Reforms in Accounting Research Paper

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Research Paper on Reforms in Accounting Assignment

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… [END OF PREVIEW] . . . READ MORE

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