The Influential Relationship between the Accounting Standards and the Global Financial Crisis Abstract

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TheInfluential Relationship between the Accounting Standards and theGlobal Financial Crisis


Thecurrent economic crisis has led to numerous changes in the world. Oneof the changes has happened in the area of accounting standards giventhe alert and warning that the crisis gave to the decision makers(Acharya &amp Schnabl, 2010). After the global recession that hitthe world, the authors of accounting standards have realized thatthere is a need for serious attention and awareness to be put inplace to avoid the occurrence of the same kind of dangers.

Moreover,the financial crisis has highlighted three main lessons for thedecision makers and authors of accounting standards that this paperwill focus on. First the paper focuses on the integrated nature ofcapital markets and the movements of the capital itself lead to theurgent need for a range of acceptable accounting standards. Second,the financial foundations, the investors and the system producershave failed to embrace fully the understanding of threats and risksthat are faced and thus the accounting materials in place must playthe critical leading role in understanding the threat to the risksthat are faced. Additionally, the accounting materials must also playa leading role and have to be significant in helping all the partiesthat are engaged in the crisis. To this end, there is urgent need toensure provide transparency for the associated risks thatinstitutions face, the financial institution, in particular, theactions are taken to overcome and solve them, and to try and provideuseful and meaningful information to the investors and thebeneficiaries alike as well as to the authors of the regulations andinstructions.

TheInfluential Relationship between the Accounting Standards and theGlobal Financial Crisis

Thefinancial accounting rules can result in creation of differentoptions that can effectively reduce the comparability and add theunnecessary complications. Thus, there is an imperative need forprocessing the financial tools to reduce the complexity and enhancethe comparability and relevance as well as provide the grounds forthe convergence of different countries globally (Beck, Demirgüç-Kunt&amp Levine, 2010).

First,there is an examination into the integrated nature of capitalmarkets, as well as the movement of capital itself, which highlightsthe urgent need for a range of acceptable accounting standards. Thefinancial reporting standards have shaped and been shaped by thefinancialization of the economy. There is a relationship betweenfinancial reporting rules and the rise of power and influence withinthe financial sector. A critical question that emerges is the meansand ways in which the financial accounting rules have affected thestrategy and structure of the accounting rules as well as thestructure of the financial services industry.

Rangeof Acceptable Standards that Have to Incorporate

Fromthe global crisis, it is widely embraced by different scholars that arange of acceptable standards needs to be incorporated (Botzem &ampQuack, 2009). The crisis came about as a result of lack ofinternational harmonization and coordination and having systems thatcan address this within the accounting standards is a solution goingforward. It is noted that the regulatory systems present in thedifferent countries were not effective to keep up with the rate ofinternationalization of the credit markets as well the growth ofcross-border banking. Prior to the creation of the Basel Committeeand the other global structures meant to address the insurance andsecurities markets issues were already way ahead. The otherinstitutions that had made lots of progress were the IMF. Theprogress in IMF was mainly evident in the Financial Sector AssessmentPrograms where most of the countries were assessed in regards to thedegree of their adherence to the international standards andregulations as well as the good practice (Kirkpatrick, 2009).

Uponthe occurrence of the crisis, it was clear that the regulators or thesupervisors had not properly cooperated in an adequate manner toallow responses to be taken at the right time and as defined by therequirements. Evidence exists pointing to the issues of coordinationof reactions within the stipulated time. A case in point is the onesthat are related to the differences that exist in the depositguarantee systems worldwide and within the economic blocks like EU.There is some deposit guarantee directive that only aims at havingminimum harmonization. Any drastic change of coverage amidst thecrisis by countries lead to very high levels of uncertainty in boththe markets and the risk for regulatory arbitrage arises.

