Role of International Accounting Standards Board in Global Financial Crisis - Essay Example

Accounting Questions Name Institution Date Introduction The recent global economic crisis is a subject of much scrutiny. Whilst the culpability is place upon several diverse groups, the role of accounting in the financial crisis is regularly examined and censured. Whether or not accounting standards played any major role in causing global financial crisis is regularly debated by regulators, accountants and businesses. Even though it can be to some extent agreed that the major cause and the underlying drivers of financial crisis are financial institutions together with home mortgage financing scheme, the role that accounting standards played in the financial crisis isn’t as clear. In its real form, fair value accounting entails reporting liabilities and assets on balance sheet at a fair value and indentifying shifts in fair value as losses and gains in income statement (Christian & Leuz, 2009). Some people are of the opinion that fair value accounting is essential for transparency and ultimate economic recovery, whilst others see fair value accounting as the partial cause of global financial crisis and a vice that should be gotten rid of. The major allegations that fair value accounting contributed aggravated the intensity of the global financial crisis is that it contributed to too much leverage in the boom periods and resulted to immense write downs in busts. This paper looks at the role of accounting standards in global financial crisis and how accounting standard boards have responded to the crisis. Part A Role of accounting in global financial crisis (GCF) The generally recognized accounting description of fair value is based upon rule FAS 157, which was issued in 2006 by FASB. FAS 157 supported by FAS 115 describes fair value, develops a framework for gauging the formerly described fair value utilizing generally accepted accounting principles and boosts disclosures of fair value. According to Christian and Leuz, (2009), fair value accounting records the worth of a liability or an assert based upon present market prices for that particular asset or in case of liabilities and assets without market price, the market cost for identical liabilities and assets. Fair value accounting can lead to enormous transformations in value on the financial statements of a company in a regularly changing market and can also make liabilities and assets to be incorrectly valued if the market prices swerve from the original fundamental value. The pro-cyclical nature of market to market accounting has downward spiral and extension of global financial crisis. The interplay amid capital requirements and fair value may have pro-cyclical impact of the declining market values on capital structures and portfolios of regulated monetary institutions. Financial organizations may overcompensate and encourage moves such as premature liquidations, raising in ill-timed situations or taking too much risk. The pro-cyclical nature of fair value has majorly contributed to the way accounting has played a major role in protracting the global financial crisis (Christian & Leuz, 2009). According to Andre et al. (2009), the pro-cyclical nature of market to market accounting was demonstrated within the mortgage backed security market since as the prices of houses turned down, mortgages went into default making the worth of mortgages associated assets to go down. Therefore, firms who were having these securities were needed to mark them down to the market resulting to an increase in their insolvency ratio. Several firms then traded the mortgage supported securities as a result of the fear that prices would further go down. As a consequence, mortgage supported securities deluged the market and supply became higher than demand, making prices to go down. As a result of this second huge decline in cost, firms were again needed to mark down their securities. Therefore, this requirement of market to market accounting generated a pro-cyclical effect in mortgage supported security market. Whist fair value accounting isn’t the cause of financial crisis, it has aggravated the crisis via its pro-cyclical nature, and the present faults that subsists within the standards. According to Spooner (2009), whist the real fair values standards themselves might not have been the perpetrator behind the global financial crisis, the incoherent implementation and the consequent misapplication of standard s contributed in three major ways to financial crisis. In particular, reporting of instant benefits on securitization enhanced and motivated increased subprime lending. Secondly, some quantities originally chosen as Level 2 and Level 1 fair values were not correct, but when borrowers started to fail to pay on home loans, companies moved to Level 3 interior estimates other than fine tuning to the actual declining fair value. The capability to utilize these interior approximates enhanced companies to go on to presume risk. Thirdly, the ultimate detection of losses along with ripple impacts via the economy led in a huge, swift decline in the quantity of capital from banks. For these three reasons, it is viewed that the misapplication of United States accounting standards played a role in the global financial crisis (Spooner, 2009). International Accounting Standards Board (IASB) response to GCF The international accounting standards board (IASB) has drafted a variety of measures