The Social Economic Context of Financial Accounting and Reporting - Essay Example

THE SOCIAL ECONOMIC CONTEXT OF FINANCIAL ACCOUNTING AND REPORTING Name Institution Date Abstract Financial statements information such as the report given on; income statement, balance sheet, or cash flow statement is significant input while evaluating a company. Accounting and financial reporting have significant consequences that are beyond the finance and economics. Financial reporting in form of IFRS has negative consequences globally. This negative effect has been discussed in the context of Lisbon Treaty. In addition, effects of financial reporting in this paper have been described in relation to the experience of China in 2000. Fair value accounting is the dominant paradigm used in evaluation of finances and is an ever present notion when evaluating different non-financial elements. In the past few decades, reporting model that has been founded on cost and transaction, has become obsolete and has been replaced by market-based-value. This paper describes how financial reporting especially the fair value accounting (FVA) has the ability to cause conflict between managers, stakeholders and the employees. As a result, the gap between the poor and the rich becomes wide. This paper has focused on the effect of fair value accounting in United States as well as in China. THE SOCIAL ECONOMIC CONTEXT OF FINANCIAL ACCOUNTING AND REPORTING Introduction Accounting and financing have been viewed as mechanical, neutral and objective processes. They play the role of helping the interested parties to understand the economic position of a firm. Financial statements information such as the report given on; income statement, balance sheet, or cash flow statement is significant input while evaluating a company (CFAI, 2013, P. 5). According to Palea, accounting and financing should be embraced as powerful calculative practices within an institutional context and that have power to shape economic and social processes (Palea, 2015, P. 2). Pale holds that, based on Lisbon Treaty financial reporting particularly in the form of IFRS impacts negatively on the European context. The impacts can be felt especially on the social market economy leading hindering promotion of social injustice and inequality. The short term focus of IFRS and in particular FVA has the potential to lead to conflicting relations between managers, employees and other stakeholders, to widen the gap between rich and poor, and to contribute to a decline in working conditions (Palea, 2015, P. 4). These all have social consequences. This paper is aimed at discussing accounting and financial reporting in terms of social, ethical, and institutional consequences. Meaning of Fair Value Accounting and how it is used in IFRS Fair Value Accounting refers to the price that is usually received when an asset has been sold or the price that is paid so that a liability could be transferred. The price is given through a transaction that can be deemed orderly between parties participating in a market and at the measurement date. This price is considered as being more relevant as well as more reliable as compared to the historical cost (Taplin et al, 2014, p. 102). Advocates of fair value accounting held that it serves the purpose of providing to the market information that is relevant and transparent. This means that fair value accounting instils market discipline and acts as an early cautioning system (Power, 2010, p. 199). Fair value accounting is the dominant paradigm used in evaluation of finances and is an ever present notion when evaluating different non-financial elements. In the past few decades, reporting model that has been founded on cost and transaction, has become obsolete and has been replaced by market-based-value. The implication of this move has become important when it comes to evaluation of the role as well as the characteristics of the financial statement. Evaluating critically the current conceptualization of the application of the fair value accounting, one is able to identify the pros and cons associated with its use (Bonaci & Tudor, 2011, p.197). Fair Value Accounting and Reporting Failures Associated to Global Financial Crisis In the contemporary world, the form of corporate organization has become complex and global capital markets have led to new challenges within the corporate world. Some of the challenges have emanated from the way organizations are run. The modern corporate forms are characterized by a separation of management control and organization ownership. The owners of an organization who happens to be the stakeholders hold differentiated portfolios. Consequently, they are never involved in the day-to-day management of the organization’s activities. Instead, the shareholders appoint managers to run the activities of the organization on their behalf. However, the interests of the shareholders and those of the managers may not align perfectly and this may lead to crisis. In such a scenario, managers may act as opportunists to pursue their individual interests instead of pursuing the interests of the shareholders. Irrespective of the presence of external and internal evaluation mechanisms put in place to protect the interest of the shareholders, such opportunism acts may still take place. Failures such as the crisis of the sub-prime mortgage in 2008 as well as the accounting scandals experienced by corporations such as WorldCom, Enron, and Tyco was indication that corporate governance or even market monitoring mechanisms are ineffective (Henry et al, 2015, p. 67; Power, 2010, p. 199). There are several critical issues associated with the application of fair value reporting. It is important to understand that all accounting standards and in this case fair value accounting must be evaluated in the