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A bank’s balance sheet possesses the unique features that are not available in a regular company balance sheet. First, banks do not have the inventory and accounts receivable items, as in a typical company’s balance sheet. Also, the accounts payable item which is listed under the current liabilities is not found in a bank’s balance sheet. As an alternative under current assets, a bank will have items, such as loans and investments, and deposits and borrowings under the current liabilities (Benston, 2008).
Historical Cost Accounting and its Rationale
Historical cost refers to the price incurred by an accounting entity to acquire an asset, as well as the payments incurred to bring the asset to a location and condition essential for the asset to be used in the firm’s operations. Historical cost accounting, on the other hand, involves measuring and reporting assets and liabilities based on the acquisition price. It is the conventional method of accounting and its major assumption is that prices remain constant (Allen & Elena, 2008). Therefore, it does not take into account the effect of changes in purchasing power on the value of assets and liabilities. Historical cost accounting approach is grounded on one fundamental belief, namely, that investors are mainly concerned with how well management has discharged its stewardship responsibility. Stewardship responsibility relates to how well management utilizes the funds entrusted to them by investors and it is measured through the financial performance of the firm, as expressed by the income statement. Thus, the most important financial statement for investors, according to the historical accounting theory, is the income statement and not the balance sheet (Markus & Lasse, 2009). The irrelevance of the balance sheet stems from the fact that it is not a good measure of management performance on the aspect of stewardship responsibility. Another argument in favor of historical cost accounting is that it provides a more objective measure of the value of assets and liabilities. Lastly, historical cost accounting is seen as being more reliable, as it is not subjected to volatility.
Mark-to-Market Accounting and its Rationale
Mark-to-market accounting entails measuring and reporting assets and liabilities on the basis of their market selling prices. The rationale behind the mark-to-market accounting is that fair values of assets and liabilities are more relevant to investors in determining the financial position of a firm compared to historical costs (Benston, 2008). Determining the financial position of a firm on the basis of historical costs is misleading, as the values of assets and liabilities change over time. Other arguments for the mark-to-market approach include enhancing consistency in financial reporting and improving comparability among firms with similar types of assets.
Proponents of the mark-to-market method contend that historical cost account is irrelevant, since it fails to show the relationship between the financial performance of a firm and its market value. Mark-to-market accounting also takes care of the effect of changes in purchasing power on the value of assets and liabilities (Ahmed & Carolyn, 2009). Fair value approach is mostly applied by financial institutions due to the nature of their assets and liabilities. Most of the assets of financial institutions, such as loans and security investments, are financial in nature and their market value can be ascertained easily. Likewise, the liabilities of these institutions, for example, deposits and borrowings are financial. Thus, the balance sheet items of these entities lend themselves to fair value accounting treatment (Allen & Elena, 2008).
Historical Cost Accounting vs. Mark-to-Market Accounting
The basic difference between the historical cost and fair value accounting is that in the historical cost method, the prices of assets and liabilities remain constant and constitute the acquisition prices of such assets or liabilities (Brunnermeier, 2009). In fair value accounting, on the other hand, the prices of assets and liabilities are adjusted to reflect their current market prices. Moreover, historical costs tend to be more objective as they are based on acquisition prices. Mark-to-market values are, however, more subjective, since they are based on less determinable market prices.
Assets Subject to Fair Value Accounting and those Subject to Historical Cost Accounting
There are assets and liabilities that can be valued using the mark-to-market approach, according to the International Accounting Standards (IAS) and IFRS, and those ones that must be valued on the basis of historical cost. The items that can be measured and reported on the fair value basis are mainly financial assets and investments. These items are usually highly liquid and they have a deep market and, at the same time, their market prices are easily determinable. In the contrast, fixed assets must be reported on historical cost basis (Cifuentes, 2008). The reason behind this rule is the fact that fixed assets are less liquid and, thus, their market prices are not easily determinable. Examples of items that could be valued using the mark-to-market approach are mortgages, loans, government securities etc. Since most bank assets and liabilities are financial in nature, they use the fair value method more in their accounting measurement and reporting, compared to the regular companies. Conversely, items that must be value on historical cost basis include machinery, buildings, plant, equipments, etc. All these items are fixed assets with relatively longer use values than other assets (Cifuentes, 2008).