Additionally,lack of international harmonization was also a challenge mainly inrelation to the division of labor between the supervisors whensorting out the daily challenges in the banks. Nonetheless,experience exists among supervisors regarding the major financialcenters and thus, they can sort out the daily banking challenges. Acase in point is the collapse of LTCM that was addressed by Fed in aneffective manner. Another level where the issues were discussed isthe Basel Committee that addressed the issue of banking supervisionin the 1980s. Even though there were complementary frameworks andplatform to share experiences with the supervisors, a criticalproblem regarded the search for long-term stable structure.Additionally, the clarity in the division of labor between thedifferent agencies had not been sorted out.

Standardsneeded to be set up in regards to cooperation between the supervisorsand central banks. Further responsibility categorization between thecentral banks, ministries of Finance and independent financialsupervisors was not properly addressed (Parker, Guthrie &ampLinacre, 2011). Arising from this type of inefficiency in the systemeffects the cooperation that is between the central banks andsupervisors hence resulted in instability in finances.

Risksand Threats underestimated by Financial Crisis

Withthe development of the financial markets in the last couple of years,certain elements of the financial system have increasingly becomevulnerable to the shocks in market operations. Over time, most of thefinancial institutions have increasingly depended on the increasedliquidity in securitization and the other wholesale funding marketsfor their financing. While operating independently, the variousagents in the market cannot easily recognize and ultimately managethe systematic risk. In most of the disrupted markets, the movestaken by the banks in regards to different activities are ideallyintrinsic and largely enhanced by self-preservation and make theentire financial system to be less stable (Laux &amp Leuz, 2009).Currently, the regulatory standards are mainly set because if everyfinancial institution remains sound, then the system in its entiretyalso remains sound.

Notably,it is this kind of approach that led to underestimation of the risksin the system especially, the risks to do with innovations in thefinancial markets. The extent of diversification increased thechances of systemic risks occurring. Some of the diversificationincluded the use of securitization markets and derivative products.The increased risks of the diversification occurred owing to theincreased complexity of the interconnection of networks between banksand the other participants in the markets.

Giventhat the agents of the financial market had links, a comprehensiveevaluation of the risks of investing in or even lending to a bankrequired all the information about the bank and the counterparties tobe shared. Sharing or relaying of this information had numerousimplications. First, in within the stable financial markets, littleconsideration on the side of the banks was seen in regards to thepotential spill-over effects. On facing broader disruption in thefinancial markets, the market participants over-compensated throughstopping to lend the parties considered as liquid and have a goodcredit history (Bengtsson, 2011).

Fromthe first implication, it appears that the factors meant that marketdiscipline was not adequate to ensure that effective management ofthe systemic risk. On the second implication, the shock that affectedone or group of firms resulted in heightened market uncertainty likeretail or wholesale runs on the affected banks.

Acase example for the risks was the notion that in most of theinstances, the circumstances of the true sale were not met in regardsto the securitization of loans. The banks in place gave credit oreven liquidity guarantees for the products. Usually, the capitalconditions for the liquidity guarantees were lower in comparison tothe credit guarantees and thus proved to be cheaper to the personissuing.

Inadequaterisk management

Itis also noted that financial institutions over-relied on theinformation and data in the recent past to use as an indicator of thefuture market performance. As noted in the above case, the stabilityin a macroeconomic environment made the investors disregard thechances of any low-probability event occurring like what was seen inthe last two years.

Italso emerged that proper accounting standards lack to help define therisk models that could be instrumental in the financial institutions.The risk models in both banks and other financial institutions turnedout to poorly represent the response of the market participants(Bezemer, 2009). Notably, the use of value-at-risk (VAR) models,which applied the volatility of asset prices over the recent past toquantify the risk that is involved in the securities that can bemarketed, lead to an increase in the tendency of financial markets tounder-price risk especially during the good times and thus led to theherding tendencies of markets.

Theaccounting standards do not provide for enough mechanism to executestress testing. Thus, stress testing has continuously proved to beinadequate. Through stress testing, banks can evaluate the effect ofsome of the extreme event on their venture, which is mostly notreflected in the conventional risk-management models or even withinthe accounting books (Bezemer, 2009). Nonetheless, the stress testthat is also used has several limitations. An example of theshortcomings is that they missed the effect of the system wide shockslike the liquidity shortages and the manner in which risks can easilybe relayed in the markets even during the challenging times.

