Reforms in accounting practices and policy

Reforms in Accounting

Over the last three years, the credit crunch and severe recession have had a profound impact upon the world of business. What happened was when the recession first began in 2007 many: banks, brokerage firms and insurance companies were over exposed to the subprime mortgage market in real estate. Simply put, a subprime borrower is someone who cannot qualify for a traditional mortgage (such as a fixed rate mortgage). The reason why is because these buyers have some kind of problem that is preventing them from being eligible for the traditional mortgages. This usually involves the buyer having: poor credit, no credit or lower income. With these kinds of mortgages, the lenders will offer a low introductory rate with little or no money down. When interest rates begin to rise, they will raise the interest that is being paid on the mortgage (which causes the monthly house payment to increase). Given the fact that these borrowers have a greater amounts of risk (from not qualifying under traditional mortgage standards), meant that once interest rates were rising, many subprime borrowers would not be able to pay their mortgages. This would set off a domino effect, as a wave of foreclosures would create a major financial crisis. The effects of this were so deep that some of the largest banks and Wall Street firms would collapse. (Reed, 2010, pp. 1 -- 10) A good example of this can be seen with the different banks that were taken over by the FDIC between 2008 and 2010. Where, they would close down a total of: 25 banks in 2008, 140 during 2009 and they have closed a total of 108 banks so far in 2010 (Suttmier, 2010). This is significant, because it shows how various accounting regulations have become ineffective. As a result, this would lead for calls in reforming the various accounting laws, to prevent such abuses from occurring in the future. To fully understand how to reform that nation's accounting regulations requires: examining the causes behind the financial crisis, how the accounting industry played a role in the collapse of many firms and possible ways that the laws can be changed to address these issues. Together, these different elements will provide the greatest insights, as to how the accounting industry can be reformed, to address the challenges that are currently facing private business.

The Causes behind the Financial Crisis

In the early part of the 20th century, if you wanted to qualify for a traditional mortgage, you were required to provide: a substantial amount for the down payment (usually 50% of the total costs). At the time, the mortgage market was unregulated and people could create whatever mortgages would make the most sense for them. As time went by, the fact that there were no accounting standards for reporting the value of these mortgages, much less laws surrounding how corporate profits were reported; meant that a large bubble would develop. In 1929, this bubble would burst, causing the Great Depression and an implosion in asset prices. By 1933, after a wave bank failures took place, the New Deal would play a major role in regulating: the mortgage markets and providing accounting standards, for a variety of companies. (Reed, 2010, pp. 1 -- 10) This program would create: the FDIC (regulating banks / deposits), the Securities & Exchange Act of 1934 (regulating the stock market / creating accounting regulations for business) and the Glass Stegall Act (limited the size of financial institutions). The Securities and Exchange Act of 1934 would establish procedures for all corporations, by requiring them to: report their numbers every quarter, have an independent auditor review these results and it would establish different accounting standards. The Glass Stegall Act would limit the size of financial institutions by: forbidding banks from paying interest in on demand deposits and it would forbid banks from becoming involved in investment banking. This is significant, because these two laws would establish a foundation for the nation's financial system and the accounting industry. As both would serve to limit the overall risks that financial institutions were taking and what kind of products they could sell to the general public. (Francis, 200, pp. 86 -94)

As time went by globalization would cause the world of banking and accounting to become more interconnected. Where, a variety of international banks and firms would compete against some of the American institutions on a global scale. This was problematic, because American firms could not become involved in the same activities as their international counterparts, because the Glass Stegall Act was in their way. This would lead to the repeal of the law in 1999 allowing for: banks, brokerage firms and insurance companies; to become involved in a variety of new investment products / businesses. Once this took place, it meant the overall amounts of speculation would rise sharply, as a variety of investors and banks began to sell these various products to the general public. The problem was that many of the investment products were not regulated under existing federal law. This meant a similar situation would occur to the time before 1929, where a people were purchasing risky investments, without having any way to evaluate them or know how much they were worth. Once interest rates began to rise and many the subprime mortgages began to default (which was one of these new investment products), it would mean that determining their value and accounting for them would be difficult. This is because the mortgage market was frozen (which meant that there were no buyers for these mortgage) and there was no way to accurately value the underlying investment. These factors would set the stage for the financial crisis that would have a profound impact upon the world economy. In this situation, accounting reforms are necessary to create a way of accurately assessing the value of different investments. If this could have take place, the effects of the financial crisis may have been less severe, as these standards would helped investors to see the overall scope of the problem. (Francis, 200, pp. 86 -94)

