Accounting Prep Essay

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Class 13-Prep The first link between accounting and the financial crisis was the way companies were valuing their assets. The three levels that are used to determine fair value start at being able to observe an assets fair value through a traded market, to being able to observe inputs, and lastly having to estimate values because there is no observable market so management has to calculate the estimates. Mortgage services rights and residual interests on securities were two types of assets that the management of these banks had to estimate. Of course management gets paid based on how well the company is doing so there is inevitably biased estimates on these assets so became overvalued. Our accounting system allows this rule so the banks who helped contribute to the crisis were only following the accounting rules but may not have been ethical about their decisions. Another factor that led our accounting system to help contribute to the financial crisis was the FASB statement that clarifies loss recognition such as 5 and 114. Even though these banks should have been recording losses in regards to potential risk factors, the losses were supposed to reflect the historical performance in the marketplace. This led to recording a smaller amount of liabilities and losses. This in turn led to higher net income and larger asset valuation in the balance sheets. Banks also on average were classifying 50% of their MBS’s and CDO’s as held to maturity, and about 36% were accounted as fair value. These investments were also a large part of the crisis and were also valued mostly by management’s discretion. Some the investments were classified as level two where management had the input prices but still was up to estimation. This is another area where accounting led to inflated balance sheet assets. With bank’s balance sheets so inflated, it allowed them to

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