Economics assignment essay writing analysis review on: Global economic crisis & accounting
Q?? Write on Global economic crisis & accounting??
Solution:
Introduction
Global economic crisis which took place in 2008 raised many questions on global financial stability. The crisis initially started in the largest economy in the world- the United States and spread to the rest of the world at a fast rate once all kinds of borrowers defaulted on their loans. Many economists tried to look for reasons for the crisis. Governments and corporates had to look into themselves to find the answers. The manner in which the crisis affected not only the economies but also the common man resulted in criticism of the financial sector and exposed the firms to their fraudulent techniques of booking profits.
One of the suggestions which came up from corporates especially banks that Fair Value Accounting was one major reason for the crisis. In this assignment, I will explore the reality behind the claim. I will be mainly finding out if there is any truth through secondary resources. There are many journals regarding the issue of Fair Value accounting and many economists’ and researchers’ view has been explained in this report.
After the various accusations, IASB finally gave into pressure from the governments and implemented few changes which were totally against their own philosophy. However, that seemed to work in the short term and we will look into the changes. Also I will explore how the changes impacted the various stakeholders and if the change was actually a success or a step backward.
IAS 39 accounting standard, which has been the bone of contention IASB and the banks, also needs to be looked into. I will explain the features of IAS 39 in this assignment. More importance will be given to the problems mentioned by the banks in IAS 39 and then what actions were taken by IASB to improve the standards.
Lastly, I will try to see how the Australian Accounting Standards Board responded in the wake of the global economic crisis. In addition I will try to understand how IASB and EU have shaped up the plans of international convergence of Australian accounting standards.
After soaking in knowledge of the above, I would be able to bring all of the topics together to understand the point of views of various parties and see the issue in a bigger picture.
Fair Value Accounting
Fair value accounting had its opponents and proponents since many decades. Those who support it argue that it’s the best way of representing market conditions for an asset since it provides the “market value” of an asset and tends to be more relevant.This, according to them, reduces opaqueness in the market and leads to corrective action if required. Historical cost accounting though being used since a long time needed to be changed and more dynamism was required in the system. (Ryan, S G, 2008)
Fair value accounting(FVA) looked to be a good replacement until the Global Financial Crisis (GFC). Many economists, bankers, politicians, corporates etc. came out in public blaming FVA for the crisis. They argue that FVA in illiquid financial markets are irrelevant and that the underlying assets’ true value is not getting reflected using the fair value system. The Level 3 inputs have been criticized as misleading and damaging to some extent. But how true are the allegations? Is FVA being made the scapegoat for companies’ bad decisions?
Is FVA responsible for GFC?
Fair value accounting has only increased the faith of the investors in the financial markets and also enabled them to access relevant financial information. Showing the most current market information, FVA gives the correct market value to the investors. It helps investors to identify current risk and shield themselves in difficult times.
If we analyse the problem during the crisis, the mortgage-based investment funds/instruments needed to determine fair values of their assets not because of any accounting rule but since they were financed by short term debt/ redeemable capital.Also, as claimed by the opponents of FVA, there is little evidence that FVA was responsible for the excessive write-downs. This has been shown extensively by Laux-Leuz in their research paper. (Laux and Leuz, 2010)
Fair Value Accounting may have had a role to play in the bailing out of investment funds by the financial institutions. But the bigger reason for the institutions to bail out the funds may have been the fear of fall in reputation and increase in funds withdrawal.
The crisis looks like to have been caused more by investors’ worries regarding the underlying assets’ prices, bad investments, higher than required leverage etc.
Response of IASB
In 2008, after Lehman Brothers collapse, IASB came under pressure from numerous banks lobbies and politicians blaming FVA for the situation the world was in. IASB finally gave in and issued amendments to IAS 39 which relaxed the fair value rules. Bischof, Brüggemann&Daske(2010) argued that it gave commercial banks the choice to “…retroactively reclassify non-derivative trading financial assets and available-for-sale financial assets …into held-to-maturity or loans and receivable category under which assets are required to be measured at amortized cost(IASB 2008, par. IN8A).”
The decision was not in line with IASB’s previous position which was strongly against any type of reclassification. Few prominent proponents of fair value easing like British Prime Minister Gordon Brown stressed the need for FVA continuation maintaining that fair value only reflects the economic scenario. But the plea went unnoticed and the IASB changed the rules.
Impact of the changes to IAS 39
During the 2008 global economic crisis, companies and governments put huge pressure on IASB, whom they blamed partially for the crisis, to stop/suspend fair value pricing for few financial assets. Thus, buckling under pressure IASB amended IAS 39 and suspended fair value accounting for few financial assets.
