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ROLE OF ACCOUNTING IN THE FINANCIAL CRISIS
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Executive Summary
The recent financial crisis was a major economic event that resulted to devastating
impacts on the global financial and economic system. The occurrence of the financial crisis was
challenging to financial managers and accountants who had the pressure to describe the causes of
the resultant financial meltdown. The major impacts of the crisis affected users of financial
statements who are in dire need of credible and reliable financial accounting information for their
decision making. Such information could only be provided by accountants, auditors, and other
financial experts, which in turn leads to the reflection that such parties played a role in the
financial crisis.
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Introduction
The 2008 global financial crisis had a wide range of devastating impacts on the global
economy, as well as on the households and businesses. With the global economy recovering
from the negative impacts of the crisis, a clearer picture of the elements of accounting that was
involved in the crisis has been developed. During the initial stages of the crisis, financial
managers and accountants had a challenging moment as they were questioned for being
accountable for the significant decrease in business earnings that mainly entailed extensive losses
especially in the determination of the fair value of financial instruments, which further led to
substantial losses that arose through the financial vehicles used across the globe. Additionally,
there were cases where such financial managers and accountants were involved in scandal-like
schemes that paid higher bonuses and returns as a result of increased in the fair value of financial
instruments and properties that were recognized in the reported financial profits and losses made
during this period. Such financial anomalies were also depicted in home loan programs that were
in the form of securitized instruments such as mortgage loans. As a result, many of the
beneficiaries started defaulting as a result of the decreasing housing prices. Subsequently,
financial institutions that had low credit rating started incurring higher losses. Such impacts of
the financial crisis spread across the globe with financial institutions aiming at earning high
profits from the booming housing investment sector. Ultimately, financial accounting and
reporting standards had a participative role in the reverberation of the financial crisis across the
globe leading to higher financial losses and other anomalies to businesses, households, and the
entire global economy.
The Role of Accounting in the Recent Financial Crisis
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During the 2008 global financial crisis and the period surrounding the global economy’s
attempts to recover from it, there were different views as to the institutions and other entities
responsible for it. However, the main entities that were viewed as playing a critical role included
accountants, auditors, investment advisors, financial institutions, credit-rating professionals, as
well as auditors (Kothari & Lester, 2011). However, the determination of who was clearly
responsible for it could not be made with finality. With this in mind and with the main aim of
determining the role played by accountants towards the upcoming of the crisis, the section could
be divided into different elements of discussion.
Fair Value and its Contribution
The Financial Accounting Standards Board has in the past implemented accounting
standards to determine the generally accepted meaning of fair value, as well as the methods used
for measuring it and the subsequent determination of the disclosure and reporting through
financial statements (Magnan, 2009). Such standards would subsequently play a key role in
decision making, which would in turn lead to major application in accounting, auditing, and
investment sectors. Such a system of the standards would help by achieving a basis upon which
financial information can be compared in a consistent manner while determining the platforms of
measuring financial performance. With this in mind, the fair value of both financial and nonfinancial assets is determined through a process of considering the value provided by the active
markets, the value of similar assets, as well as through a system that gives managers and other
financial experts to manipulate the values of such assets. As such, the fair value of assets plays a
key role in the determination of the value of assets that are dealt with in the market, which in turn
leads to an overall impact in the activities taking place in the economy.
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The determination of the link between capital regulation in the economy and accounting
for the fair value of assets acts as a viable way through which research can determine the
contribution of fair value elements towards the crisis (Laux & Leuz, 2009). Through the
manipulation of the fair value of assets by financial experts, such as accountants, it is possible
that the asset values provided by such parties could digress from their basic and real market
values. Such a probability could cause financial institutions to write down or devalue their
reported asset values in schemes aimed at depleting their capital at the expense of the investors in
the market. Subsequently, asset devaluation may force such financial institutions to offer such
assets for sale with the aim of closing down their non-performing business. Such events could
spread in the market while affecting other institutions with the events trickling down to the
associated parties, including investors (Magnan, 2009).
In practice, financial assets include securities, trading assets, leases, as well as loans. In
most instances, such assets are the majority category for banking institutions. Such assets are
tested for their value by considering their future cash flows (Laux & Leuz, 2009). However, in
most instances, loans are devalued as creditors are at risk of default, especially in cases where
their debtors are under a financial crisis, which was a common phenomenon in the recent global
financial crisis. During the onset of the financial crisis, financial assets that were held by banking
institutions were usually manipulated by accounting and financial experts. Ultimately, most of
the financial assets that the banking institutions dealt with were not subjected to the fair value
test and were not truly reported in the financial statements from such institutions.