Situation Leading to the 2008 Financial Crisis
The 2008 financial crisis was caused by a bubble in the mortgage industry in the US A. A bubble refers to the movement in market prices of assets that does not result from the changes in the market fundamentals (Markus & Lasse, 2009). Over the years, evidence has shown that economic bubbles arise when there is an excess liquidity or credit availability in the economy. Such high liquidity or credit availability leads to increased demand for the underlying asset. Thus, liquidity or credit must be present during any economic bubble, otherwise, speculators would not be able to move in and drive up the prices (Brenston, 2008). However, availability of liquidity and credit only create a favorable environment for the bubble. The bubble itself is caused by more real factors. The factors behind the 2008 housing bubble included the agency problem, mispricing of risk, and inadequate securitization of mortgages to diversify the risk throughout the financial system.
The first cause of the 2008 housing bubble was an agency problem. This agency problem lied within the mortgage brokers. Before an investor buys a home, he or she first meets a mortgage broker who acts on behalf of a financial institution. Mortgage brokers are paid by the financial institutions and they work for on a commission basis (Ahmed & Carolyn, 2009). Therefore, their earnings are directly linked to the number of mortgage applications that they pass on to their respective financial institutions. This situation creates a moral hazard in that brokers can qualify even those mortgage applications with high risk of default, so as to make more earnings. Since financial institutions do not usually monitor the quality of loans handed over to them by brokers, this creates a loophole where bad mortgage loans can find their way into the financial system (Brunnermeier, 2009).
The agency problem extended to the banks as well. When banks make mortgage loans, the loans are often packaged and sold as securities in what is known as securitization (Markus & Lasse, 2009). As long as banks can securitize mortgage loans and receive their fees, the default risk on the loans is not a major concern to them, and they will be willing to make more mortgages, regardless of the level of default risk that they are assuming.
However, the major cause of the financial crisis was perhaps a political one. Because of the pressure from the government, banks were encouraged to make more mortgage loans to the poor to enable them own homes (Ahmed & Carolyn, 2009). Moreover, banks were required by legislation not to discriminate against the poor in making these mortgages. As a result, the level of default risk assumed by banks increased dramatically. The government, in turn, promised to guarantee the mortgages through the Fannie Mae and Freddie Mac Corporations (Markus & Lasse, 2009). This further worsened the moral hazard of banks in making and securitizing mortgages selling them even to international investors, since the loans carried no risk, as they bore the guarantee of the government. Further, the reserve requirement of Freddie Mae was kept very low to enable it purchase and guarantee more mortgages by banks, while the Federal Reserve lowered interest rates to make mortgage payments low. These factors caused the housing prices to rise. Home owners were able to access equity loans to repay the original loans, until the housing prices reached their climax in 2006 (Benston, 2008). At this point, mortgage holders were unable to access loans to pay the initial loans and default rates on the loans started to skyrocket.
Mark-to-Market Accounting and the Housing Bubble
The contribution of fair value accounting to the housing bubble and to the resultant, financial crisis was very significant. The surge in housing demand made the balance sheets of banks look very healthy, as the banks reported their mortgage assets based on the prevailing market prices (Benston, 2008). Investors could, therefore, not suspect that the healthy financial positions of banks were due to a bubble, and that in fact, banks were bearing more default risk than usual.
Before the financial crisis, many banks were using fair value method for recognizing and reporting their financial transactions. The reason for using this approach was to provide more relevant financial information to investors and to reflect the market value of the company which is very relevant to customers (Cifuentes, 2008). Those banks that used the historical accounting approach are the ones which were rather conservative, and whose financial assets could not be marketed readily. Thus, it was rather difficult to determine the market value of their assets.
Occurrences During the Financial Crisis
During the financial crisis, the default rates on the mortgage loans increased massively. Home owners from being unable to access credit to repay their loans started to lose their homes to financial institutions. The values of the recovered properties were very low, since the properties were sold at fire-sale prices (Brunnermeier, 2009). As a result, banks had to make the major write-downs of assets to reflect the prevailing market prices as per the requirements of fair value accounting. Reporting the value of mortgages at the fire sale-prices that were obtaining in the market did not, however, reflect the true value of those mortgages, and it only worsened the financial crisis.
