Fair Value Accounting, Historical Cost Accounting, and Systemic Risk

Fair Value Accounting, Historical Cost Accounting, and Systemic Risk: Policy Issues and Options for Strengthening Valuation and Reducing Risk

Michael D. Greenberg
Eric Helland
Noreen Clancy
James N. Dertouzos
Copyright Date: 2013
Published by: RAND Corporation
Pages: 108
https://www.jstor.org/stable/10.7249/j.ctt5hhv55
  • Cite this Item
  • Book Info
    Fair Value Accounting, Historical Cost Accounting, and Systemic Risk
    Book Description:

    In the wake of the 2008 financial crisis, conflicting arguments have been made about fair value accounting (FVA) versus historical cost accounting (HCA) and the role that each played in the crisis. This report examines the relationship between both types of accounting practices and systemic risk in the financial sector, providing recommendations on how FVA and HCA can both be improved.

    eISBN: 978-0-8330-8366-1
    Subjects: Finance, Law, History

Table of Contents

  1. Front Matter
    (pp. i-ii)
  2. Preface
    (pp. iii-iv)
  3. Table of Contents
    (pp. v-viii)
  4. Figures and Tables
    (pp. ix-x)
  5. Glossary
    (pp. xi-xii)
  6. Summary
    (pp. xiii-xviii)
  7. Acknowledgments
    (pp. xix-xx)
  8. Abbreviations
    (pp. xxi-xxii)
  9. CHAPTER ONE Introduction
    (pp. 1-6)

    Fair value accounting(FVA) refers to the practice of periodically revaluing an asset (or a liability), based on current prices in a liquid market.¹ Fair value accounting is commonly distinguished from the competing method ofhistorical cost accounting(HCA), in which the book value of an asset is based on the price that was originally paid for it. In practice, both of these perspectives on asset valuation are deeply embedded in the generally accepted accounting principles (GAAP) framework in the United States, and each is defined by an elaborate set of accounting standards, methods, and metrics.² The details of how...

  10. CHAPTER TWO Background: The Debate over FVA and HCA
    (pp. 7-16)

    The purpose of standardized accounting is to provide sufficient financial information to investors, shareholders, creditors, managers, and others, so that each can make meaningful assessments about the value and sustainability of firms. In a vacuum, judgments about value can often be subjective. What one person deems to be priceless artwork, for example, might be viewed by another as lacking any merit or value. In the context of the financial world, commonly agreed-upon standards for accounting can help to establish consensus and objectivity in valuation practices. Since financial statements are used by a variety of people for a variety of purposes,...

  11. CHAPTER THREE Systemic Risk and Accounting Approaches
    (pp. 17-26)

    A central question raised in the wake of the financial crisis of 2008 has been whether accounting standards, and FVA in particular, contributed directly to systemic risk across the entire financial infrastructure. Many critics have argued that the requirement that banks mark their assets to market had the effect during the 2008 crisis of spreading and accelerating a sell-off, with the consequence of further eroding asset prices and creating a feedback loop of deleveraging, evaporating liquidity, and destabilized bank balance sheets and income statements.

    Several of our interviewees related a version of this story. Yet this perspective raises several questions....

  12. CHAPTER FOUR Accounting Standards and Prudential Regulation
    (pp. 27-42)

    The preceding chapter described a set of theoretical conditions under which FVA, but not HCA, can produce contagion of risk across otherwise unrelated firms or industry sectors. An integral part of this liquidity pricing story in the banking sector involves the regulatory capital requirements that determine how much capital a bank needs to hold for a given level of assets. These requirements are also central to many of the anecdotal accounts suggesting that FVA was a primary driver of the financial crisis in 2008.

    Any discussion of the relationship between accounting standards and regulatory capital requirements for banks raises basic...

  13. CHAPTER FIVE Lessons from Historical Episodes Involving Accounting Standards, Systemic Risk, and Financial Crisis
    (pp. 43-54)

    In Chapters Three and Four, we explored the conceptual links between FVA and HCA accounting standards, prudential regulation, and systemic risk. We also reviewed the recent empirical literature concerning the financial crisis of 2008 and the extent to which FVA-driven risk contagion actually did play a major role in that crisis. Notably, we touched on the conceptual argument for how HCA may sometimes contribute to episodes of financial crisis, risk contagion, and/or the accumulation of undisclosed losses within institutions. Although the links between HCA and systemic risk have not been focal in the 2008 debate, those links have nevertheless been...

  14. CHAPTER SIX Implementation and Risk: The Challenges to Doing FVA and HCA Well
    (pp. 55-64)

    One of the themes that arose repeatedly in our interviewing about FVA and HCA is the premise that it is possible to apply both methods poorly, in ways that can generate misleading information about asset values. For example, multiple people commented on the difficulties and challenges associated with applying FVA in the middle of a liquidity crisis, particularly in the abrupt absence of a meaningful reference “market price” to mark to. Others spoke about the problems and subjectivity associated with impairment accounting in an HCA framework. In both cases, the underlying implication was that asset valuation processes can sometimes be...

  15. CHAPTER SEVEN Conclusion and Policy Options
    (pp. 65-72)

    FVA and HCA represent two basic accounting approaches to capturing information about the value of assets. In this report, we examined the long-standing debate over the relative merits of these two approaches and their contributions to risk in the financial system. More specifically, we sought to address two questions:

    1. What is the relationship between accounting standards (FVA and HCA) and “systemic risk” (i.e., the contagion of financial risk across institutions, with the potential to destabilize the entire financial system)?

    2. What kinds of regulatory, governance, and accounting standards options might policymakers consider to respond to concerns about systemic risk?

    We conclude...

  16. APPENDIX An Overview of HCA and FVA
    (pp. 73-80)
  17. References
    (pp. 81-86)