Balance Sheets and Financial Transparency - Essay Example

Balance Sheets and Financial Transparency Submitted by: XXXXXXX Number: XXXXXX of XXXXXXXX XXXXXXX XXXXXXXXSubject Code: XXXXXXX Date of Submission: XX – XX – 2014 “The use of off – balance sheet accounting continues to undermine the financial transparency of company financial statements” Introduction: Over the past few years there have been some of the most challenging financial crisis that has hit the world economies post the Great Depression. This impact has been felt for numerous years and the overall impact has not only been on the individual firms however on the overall global financial systems. The impact has been evident on the families, business and individuals of both Main Street as well as Wall Street (Ketz, 2003). These events have led to a consensus where companies need to have more accurate accounting for the balance sheets to be more viable and to be able to remain strong in the market places (Emmott, 2009). This clearly has been a clear show of more transparency and there is more focus on the need for accuracy and honesty in the financial statements. The main focus of this paper is to discuss the need for transparency and proper acknowledging and understanding of assets held off balance sheets. The paper will discuss some well-known cases of issues and dramatic falls of companies like Enron and the author’s views and discussion on the use of off-balance sheet accounting. The author is clearly against the off – balance – sheet approach and the paper mainly focused on providing a clear rationale and discussion for the same. Corporate Governance: An overview: Corporate Governance is a multi – faceted subject and is focused on ensuring a clear accountability of individuals in the company by focusing on the mechanism of reducing the ‘principal – agent problem’. According to Jesus Estanislao, “Corporate governance is about performance. Corporations must deliver good results not only to the shareholders, but also to all of the stakeholders, the community, the society, and the economy as a whole” (CIPE1, 2005, p.1). However it is not been given the kind of importance or recognition it requires from the universities and the academic courses. Corporate governance is a set of rules and regulations which define the relationship between stakeholders, management and the board of directors of a company (Macey, 2008). These rules and regulations affect the operating of companies to a great extent and in simpler terms it identifies the issues that are based on the ownership and control of a company. Financial accounting is also a major part of the overall ability of the company to keep up the corporate governance (Murphy, 2008). Case of Enron: The importance of corporate governance is a well-blended mix of both the contribution of business’s prosperity as well as the accountability. The accountability of companies with the societies and the environment around keeps balanced corporate governance and leads to the success of the companies. There have been a number of reports which highlight the ongoing global financial crisis and the tightened monetary policies across the world, in order to overcome and foretell any major difficulties for the world economy in terms of the rest of this year (Thomas, 2002). One such example is clearly the case of Enron where the company was focused on cooking up the books to reveal a different position of the company and to display a different position as compared to the actual condition. Here there have been a number of analysts that had tried to understand the financials of the company, however the company’s books and the reality went on to provide two very different pictures of the markets. According to the financial statements, it was seen that the company was operating in losses; however the stocks of the company were being traded at $ 90 per share (Thomas, 2002). Enron had a high level of support from the banks and this allowed the company to create a number of offshore entities which would make the company look more profitable than it actually was. The company went on to make numerous risky deals and Enron clearly has led to huge cash shortfalls. The company stock slowly slipped to below $ 40 and by end of 2001 the company needed to file for bankruptcy (Thomas, 2002). It was one of Enron’s approaches where the company manufactures false profits by including special purpose entities which would conduct the transactions off balance sheet. Here the main goal was clearly to avoid the financial reporting. Discussion: Since the number of revelations of build-up of off – balance – sheet exposures has increased especially across the large financial institutions, this has not only impacted or weakened the organizations themselves, but has also led to immense pressure and risks for entire financial systems ( U.S. Government Printing Office, 2010). With the immense levels of issues and failures that have been identified, there are numerous experts, market participants, regulators and investors who are for change in the area. The off-balance-sheet entries are clearly an issue which has