Fair value or ''mark-to-market'' accounting – which adjusts the reported value of a firm''s assets to reflect changing market prices – leads to bigger financial bubbles and crashes than an environment in which accountants use measures of fundamental value. That is the conclusion of experimental research by Shengle Lin, Glenn Pfeiffer and David Porter, published in the October 2017 issue of the Economic Journal.
The results of their study have potentially far-reaching implications for accounting standard-setters as well as future bank regulatory policy. As the researchers comment:
''Accounting is often viewed as a mere reflection of economic activities with little impact on the underlying economic reality. Our evidence suggests otherwise.''
Among the most striking phenomena in economics is the propensity of market prices occasionally to exhibit unusual run-ups, or bubbles, followed by crashes in which prices fall to more reasonable levels. The use of fair value accounting by banks and other financial institutions has been posited as a factor contributing to recent market crashes.
Fair value or ''mark-to-market'' accounting refers to the practice of increasing or decreasing the reported value of assets in a firm''s balance sheet to reflect changes in the market prices of those assets. Proponents of this technique argue that the market value of an asset is more relevant than its acquisition cost for investors and creditors seeking to gauge potential returns.
But when market prices do not reflect value, as in the real estate bubble in 2007, could fair value accounting contribute to distortions in asset values that are later unwound during a financial crisis?
To answer this question, the researchers studied a series of 21 laboratory markets in which participants were allowed to trade shares of an asset that paid a cash dividend at the end of each of 15 trading rounds.
At the end of each round, participants were presented with a balance sheet detailing their cash position and the value of their shares. Based on prior research, the authors knew that these markets were prone to price bubbles.
The results are striking. While all the markets experienced a price bubble, the bubbles in the markets with fair value reporting were significantly larger than those in the markets with fundamental value reporting.
Prices in the former exhibited a faster run-up, peaked at a higher level and then crashed when the loans came due. The use of fair value accounting clearly contributed to the creation of a price bubble in these markets.
Allowing participants to borrow cash created an additional issue: some were unable to repay their loans once the bubble burst. When loans came due, those with insufficient cash balances were forced to liquidate shares to repay their loans.
If share values were too low to cover the loan balance, the participant was considered in default on the loan. The researchers discovered that the frequency of loan default was higher in the fair value markets than in those where fundamental value was reported.
The accounting profession has supported fair value reporting because it provides better information to investors and creditors about a firm''s investment activities. But since it is also used to regulate banks and other financial institutions, fair value accounting may well have added to the excess liquidity that fuelled recent market bubbles.
Because reducing the impact of these bubbles is critical to economic health, this research has potentially far-reaching implications for accounting standard-setters as well as future bank regulatory policy. By separating regulatory capital requirements from fair value reporting rules, accountants can provide useful information to investors while avoiding a repeat of the recent financial crisis.
''Accounting Standards and Financial Market Stability: An Experimental Examination'' by Shengle Lin, Glenn Pfeiffer and David Porter is published in the October 2017 issue of the Economic Journal. Shengle Lin is at San Francisco State University. Glenn Pfeiffer and David Porter are at Chapman University
