, Simonova, Scarlat (2009). Fair value accounting is said to be pro-cyclical

because the value of a financial account measured at fair value is positively correlated

with market fluctuations.

In more technical terms, the Financial Stability Board describes pro-cyclicality as “the

dynamic interactions (positive feedback mechanisms) between financial and the real

sectors of the economy”; Otherwise, the SEC recognised pro-cyclicality as “the

amplification of otherwise normal cyclical business fluctuations”.

In details, in times of economic growth, overstatement of profits and write-ups in assets

measured at fair value allow financial institutions to increase their leverage and limit

their incentives to create reserves that may be drawn on in times of crisis (Adrian, Shin,

2008). In busts, fair value accounting puts a downward pressure on pricing in already

weak markets which results in further declines in market prices. In order to counteract

the write-downs caused by fair value accounting, financial institutions may have to sell

securities in illiquid markets although the original intentions may have been to hold

those investments to maturity. Such forced or motivated sales become observable inputs

for other institutions that are required to rely on fair value accounting to mark their

assets to the market. At the same time, the low interest of non-distressed sellers to enter

such markets does not allow the prices to recover to or above the fundamental value

(Lefebvre, Simonova, Scarlat, 2009).

According to the Financial Stability Board (2008), financial system procyclicality can

be traced to two fundamental sources. The first source is limitations in risk

measurement. Measures of risk and the assumptions underlying risk measurement

practices tend to be highly procyclical. Near-horizon estimates of quantitative inputs

such as short-term volatility, asset and default correlations, probabilities of default and

loss given default all move procyclically. For instance, credit risks were underestimated

during economic growth before the financial crisis, but during the market turmoil of

2007, prices of complex financial products tended to fall faster, because of adjusted

underestimated risk parameters, thus creating a pro-cyclical effect.

The second source is distortions in incentives. Collateral-based lending or margin

requirements can protect lenders and traders from actions taken by counterparties that

could erode the value of their claims. But by establishing a direct link between asset

valuations and funding, fluctuations in margin requirements can exacerbate

procyclicality. For instance, in the late expansion phase before the crisis, from an

individual agent’s perspective it might have been difficult to refrain from engaging in

risky investments because of short-term profit objectives and fear for diminishing

market share. Short-term horizons for risk measurement add to pro- cyclicality by

creating a distorted view for investors, encouraging them to invest, even when the

downward trend had already been anticipated. These actions of agents might have been

rational from an individual perspective but proved devastating for the financial system

as whole.

Similarly to Magnan (2009) the Financial Stability Forum Report concludes that fair

value accounting accompanies valuations that are more sensitive to economic lifecycles

and therefore incorporate pro-cyclicality. Furthermore, the pro-cyclical effect of fair

value accounting, would create an additional pro-cyclical effect on investment

decisions. Fair value accounting would have created a distorted view for investors

because unrealized gains of complex financial products were recognized and not

sufficiently corrected downwards for risk factors. The present application of fair value

implies that losses are recognized when an actual loss event incurred. With the

‘expected loss model‘, recommended by the FSF, losses are recognized when losses are

expected by introducing provisions that can cover for expected volatility in economic

downturns. This however, requires careful standardization to prevent income smoothing

activities. Another measure suggested by the FSF is the adoption of capital buffers, built

up in times of economic growth that function as a safety net in times of economic

downturn (FSF, 2009).

Empirical studies

The upcoming debate surrounding fair value and the economic crisis has led researchers

and regulatory institutions to form opinions about a potential for pro-cyclicality of fair

value accounting. In this regard, the “study on market to market accountingas” carried out

by SEC in 2008 was worthy of special attention as it provide the necessary insight for

assess critically whether a potential for pro-cyclicality of fair value accounting exists.

The SEC, in response to the upcoming debate concerning fair value accounting in

relation to the financial crisis, has examined those concerns by analyzing a sample of

fifty financial institutions that were selected from a broad-based population of financial

institutions active in the United States. The sample included banks, broker-dealers,

insurance companies, credit institutions and government sponsored entities (GSE’s).

The sample was ranked by total reported value of assets at most recent fiscal year end.