A quick analysis shows that the amendment which led to suspension of fair value pricing led to notable increase in asymmetry in information. It openly undermines confidence of the investor in the disclosures of the banks. The detailed explanation will explore and explain the amendment done by IASB which eventually helped the companies and banks to report profits that were not real.
Also, the global accounting convergence is only decreasing rather than increasing as originally planned and which is what the world needs.
The move gave temporary relief to banks that could now show higher net income and shareholder equity. This implies that the corporates were happy with the fair value reclassification because of the capital restrictions which are of regulatory nature and are connected to accounting measures. Regulatory capital restrictions were one of the main incentives of the management from the point of view of risks due to regulatory costs. Costs would have been incurred if the regulatory restrictions were not abided by and if supervisory actions were undertaken. Regulatory measures always result in significant loss in shareholder value which can even go up to closure of the bank too.
The discretion introduced by the amendments in the accounting practices gave the banks the means of regulatory arbitrage to fulfill the required threshold. The banks, thus, avoided the costs without ever publishing the fact to the public. So, if a bank faced the regulatory costs risk, then the amendment of fair value reclassification helped them to increase the regulatory capital during the crisis.( Zhao,C, Haswell, S & Evans, E, 2008)
The fact that bank failures generally lead to failure of other banks or other sectors in the economy, governmental pressure for reclassification option can be interpreted as a way to show that the banks are in a healthy state. This proves that the amendment was introduced to satisfy stakeholders rather than actually doing any good. It was a measure of covering up essential information and facts, which otherwise were reflecting the true value of the organization.
Banks have been abusing the reclassification option given to them by reducing and redacting fair value data from their financial statements. This has increased the economics costs due to a rise in the worsening of information asymmetry. The above mentioned effects could have been reduced if the banks reveal the result of reclassification in the footers of the financial statements. But it is not being done with sincerity. (Bischof, Brüggemann&Daske, 2010)
It is important because IASB had been maintaining that if it didn’t listen to European Union to amend the fair value accounting rules, then European Union would have carved out reclassification rules without even any accompanying disclosure documents.
Changes in accounting standards are not the solution for a financial crisis of the magnitude witnessed in 2008. It can only increase the transparency and credibility of the finance market rather than solving a complex issue. (Arslan Khalid, 2009)
IASB was never set up to save banks by modifying accounting rules. It’s a task of policy makers and government regulators. IASB had firm view on not implementing the idea of reclassification option. It had to deviate from its stance since it was arm twisted by the European Union as they threatened to establish a carve-out in IAS39 which would have only worsened the situation. Banks troubled by economic crises should be ably supported by more solid steps rather than just covering up underlying issues rather than solving them head on.
The amendment did not create any level playing field between US and EU. Moreover, IASB had initially meant the use of reclassification only in “rare circumstances”, for example, the financial crisis. However, majority of the reclassifications have been used in categories where rare situation is not required and could have been used in normal market conditions also. (Bischof, Brüggemann&Daske, 2010)
PART B
IAS 39, problems related with it and IASB’s amendment:
A significant need for regulation with respect to derivative and such products have risen due to the fast growth and development in the use of derivatives by companies more frequently since 1980s. Therefore, the independent body International Accounting Standards Board (IASB) issued 2 new standards namely IAS32- “Accounting for Financial Assets and Liabilities” and IAS39 – “financial Instruments- Measurement and Recognition” in 1997 and 1998 respectively. The former’s purview was classification as well as information disclosure related to financial instruments by the issuer, whereas the latter dealt with the accounting part of the financial instruments.
However, due to many criticisms IASB had to amend changes or modify the IAS39 more frequently in the following years. Many critics argue that the standards proposed are not in line with the practices and, therefore, are debatable and controversial most of the times (Bryer R). The recent financial crisis which resulted in plummeting of few of the world’s largest banks (investment banking predominantly) spurred discussions and arguments over the effectiveness and the relevance of the accounting standards due to the sudden decrease in the profits of the banks which mainly consisted of mortgage backed securities whose valuations disappeared due to the mortgage bubble burst in the US market. Governments under pressure demanded IASB to look into the matter and advise a solution in accounting policies with respect to financial instruments (especially derivates and other complex products). The following paragraph throws light on the issues related to IAS 39 prior to the amendment which would clearly indicate the reasons for IASB’s decision regarding to amendment.
As already mentioned above, IAS 39 deals with measurement and recognition of financial instruments, according to which companies are expected to value their assets at their fair value such that it reflects the value at which the asset can be exchanged between two parties in an arm’s length transaction (Linner&Olmsater, 2011). This approach implied that the fair value of assets had to be reflected in the balance sheet of the company at each reporting date i.e. end of each quarter & financial year. Further, the changes in the fair value are to be reported in the income statement as profit or loss as recognized while doing the valuation.