been identified to be a major concern by the President’s Working Group and there have also been a number of reports and recommendations related to the Financial Stability Forum. There has also been number of policies like the Counterparty Risk Management Policy specifically for the private sector with the aim of providing more accurate view of the company’s exposure. The United States of America has clearly been faced with immense issues in the past with the issue of subprime crisis. By 2006, the US housing market was flourishing and the general public was given an easier way to buy a house with simpler loans. This increased the demand also led to increased prices. This led to an attraction of the investors who only bought houses as an investment to sell them for a higher price in the future (BBC News, 2007). This was referred to as a ‘classic speculative housing bubble’. The rising prices on one end and the bad loans on the other end (bad loans refers to the loans given to people who cannot afford to pay the mortgages), together led to people refinancing their loans each time they found it difficult to pay off a mortgage. This led them into further debt in order to pay off the older debts. However within the markets, although the house prices were at a rise, the average household income of the country did not increase. The people found it difficult to afford and this simply led to the big housing bubble to burst (Jarvis, 2009). Here the value of the property started to decrease and there was now a reverse action that took place in the markets. People started to default on their mortgage payments and this kept increasing over time. There was now an increase in the supply of houses and the demand was much lower which led the prices to slash and plunge in the late 2006 and early 2007. It is however important to note here that the subprime crisis was not only due to the excess liquidity, leverage, and complex products but was due to the accounting rule which allowed the mortgage backed securities to be held off the balance sheet ( U.S. Government Printing Office, 2010). The lack of transparency in the markets is clearly one of the key reasons for the main issue of the subprime mortgages and these risks are clearly away from the investor view and more closely reviewed by the regulators. Several companies hold large amounts of assets off – balance sheet and this is clearly not a sense of transparency. Investors form a major part of every company and the financials of the company act as a means to disclose the overall performance to the investors. Hence if a company does in fact keep assets off the balance sheet, then this would simply leas to lack of the complete truth for the investors thereby leading to some uninformed decisions as well ( U.S. Government Printing Office, 2010). Conclusions: There is clearly a lack of trust in the financial sector post all the different corporate governance failures and the numerous frauds that have taken place in the past. The FASB has also been focused on securitization of the accounting over the past two decades. There is clearly a need for accounting securitization and limiting and eliminating the overall off-balance-sheet entities. This is evident from the fact the FASB has also moved on to remove the designation of the “qualified special purpose entity”, i.e. the firms which were permitted as a means to move the mortgage backed securities off the balance sheet ( U.S. Government Printing Office, 2010). This has been effective since 2010 and the fact that the FASB has also incorporated such a clause clearly brings out the need for a correction that is required. Bibliography BBC News. (2007, November 21). The downturn in facts and figures. [Online] Available at: http://news.bbc.co.uk/2/hi/business/7073131.stm [Accessed 3 February 2014]. CIPE. (2005). Why Study Corporate Governance., p.1 [Online] Available at: http://developmentinstitute.org/Member/hassen_CG.aspx [Accessed 3 February 2014]. Emmott, B., 2009. The three worst words of all: ‘off balance sheet. [Online] Available at: http://www.billemmott.com/article.php?id=220 [Accessed 1 February 2014]. Jarvis, J. (2009). The Short and Simple Story of Credit Crisis. Retrieved January 13, 2014, from The Crisis of Credit: http://www.crisisofcredit.com/ Ketz, E., 2003. Hidden Financial Risk: Understanding Off - Balance Sheet Accounting. Hoboken: John Wiley & Sons. Inc. Macey, J. R. (2008). Corporate Governance. New Jersey, United Sates of America: Princeton University Press. Murphy, R., 2008. Northern Rock: Why Granite must be nationalised. [Online] Available at: http://www.taxresearch.org.uk/Blog/2008/02/20/northern-rock-why-granite-must-be-nationalised/ [Accessed 3 February 2014]. Thomas, W., 2002. The Rise and Fall of Enron. [Online] Available at: http://www.journalofaccountancy.com/Issues/2002/Apr/TheRiseAndFallOfEnron.htm [Accessed 31 January 2014]. U.S. Government Printing Office, 2010. Transparency in accounting: proposed changes to accounting for off-. [Online] Available at: http://www.gpo.gov/fdsys/pkg/CHRG-110shrg50413/html/CHRG-110shrg50413.htm [Accessed 31 January 2014]. Read More