The Beginning of the End

After Glass Stegall was repealed, many different financial institutions began to combine and focus their operations on selling a variety of products. The subprime mortgage market would see a large pick up in the underwriting, marketing and aggressive trading of these securities. When you combine this with the forces of globalization, the large financial firms had offices in many countries around the world and began to market them as a safe way to invest. What they were not telling investors and the public was that these markets were largely unregulated, meaning that they were not subject to the same reporting requirements as other securities (such as common stocks). Under the Securities and Exchange Act of 1934, all common stocks were required to be registered with the Securities and Exchange Commission (SEC). They had the power to regulate the markets and the way investments were sold to the public. Since many of these new mortgages did not qualify as a security under the law, meant that they would not have to file with the SEC nor have their markets regulated. As a result, a variety of different financial institutions did not have any kind of way for determining the value of subprime mortgages. Once the financial crisis began, the fact that these markets were unregulated caused the majority of banks to under estimate their exposure, to these markets and the actual values of the underlying investment. This would cause many of the different banks and brokerage firms, to make statements that about how they were well capitalized to handle the crisis. Only to find out that the firm was on the brink of financial collapse. A good example of this would be Lehman Brothers and Bear Stearns. These were some of the top financial firms in the country, which went almost overnight into either: a near or a total collapse. This is significant, because it shows how the lack of accounting laws and the elimination of the Glass Stegall Act, would play a major role in contributing to the crisis. (Brown, 2009, pp. 401 -- 431)

How the Accounting Industry Played a Role in the Collapse of many Firms

The accounting industry played a rather indirect role that was the logical result of changes in: the markets and the repeal / inability of existing laws to cover certain areas. Then, when you combine this with the fact the many CEO's were reluctant to state publically that they were facing a liquidity crisis, meant that many bankruptcies would come out of nowhere. As there was no way to evaluate the value of the investments that many banks could not sell. At which point, many companies began to make statements that were simply untrue or grossly inaccurate. A good example of this can be seen with Lehman Brother in March 2008. Despite the fact that the company was facing a severe liquidity crisis, management continued to play down the effects. With them saying in their first quarter 2008 earnings report that they had: a liquidity pool of $34 billion, unencumbered assets of $64 billion and $99 billion in regulated assets. At the same time they affirmed the Moody's credit rating of A1, on the basis of the company's capital basis and liquidity. (Kuhlengisa, 2008) This is problematic, because when looking at this statement and considering what would happen a few months later, it was obvious that managers / executives knew something was wrong. Instead of disclosing this fact to investors, they continued to play down the effects on its overall bottom line, until it could no longer be hidden. The way the accounting industry would help to perpetuate the collapse, is by having independent auditors making conservative estimates on those assets that were frozen. Using the Lehman Brothers statement, the $64 billion in unencumbered assets was more than likely a conservative estimate. Where, many firms would have two different ways of attempting to value these investments (market value or fair value). Normally market values will provide the most accurate picture, as to the underlying value of the investment. The problem is that when you reduce regulations that curtail risk taking; large boom and bust cycles are created in the economy. This would cause the market value of these securities, to become grossly over inflated. Once the economy began to slow, there was no way to accurately value these assets, as the credit markets became frozen. Fair value is more conservative. Yet, the problem with using this standard is the board must determine what would apply. This can vary from one company to the next. Evidence of this can be seen by looking no further than RMBS (a subprime mortgage security that Lehman Brother had valued in the weeks before its collapse). Where, it would have the fair value of the investment listed at $.39 cents on the dollar, while AIG (the company insuring the mortgage) would value it at $.69 cents on the dollar. This is because the lack of having a standard for valuing these investments would only make the situation worse; as a more optimistic view could be presented than what was really occurring. (Brown, 2009, pp. 401 -- 431)

Another way that the accounting industry may have helped indirectly contribute to the financial crisis is not enforcing the law. When firms like Lehman Brothers were making statements that were not true, auditors had a duty to report to regulators that the firm was having financial difficulties. Under the Securities and Exchange Act of 1934, it requires all companies that are publically traded, which have information that could impact shareholders, are required to disclose this information to the SEC immediately. The fact that executives did not do so, was reflecting that they did not want to see the price of the stock fall or receive negative publicity from their announcement. This is in volition of the Securities and Exchange Act of 1934, which requires them to disclose such information. (Francis, 2000, pp. 86 -- 94) Using the Lehman Brothers example, if an investment is being valued at $.39 cents on the dollar and cannot be sold immediately, this could impact the financial position of the company. Any executive or CEO that knows what they are doing would say that this is a very disturbing sign. The problem is that SEC has trouble effectively prosecuting these individuals. As the differences in accounting standards, would be used to show, that executives were following the law by valuing the investment more conservatively. Therefore, if Lehman Brother executives could be charged anyone who makes these claims should be as well. When facing these kinds of situations, the odds are small that executives who make such statements will be prosecuted, as the standard for showing that they violated law (when they really did) was too cumbersome. For the accounting industry, this would set the standard that they should be loyal to the firms they are auditing, because making such claims could be irresponsible. As result, an atmosphere develops, where everyone will keep quite over what is occurring. Then, once the situation become so bad; the truth will be revealed.

Possible Ways that the Laws can be changed to Address these Issues