This post is provided by our first “guest blogger” Sebastian Botzem. He is research fellow at the department „Internationalization and Organization” at the Social Science Research Center (WZB) in Berlin.

Fair value accounting has been identified as one of the causes of the current global financial crisis (see, for example, on this blog “Fair Value Accounting in Retreat?“). While it would be unfair to bookkeepers, accountants, auditors and academics to make them solely responsible for the loss of wealth and jobs, the present twists and quirks with regard to accounting policy are remarkable and merit closer attention.

A good example to show that the logic of accounting is questioned is Germany’s “bad bank”  solution: In principle there seems to be agreement to clear balance sheets from heavily impaired assets in order to free up capital and cut the risk of further writedowns. How that should be done, however, remains a big question. One of the great unknowns is of course how to determine the price for the assets to be transferred. Also, it needs to be determined how and to which degree the German taxpayers are eventually being burdened with liabilities not just for years, but for decades. The legal construction is also interesting: Germany’s “bad banks” are supposed to be set up as Special Purpose Entities (SPE). Günther Merl, former speaker of Germany’s public banking rescue fund Soffin (Sonderfonds Finanzmarktstabilisierung, in English: Financial Market Stabilization Fund), has just argued in the German quality daily Süddeutsche Zeitung that the government should exempt the proposed “bad banks” from the usual regulation that applies to financial institutions. The intention of such a move is to allow for accounting provisions that treat “bad banks” not as banks. The creation of Special Purpose Entities – one cause of much of the turmoil at financial markets – to rescue financial institutions indicates the dire straits market advocates are in.

This episode points to a general trend in accounting at the time of crisis: Principles and logic seem to be much less important than accounting text books and the usual free market sermon indicates. Now, fair value accounting makes life quite difficult for the advocates of mark-to-market and mark-to-model accounting. The greatest challenge is how to argue in favour of markets in a time when they collapse. The inner circle of global accounting experts found their own interpretation: currently markets are merely “inactive”. Assets are supposed to retain value, the markets just do not show it. The irony of it all: More conservative value estimations such as historical costs were criticised and subsequently marginalized for not being market values.

The current crisis, however, puts the fair value debate into another light. What could be behind the fact that those who once argued only the market shows the true value now cannot admit that the value of a financial instrument is zero when there is no buyer? How can the softening of once crystal clear pro-market ideologies be explained? One possible interpretation of the current intellectual flexibility of many free markets’ advocates could be that they were less interested in fair values but rather in raising values.

A look back at what happened over the last years is quite illuminating: There is no doubt that fair value accounting is pro-cyclical. This means that in times of growth, rising values reinforce each other. Raising shares and bonds are usually good for the value of financial instruments such as asset-backed securities. Their increase in value contributes to, among other things, increasing share prices which are interpreted as stronger companies’ performance. This improves ratings and frees up more capital for further activities. And the beauty of it all is that managers benefit from good performance indicators and dividends are high. Even more important: The profit distribution does not depend on realized gains. It is derived from a firm’s fair value. Gains can be distributed via dividends and stock options before there has been effective money transfer.

In times of crises, as we have seen over the last months, this virtuous circle turns vicious: Falling prices lead to writedowns and reduce balance sheet values. Assets are going down in price and the markets for financial instruments go down or collapse. And here is the interesting twist: Now all of a sudden, markets do not seem to indicate fair values any longer. No one seemed to have problems with paying out dividends and manager compensation out of unrealized gains. The collapse of entire markets on the contrary, is interpreted as the “inactivity” of markets.

There should be no mistake, my argument is not to hold on to fair value accounting no matter what. Rather, I argue, to review the principal in general and not just interrupt its application in a time of crisis. Accounting academics and practitioners will have to examine the crisis carefully and provide answers to the contrasting norms applied during good times on the one hand and bad times on the other. One impression they have to counter is that accounting logic and principals play less of a role than the material interest of mangers, shareholders, consultants, analysts and auditors.

This debate is of course far less novel than one might think. Berthold Brecht, Germany’s famous poet, playwright and director, raised one of the big questions with regard to the business of finance decades ago. In his famous Threepenny Opera dating from the late 1920s he asks: “What is breaking into a bank compared to founding a bank?” The invention of “bad banks” and of “inactive” markets certainly has not made it easier for us to come to an answer.