light of how they are consistent with the various objectives made by the European Union as outlined in the Lisbon Treaty. At the time of the latest financial crisis, fair value accounting captured the attention of many stakeholders including global accounting and banking regulators, US congress as well as the European Commission. The critics were for the view that fair view accounting made significant contribution towards financial crisis and also intensified the finance crisis in financial institutions in the whole world. Others argued that fair value is irrelevant and can be very misleading when valuing assets that have been held for a long time and more so for those assets that have been held to maturity. The argument was that prices can be distorted by various factors such as; investor’s irrationality, market or even liquidity issues (Palea, 2015, p. 5; Power, 2010, p. 200). Fair value can be considered as a cause of crisis as explained below. It has been considered as having procyclical impacts on real economy financing. The former FDIC (Federal Deposit Insurance Corporation) Chairman, William Isaac, held that the regulation of fair value accounting was the major cause of the latest financial crisis (Palea, 2015, p. 5). This claim was supported by many scholars who argued that fair value reporting lead to a downward trend in financial markets which in turn worsened the recent crisis and intensified the credit-crunch. For instant, in the year 2007, there was an emergence of a noteworthy signs of weakness within the real estate market in United States. In addition, the mortgages non-payment resulted in an abrupt increase in foreclosure of the real estate market. As a result there was a downgrading of striking financial instruments like securitized mortgages which took the likeness of CMOs (collateralized mortgage obligations) which in turn resulted to a negative impact on their prices. Additionally, the financial crisis was worsened by the derivative markets which were negatively affected by defaulters who failed to pay the mortgage assets. Due to mark-to-market regulations, the financial institutions’ asset values and more so for the mortgage- backed securities went down significantly. In this state, the market was so distressed and it became so difficult to disperse these securities and compounded by lack of demand for the securities, their market values declined. The banks were forced to disperse their securities due to the fear of contagion effect and this resulted into more depressed prices forcing write-downs. Consequently, banking institutions incurred huge losses which in turn impaired their ability to give loans significantly, inducing a domino effect (Palea, 2015, p. 6). Allan and Carletti gave different account on how fair value reporting led the crisis. They argued that at a time when market-to-market accounting comes to application, the financial institutions’ balance sheets are influenced by the short-term market fluctuations which actually fail to give a reflection of their fundamentals (Plantin et al, 2008, p. 88). At the time of financial crises, the prices of assets are normally a reflection of the liquidity amount but not of the asset’s cash flow in the future. The asset fair values may as a result go below the liabilities in such a way that banks become insolvent irrespective of their ability to cover their commitments entirely if the assets were allowed to reach maturity. Similarly, Platin indicated that mark-to-market accounting causes an artificial volatility within the financial statements. Instead, it reflects the accounting norms’ consequences rather than reflecting the actual underlying fundamentals and this distorts the actual decisions. According to their analysis, the negative impacts of mark-to-market accounting are particularly severe when it comes to long-lived assets, illiquid assets and senior assets. Such assets are actually the key factors that attributes to the bank’s balance sheet as well as for the insurance companies (Palea, 2015, p. 6). How Financial Accounting and Reporting has Affected China The accounting system in China was dominated by historical cost principles between 1978 and 1996. However, a pilot fair value that was conducted between 1997 and 2000 led to an accounting reform that required the use of fair values in some of the sixteen accounting standards. The reform in the three accounting standards failed and it was discontinued in 2001. In 2006, China adopted new set of generally accepted accounting principles (GAAP) that were nationally accepted. The GAAP comprised of 38 standards and a conceptual framework. Among the standards was the fair value and for the first time it was formally recognized and accepted as a metric within the conceptual framework. The fair value was required in 25 out of the 38 standards and it has been in use to date. It appeared that between 2001 and 2006, there was a dramatic turnaround in China. The adoption of fair value accounting changed from being a total failure to a very successful achievement in China (Bewley et al, 2013, p. 3). Fair value accounting was introduced into China’s accounting standards between 1997 and 2000. This led to a several accounting scandals. This was because the fair value accounting allowed firms to recognize profits derived from debt restructuring as a source of income. It was witnessed that some listed firms converted net losses to profits just by engineering a debt reorganizing transactions meant to utilize non-monetary assets as a means of paying off debts. These firms then went ahead to claim the difference that was seen to exist between the fair value and the carrying value of the assets as a profit. Similarly, there were incidences where some listed firms allocated proceeds initially meant to be in the equity offerings to some