Economic Meltdown and Accounting Practices - Coursework Example

Introduction Thousands of corporations are present on the global economic scenario with millions of employees. Many corporations are economically stronger than a bunch of countries put together. In the new global scenario devices of communication have made corporate structure even more complex and elaborate. Therefore the environment in which data is produced and analyzed is very changing rapidly. Globally there is a movement of producing and collecting data in more comprehensiveness and detail. As mentioned these phenomenons are results of increasingly complex data and changing environments from where data is collected. This need is further fueled by increasing number of global scandals involving corporations, involving data manipulation and fraud. Global accounting standards such as IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles) are aimed at removing any problems arising from increase in data size. Accounting Principles These principles i.e. both IFRS and GAAP aim to making financial reporting more international. The representation of accounting statements is the first steps. The aim of these measures is to actually reduce the time spent in compilation of data and information. When data is compiled from varied sources it becomes difficult to explain the data in general terminologies. These principles therefore aim to represent data in such a way that it is internationally recognized and understood. When on an international level every corporation uses the same rules and regulations to explain data it becomes easy to comprehend and review. Representation, Control and Accountability A common language (similar representation) makes is easy to compare data. For example if each country was using different standards than it would be impossible for investors to make international investments. This is because each investor will have to be familiar with hundreds of different accounting standards in order to actually compare which corporation was better. This is not only on an international level but locally even investors would find it impossible to compare information if there were no international accounting standards. Control is another important aspect of accounting principles. When target users know where each information piece is supposed to be it becomes very easy to actually control functions and processes. Shareholders for example are usually familiar with limited amounts of technical accounting knowledge, because the information is placed in exact places each time they can easily understand and control their corporations. Therefore this makes the information more reliable and trustworthy. Investors can thus easily interpret the information and can make bold investment choices. On a government level this brings in accountability. When using specific accounting standards it becomes very difficult and almost impossible to manipulate data. Any discrepancies in this regard would easily point out to fraud and accountability is thus increased. From a professional analysts point of view it is impossible to asses and understand accounting information unless proper formats are not used to arrange and prepare information. Global Recession The recent recession in the global economy has changed perception about many accounting and financial perspectives. Discussions into what triggered this global recession has been focused mainly on accounting practices. If we look into a history of recent global recession we will see that it was stemmed in the American Economy. The housing sector was showing a phenomenal boom in the last few years. This was due to a large inflow of foreign funds and low interest rates created an environment where acquiring credit was becoming increasingly easy. This easy credit led to massive leasing of houses and fueled what we now call the subprime mortgage crisis. To really understand this phenomenon we must understand that investment bankers have their increments and bonuses linked to the amount of loans they make. Unethical lending was therefore witnessed, in order to increases their own bonuses, loans were given out with the proper due diligence. This drove prices to sky high and more loans were made and the cycle continued. The prices were however mainly driven up by investors and the demand was therefore artificial. Once investors started pulling out of the market, the prices went rock bottom. The houses originally purchased for millions were now merely a few hundred thousand. Most of these purchases had however been made on credit. Once prices fell, people refused to pay mortgage which led to a total collapse of the financial system. This however didn’t stop here. As the American economy went into recession other economies in business or which were dependent on the American economy also went down. These mostly included two types of economies. The most effected were countries exporting to America. They experienced a severe blow as consumer spending in American hit rock bottom. This happened because the American consumer system is fuelled entirely by credit. People use credit cards to make purchases and pay bills etc. Once the banking system went down there was a lack of market liquidity which forced consumer spending to come down. The role of accounting principles was taken in questions after the crisis. The question is how we can make accounting principles more stringent to stop similar happenings in the future. This does not necessarily mean that the crisis was in fact fault of bad accounting principles. There