From the different impacts of the fair value aspect, a debate has been up as to whether
fair value accounting was a contributor of the recent financial crisis. Prior to the upcoming of the
crisis, majority of the mortgage and corporate bond instruments were performing well (Kothari
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& Lester, 2011). However, after the financial crisis their prices had decreased below their fair
market value as a result of the freezing financial markets. From a different perspective, fair value
accounting has been criticized that it undermines crucial basics of effective financial reporting,
including reliability, authenticity, as well as conservatism with the main argument being that it
does not attain such credentials. In some instances thereof, it can be argued that fair value
accounting is less accurate as compared to historical cost accounting as by using the fair value to
determine the price of financial assets financial institutions record long-term impairments on the
real market value, which in turn leads to a misrepresentation of the short term changes in the
price of such financial assets (Magnan, 2009). Through such arguments against fair value
accounting, it can be substantiated that it was a major contributor to the fluctuating price levels
of the financial assets offered by financial institutions in the wake of the financial crisis.
Furthermore, in the computation of the fair value of assets by financial institutions,
inadequate consideration was frequently given to the normal factors that affect such fair value
(Laux & Leuz, 2009). In this view, it is basically impractical to determine the factors that
impacted the fair value of financial instruments during the financial crisis; a period marked by
short term changes in market conditions with such changes even occurring overnight. Such led to
inadequate fair value guidance in the global financial market in a period of illiquid and
fluctuating markets. Furthermore, such an instance was deteriorated by fluctuating risk
management procedures to govern the market conditions and thus, the fair value of the assets. As
a result most investors were rising to the occasion to buy or sell respective financial instruments
and properties, which led to a rush for overvalued assets such as assets in the housing sector
(Laux & Leuz, 2009). Such rushes led to insufficient review of credible information on
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investment and savings, which in turn led to the fluctuations that were occurring in the markets
and thus, adding to the seriousness of the looming global financial crisis.
Role of Auditors
The main objective that drives the demand for an audit is the need to ensure credibility
and reliability of financial information to ensure that it plays its role in decision-making
processes carried out by the users of financial information such as investors (Clinch, Stokes, &
Zhu, 2012). It is important to ensure that an independent party verified and gives an independent
opinion on the financial statements of the respective firm of interest. This makes it easier for
institutions to attract the attention and confidence of the uniformed public for investments in
such firms. In this view, it is crucial for a company to invest in an independent party in the form
of an auditor to provide an opinion on the reliability and credibility of information provided to
the users of financial statements.
The provisions of the element of information asymmetry provide the basis upon which
auditors are important in bridging the information gap that could prevent such market anomalies
as those depicted during the recent financial crisis (Kothari & Lester, 2011). Such information
asymmetry is a situation created when one party has more or more viable information as
compared to their counterparts in a transaction. It could lead to challenges to the decisionmaking processes between the two parties, which in turn leaves one party at the expense of the
other, which could in turn lead to market inefficiency. The occurrence of the 2008 financial crisis
led to the depiction of some evidence of the concept of information asymmetry. During the
financial crisis when the market conditions were highly unstable, investors could not interpret
and differentiate between different securities since most of the securities were depicted in the
form of highly-priced instruments such as the sub-prime loans that were popular during this
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period. It is likely that financial institutions that offered most of the available financial
instruments in the market had better information on the events that were happening or likely to
occur in the market due to the impacts of the crisis (Clinch, Stokes, & Zhu, 2012). As such, had
more useful information been made available to households and businesses in the global
economy, they would have avoided investments, such as mortgages that were backed by nonviable financial instruments. The situation present during this time was adequate evidence that
there was information asymmetry in the market, where auditors had the professional ability to
provide more useful and adequate information to the investors on such instances. It is the need
for credible and adequate information that could have bridged the gap between the participants in
the market and thus, reduce the market inefficiencies brought about by financial crisis.
The quality of information provided auditors could have played a role in the recent
financial crisis. Conditions such as independence and expertise have a great influence on the
audit quality and thus, information provided (Clinch, Stokes, & Zhu, 2012). An audit with high
quality is preferred best as it gives more assurance as to the credibility of financial information
and thus, provides a better platform through which investors can form viable decisions. It is
important to note that credible information, especially with little or no material misstatements
plays a key role in making decisions in capital markets, which was a crucial sector of the
economy during the financial crisis. Industry specialists and auditors work hand-in-hand in the
provision of credible information for investors in the stocks and securities markets. From this
perspective, the financial crisis was faced with rampant cases of unreliable financial information
being disseminated to the public, which gives evidence that auditors who allowed the provision
of such information had a role to contribute during the financial crisis (Laux & Leuz, 2009).
Contrariwise, as the quality of the audit decreases, there is higher probability that most of the
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material information that ought to be disclosed to investors will be excluded and not detected. In
this view, even in instances where information used by investors to make investment decisions
was provided by audits carried out in compliance with the provisions of the Generally Accepted
Auditing Standards, there is high probability that the audits failed to discover information that
could mislead the users (Kothari & Lester, 2011). The failures of the auditors during the
financial crisis was further aggravated by the accountants who could not provide full information
on the financial performance of their respective firms as they sought to conceal the real
performance to the failing industries at the time, including the failing mortgage firms that were
many during the period of the financial crisis. It is because of such failures that the entire
framework of investors, financial advisors, investment advisors, and financial institutions was
provided with less viable information to make viable decisions.
