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FAIR VALUE ACCOUNTING AND SUB-PRIME Michael r. Young INTRODUCTION A proposition creeping its way into the discussion about the financial market dislocations arising from sub-prime loans is that it’s really our accounting system that is to blame. The argument is that new accounting rules are requiring writedowns that actually exaggerate losses and that financial markets are thereby being driven to levels that are artificially low. A consequence, as summarized by The Wall Street Journal, is a “rebellion” by those who are “blaming accounting rules” for exaggerated losses and calling for new rules that would, in essence, dampen financial market volatility. That is certainly one way of looking at it. And, no doubt, the billions in writedowns of mortgage-backed instruments and accompanying volatility in financial markets since this past summer have been no fun. Still, we should be slow to blame the accountants or new accounting standards for the sub-prime meltdown. To the contrary, some may be expected to point out that the aftermath of the sub-prime difficulties has put to the test a financial reporting system that has responded as it should. BEHIND THE SCENES: FAS 157 For those inclined to blame the accounting, the real culprit in the sub-prime mess is a fairly new standard, “Statement of Financial Accounting Standards No. 157” or “FAS 157.” Issued in September 2006 and scheduled to take effect this past November, GAS 157 speaks to the valuation of certain kinds of assets, namely assets that should be recorded at fair value. Applicable to, among other things, financial instruments of the sort relevant to sub-prime loans, the standard specifies that such assets are to be recorded at the price for which they could be sold, that is, “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market par