were however some weaknesses which were exploited by investment bankers. These weaknesses allowed them to engage in activities which led to financial crisis, such as excess lending. Aims and Objectives The aim of this report is to establish a relationship between the economic meltdown and accounting practices. The paper will analyze the reasons for the meltdown and point out the reasons that pertain to accounting practices. These reasons will be discussed in detail and interpreted. The steps taken by governments to stop such practices from taking place in the future have also been discussed. We will try to understand government rationale behind these steps. This rationale will explain if the steps taken are aimed at improving accounting practices or not. On the basis of these two criteria we will judge whether weakness in accounting principles of representation, control and accountability have led to the crisis. Research Methodology The research carried out in this paper is secondary in nature. The main sources of information are articles journals and books on the topic under discussion. The mode of study is more exploratory in nature. We have tried to establish a framework on which further research can be carried out. The dependent variable is economic recession. The independent variables are control, representation and accountability. The research will try to establish a relationship between the dependent variable and the independent variables. Literature Review Shah (2009) described that the effects of Global Economic crises would not be the only to the United States but everyone across the globe is going to be effect because of so much interdependence and integrated Global System. As, world has witnessed that this crisis turns out to be a recession, second to Great Depression in its impact. The countries around the globe, even the rich and developed nations tried to save their financial system and institution with different bailout plans. There can be various reasons and root causes to the crunch but above all were the huge amount of subprime mortgages and loans in the Real Estate of United States. In the early times of Recession, Cox (2008) tried to describe this factor of bad debts in real estate. Mortgages loans funds were available in abundance leading to the greater demand from the customers. This pull resulted in Subprime loans that exceed from the ‘Prime’ loans and the borrowers were failed to repay their mortgages payments. This leads to the collapse of firms like Lehman Brothers, Bear Stearns, Fannie Mae and others. The attractive subprime loans market not only takes the intention of local investors but also foreign firms primarily European firms. The foreign inflows and prevailing low interest rates at the time make ease for the customers to take home loans. The demand raised the prices of real estate. Lending companies get into surge of finding potential buyers of real estate, as many as they can. Everyone was in the greed to maximize the returns in this point in time. Then, Lending companies started to look for the customers that were with moderate and bad credit rating and low income levels, in disregard of financial backup or securities, exposing their own selves to more risks. These loans are the Subprime. Overbuilding makes the surplus inventory that was one of the reasons that initiated the drop in Prices. This simple fall in prices was the start of a Recession because it was contributed with many other factors. “The Indian Blogger: Life & Times in India” talked in common terminologies to make this crisis understand, as it is not as straight forward as it seems to be. In the article, ‘Reasons for Global Recessioni’, states that the increasing liquidity and returns in subprime mortgages attracted other financial institution to reap higher returns. Subprime mortgages were not designed for this purpose. The main aim of subprime mortgages was to help out the customers of moderate credit ratings to own some property. Mortgage Back securities were owned by the financial institutions in order to diversify their portfolios and heavy investments came in that made subprime mortgages a huge segment. The mechanics that was in favor of this option favors the returns on investment only when the prices are rising. That was, the case in the start. But US Real Estate prices started to come down, making these Loans risky and unprofitable. The prices were going down but the interest was going up, many of them opted to default and vacate the home. The price fall takes the value of homes and Real Estate lower than the amount of loans. That forces the lending companies to record losses on the loans. The lowering value leads to drops the value of MBS hurts the portfolios of banks and financing institutions eventually destroy their capital. An estimate of losses exceeds $512 billion on Subprime loans. Figures stated at the article “Reasons for Global Recession” Citigroup faced the biggest blow of $55.1 billion follows by Merrill Lynch with $52.2 Billion. $260billion losses were faced by the US based firms and $227billion was faced by European firms, leaving Asian firms with $24billion. This crisis takes down Lehmann Brothers, the Fourth Largest Investment Bank, to the bankruptcy. Merrill Lynch got acquired by Bank of America. In United Kingdom, British bank Bradford & Bingley was nationalized. UK’s Lloyds TSB acquired its Scottish Banking Group, HBOS. It is also discussed that the lack of credible rules in Globalized Economy spread the crisis all over the world, impacting and crashes many markets