The sample included 30 large financial institutions covering 75% of all financial

institutions’ assets, and 20 smaller issuers. The study analyzed to what extent, financial

institutions’ assets and liabilities were valued at fair value and what the impact of fair

value was on equity and income statements. Also the change in classification between

the three hierarchy-levels prescribed by SFAS 157, were measured over 2008 (shifts

between levels: a shift to level 3 valuations indicates pro-cyclicality) (Van Schijndel,

2010).

From the sample of financial institutions studied, the Staff observed that fair value

measurements were used to measure a minority of the assets (45%) and liabilities (15%)

included in financial institutions’ balance sheets. The percentage of assets for which

changes in fair value affected income was significantly less (25%), reflecting the mark-

to-market requirements for trading and derivative investments. However, for those same

financial institutions, the Staff observed that fair value measurements did significantly

affect financial institutions’ reported income (SEC, 2008).

The change in classifications of assets and liabilities valued at fair value was measured

over time, from the first quarter-end to the third quarter-end of 2008. Findings revealed

that the classification of both assets and liabilities was fairly consistent over time.

Although classifications had remained consistent over time and the percentage of level

3 classifications had been relatively low, changes in level 3 fair value valuations had a

significant impact on firms’ equity. Institutions with the highest percentage of level 3

liabilities reported the highest losses in equity.

The net-portion of fair value was calculated at 30% (45% assets - 15% liabilities),

indicating the net-effect of fair value, which could have negatively affected the balance

sheet and income, as a result of falling market prices. The SEC concluded that,

especially for banks and broker-dealers, income statements were negatively influenced

through the use of fair value accounting. The total sum of all fair value gains and losses

for the first three quarters of 2008, related to recurring fair value adjustments, was

approximately 56.5 billion dollars. The SEC acknowledged that fair value accounting

could negatively influence equity and income and could therefore incorporate pro-

cyclicality. However, the SEC did not conclude that fair value accounting had played a

significant role in causing the financial crisis but that inadequate credit grant decisions

and weak risk management concerning regulatory capital requirements were the main

areas of concern in relation to the financial crisis (SEC, 2008).

Research methodology and hypothesis development

On the basis of the methodology used by the SEC, the main question surrounding this

analysis concerns the role that fair value accounting, and its procyclical nature played in

the current financial crisis (2006-2009).

Because financial istitutions were at the center of the financial crisis, I focus my

discussion and analysis on the effects of financial reporting by banks and insurance

company. In details, I have taken into consideration a sample of 46 financial

institutions, 33 banks and 13 insurance companies, that represent the largest stock

exchange listed banks and insurance companies in Europe.

The following table shows the financial institution that have been the object of my

analysis:

Companies that are included in the total sample Allianz SE Insurance Alpha Bank Bank Aviva Insurance AXA Insurance Banca Monte Dei Paschi Di Siena Bank Banco Bilbao Vizcaya Argentaria Bank Banco Commercial Portugues Bank Banco de Sabadell Bank Banco Espirito Santo Bank Banco Popular Esp Bank Banesto Bank Barclays Bank BNP Paribas Bank Cnp Assurance Insurance Commerzbank Bank Credit Agricole Bank Deutsche Bank Bank Deutsche Postbank Bank Dexia Bank DnB NOR Bank EFG Eurobank Bank Erste Group Bank Bank Generali Assicurazioni Insurance HSBC Hids Bank ING Group CVA Insurance Intesa-SanPaolo Bank KBC Group Bank Lloyds Banking Group Bank

Muenchener Rueckversicherungs Reg Insurance Mapfree S.A. Insurance Nataxis Bank National Bank of Greece Bank Nordea Bank AB Bank Old Mutual Insurance Prudential Insurance RBS Bank RSA Insurance Group Insurance Skand Emskilda Bnk (SEB) Bank Soc Generale De France Bank Standard Life Insurance Svenska Handelsbank Bank Swedbank Bank UBS AG Bank Unicredito Spa Bank Unione di Banche Italiane Bank Zurich Financial Service Insurance

To examine pro-cyclicality of fair value accounting I use, as mentioned before, the

approach derived from the methodologies used by the SEC (2008) that measures pro-

cyclicality by the extent to which assets and liabilities are valued at fair value and the

net-effect of assets and liabilities valued at fair value (percentage of assets – percentage

of liabilities valued at fair value). The net-effect indicates the volatility introduced in the

financial statements. A positive net-effect causes pro-cyclicality  (SEC, 2008).

