Chapter 9: Executive Summary – Fair Value Accounting: Policy Issues Raised by the Credit Crunch

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section III: Governance, Incentives and Fair-value Accounting

Background

The practical applicability of fair value accounting has been tested by the severely illiquid and otherwise disorderly markets for subprime and some other positions during the ongoing credit crunch. This fact has led various parties to raise three main potential criticisms of fair value accounting. First, unrealized losses recognized under fair value accounting may reverse over time. Second, market illiquidity may render fair values difficult to measure, yielding overstated or unreliable reported losses. Third, firms reporting unrealized losses under fair value accounting may yield adverse feedback effects that cause further deterioration of market prices and increase the overall risk of the financial system (“systemic risk”). These parties typically advocate one of two alternatives: either abandoning fair value accounting and returning to some form of amortized cost accounting or, less extreme, altering fair value accounting requirements to reduce the amount of firms’ reported losses. While each of the potential criticisms of fair value accounting contains some truth, all of these criticisms are overstated and do not acknowledge the far more severe limitations of the advocated alternative accounting measurement approaches.