Fair Value Accounting Practices and Financial Performance of Commercial Banking Industry

S G Sisira Dharmasri Jayasekara, K L Wasantha Perera and A Roshan Ajward

This conceptual paper discusses the impact of fair value accounting practices on financial performance of commercial banks in relation to the established banking theories i.e. Credit creation, fractional reserve and financial intermediation theory. These theories are discussed in view of historical cost accounting principles and fair valued accounting principles considering the financial performance during different stages of economic conditions. The analysis shows that fair value accounting practices in banks create reserves in economic booms improving financial performance and deteriorate created reserves in economic downturns causing financial crises. Enhanced financial performance in terms of unrealized gains improves the overall efficiency of banks in view of production approach of the financial intermediation theory. Therefore, it can be interpreted that external factors such as accounting, infrastructure, and technology can influence efficiency of the financial intermediation process. This is the first study to discuss the implications of fair value accounting on banking theory in view of performance of financial institutions and stability of financial system.