To calculate the net effect, the following variables need to be collected over the years

2006-2009:

1) Balance totals;

2) Total financial assets at fair value;

3) Total financial liabilities at fair value;

4) Percentage financial assets valued at fair value of balance total;

5) Percentage financial liabilities valued at fair value of balance total;

2006 2007 2008 2009 Average

13 insurance companies Financial assets at FV (% of balance total) 65% 60% 55% 58% 59%

Financial liabilities at FV (% of balance total) 10% 11% 8% 12% 10%

Net-effect 55% 49% 47% 46% 49% 33 Banks Financial assets at FV (% of balance total) 38% 41% 47% 42% 42%

Financial liabilities at FV (% of balance total) 22% 25% 35% 26% 27%

Net-effect 16% 16% 12% 16% 16% Total sample (46) Financial assets at FV (% of balance total) 45% 46% 50% 43% 46%

Financial liabilities at FV (% of balance total) 20% 23% 33% 24% 25%

Net-effect 25% 23% 17% 19% 21% Table1: Results: The percentage of assets and liabilities at fair value of the balance total, and net-effect of fair value accounting over the years 2006-2009

The analysis show that insurance companies value a larger percentage of assets and a

lower percentage of liabilities at fair value (on average: assets 59%, liabilities 10%),

compared to banks (on average: assets 42%, liabilities 27%), resulting in a larger net-

effect of fair value accounting for insurance companies (on average 49 % compared to

16% for banks). The total results indicate that the tested financial institutions value 46%

of financial assets and 25% of financial liabilities at fair value, resulting in a net-effect

of fair value accounting of 21% (on average over 2006-2009).

Table 1 also shows that the portion of assets and liabilities at fair value, remained fairly

consistent over the year 2006. There were no significant changes in the level of assets or

liabilities at fair value over these years. In 2007, banks show a significant increase of

liabilities at fair value, however this had little impact on the total net-effect in 2007, due

to a simultaneous increase of banks’ assets at fair value.

Banks continued to increase the level of liabilities at fair value significantly in 2008.

Combined with a significant decrease of assets at fair value for insurance companies,

this resulted in a significant lower net-effect during the crisis in 2008 (net-effect

dropped from 23% in 2007 to 17% in 2008). After increasing the level of liabilities at

fair value in 2007 and 2008, banks significantly decreased the level of liabilities at fair

value in 2009. The impact however, on the total net-effect of fair value accounting, was

largely compensated by a decrease of assets at fair value by banks, though the total net-

effect slightly increased in 2009, to almost 20%.

Another method to determine pro-cyclicality is the analysis of shifts between the three

fair value hierarchical levels. An increase in level three classifications indicates

increased volatility and thus increased pro-cyclicality. To assess whether the crisis in

2008 led to an increase of level 3 valuations is therefore difficult to determine, since not

many companies disclosed the fair value hierarchy voluntarily before 2008 (in

accordance with IFRS 7, financial institutions are required to disclose a 3 level fair

value hierarchy since 2009), making it difficult to analyze whether the financial crisis

went with an increase in level 3 valuations of assets and liabilities at fair value.

Most of these companies disclose some form of a fair value hierarchy, but did not

distinguish between assets and liabilities at fair value, adopted a two level fair value

hierarchy or disclosed only the fair value hierarchy for assets. The lack of disclosure has

a shock on the usefulness of the financial statements, making it difficult for investors

and analysts to determine the risks linked to level 3 positions of financial institutions.

For this reason we consider the shifts between fair value hierarchical levels for ING

Bank, one of the most prestigious European bank and insurance company .

FV hierarchy 31/12/2006 31/12/2007 31/12/2008 31/12/2009 Financial assets Level 1 59% 63% 55% 43% Level 2 30% 36% 38% 56% Level 3 11% 1% 7% 1% Financial liabilities Level 1 69% 52% 61% 25% Level 2 31% 47% 39% 75% Level 3 - 1% - -

Table 2: Amounts in millions of Euros. Shifts between fair value hierarchy levels over the years 2006-2009.