The standard also stated the broad procedure through which the financial assets were needed to be valued (Linner&Olmsater, 2011):
- If the asset is traded in the market, i.e. a quoted market price is available, then the market price should be used as the fair value as it is assumed that market prices reflect the fair value of an asset.
- If no market price quote is available, then the company needs to value the asset using recent market prices of similar assets or use a valuation model that was proven reliable in the past.
- A subjective valuation method should be used which would discount the future expected cash flows from the financial assets to the valuation date. The valuation model is also expected to include risks like credit risks, interest rate risks etc.
The accounting standard boards across the world strongly believed that market prices reflect the fair value of the asset as the prices are defined by the market forces of demand and supply. However, the recent financial crisis proved this theory wrong when most of the financial assets were valued close to zero. Thus, the model of fair value failed to be effective when the market prices were not available as well as during crisis such as mentioned above. The figure below summarizes the IAS39:
Many critics have highlighted the fact that the fair value of financial assets using mark to market pricing technique does not reflect the fair value nor does it reflect the economic reality (Linner&Olmsater, 2011). This method also results in high earnings volatility as there is a frequent change in the reported value of the asset, thus increasing the probability of loss due to any adverse situation in the markets, much like the recent crisis. One of the critics has blamed this technique for being the “principal cause” of the crisis and also demands for a change or modification in the accounting standard as it had been in the debate both during the booming economic cycle as well as in the recessionary phase.
Therefore, in reply to all the debates, discussions, and arguments across the world, IASB had to bring some changes in the accounting standards so as to eliminate the difficulties of fair value and provide a well explained methodology to provide companies to accurately reflect the prices/value of the financial assets.
Following paragraph highlights the steps taken by the IASB to address the situation in the midst of the Global Financial Crisis:
- IASB in a press release on 13 Oct 2008 issued amendments to IAS 39 with respect to reclassification of the financial instruments. This was done mainly to ensure a level playing field for companies under IASB as US GAAP permitted such reclassifications, although only under rare circumstances (such as the Global Financial Crisis).
- The amendment permitted the companies, only in certain circumstances, to reclassify its non-derivative financial assets out of fair value classification into profit or loss (International Accounting Standards Board, 2008)
- It further permits the transfer of an asset from available for sale category to the loans and receivables category, provided they fit the definition of it and the company aims to hold the asset International Accounting Standards Board, 2008).
- It has clearly mentioned that reclassification is not allowed after initial recognition (as per fair value) is already done International Accounting Standards Board, 2008).
- Post reclassification, the company is not permitted to reverse the profit or loss already incurred till the reclassification date. Further, the fair value on the reclassification date is reflected as the cost of the asset. International Accounting Standards Board, 2008).
- It also mentioned that if the entity/company reclassifies a financial asset and it is found that the present value of the future cash flows has increased, then there should be an adjustment recorded against the effective interest rate rather than the carrying amount of the asset International Accounting Standards Board, 2008).
The amendments stated above have been received with many criticisms, as it is believed to have helped firms in reducing their reported losses, however, it still seems to reflect a rosy picture of deeply troubled companies. The detailed assessment of the IASB’s amendment has already provided in the previous section of Critical Evaluation.
PART C
Australian Accounting Standards Board (AASB) amended Australian accounting standards to ensure they remain consistent with new standards issued by the International Accounting Standards Board (IASB).
In response to the global economic crisis, AASB amended AASB7 and AASB139 to decrease the differences between IFRS and US GAAP in October 2008. The new standard, after the amendment permits an entity to:
– Reclassify financial assets(non-derivative) which have been assigned at fair value through loss or profit by the institution during initial recognition
– Shift a financial asset from AFS(available-for-sale) to loans &receivables category that had met the definition of loans & receivables ( i.e, only if the asset has not been assigned for sale), only if the institution has the intention to keep the asset for the near future.
New requirements related to disclosures have been introduced into AASB7 for assets that are reclassified.
The entity won’t be able to reclassify a financial asset before 1st July, 2008. Additionally, any reclassification change of a financial asset after 1st November will take effect from the date of reclassification.
Also, AASB, in 2009 made 3 amendments to Australian Accounting Standards in the field of embedded derivatives. It clarifies the accounting treatment for embedded derivatives and those amendments are applicable only after 30th June, 2009.
Influence of IASB on AASB towards convergence of Australian Accounting Standards
This section raises some critical questions and tries to answer them so as to understand the reason behind AASB’s decision to converge their accounting standards with that of IASB’s
Why did AASB decide to converge its accounting standards with that of the global accounting standards? The following benefits come to the mind on why AASB wants to converge its accounting standards and particularly with IFRS:
– It will help attract higher amounts of capital to Australia. This will, in turn, help lower the capital cost
– Using same standards globally helps decrease costs for auditing and also for the users of multinational entities’ financial report find it easier to understand without the need of re-casting
– Besides, it will also help in filling up few gaps existing in Australian GAAP such as financial instruments (Australian Accounting Standards Board, 2009)
Australia decided to adopt IFRS in 2002. So what were the differences between Australian GAAP and IASB in 2002, that Australia decide to adopt IFRS?