Creditrating agencies failed to evaluate risks

Thecredit rating agencies who are critical to the issues of globalfinancial crisis failed to assess comprehensively or comprehend thefinancial risks of the new complex products that led to the crisis.It was largely assumed that the credit rating agencies weregatekeepers to the global credit markets. Credit ratings agencies areknown to have a lot of influence on the accessibility of capitalmarkets and the different pricing terms on which the borrowersreceive credit. The influence is evident as they are put in charge ofissuing and continually monitoring several credit ratings on debt andother securities that are given by governments, corporations, andsecuritization vehicles.

Theother issue that led to the financial crisis and tied to theaccounting standards is the fact that most of the structured financeproducts were highly rated. Nonetheless, the method that was used inthe ratings did not in any way capture the sudden and dramaticincrease in the delinquencies and the foreclosures in the housingmarket in the US, especially from sub-prime mortgages (Rudd, 2009).

Additionally,owing to the conflicts of interests like the reliance on the creditratings on issuers to pay their fees and the provision ofrecommendations by the employees on the methods of achieving thedesired rating, there has been lots of questions raised in regards tothe integrity of credit ratings. Moreover, the meaning of structuredfinance ratings was one of the main causes. Credit rating agenciesmainly relied on the rating symbols to help in financing the productsthat were identical to the ones that were used in the securitiesconventional fixed incomes of corporate even after having lessbackground with little comprehension of the well-crafted financeproducts (Erkens, Hung &amp Matos, 2012).

Withoutproper accounting standards, remuneration can also pose to be a greatissue. During the financial crisis, the remuneration systems spurredrisk taking. It was established that the compensation for thepractices in financial institutions that armored lax iscountersigning and excess taking of risk, which is considered as asignificant contributor to the financial crisis.

Notably,financial institutions led to the creation of distorted incentivesfor employees by rewarding the capacity of the volume of the loan oreven having the transactions undergo lots of security check. Thefinancial crisis would then occur from this as lenders took poorquality loans which they also sold in the secondary market thuspassing the risk to the investors. In their work, Carmona andTrombetta (2008) noted that during the 1990s, as banks started theirfocus on faster share growth and expansion of earnings, theirstrategy led to growth in earnings through income and fees generatedby the process of securitization.


Onereason for the global financial crisis was the reason thattransparency and reliability in financial information was absent. Inlight of the global financial crisis, the administrations needed towind up progressively straightforward, dependable in reporting of thefinancial information to guarantee powerful correspondence of thefinancial effect on the legislature subsequently bringing about thefew activities that were started (Carmona and Trombetta, 2008).

Reliabilityand transparency in financial reporting entail preparing financialstatements on an accrual basis by governments. Additionally, it isdone through accounting standards that are developed by independentstandards and accounting regulations that are set in the interest ofthe public. The process also involves the auditing of financialstatements using accepted auditing standards (Humphrey, Loft &ampWoods, 2009). Governments have a duty to remain accountable at everylevel, quality or even in regards to the cost of services that theyoffer to the populace. To remain accountable, the government has toprepare financial statements that are clear and must properlyindicate how they have used the funds that are given to them bytaxpayers and other contributors. This kind of reporting shouldinclude the actions of the government in regards to the response tothe financial crisis.

Theaccounting standards used in the preparation of the financialstatements of the government play a critical role in transparency andaccountability. The government’s size determined by the level ofpublic debt and the operations of the local markets it significant tohave in place the accounting standards that ensure transparency andgive guidelines for consistent reporting.

Additionally,a set of accrual-based accounting standards is essential to help inthe reflection of the concerns of policy decisions. Cash basisaccounting standards when used by the governments mostly in the largeand highly connected economies, lead to a reduction in accountabilityand transparency.


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