Accounting industry role in the 2008 financial crisis

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)

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

The obvious disparities in the law show how something needs to be done, to address this situation. The problem is that there must be some kind of balance taken, where you want to regulate the industry to prevent irresponsible risk taking. At the same time, you want to give regulations enough flexibility to adapt to the changes that are occurring. This means that an effective accounting standard must be created; for all businesses to follow when they are determining the value of various assets. If such a standard was in place, this would make it easier for: auditors, regulators and investors; to determine a firm's exposure to various amounts of risk. Over the course of time, this would allow for increased transparency, as everyone would know how all of firm's assets are being accounted for. Then, there must be some kind of mechanisms in place to regulate: these new financial products, the markets they trade on and the size that a firm can become. There have been recent changes by the federal government, to address some of the issues that were outlined above in the recent financial reform law. Where, it would cover a number of different elements to include: limiting the size of banks, having an independent board that will monitor the financial system for risk, its increases net capital and it would regulate the subprime mortgage market. (Wagner, 2010) This is significant, because it shows how the law addresses the systematic risk, but it does not address specific accounting issues most notably: what standards are used for valuing different investments and strengthening the provisions for reporting financial irregularities in the Securities and Exchange Act of 1934. This is important, because it shows how the lack of standards would contribute to the situation, by creating a greed run amok mentality. While, there have been significant changes to the law recently, they only address certain parts of the larger financial system as whole. In order to have effective accounting reforms, you must have a way of monitoring and limiting the culture of permissiveness (when it comes auditors and the firms they are working with). Where, auditors do not want to look out for the best interests of the general public, even though they know the company could be making statements that are untrue. Until these issues can be rectified, the financial reforms will be similar to the New Deal, where they will provide increased transparency and help protect against risk. Yet, over the course of time these changes will be ineffective, because they did not address the culture inside Corporate America itself.

Clearly, the accounting industry needs to be reformed, by having improved standards in place that will address how various assets are valued. At the same time, it must provide a mechanism for going after executives that knowingly lie to shareholders, about the financial state of the company. These two issues need to be addressed, because they attack some of the causes of the financial crisis, by preventing greed from becoming out of control. If you can control this emotion, by limiting risk and through effective accounting reforms, you have the ability to increase the transparency and stability of the financial system. Until these issues can be addressed, it means that the culture, which helped contribute to the crisis, will continue to fester in one way or another.