How to Fix a Financial Document-the Subprime Mortgage Crisis - Literature review Example

How to Fix a Financial Document PART 1 According to Bogoslaw , the recent subprime mortgage crisis in 2008 which has resulted in the global financial crisis which has blown apart the buoyancy of investors and there is an immediate need to enhance accuracy and intelligibility in the presentation of financial datas to boost the confidence of investors around the world. Subprime mortgage can be explained as an inferior class residential mortgage that is secondary to prime mortgage. The economists have warned that it is necessary to reform and regulate the financial markets around the world from the lessons learned from the subprime mortgage crisis. Subprime mortgage crisis has strengthened the need for the way and manner in which listed companies should reveal their financial datas. Majority of the subprime mortgages was securitised through a new kind of risky financial instrument namely “ Collateralised Debt Obligation “ ( CDOs) and marketed in the global financial market as coupon bearing bonds. Banks and financial institutions all around the world have invested in CDOs which infected badly the networth of these banks and financial institutions. Critics are of the view that the main culprits were the existing accounting standards employed by the companies as they depicted the financial of the company inaccurately. There is a necessity to enhance the financial intelligibility and dissemination so as to boost the confidence of the investors. The main issue is that the majority of the companies failed to offer an accurate and an exhaustive dissemination of their financial worthiness, which is mirrored by incomplete dissemination of liabilities, not reflecting the real value of the assets and aggregate risk on balance sheets of companies around the world. Both the financial regulators and analysts have demanded that there should be an enhanced transparency in the revelation of accounting info by companies. Banks which suffered negative networth due to subprime mortgage crisis have called for fair-value accounting for diminished assets is to be annulled to permit the deteriorated credit markets to resurrect. William Isaac damned the Financial Accounting Standards Board’s regulation demanding that the assets should be measured as per current market value despite the fact there existed no market for such assets. This rule would compel the companies to write off the values of such impaired assets, which would end in a decrease in equity and would hamper the future funding from banks. On September 2008, due to pressure exerted from financial –service industry for annulling fair-value accounting, “U.S Securities & Exchange Commission (SEC) and the Financial Accounting Standards Board “released a ruling that permits companies to value their assets employing their own judgments and financial models in the absence of any market for such investments or assets or when the assets are disposed off at fire-sales prices. As per Paul Miller, management has the onus to investors to abreast the developments in capital markets and about the company’s eventual cash flows and proposed usage of any capital that would be raised. The share prices of a company may be plummeted if the management resort to illusionary earnings by providing financial information that is hard to be trusted and to be reliable. Miller has stressed that both “off-balance sheet financing and pension –fund accounting under U.S Generally Accepted Accounting Principles (GAAP)” should be reformed immediately. To revamp the current lease accounting procedures, both IASB and FASB are in the efforts to draft a standard that would specify that all the companies should disclose their leases by way of capitalisation in their balance sheets. Miller also points out that new FAS 158 in the US is demanding the companies to net off their pension liabilities and should depict the same in the balance sheet instead of showing them in the footnotes. Due to the global financial crisis, the investment about $ 1 trillion of pension funds had already lost their original face values and there is a need to divulge these anguished assets to present real value in the balance sheets. As per Kenneth Scott of Hoover Institution , though Collateralised mortgage obligations ( CMOs) can still be regarded as a reliable security by enhancing the transparency but issue with these assets emanated from the redesigning the less viable CMOs along with CODs and with “CDO squared “ –a variety of derivative products from another derivative. According to Scott, once repayment of mortgages was abruptly stopped by the low-income people due to the financial crisis, the losses were surmounting, and it was not able to accurately assess the actual loss due to non-availability of the data bank about these CDOs and CODs and the rating agencies may help in this regard as they have already collected data’s about these derivative instruments. As per Walter Pagano, the investor confidence in the market can be boosted by implementing severe capital norms and demanding to keep liquid assets in large volume than in the past. Walter Pagano also suggested that to have more current debt to capital ratios and to have more corporate governance of various issues pertaining to balance sheets of companies may reduce these types of future losses. As per Philip Moyer, use of XBRL in the U.S would facilitate to establish a common set of tags for line items on the balance sheet of companies, which would permit analysts to compare and contrast between companies. According to Cindy Fornelli, investors are in a necessity to access to mechanisms that will facilitate them to make deeper analysis of financial statements of any company. Fornelli is of the opinion that companies should initiate to publish major performance pointers in their financial reports for their specific industry, and this will facilitate investors to analyse and compare between competing industries on the voluntary basis. As per Christine DeFabio , the issue is not restricted to financial reporting and accounting, but it also includes broad-footed practices across the business atmosphere which includes the corporate’s capacity to pool cash and