and recommendations in response to global economic crisis. Acharya et al (2009) argue that as a portion of its response to global economic crisis, the international accounting standards board has taken several actions to address commendations put forward by G20 heads in November 2008. These actions include improved accounting for the off balance sheet items where IASB has published several proposals to improve and strengthen the requirements fro the identification of entities that a firm controls. The board has also published other proposals on the off balance sheet items, including derecognition of liabilities and assets. Another key action is the novel disclosure requirements connected to impairment whereby the IASB together with the US financial accounting standards board (FASB) have proposed transformations in disclosure requirements for the impairments to get in a universal outcome. These proposals are aimed at enhancing firms to disclose the loss or profit that would have been documented if all the financial assets apart from those grouped as fair value via loss or profits had been gauged utilizing amortized cost (Acharya et al, 2009). Acceleration of attempts to address wider matters of impairment on an internationally consistent basis is another action taken by IASB to curb global financial crisis. Ryan (2008) notes that both the FASB and IASB, who have diverse impairment requirements in their respective standards have requested their staff to jointly consider how present requirements related to reverses of impairment losses may be transformed. These proposals are expected to offer more information on the comparative reliability of fair value measurement as well as improve the comparability amid entities on the impacts of their value measurements. The disclosures are also expected to increase the convergence of US generally accepted accounting principles (GAAP) and IFRSs. Additionally, these amendments are expected to enable disclosure requirements on the extent and nature of liquidity risk that raises form monetary tools to which entities are exposed. Extent to which IASB’s actions are likely to have an impact on global financial stability The accounting rules together with capital requirements put forth by the IASB are expected to restore global financial stability through curbing their pro cyclical nature. According to Ryan, (2008), the pro cyclical nature of the accounting is attributed by two major principle aspects namely treatment of impairment and fair value measurement. IABS can lead to global financial stability through improvement of standards that deal with evaluation of financial tools on the basis of their liquidity and holding horizons of investors, whist affirming framework of the fair value accounting. Enhanced disclosures on fair value measurements are vital in ensuring global financial stability particularly in the light of the current market conditions. Enhanced disclosures are important to individuals and institutions using financial statements helpful information on methodologies, valuations and uncertainty connected with the fair value measurements. In addition, IASB’s amendments will clarify and enable subsisting disclosure requirements on the extent and nature of liquidity risk that arises from financial tools. These clarifications are vital in addressing application matters raised by auditors and users. Enhanced disclosure requirements leads to disclosures that better enhance users to valuate the exposure of an entity to liquidity risk emerging from fiscal instruments and the way an entity can manage financial risk (Ryan, 2008). Part B IASB amendment of IAS 39 in response to GCF and problems associated with IAS 39 At the peak of global financial crisis in October 2008, international accounting standard board was put under immense political pressure and permitted financial firms to defer fair value accounting for chosen financial assets. The IASB forwent any frequent due procedure to issue immediate amendments to IAS 39 to allow for reclassification of financial instruments and to unwind fair value accounting. The amendments of IAS 39 is to permit firms reporting under IFRS to retroactively regroup financial assets formerly gauged at fair value into classes that need measurement at the amortized cost. This implies that firms were to efficiently discard fair value accounting for these assets. The decision of IASB to amend IAS 39 was as a result of immense lobbying form banking regulators and politicians majorly from Europe, which ended in the European Union making threats to make amendments on IAS 39 unilaterally (IASB, 2008a). According to Spooner (2009), accounting for fiscal assets under IAS 39 is grounded on three diverse measurement bases namely: fair value via loss or profit, fair value via other comprehensive income and amortized cost. Derivatives, financial assets and trading securities selected under fair value choice are gauged at fair value via loss or profit. Available for sale assets are gauged at fair value via other comprehensive income. Receivables and loans together with marketable debt securities categorized as held to maturity are gauged at amortized cost. After preliminary identification, five forms of reclassification of assets gauged at fair price are possible under the amended IAS 39. The problem with the initial IAS 39 is that it only permitted the reclassification 0f available for sale assets into the held to maturity group. The amendment of