The Amount of Assets Marked-to-Market During the Crisis
During the financial crisis, JP Morgan had about $13.4 billion of assets marked-to-market. The company had to write down the value of these assets by $3.6 billion in 2008 due to the fall in mortgage-related prices (Cifuentes, 2008). Goldman Sachs, on the other hand, had a total of $83.2 billion in fair valued assets during the financial crisis. The company sustained a loss of $2.2 billion in write-downs as a result of the crisis. Other financial institutions which had to write down their assets due to the crisis include the Lehman Brothers which wrote down 4 percent of its $39 billion mortgage-related assets.
Gold Sachs and Morgan Stanley’s Move to lessen the use of Fair Value Accounting
The move by Gold Sachs and Morgan Stanley companies to reduce the use of fair value accounting for their assets was geared towards reducing their exposure to the volatility of market prices (Benston, 2008). Use of historical cost accounting hedges the companies against this volatility, while at the same time requiring them to hold fewer reserves as per the legislative requirements. Legislation requires those companies using the fair value accounting on their assets to hold more reserves, as they are exposed to more market volatility. Companies using historical cost method, on the other hand, do not have hold much reserves, which means that they can make more loans.
The move by Gold Sachs and Morgan Stanley regarding the use of historical accounting on assets is likely to affect loans and mortgage-related assets which are usually long-term in nature (Ahmed & Carolyn, 2009). Some of the companies’ assets that are bound to remain marked-to-market are investments in securities. This form of assets is highly saleable, and is not subject to massive write-downs in value in the times of financial crisis, due to the strict regulations in capital markets (Cifuentes, 2008). Thus, the assets are well guarded from volatility that may arise from such a crisis.
Rationale for Gold Sachs and Morgan Stanley’s Move
The key reason behind the change in accounting policy by the two companies is to reduce their exposure to market volatility that greatly undermines the value of a company that is using the fair value approach in times of a financial crisis (Allen & Elena, 2008). The move also benefits the companies in that they will not be required by legislation to hold a lot of reserves, as in the mark-to-market approach. The released reserves will then be available for making more loans which will improve the companies’ earnings. Decreased volatility also enhances the stability of the companies’ earnings which increases the investors’ confidence. Positive investor confidence, in turn, leads to improved value of a company’s stock (Allen & Elena, 2008).
Arguments for Use of Mark-to-Market Accounting
Proponents of fair value accounting claim that the method provides more relevant financial information to investors regarding the financial position of a company, compared to the historical cost approach (Benston, 2008). This approach also reflects the effects of changes in purchasing power on the value of assets and liabilities something which is not possible with the traditional approach. Moreover, it has been argued that fair value accounting links the performance of a company to its market value (Markus & Lasse, 2009). This is a very important feature of this approach, since a company’s performance reflects how well management is using the investors’ funds.
Arguments against the Use of Fair Value Accounting
The key contention against the mark-to-market accounting method rests on the fact that the method relies on subjective measures to determine the values of assets and liabilities. It is difficult to determine accurately the selling price of an asset or liability, especially if the item does not have a very liquid market (Ahmed & Carolyn, 2009). However, assets and liabilities that are readily marketable, such as government securities, are easy to account for using the fair value method. Also, the approach exposes a company to the market volatility causing it to suffer heavy losses during times of financial meltdowns (Cifuentes, 2008). Such volatility is detrimental to investors’ confidence and can adversely affect the value of a company’s stock, as volatility of earnings is one of the factors that affect the stock prices.
Changes in Regulations Affecting the Use of Fair Value Accounting Since the Financial Crisis
It is widely believed that the use of mark-to-market accounting by financial institutions exacerbated the financial crisis (Brunnermeier, 2009). To prevent the recurrence of this situation, several legislations have been passed by both the US government and the SEC which are aimed at reducing the banks’ use of fair value accounting (Markus & Lasse, 2009). The rules that have been made concentrate on requiring those financial institutions using the mark-to-market method to hold more reserves against their assets. There are also some asset categories which cannot be reported on fair value basis depending on the level of their liquidity and risk.
Fair value accounting has been largely blamed for escalating the effects of the 2008 financial crisis. As a result, the US government and SEC have lobbied for the use of historical accounting approach to improve the stability in the financial system. Both the historical and fair value accounting methods have their pros and cons and they should, therefore, be applied judiciously. It seems that the best approach is to look at which assets and liabilities are best suited for the historical approach and the ones best suited for the fair value accounting.