access to capital. Part II Fair Value Accounting of Impaired Assets As per Bogoslaw, many companies and banks during the subprime mortgage crisis, failed to divulge an accurate and a complete illustration of their financial status, which is mirrored in poor disclosures of liabilities, asset values, and general risk on balance sheets of companies. As per SFAS 144, an impairment loss is to be acknowledged if the carrying cost of a long-lived asset is not recoverable immediately without any fire-sales. This standard also stipulates that an asset should be tested for impairment if the changes or events in current scenarios point out that the assets carrying value may not be recoverable. As per IAS 36, impairment loss happens when carrying amount of an asset surpasses the recoverable amount from such an amount. Further, under IFRS, impairment losses were recognised early than under U.S GAAP. During the subprime mortgage crisis, many companies failed to recognise the signals that impairment losses may have happened. If a company intentionally omits to record the impairment losses, then it is tantamount to a fraud on the part of the company both under IFRS and U.S GAAP. (Zack 2010:104). Bogoslaw stresses that fair value accounting for impaired assets is necessary to reflect the company’s true value of the assets that have been impaired due to financial crisis or passage of time. For example, AIG collapse was due to CDS on CDOs supported by subprime mortgages, yielded collateral calls and unrealised valuation losses that surrounded AIG in the year 2008. AIG witnessed the risks of falling mortgage markets, due to abhorrently insufficient risk control and valuation of impaired securities as collateral calls surmounted unexpectedly. (Warren 2010:24). IFRS demands that all long-term assets must be re-evaluated annually for any reversal value. This is a poignant deviation from GAAP while the IFRS and GAAP are striving to unite on the cannons of impairment testing and accounting as impairment accounting and testing do prolong to be confront even now.( Oxford Business Group 2010:267) Thus, I agree with Bogoslaw view that in resisting to the pressure to annul fair-value accounting, the SEC issued a new ruling that companies are permitted to employ their judgement to value an impaired asset or to employ their own financial model in the absence of any market for such an asset or when it being disposed off at fire-sale price. Off- Balance Sheet Financing Risks Off-balance-sheet transaction in a financial statement may happen due to derecognition norms in which assets are transferred through securitisation from the balance sheets or through grouping of such SPEs. It is to be observed that though Section 401 of SOX is intended to enhance the control over off-balance –sheet arrangements, but this section never stops giant global banks from concealing their subprime mortgage coverage with their use of the off-balance-sheet mechanisms. In the case of Citigroup, investors were unknown about the giant risk vulnerability from the subprime mortgage market when these were bought back by the new CEO, Vikram Pandit which was known as qualified special –purpose entities (QSPEs) back on its balance sheet. In January 2008, Citigroup had promptly written off the part of an $18 billion from the off-balance- sheet amount. Under IFRS, high-risk mortgages can be kept off balance sheet with the employment of such QSPEs. (Tarantino & Cernauskas 2009:95). There are poignant variance in the treatment of off-balance sheet structuring between US FASS and IASB. Both FASB and IASB are moving speedily to converge with their off-balance sheet norms with the aim that off-balance sheet risks be obviously recognised and presented in the financial statements. For instance, IAS 39 makes coverage of off-balance sheet arrangements and is more preventive in authorising their usage than the analogues' U.S standard namely FAS 140. However, there are some proposed amendments to FAS 140, which would make more arduous to decertify the assets than in the past. (Tarantino & Cernauskas 2009:95). Pension Funds Accounting It is to be noted that during the subprime mortgage crisis in 2008 alone, about 1,500 the giant public companies from U.S.A have lost an aggregate of $280 billion from their pension funds. Majority of the subprime mortgages was securitised through a new kind of financial instrument namely “ Collateralised Debt Obligation “ ( CDO’s) and marketed in the global financial market as coupon bearing bonds. Major financial institutions around the world invested in CDO’s. Rating agencies have given high ratings for these instruments. Because of AAA ratings, major insurance companies, hedge and pension funds and much government owned institutions around the world made their investments in these bonds. The major portion of these bonds was sold to pension funds and European banks. (Brownell 2008:51). Pension liabilities that run through the shareholder’s equity are impulsive, subject to the vagaries of the financial markets, and if it is incorporated, would make large swings in the ROIC (Return on Capital Employed) which are just mirroring the financial markets. For instance, the accrued pension liability of Lockheed Martin’s increased to $12.2 billion during 2008 from just $1.2 billion mainly due to an unrecognised, large actuarial loss emanating in part from a giant decline in the equity markets and a decline in the discount rate employed to project pension fund benefit obligations. For the funded status of the pension plans, SFAS 158 has changed the reporting requirements (Hackel & Kenneth 2010:256). Generally , companies will recognise the overfunded or underfunded status of a defined pension benefit postretirement plan either as a liability or an asset and recognise any changes in the funded status in the period in which such modification happens through accumulated other widespread loss or income , which is a part of the stockholder’s equity.