IAS 39 by IASB offers four more forms of reclassification in exceptional situations like the 2008 global financial crisis (IASB, 2008a). Under the amended IAS 39, trading assets might be reclassified into Available for sale (AFS), held to maturity (HTM) and Loans and receivables (L& R) and AFS assets might be reclassified into loans and receivables group if they qualify as debt instruments. Equity instruments are only qualified for reclassification from trading group into AFS group. Assets for which IAS 39 fair value choice is utilized together with fiscal derivatives are not liable to reclassifications. According t IASB, (2008b), prior to its amendment IAS 39 forbid reclassifications of fiscal assets once they are identified as held to trading. The amended IAS now permits particular reclassification but with extremely specific requirements. Generally, amendments permits equity securities grouped as held for trading to be regrouped into AFS group only in rare situations. Equity securities can’t be regrouped to L&R or HTM because they don’t meet the description of either group. The amended IAS 39 allows debt securities that qualify to be defined as L&R to be regrouped as AFS or held for trading to L&R if the body has ability and intention to hold financial assets for projected future or until maturity. Actions of IASB to improve IAS 39 The IASB amended IAS 39 to allow for reclassification of financial instruments to make sure that there is concurrent introduction of the disclosure requirements on the utilization of the option. The IASB amended IAS 39 to allow five forms of reclassification with varying accounting outcomes. IASB (2008b) notes that Overall, three effects on measurement of assets and identification of losses and gains are distinguishable. Firstly, reclassification from trading group into L&R or HTM group influence both equity and net income in an impairment is not triggered, since fail value losses or gains are not recognized in loss or profit and therefore in equity. Secondly, recategorization from trading group into AFS group influence net income but doesn’t affect equity because fair value losses and profits are still regarded in revaluation reserve as a portion of the equity of shareholder but are currently reported in OCI other than in loss or profit unless there is an impairment. Thirdly, regrouping from AFS group into HTM or L&R group affect equity and not net income since fair value losses and gains haven’t been formerly regarded in income statement but only in OCI except if there is a trigger of an impairment (IASB, 2008b). Part C How and why the Australian Accounting Standards Board (AASB) responded to the global financial crisis. The Australian Accounting Standard Board (AASB) has responded to the global financial crisis through amending Australian accounting standards to make sure they stay in line with novel accounting and reporting standards issued by IASB. According to AASB, (2011), the global economic crisis has resulted to concerns on the classification of particular forms of financial assets under the international financial reporting standards in comparison to United States generally accepted accounting principles. These changes are aimed at allowing financial entities to reclassify chosen stressed fiscal assets in tandem with global accounting standards. Well formulated and consistent accounting standards offer useful and accurate information to partakers in capital markets and enhance transparency, investor confidence and market integrity. In mid October 2008, IASB transformed the principles to permit entities to select to regroup numerous fiscal instruments from the basis of fair value measurement or market to market measurement, to a cost in particular situations. The AASB’s and IASB’s response creates a portion of a joint approach to international standard setters to deal with fiscal reporting challenges connected with the global financial crisis. Globally, this work is under the support of international organization of securities commissions and locally by Australian financial reporting council. These amendments make sure that Australian entities are capable of utilizing accounting treatment constant with those offered in other jurisdictions (AASB, 2011). According to Sherry (2009), the AASB has also responded to global financial crisis through replacing IAS 39 with the amendments being undertaken in three major phases; impairment, hedging and classification and measurement. The objective of the board to reevaluate the accounting fro the financial instruments is to offer information that is helpful to financial statement users for decision making and to help users in establishing the timing, uncertainty and amounts of cash flows to entities. In the classification and measurement phase, AASB responded to IASB’s exposure draft ED/ 2009/7financial instruments. The AASB supported the objective of IASB to simplify requirements for fiscal instruments, particularly in respect to minimization in classification groups and eradication of tainting rules connected with HTM classification (Sherry, 2009) In the impairment phase, AASB responded to IASB request for information on feasibility of an anticipated loss model for impairment of fiscal assets, to help IASB to develop an exposure draft with recommendations for an anticipated loss model. In the hedging phase, AASB has liaised with constituents to recognize particular areas of hedge accounting requirements that can be simplified