of the shareholders who were mostly politicians. Fair value allowed non-monetary transactions to be effected and this had negative impacts on the few stakeholders who had no political connections. There were incidences where two firms using their majority shareholders exchanged assets at a settled fair value which was higher than the book value acknowledged as a gain. From such as a transaction, the created gain would then be realized as cash or any other monetary assets. The net result was that the monetary assets that were realized through such dubious means were transferred the individual accounts of the corrupt shareholders instead of being utilized by the firms (Bewley, 2013, p. 20). In 2000, there was an official audit in 1290 large state organizations and the findings were that approximately over a third of these companies falsified their accounts. The illegal money exceeded US$12.5 billion. The falsification of accounts was linked to the abuse of fair value accounting. As a result the enormous abuse, the China’s Ministry of Finance revised the presence of fair value accounting standards in 2001. This was only a year after non-monetary asset exchange had been released and only two years after investment standards and debt restructuring standards had been released. The resulting action was that the fair value accounting was suspended completely after the accounting standards were revised. The fair value accounting was then replaced with carrying value. Since that time, firms were not allowed to acknowledge gains obtained from restructuring. Instead, gains were not allowed to be directly credited to equity (Bewley, 2013, p. 20). Fair value accounting abuse in China was linked to poor corporate governance as well as due to immature capital markets. It had become difficult to define a fair value for assets that were non-monetary in a circumstance where an active market having quoted prices never existed for most of such assets. Similarly, in most cases debt restructuring and non-monetary transactions in China were related-party transactions. As a result, some listed firms misused the policy and window-dressed their individual financial statement. Despite the fact that the fair value accounting was suspended immediately, China incurred significant economic and political costs. In the first place, the regulations were no more consistent with the IFRS and as result, China’s efforts to get integrated into the global economy were impaired. This was because comparing financial reports of the listed companies in China with the firms that were compliant to the IFRS was not possible. Secondly, the embraced revised regulations did not seem fair to the creditors. On the other hand, the restructured debt at this point was only recognized on the side of the creditor’s account as carrying value instead of fair value. This meant that any resulting loss yielded no tax benefits due to the fact that it was identified directly in equity rather than on the income statement. The crisis that was experienced was that there was friction for firms that sought debt financing (Bewley, 2013, p. 21). The suspension of fair value accounting did not enable the Ministry of Finance to achieve its goal of eliminating fraudulent reporting. It was reported that firms could conform to the revised regulations but somehow could still employ creative accounting techniques to bypass the standards. However the impact was not as severely experienced compared to the time fair value accounting was being used (Bewley, 2013, p. 21). Conclusion Financial reporting has significant impacts on various constituencies. Negative impacts associated with misuse of the financial reports affect not only the firms, but also the simple employees, stakeholders as well as a government as a whole. It is therefore important to consider accounting standards in regard to social-economical context. The effect of inappropriate use of the accounting standards has been felt at global level affecting both developed and developing nations. BIBLIOGRAPHY Bewley, K., Graham, C., & Peng, S. (2013). Financial Reporting and Auditing as Social and organizational Practice: Towards Understanding How Accounting Principles Become Generally Accepted: The Case of Fair Value Accounting Movement in China. [Online] Available fromhttp://www.lse.ac.uk/accounting/Seminars-and-Workshops/AOSworkshop/BEWLEY.pdf Bonaci, C. G., & Tudor. T. (2011). Fair Value Emphirical Studies: An Overview on Accounting Research Literature. [Online] Available from http://www.oeconomica.uab.ro/upload/lucrari/1320112/01.pdf CFA I Institute. (2013). Fair Value Accounting and Long-Term Investing in Europe: Investor Perspective and Policy Implications. http://www.cfainstitute.org/ethics/Documents/fair_value_and_long_term_investing_ineurope.pdf Henry, T. F., Murtuza, A., & Weiss, R. E. (2015). Accounting as an Instrument of Social Justice. Open Journal of Social Sciences, Vol. 3. Palea, V. (2015). The Political Economy of Fair Value Reporting and the Governance of the Standards-Setting Process: Critical Issues and Pitfalls from a Continental European Union Perspective. Critical Perspectives on Accounting, Vol.29. Plantin, G., Sapra, H., & Shin, H. Song. (2008). Fair Value Accounting and Financial Stability. [Online] Available from https://www.princeton.edu/~hsshin/www/BdFFSRmtm.pdf Power, M. (2010). Fair Value Accounting, Financial Economics and the Transformation of Reliability. Accounting and Business Research Journal, Vol. 40, No. 3. [Online] Available from http://www.lse.ac.uk/accounting/pdf/MKP%20Accounting%20and%20Business%20Research%20%283%29.pdf Taplin, R., Yuan, W., & Brown, A. (2014). The use of Fair Value and Historical Cost Accounting for Investment Properties in China. Australian Accounting, Business and Finance Journal, Vol. 8, No. 1 Read More