( Porter & Norton 2010:13). It is to be observed that FAS 158 transforms not the substance of display of a company’s pension commitments. Due to recent changes in the reporting under FAS 158, major financial ratios will be impacted. There will be a decrease in the assets and equity for those companies which has overfunded pension plans and their liabilities is expected to increase in case of companies, which have underfunded pension plans. Due to categorisation of unamortised pension impairments or gains or earlier service charges, there is likely to happen some changes in the company’s financial ratios. However, in general, the categorisation of pension-associated items of liabilities, equity and assets have the lesser impact on companies. Due to subprime mortgage crisis, many of the pension fund investments were affected, and this has resulted in the negative changes in the financial ratios of these companies, and hence it had negative impacts on the images of these companies. (Paik & Lark 2008) As per Miller, new FAS 158 in the US is demanding the companies to net off their pension liabilities and should depict the same in the balance sheet instead of showing them in the footnotes. Due to the global financial crisis, the investment about $ 1 trillion of pension funds had already lost their original face values and there is a need to divulge these anguished assets to present real value in the balance sheets. Off-Balance Sheet Financing – Lease Accounting In the mid 2009, a movement to homogenise international accounting regulations, with the FASB and the IASB which aligns towards this target of reforming the lease accounting. Treatment of leases has been identified as one of the vital elements for reformation to be achieved. It seems that both IASB and FASB will need all leases to be capitalised despite the fact that these are now grouped as operating leases. Thus, this change in grouping would have a grave impact on many corporate financial statements. For instance, Credit Susie projected that the S&P 500 companies would employ about $369 billion in assets that are in the guise of operating leases. Thus, these operating leases have not been reported either as liabilities or assets, and instead they have been treated as off the balance sheets. Grouping these leases on the balance sheets by capitalising them would enhance the average liabilities by about 2% but the overall effect would be much greater for some companies. Though it may be agonising to some companies, but definitely it would assist the investors to recognise a company’s liabilities and obligations. (Brigham & Ehrhardt 2010:740) Part III Eliminate Or Restrict Off-Balance Sheet Vehicles: Stricter accounting rules should be issued by IFRS on the off-balance sheet risky investments and should demand adequate and sufficient capital to corroborate them. For instance, Spanish central bank was approached by some local banks to permit them to start a special investment vehicle which would allow them to establish special network investment vehicles to benefit from off-balance sheet holdings of mortgage-supported CDO’s without earmarking sufficient capital to support them. However, Central Bank of Spain denied permission without charging an 8% capital charge on SIV (Special Investment Vehicle) assets. This deterred their efforts to deal in CDO’s and thus saved them from losing their capital later. (Crotty & Gerald 2008: 7). Implement More Regulatory Over-Sight To the “Overshadow Banking Setup."” The phantom banking system through its SIV or off-balance sheet structure had been actually responsible for the current global crisis. This shadow banking setup should be brought under government regulatory control. Investment banks should be asked to file compliance report on a mandatory basis to SEC to avoid such a grave financial crisis in the future. New IFRS accounting guidelines should be issued to cover these shortcomings. (Crotty & Gerald 2008: 7). To Introduce A Financial Safeguard Method Central Bank or government should introduce pre-approval procedure for new financial innovative, risky products like CDO’s etc., For instance, the US Food and Drug Administration is the supervising authority to decide whether to allow a new drug in the market or not. New IFRS accounting guidelines should be issued to report the value of these securities in the companies’ balance sheets, to control and regulate such securities with adequate risk control measures. (Crotty & Gerald 2008: 7). Other Important Recommendations In general, as evidenced by the recent subprime mortgage crisis, the theory of efficient capital markets should not be encouraged hither after. Serious financial regulatory reform should be introduced and implemented. To avoid the future financial crises, we should immediately introduce powerful laws and international accounting guidelines to plug the loophole that exists in off-balance sheet pension liabilities, off-balance sheet lease accounting, new accounting guidelines for innovative financial instruments like COD s etc and to have effective checks on financial markets and compel them to act in the public interest. (Crotty & Gerald 2008: 11). List of References Brigham E F & Ehrhardt M. (2010). Financial Management: Theory and Practice. New York: Cengage Learning. Brownell, Charles. (2008), Subprime Meltdown From U.S Liquidity Crisis to Global Recession. New York: Solving Difficult Sudoku. Crotty James & Epstein Gerald. (2008). Proposals for effectively Regulating the U.S Financial System to Avoid Yet Another Meltdown. Massachusetts. University of Massachusetts Press. Hackel C FA & Kenneth S. (2010). Security Valuations and Risk Analysis. Assessing Value in Investment Decisions. New York: McGraw Hill Professional. Oxford Business Group. (2010). Report: Qatar 2010. Oman: Oxford Business Group Publishing. Paik, Gyung & Lark, Jeff. (2008). ‘The Impact of the New Pension Accounting Rules (FAS 158) on Financial Statement Analyses.’ Journal of Academy of Business and Economics. Vol 8 (1). Porter, Gary A & Norton, Curtis L. (2010). Financial Accounting: The Impact on Decision Makers. New York: Cengage Learning. Tarantino A & Cernauskas D. (2009). Risk Management in Finance: Six Sigma and Other Next-Generation Techniques. New York: John Wiley & Sons. Warren Elizabeth. (2010). AIG Rescue, It’s Impact on Markets and the Government’s Exit Strategy. New York: Diane Publishing Co. Zack, Gerald M. (2010). Fair Value Accounting Fraud: New Global Risks and Detection Techniques. New York: John Wiley & Sons. Read More