Global Financial Recession - Literature review Example

Introduction During the past two years, the entire world has been affected by a global financial recession tagged as the “longest and deepest since the 1930s” (Cooke, Feb. 2009). Although the effects were readily obvious and measured, the question as to why the financial recession happened in the first place was not readily (or satisfactorily) answered. One area receiving such blame is financial reporting. Critics have pointed out that accounting rules have brought about the financial recession or have made it worse. In particular, mark-to-market accounting was said to have caused more sufferings for banks and financial institutions. Defenders of financial reporting, on the other hand, said that the accounting standards did not cause the crisis; instead, bad credit management and illiquidity were the primary suspects for the financial crisis. Ignoring everything else, did financial reporting really cause the crisis? Or was it just a convenient scapegoat for those who really caused the crisis? This paper attempts to answer whether or not financial reporting really caused the financial crisis, in part or in whole. The Blame Game Defined by BusinessDictionary.com as a “period of general economic decline”, the world has seen higher unemployment rates, sluggish wages and decline in sales in the retail industry because of this financial recession. It also started a widespread blame game as to what or who caused the crisis. In a poll conducted by Time Magazine, there are said to be 25 people to blame for the crisis, including former US presidents, government officials, regulators, heads of financial institutions and even, the American consumers. In a March 31, 2009 article by MarketWatch.com, 80% of those who responded on the survey conducted by MarketWatch said the blame should be “on banks and other financial institutions”. Other people says that “economists must bear blame for recession” (Skidelsky, April 25, 2009) because of their push for deregulation and free market. Still others blame accounting rules; particularly the “mark-to-market accounting” (Kestenbaum, Oct. 29, 2008) rule, which when applied to the financial statements caused the financial position of the company to go down. Is Financial Reporting to Blame for the Financial Crisis? Is financial reporting the reason behind the current financial crisis or the global financial recession? The straight answer from this writer is NO, financial reporting did not cause the crisis. However, to give weight to both sides, the following is a brief discussion on why experts think financial reporting is or is not to blame for the current financial crisis. Yes, Financial Reporting is to Blame For quite a number of people and even experts, the answer is yes. Or more precisely, the blame is on the requirement of mark-to-market accounting. In his letter to the US Securities and Exchange Commission or SEC dated Oct. 29, 2008, William M. Isaac, former chairman of the US Federal Deposit Insurance Corporation, believes that “one of the biggest culprits is mark-to-market accounting promulgated…by the Financial Accounting Standards Board and accepted by the SEC” (2008, page 5). Mr. Isaac went on to say that the mark-to-market accounting forced banks to record short-term losses on their investments instead of giving banks enough flexibility to assess the recoverability of the investments’ costs. This meant showing investment values in the balance sheet that are “well below their real economic value” (Isaac, 2008, p. 6). In a separate paper, Michel Magnan, a Professor and the Lawrence Bloomberg Chair in Accountancy, wrote that although there is no definite conclusion as to whether accounting caused the crisis, “there is reason to believe that fair value accounting…may have contributed to the acceleration of the crisis, especially in the financial sector” (2009, page 13). In a separate article, two economists, Brian Wesbury and Robert Stein (2009), wrote that fair value (or mark-to-market) accounting should die. According to them, these rules “undermine the banking system…and make markets even less liquid”, which, in turn, hurt the economy and stunts (or even reverses) economic growth. No, Financial Reporting is Not to Blame On the other side of the coin, several experts and accounting standard-setting bodies do not believe accounting is to blame. According to Robert H. Herz, Chairman of the Financial Accounting Standards Board or FASB, in his June 26, 2009 speech to the National Press Club, “accounting did not cause the crisis and accounting will not end it” (page 3). Mr. Herz’s reply to the question on whether or not accounting is to blame for the financial crisis was echoed by other regulators or accounting experts. In its 211-page report, the US Securities and Exchange Commission (US SEC) observed that mark-to-market accounting (which is the specific accounting rule most commonly blamed) “do not appear to be the cause of bank and other financial institution failures” (2008, page 7). Instead, in the same report, the US Securities and Exchange Commission (SEC) observed that “the liquidity positions of some financial institutions, concerns about asset quality, lending practices, risk management practice, and a failure of other financial institutions to extend credit appear to be the primary drivers” (page 136). This made the US SEC not recommend suspending mark-to-market accounting. Why Financial Reporting Did not Cause the Financial Recession? Earlier, this writer wrote that the straight answer to the question of whether or not accounting caused the financial crisis is no. This section discusses the reason behind such an answer. The Purpose of Financial Reporting What is really the purpose of accounting or, more precisely, financial reporting? For