In view of these arguments, it is clear that different parties were involved in causing or
aggravating the financial crisis (Clinch, Stokes, & Zhu, 2012). However, it seems that auditors
could have directly contributed to the crisis, especially given the great role they play in the
operations of financial markets and in providing information that could be required in making
decisions in such sectors. In most account reports and financial statements during the process of
failing following the crisis, most firms made a wide range of material misstatement, while failing
to disclose some of their information, especially in relation to decreasing performance. The
auditors played a key role in the process of wrong investor decision-making process as they
overlooked whether the financial statements disclosures were in adequate reflection of the
respective firms’ performances and financial strengths (Magnan, 2009). During the crisis,
investors were disappointed by failed investments and increase in failure cases for companies. In
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light of this information, auditors could have prevented the crisis by ensuring that the broad
purpose of quality audits satisfied the requirements of an efficient audit exercise.
International Accounting Standards Board’s (IASB) Role
The IASB, through its ability to influence the International Financial Reporting Standards
(IFRs) had a key role in influencing the principles and policies behind international financial
reporting and accounting (Clinch, Stokes, & Zhu, 2012). It is through its influence that the
standards could be changed in such a way that the impact could be to cause or aggravate the
recent financial crisis. During the financial crisis, the IASB was under pressure from the political
fraternity within the European Union who were giving threats that could withdraw their support
of the IFRS if the IASB could not support their bid to reclassify some of the financial assets.
Earlier on, the European Union had demanded that all public listed companies within the region
fully adopt the IFRS for reporting purposes. In the early periods of the financial crisis in 2008,
the IASB amended its standards to provide for the reclassification of financial instruments that
initially had a fair market value attached so that they could be reported at an amortized cost
(Magnan, 2009). Following this amendment, publicly listed firms could reverse losses that were
earlier recognized while reporting their financial instruments in the subsequently amortized
costs. In light of this information, it is important to note that the resultant disclosure of the losses
made by entities and their respective securities was onerous in that entities that reversed their
losses could not report their real profits or losses and performance thereof. Such could have
misguided investors and other users of financial statement information in their decision making,
which in turn could impact the stability of the market (Laux & Leuz, 2009). Additionally, the
resultant situation had it that such entities were fully equipped with information and thus, there
was an information gap in the market leading to some of the features of the crisis.
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Changes in standards regulating off-balance sheet regulations, as well as the restricted
recognition of some items on the balance sheet had some impacts on the decisions made using
such information (Kothari & Lester, 2011). The subsequent consolidation of securitization
instruments did not require them to be entered in financial statements that involved groups. Such
a deregulation lead to loan obligations and profits or losses related to these securitization
instruments not being included in the group’s financial statements. However, after the financial
crisis when these financial instruments became default, the group had the responsibility of
passing the losses to investors and they later agreed that they had controlled the securitization
instruments. In relation to derecognition of some items in the financial statements, the IASB
required that companies should evaluate some specific transactions so that they could restrict
some of the financial statements from being recognized in the balance sheet, as well as in the
other financial statements (Clinch, Stokes, & Zhu, 2012). Such reductions in some of the items to
include in the financial statements led to insufficient information that could be required by the
users of the financial information in the market. In this view, such deregulation aspects of the
IASB led to reduced reliability and thus, credibility of information available to investors for their
decision making. As such, it was a leading indicator that the IASB played a role in the
occurrence of the recent financial crisis.
Conclusion
The recent global financial crisis had a wide range of impacts on business operations and
the global market stability. The causes of the crisis were attached to different parties, especially
the ones with the responsibility to carry out operations that aid in the achievement of market
stability. In this view, the role played by financial reporting and accounting in the provision of
reliable and unbiased information during the financial crisis remains a matter of keen attention.
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The existing financial standards could have contributed to financial stability through the
provision of transparent information. However, as financial institutions were highly
discriminative in the amount of information they exposed to the market, users of financial
statements information did not have adequate information to use in making decisions relating to
investment and other financial activities in the market. In determining the role played by
accounting in the recent financial crisis, the professional responsibility of auditors in providing
reliable and credible information is of keen interest. As most of the auditors could not directly
reflect the failing stability of such entities as financial ones, they ended up providing inadequate
information to investors. Additionally, the standards formulated and implemented by the IASB
required discriminative inclusion of some financial instruments. As a result, the information
communicated by the financial statements was inadequate to deliver a complete financial picture
to the investors and other participants in the market. Owing to the importance of the credibility
of financial information in the market, financial accountants played a role in causing or
aggravating the recent financial crisis.
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References
Clinch, G., Stokes, D., & Zhu, T., 2012. Audit quality and information asymmetry between
traders. Accounting & Finance, 743.
Kothari, S., & Lester, R., 2011. The Role of Accounting in the Financial Crisis: Lessons for the
Future. Retrieved April 6, 2016, from
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1972354
Laux, C., & Leuz, C., 2009. The crisis of fair-value accounting: Making sense of the recent
debate. Accounting, Organizations and Society, 6–7.
Magnan, M., 2009. Fair Value Accounting and the Financial Crisis: Messenger or Contributor?
Accounting Perspectives, 8(3), 189.