and economies of the world. The hype in the prices of Real Estate was considered to be the overall deregulation of financial markets that was done by the governments itself. The main point of this meltdown was the hunger to achieve the returns in double digit percentages that leads to the encouragement of securities like Mortgage Back Securities. Basel II Basel II is a recommendation of banking laws and regulation issued by the Basel committee on banking regulations. The Basel II accord was initially issued in 2004 but continuous changes have been made since than to improve its application. The economic meltdown has really hastened adoption of Basel II by most countries. The Basel basically aims to ensure that banks are wise in their decisions regarding lending and borrowing. It is also a safeguard against any problems that might arise in case of an international collapse of financial systems. This is accomplished by establishing rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves which are enough to balance out the risk the bank is exposing itself to by lending and investment. These rules basically prompt banks to maintain greater levels of capital if they are willing to take greater amounts of risk. Banks therefore try to minimize their risk taking activities to avoid seeking more capital. In wake of the economic recession many governments are increasingly relying on Basel as a means of avoiding similar events in the future. This is because the Basel II discourages activities which can trigger another subprime mortgage crisis. This is done by allocating risk classes to different investments. The risk class of consumer loans is taken as the highest. Therefore banks do not engage in high risk activities that would increase their risk and force them to keep more capital. The Basel II has basically between divided into two pillars, namely Pillar 1 and Pillar 2. Pillar one deals with the three common type of risks faced by a bank i.e. credit risk, operational risk and market risk. The three components can be calculated using different approaches. Credit risk can be calculated using standardized approach, Foundation IRB and Advanced IRB. Operational risk by basic indicator approach (BIA) standardized approach (TSA), and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). There is only approach however to calculating market risk which is called the value at risk of VAR approach. The pillar two basically deals with regulatory aspects of first pillar. It also reduces other risks such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk. The Basel II is an effort, in perspective of our topic to increase the control, representation and accountability of financial information. It establishes a framework which gives adequate representation of baking investment to shareholders. This increases both representation and control over investments made by banks. Moreover this increases accountability. When bankers are given rules and regulation about the amount of investments that can go to different fields, becomes impossible to manipulate data and make risky investments. This goes a long way in making investment bankers more accountable. Analysis The lack of proper representation and accountability has been one of the major reasons of the recent global meltdown. If there was information about level and risk of assessment in accounting representation the incidents such as subprime mortgage could have been avoided. This is because when bankers know that all their actions are being reported they make more cautious investment decisions. The literature review also points out to the lack of a global accounting frame work which could warm investors of an impending doom. The accounting principles lack such a framework which could clearly point out the present conditions of any particular investment bank etc. The relationship between the dependent variable of economic recession and independent variables does exist. This is proved a mentioned in the literature review because of a relationship between bad accounting practices and bad investment decisions. According to our research if these accounting principles were more comprehensive to begin with a meltdown could have been avoided. The steps taken after the meltdown also point to the significance of accounting principles of representation, control and accountability as being important in preventing such happenings in the future. Basel II is aimed at specifically improving these three aspects of accounting information. Although formulated in 2004, many changes have been made to make it more practical. Governments are encouraging its implementation which was not the case earlier. Recommendations Implementation of Basel II to stop bankers from taken any undue risk with other people’s money. Reviewing accounting principles continuously to encourage changes which can make these principles up to date with current economic requirements. Providing a global framework which would avoid any global economic meltdowns in the future. Conclusion The research has pointed out towards a relationship between accounting practices and economic meltdown. Therefore there is urgent need to examine these principles in order to avoid such happenings in the future. This should be carried out on a global scale because currently there is no single economic entity rather the whole world acts as a single economic entity and problems in one part trigger a global even. Thus there is need to examine accounting principle in further detail to really understand roots of economic recession. Read More