to help in replacement of financial instruments standard. In is in response to IASB agreement that hedging requirement shouldn’t be fully eradiated, and that steps must be undertaken to considerably lessen the intricacy of the present hedge accounting requirements (Sherry, 2009). Influences of IASB on AASB in pursuing an international convergence of Australian accounting standards According to Godfrey and Chalmers (2009), the major goal of AASB is to constantly improve the superiority of universal purpose fiscal reports in Australia, in order to enable users of financial reports to be capable to make and assess decisions on the allocation of scant resources. This will help in the maintenance and improvement of the effectiveness of capital markets in Australia and improvements in the accountability of public and private sector reporting bodies. Because there is significant convergence amid standards issues by nationwide and global standard setting bodies, AASB will be highly influenced by the standards set by IASB because in order to ensure international convergence of Australian accounting standards, AASB have to work under the standards outlined by IASB to ensure that Australian accounting standards are compatible with standards of IASB. This is aimed at ensuring that Australian standards are of superior quality standards (Godfrey & Chalmers, 2009). The objective of IABS is to develop a sole set of superior quality, enforceable and understandable international accounting standards, global financial reporting standards and convergence of nationwide accounting standards and the IFRS. Therefore, AASB will be influenced by IABS mandate because AASB global convergence aim is to pursue, via partaking in activities of IASB , the creation of a globally acknowledged sole set of accounting standards which are adoptable in Australia and other nations for both local and global use so as to increase the comparability of fiscal reports prepared in diverse nations and offering partakers in global capital markets with improved superior information on which they can bade credit decisions and investment (IASB, 2008a). Conclusion From the above discussion, it is evident that accounting standards particularly fair value accounting played a major role in the global financial crisis. Even though fair value accounting did not cause the crisis, it greatly exacerbated the severity of the crisis through its pro cyclical nature which resulted to downward spirals in financial institutions. In addition the incoherent implementation and the consequent of standards of fair value accounting aggravated the intensity of the global financial crisis. In order to curb the global financial crisis, several accounting bodies have come up with measures that will ensure quality accounting standards. The international accounting standard board has come up with several recommendations that are aimed at restoring global financial stability. These proposals include improved accounting for off balance sheet items to strengthen and improve requirements for recognition of entities that a company controls as well as derecognition of assets and liabilities. The board has also come up with new disclosure requirements connected to impairment to enhance firms to disclose their gains or loss that had previously been measured using amortized cost. The board has also amended international accounting standard 39 to allow firms to reclassify their financial instruments and to unwind fair value accounting. The Australian accounting standard board has also responded to the global financial crisis through amending Australian accounting standards to ensure that they are consistent with the new accounting and reporting standards that have been issued by IASB. References Christian, L., & Leuz, C., (2009). The crisis of fair –value accounting: Making sense of the recent debate. Accounting, Organizations and Society, 34(6): 826-834. Spooner, A., (2009). Fair value and financial instruments. London: Routledge. Andre, P., Dick, W., Walton, P., & Richard C., (2009). Fair value accounting and the banking crisis in 2008: Shooting the messenger. Accounting In Europe, 6(1); 3-24. CFA Institute, (2008). Re: Amendments to International Accounting Standards no 39 (IAS 39). Letter to the EC Accounting Regulatory Committee, London, October 14. AASB., (2011). Improving accounting for financial instruments. Retrieved on August 15, 2012 from http://www.aasb.gov.au/Publications/eNewsletter/Issue7_Global_Financial_Crisis- .aspx?preview=true Sherry, N., (2009). Australian accounting standards amended in global action to address impact of credit crisis. Retrieved on August 15, 2012 from ttp://ministers.treasury.gov.au/DisplayDocs.aspx?doc=pressreleases/2008/067.htm&page ID=003&min=njs&Year=&DocType= Acharya, V, Richardson, M., Roubini, N., & philippon, T., (2009). The financial crisis of 2007- 2009: causes and remedies. Financial Markets, Institutions & Instruments, 18(2); 89- 137. Ryan, G., (2008). Accounting in and for the subprime crisis. Accounting Review, 83 (6); 1605- 1638. IASB. (2008a). Reducing complexity in reporting for financial instruments. Discussion Paper, London. IASB. (2008b). Reclassification of financial assets – amendments to IAS 39 financial instruments: recognition and measurement and IFRS7 financial instruments: Disclosure. London, October 13. Godfrey, J., & Chalmers, K., (2009). Globalization of accounting standards. UK.: Edward Elgar Publishing. Read More