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Fair Value Accounting

In: Business and Management

Submitted By azhar
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Journal of Economic Perspectives—Volume 24, Number 1—Winter 2010—Pages 93–118

Did Fair-Value Accounting Contribute to the Financial Crisis?
Christian Laux and Christian Leuz

I

n its pure form, fair-value accounting involves reporting assets and liabilities on the balance sheet at fair value and recognizing changes in fair value as gains and losses in the income statement. When market prices are used to determine fair value, fair-value accounting is also called mark-to-market accounting. Some critics argue that fair-value accounting exacerbated the severity of the 2008 financial crisis. The main allegations are that fair-value accounting contributes to excessive leverage in boom periods and leads to excessive write-downs in busts. The write-downs due to falling market prices deplete bank capital and set off a downward spiral, as banks are forced to sell assets at “fire sale” prices, which in turn can lead to contagion as prices from asset fire sales of one bank become relevant for other banks. These arguments are often taken at face value, but evidence on problems created by fair-value accounting is rarely provided. We discuss these arguments and examine descriptive and empirical evidence that sheds light on the role of fair-value accounting for U.S. banks in the crisis. While large losses can clearly cause problems for banks and other financial institutions, the relevant question for our article is whether reporting these losses under fair-value accounting created additional problems. Similarly, it is clear that determining fair values for illiquid assets in a crisis is very difficult, but did reporting fair values of illiquid assets make matters worse? Would the market have reacted differently if banks had not reported their losses or used a different set of accounting

Christian Laux is Professor of Finance, Vienna University of Economics and Business,

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