– -IFRS have always been known to be much more detailed in the field of financial instruments recognition, and post-employee benefits.
– Whereas Australian GAAP was more comprehensive in areas such as intangible assets, insurance etc.
Australian accounting standards and the setting processes has been traditionally known as one of the highest quality standards. But they are different from the rest. It becomes extremely difficult for maintaining an accounting standard of such a large country which is different from other parts of the world. It is imperative to look to adopt the existing international standards. Australia has already a member in the International Accounting Standards Board and has been constantly looking at bringing the accounting standards as close to the international standards as possible.
So was the decision to move to IFRS influenced by the decision of European Union to adopt the IFRS? It doesn’t look like that since European countries had not made it mandatory to follow the new IAS. Initially, only certain pockets in Europe had been asked to follow the standards. Australia genuinely felt the need for a global accounting standard and that it had to be a part of it. (Bowrey, G, 2007)
The USA has decided not to adopt IFRS and continue with the US GAAP but the world has witnessed gradual convergence of the two accounting standards. In a way, though USA is not directly adopting the IFRS, but it is making an effort to slowly unify the accounting standards followed worldwide. This had been proved by the statement of Sir David Tweedie, the then chairman of the International Accounting Standards Board that the US GAAP is aligning itself with the IAS. This may also have been a reason why Australia decided to go for IFRS as their accounting standard.
The Norwalk Agreement, in which there was a memorandum of understanding signed between the IASB and US Financial Accounting Standards Board, works towards reducing the difference between the IASB’s International Accounting Standards and US’s Generally Accepted Accounting Principles.
The convergence of IASB and US GAAP has been a 12 year process and a new important IAS has been formulated based on the current US Financial Instruments accounting standard. That means that when Australia adopts the IASB, it is a step closer to the existing US GAAP.
Even though Australia had planned to adopt IFRS in its entirety, it retained few characteristics like Insurance and extractive activities. The existing accounting standards in Australia like AAS31, 29 and 27 do not have any equivalent in the international standards. They pertain to the public sector and also, few other standards like AASB 1022, 1023 cater to the Insurance and Extractive industries. For these kinds of standards, AGAAP had decided to keep them in force until international standards catering to the above purposes are developed.
Also, Australia has its own representative in the IASB. So it was not as if Australia totally got influenced by IASB without giving a thought on the advantages.
Conclusion
In the assignment, we tried to explore various issues related to global financial crisis, fair value accounting, IASB, IAS 39 etc. Fair Value Accounting which was being blamed partially for the global crisis was being defended vigorously by IASB until it decided to allow reclassification of certain financial assets. Even though it can be argued that Fair Value Accounting was responsible to an extent, the banks should have done better to just put a veil over their mistakes and change the accounting rules.
We saw that the change in the rules helped the banks in the short term and helped the stock markets grow on the basis of modified accounting standards and difference in reported financials by the banks. From the investors point of view, they lost the transparency associated with Fair Value Accounting, what they gained is more confident banking organizations and also avoidance of closure of financial organizations. Moreover, it allowed government some space and time to look into forward looking measures to deal with the crisis.
But in the long term, banks and governments alike were exploiting the change in the accounting standards. They tried to use the reclassification to their advantage irrespective of the impact of global economic crisis. Also, it helped them to build up their regulatory capital during the crisis, thanks to accounting changes introduced.
IAS 39 was thoroughly looked into in the Part B of the assignment and few problems were covered. Part B consisted of detailed analysis if the problems with respect to IAS 39 prior to the financial crisis, it was found that the IAS39 was thoroughly criticised by the corporate world who demanded a more less restrictive and feasible accounting standards in order to reduce the volatility in the balance sheet of the organizations (banks). IASB’s recommendations were highlighted which resulted in some respite to the banks during the financial crisis.
The effect on and action taken by the Australian Accounting Standards Board (AASB) was discussed in Part C. AASB has been trying to converge its accounting standards with IASB since almost 2002. It was a good decision given that almost the entire globe is moving towards a common accounting standards or similar rules. Having said that, it would be unfair to say that it got influenced by IASB, rather Australia looked at IASB for its own good.
If you want Economics management Assignment Help study samples to help you write professional custom essay’s and essay writing help.
Receive assured help from our talented and expert writers! Did you buy assignment and assignment writing services from our experts in a very affordable price.
To get more information, please contact us or visit www.myassignmenthelp.Com
