Is Financial Reporting Culpable in Whole or Part for the Global Financial Crisis - Example

Accounting did not cause the crisis. Is financial reporting culpable in whole or part for the global financial crisis? Bear Stearns and Lehman Brothers collapsed; AIG was bought out by tax payers, after going bankrupt, Washington Mutual was seized by the US Federal Regulators; DJIA plunged to one-third of its value, evaporating the value from the retirement funds and college savings. Unemployment rose and number of home foreclosures shot up. USD 700 bail out was passed by the US Congress – this is a snapshot of the economic crises, business scandal and the financial disaster that took the whole world by storm. The reasons for the crises are yet to be certain; it is believed that greed and corruption are the sole reasons for the economic crises. Fraudulent parties involve business executives, who lied to analysts, credit rating agencies that over rated securities, mortgage lenders who falsified loan documents. The blame cannot be casted on intentions but incautious approach in creating new products and services and persuading people to buy and invest was. Former Federal Reserve Chairman, Alan Greenspan (2008) pointed out that “once in a century credit tsunami” occurred because of the quantitative default in the complex economic valuation models; Christopher Cox (2008), head of SEC pointed out that the credit default swaps acted crazy, as opposed to its theoretical functioning. But nothing can be singled out as a prime reason; the world of finance is and was entwined and entangled with complex interrelationships and interdependencies. Not only the corporations but role of regulators played a significant role in fueling the turmoil; the excessively loose macroeconomic policy, inadequate regulation of the sub-prime mortgage market, loose control of the credit rating agencies and the lack of centralized clearing house for credit derivatives amongst all. As the credit crisis unfolds, we will hereby review first the role of financial accounting, auditing, management accounting and the regulatory institutions that oversee the accounting and auditing practices and later come to determine if it can be held out as sole reason for the crisis. Financial reporting is the outcome of the external audit; it is a tool to entice public’s trust in the performance of the corporations and the management. Financial reporting as seconded by the external auditors reassures all the stakeholders to have a financial interest in the company, as deemed by the Committee on Financial Aspects of Corporate Governance (1992). Over time, investors have relied on the financial statements of corporations, and so does the regulators to infer their conclusions regarding liabilities, risks, economic exposures. But, here comes the problem, as this doesn’t show the true picture. For example, take banks into view, although there were multiples of accounting standards, and disclosure requirements but probing gives us a clear outlook. In addition to the assets and liabilities on the balance sheet, there was approximately a USD 500 billion, they were holding, off-balance sheet! Inflated real estate and derivatives values, soared company’s profits and minimized the visible risks of company operations. Reuters (2008) quoted that accounting led to creative fiction about and sludge assets kept clogging up the balance sheets. Among the many reasons cited as the causes of crisis, some include: Imprudent mortgage lending by relaxed lending regulations and credit history Housing bubble Global imbalances in deficits and surpluses of various nations Securitization of sub prime loans packaged as AAA bonds Lack of transparency and accountability in mortgage finance Failure of rating agencies Mark to market accounting as FASB required institutions to report prices of the securities at the current market levels Deregulatory legislations that permitted engagement in risky transactions Development of shadow banking system that allowed risky financial activities to be a domain of non banking financial institutions Non bank runs caused by liquidity problems Off balance sheet financing Government mandated sub prime lending for low income borrowers Failure of risk management systems Financial innovations and complex transactional instruments with which regulators, accountants, rating agencies were still unfamiliar Bounded rationality resulting from behavioral finance Bad and complexly built computer models Excessive and relaxed regulation of leverage because of loose monetary policy Speculative and risky credit default swaps Over the counter derivatives Narrow mindedness towards short term incentives (Jickling, 2009) Financial reporting forms a fundamental foundation for insolvency and credit rights, corporate governance, insurance and banking supervision, and securities regulation. This reporting is derived from accounting and the auditing standards. The quality of financial reporting thus becomes imperative because it has its linkages to economic growth. Financial information from accounting and auditing leads to private sector growth, which leads to job creation, financial sector growth which leads to improved access to credit; and leads to development of capital markets. The cycle has its roots in Martin Gruell’s following words: “No transparency, no trust; no trust, no credit; no credit, no investment; no investment, no growth! So there is a simple logic: financial reporting is an