some, it is simply to record and keep track of the daily transactions of a business. For others, accounting is a system used to prepare fairly accurate financial reports. Which leads us to the next question – what is the purpose of financial reporting? According to Paul B. W. Miller and Paul R. Bahnson (2009), professors in the University of Colorado and Boise State University, respectively, the primary “function of financial reporting is to promote economic growth and stability through efficient capital markets. It serves this function by helping users to assess the amount, timing and uncertainty of future cash flows”. By their purpose alone, accounting and financial reporting are geared towards the promotion of economic growth provided accounting rules are applied and followed diligently. This is in theory, what about in practice? Accounting in the Real World In the real world, accounting plays a dual role. According to Peter Christensen and Gerard Feltham (2004), accounting can take on a “decision-facilitating role”, where accounting “provides information that affects a decision-maker’s beliefs about the consequences of his actions” and a “decision-influencing role” where anticipating the accounting results “may be used to represent the predicted consequences” (page 1). In addition, according to FASB’s (2008) draft Conceptual Framework for Financial Reporting, the “objective of general purpose financial reporting is to provide financial information that is useful…in making decisions in” for “capital providers” (page 1). These roles mean that accounting has become a more dynamic tool than its simple recording, summarizing and reporting function. Accounting has now become the basis for decision-makers to formulate their decisions based on what they think will be the accounting results. However, the key words here are “facilitating and influencing” and “providing financial information”, which mean that financial reports are still only tools for decision-making. Accounting and the resulting financial information or reports, however, are not the only tools and these are not, by any means, always the correct tools. A well-informed decision-maker will not rely only on the financial reports but also on other sources as well. In fact, as Miller and Bahnson (2009) wrote, the financial information users (such as the capital markets) have, in general, access to not only the accounting information but also other non-related (but equally or more relevant) information as well. If these other information is more relevant and more realistic, the accounting information will be set aside for this information. Thus, accounting, in its entirety, cannot really single-handedly force any economy or market to go down as it is not the only one the market is relying upon to produce their much-needed information. Limitations of Financial Reporting Another reason why financial reporting is not to blame for the financial recession is that it has its limitations, making it not powerful enough to have caused the recession. According to the Financial Crisis Advisory Group or FCAG (2009), financial reporting “only provides a snapshot in time of economic performance and cannot provide perfect insights”. The dependency of financial reporting on reliable data, “well-functioning markets…proper infrastructure, and the use of…proper processes for price verification and…valuation of assets and liabilities” limits financial reporting and its effectiveness to the quality of these factors. In essence, financial reporting is only as good as the underlying data and the processes making these data. Financial Reporting Role in the Recession’s Resolution Perhaps the biggest proof that accounting or financial reporting did not cause the financial recession is the fact that there are a lot of people who believe that maintaining the accounting rules and even improving them (not correcting them) will play a vital role towards resolving the current recession and prevent it from recurring again. The International Accounting Standards Board (2008) has already taken steps “in response to the global financial crisis” such as new disclosure requirements, improving the “accounting for off balance sheet items” and ensuring that certain financial instruments accounting standards are followed accordingly. The FCAG (July 2009), which was specifically formed to address the crisis through the accounting point of view, has already presented its recommendations on the improvements of financial instruments, convergence of the IFRS and the US GAAP and continued consultation with the regulators. Conclusion In summary, financial reporting did not cause the financial recession, either in whole or in part. Financial reporting is only a tool that cannot be the only one used in analyzing the company, economy or the market. Financial reporting also has its limitations, making it unable to single-handedly cause a financial crisis. Financial reporting is only as good as the one who is analyzing the data or the underlying infrastructure processing the data contained in the financial report. It only shows a snapshot of time and is only responsible for capturing the results of the financial transactions and decisions. Lastly, the continuous thrust and the call for the improvements in financial reporting and accounting rules mean that accounting is not viewed as the one that caused the recession but as the one that can, ultimately, provide the solution to the current recession and prevent one from happening in the future. Works Cited 1. 25 People to Blame for the Financial Crisis. Time Magazine. http://www.time.com/time/specials/packages/article/0,28804,1877351_1878509_1878508,00.html (accessed September 27, 2009). 2. Christensen, Peter Ove and Feltham, Gerald A. 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