Overall, ING Bank only a small percentage of assets are classified as ‘level three’

valuations, volatility and related devaluations of these assets proved to have a

significant impact on income.

The following table show the results of 10 companies that voluntarily adopted the fair

value hierarchy from 2007:

2007 2008 2009 10 financial institutions Level 3 assets (% of financial assets at FV) 2,90% 3,05% 3,3% Level 3 liabilities (% of financial liabilities at FV) 2,41% 2,30% 2,77% Net-effect: 0,49% 0,75% 0,53%

Table 3: Level 3 assets (% of total assets at FV), level 3 liabilities (% of total liabilities at FV) and the net-effect of level 3 instruments for 10 companies that discosed fair value hierarchy for 3 consuntive years.

The results lead us to conclude that financial institutions classified only a small part of

assets and liabilities as level 3 valuation over 2007, 2008 and 2009. In addition, the

portion of level 3 assets and liabilities remained fairly constant over the three tested

years. This invalidates the expectation that the results from 2008 would show a

significant increase of level 3 valuations. This could be explained with the fact that

financial institutions tend to limit the classification of level 3 instruments, since these

constitute the most risky positions, especially in times of economic downturn. As also

noted by SEC (2008), financial institutions may be reclassified a large portion of level

3 valuations to historical costs. The effect of level 3 valuations on pro-cyclicality is

therefore considered limited.

Finally, it should be noted that the methodology used herein uses the net-effect which

only maintains an indication of the volatility impact on financial statements. A large

net-effect would introduce volatility and would therefore indicate pro-cyclicality, but

does not actually measure the increased volatility and pro-cyclicality. Furthermore,

impairment of assets are not taken into consideration; however, fair value accounting is

not directly related to asset impairments because many of the impaired assets were not

recognized at fair value (Plantin, Sapra, Shin 2008).

In conclusion, although it may seem that the fair value regime would have enhance the

recent financial crisis, the empirical results presented herein seem to suggest that the

claim that fair-value accounting exacerbated the market turmoil is largely unfounded.

Concluding remarks

The fair value regime represents an evolving accounting system which has now

permeated the regulatory environment and made its way into the social landscape. With

the globalization of capital markets and the advent of complex financial instruments in

use today, it has become clear that fair values of assets and liabilities are of greater

interest to investors than their historical costs. This will only become more intense as

economic borders evaporate, as economies develop, as financial markets evolve, and as

the public commands heightened accountability largely resulting from improved

comprehension and confidence.

While neither fair value accounting nor its main alternative – historical cost – are free

from shortcoming, the cases presented herein intend to show fair value accounting in a

positive light – having the distinct advantage of being able to better reflect the reality of

current financial and economic conditions.

The analysis presented lead us to conclude that, contrary to what many of fair value

contend, fair value accounting played little or no role in the financial crisis; therefore, it

could be blamed neither having caused nor having exacerbated the financial crisis; this

would be like “shooting the messenger” (Plantin, Sapra, Shin, 2008). The volatility we

can observe in the markets is an economic event and has not been invented by the

IFRSs. It is clear that the valuation of certain securities might be artificially low and

could recover, though it is the duty of accounting reflecting the current situation and not

necessarily a probable future and one should bear in mind what Sir Tweedy

said:“Accounting has to reflect facts, not assume stability where it does not exist”

(Bruce, 2008).

The success of fair value accounting will nevertheless reside in the world’s ability to

harness its potential. However, as the financial crisis portrays, there is a need to enhance

clarity and to promote transparency of information associated with measurement and

recognition of accounting amounts relating to, and disclosure of information about,

financial instruments, especially regarding level 3 valuation, were insufficient for

investors to assess properly the values and riskiness of affected bank assets and

liabilities (Barth, Landsman, Wayne, 2010)

A certain simplification of the accounting standards for financial instruments may also

be beneficial – to preparers, to analysts, to investors, to regulators, and to the broader

public. And this may be complemented by shifting to a single, high-quality global

standard to ensure consistent application and enforcement. Moreover, it is imperative

that we stabilize market behaviour with a system befitting of the confidence that the

financial markets seek to re-establish.

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