essential building block for financial intermediation, foreign investment, and sustainable economic development.” An evident example is from Lehman Brothers, on its year ending 2007 annual accounts, the company received an unqualified audit opinion, but later on its first quarterly accounts of 2008 (Jan to Mar), it received a healthy opinion from the auditors. As time passed, the healthy bill could not do any good to it, the investment bank ran into financial trouble in August 2008, and declared bankruptcy on 14 September of the same year. According to US Securities Exchange Commission, 2008, Bear Sterns, America’s fifth largest bank, Carlyle Capital Corporation, another of America’s second largest mortgage provider, the Thornburg Mortgage all received unqualified audit opinions from their auditors and very soon ran into liquidation, bankruptcy etc. This situation raises concerns and doubts on the financial reporting and the intentions of the auditors, there is seen a potential conflict of interest – because statutory role of auditors, is in conflict with their arrangements with the financial institutions. Therefore, when we wonder whether the financial reporting adds credibility to the financial statements and serve the purpose that it is designed for – the look into the financial health of the corporation for the various stakeholders, including investors – there are some concerns regarding it. The trust on auditors is also shattered because it is assumed that they carry inside knowledge about the corporations. The sentiments derived from the audit opinions do not suggest so. Whereas, looking from the auditors perspectives, cannot be ignored and so the financial reporting is not solely to be blamed for the occurrence of the financial crisis, since the events unfolded so suddenly that auditors did not get enough time to make any judgments to the same (Prem Sikka, 2009). This leads us to the underlying level of the knowledge of the auditors regarding the financial innovations that had eclipsed the whole financial world. Though, the maturity level of these innovations was at a stage of onset, where the penetration into these instruments should not have increased to a substantial size even, but motivations of greed and profit lured investment bankers to channelize investors’ savings into these unproved areas yet. Foremost, the understanding about the ‘derivatives’ which have proved to be fatal for both financial and non financial businesses was weak. The US Government bailout of Long Term Capital Management showed that even the Nobel Prize winners had difficulties in valuing derivatives (Dunbar, 2000). The concept of Fair Value Accounting (FVA), also known as marking to market in the financials, for the financial reporting purposes has been under debate for some time. There are proponents and opponents in favor of FVA; the proponents argue that FVA has played a role of proverbial messenger (Turner, 2008; Veron, 2008) and opponents say that it contributed to the worsening of the crisis. With FVA the price of the assets and liabilities is determined, which is placed on the balance sheet. Under the IFRS rules, Fair Value is that price at which an asset could be exchanged and liability settled among the parties to the exchange. But under US GAAP and IFRS, there are rules based on classification, indicating which items are to be reported at fair value and which at historical cost. Based on their classification, the unrealized gains and losses reported may or may not affect the net income. Because of FVA’s procyclical nature and its ties with the accounting system, the financial crisis may become a self-fulfilling prophecy, which triggers the sale of assets. Alen and Carletti (2008), pointed out that FVA in its pure form, can create contagion effects. Driving to conclusions, after all this it is obvious that accounting and financial reporting played a role in accelerating the financial crisis; but in practice they cannot be solely blamed for the downfall of the economies all over the world. Because, bearish levels of interest rates, role of investment bankers in financial innovations, oversight of the regulators, governments support towards sub prime mortgage lending, housing bubble, role of rating agencies and behavior of the investors compiled led to all of it. These intricate independencies could not be separated out. References Allen, F., & Carletti, E. 2008. Mark-to-market accounting and liquidity pricing. Journal of Accounting and Economics. Cox, C. 2008. Testimony: Lessons from the credit crisis for the future of regulation. The financial crisis and the role of federal regulators. Hearing before the Committee on Oversight and Government Reform, House of Representatives, 110th Congress. Committee on the Financial Aspects of Corporate Governance, 1992. The financial aspects of corporate governance (Cadbury report). London: Gee Dunbar, N. 2000. Inventing money: The story of long-term capital management and the legends behind it. Wiley. Greenspan, A., 2008. Testimony. The financial crisis and the role of federal regulators. Hearing before the Committee on Oversight and Government Reform, House of Representatives, 110th Congress. Hegarty, J. 2009. Financial Stability and Financial Reporting Learning from the Crisis – Rebuilding Trust Jickling, M. 2009. Causes of the financial crisis. CRS Report for Congress Sikka, P. 2009. Financial crisis and the silence of the auditors. Accounting, Organizations and Society, Vol. 34 Read More