Financial Instruments Accounting Controversy During the 2008 Crisis

This essay provides an in-depth analysis of the controversy and complexity surrounding the accounting for financial instruments during the 2008 financial crisis. It explores the debate among accounting professionals regarding the causes of the crisis, focusing on the weaknesses in accounting standards, particularly the use of fair value mark-to-market accounting, the delayed recognition of losses, and the complexities in balance sheet structuring. The essay examines differing views on fair value accounting, pro-cyclicality, and the role of accounting standards in the crisis. It also discusses the development of new accounting standards by IASB and FASB, particularly IFRS 9, to improve financial information relevance and reduce complexity. The essay concludes by emphasizing the need for improved risk management, corporate governance, and the development of new approaches for valuing financial instruments to prevent future financial crises. The analysis draws on several academic sources to support its arguments.

Advanced Financial Accounting
1

Introduction
The financial crisis that occurred in the period of 2007-2008 was attributed mainly to
occur due to mark-to-market accounting that caused the melt down of the U.S. financial system.
The accounting professionals has emphasized on the weakness existing in the current accounting
standards that results in the occurrence of global financial crisis during the year 2008 (ACCA,
2011). In this context, the present essay emphasizes on the controversy and complexity
surrounding the accounting for financial instruments at the time of 2008 financial crisis.
Controversy and complexity surrounding the accounting for financial instruments at the
time of 2008 financial crisis
The global financial crisis has caused the debate among the accounting professionals
regarding the reasons responsible for its occurrence. It has been argued by the financial analysts
that current deficiencies in the accounting standards and their application have contributed to the
collapse of the financial system. The main weaknesses as pointed out by the financial analysts in
the accounting standards are use of fair value mark-to-market accounting approach in illiquid
markets, the delayed loss recognition arising from financial instruments such as loans and the
complexities in the structuring of the balance sheet (Zadeh, Barth and Landsman, 2013). The
major point of criticism in the current financial reporting standards was use of fair value
accounting that as per the views of many financial experts contributed to financial breakdown.
The use of fair value accounting has caused the pro-cyclical of financial instruments by
recognizing excessive losses that resulted in large sale of assets and debt repayments (Pozen,
2009).
The pro-cyclicality of the accounting leverage refers to the decrease in the debt amount
during economic downturn and increase during upturn. Thus, it has been argued that fair value
accounting model has lead to the reporting of excessive profit and losses leading to the
development of a vicious cycle. The decline in asset price has caused their write-downs leading
to their forced sales for meeting the capital requirements and thus increasing the price of assets.
On the other hand, some financial experts have a different view in relation to the use of fair value
accounting. The fair value accounting approach provides early signs of inflated asset values and
thus it can help in overcoming the occurrence of a corporate scandal. Thus, there are differing
2

views in relation to the contribution of fair value accounting practices to the global financial
crisis (Zadeh, Barth and Landsman, 2013).
The accounting standards are not responsible for the wring accounting of financial
instruments during the crisis as pointed out by various financial experts. It can be realized from
the fact that banks adopt the use of historic cost approach for asset valuation. However, the value
of these assets was also overstated despite of the fact that these assets are not marked to market
and are not subjected to liquidity in market. Also, the provision for recognition for losses was too
complex during the crisis that has caused the delay in identifying the losses on loan portfolios.
Also, the complexity involved in implementing the off-balance sheet standards has also caused
the understatement of losses in the financial system during the crisis. Thus, it can be said that
accounting standards are not responsible for introducing pro-cyclicality in the financial system
(Jarolim and Oppinger, 2012).
On the basis of above discussion, it can be said that only improving the current
accounting standards cannot restrict the occurrence of financial crisis as there are other economic
and governance issues that are responsible for financial collapse. The development of accounting
standards for improving the transparency and reliability of financial information is essential for
minimizing the chances of financial crisis occurrence in future context. In this context, it is also
essential that adequate risk management and corporate governance systems need to be developed
for safeguarding against the financial crisis. The major factors responsible for the economic
downturn during the global financial crisis were asymmetry in accounting for stating gains and
losses, use of fair value accounting and pro-cyclicality. However, there has still no relation
determined between the fair value accounting and pro-cyclical accounting leverage. Thus, there
is no single factor but a combination of various factors that led to the collapse of global financial
system in the year 2008 (ACCA, 2011).
The accounting of financial instruments is a topic of debate among the accounting
professionals ever since the global financial crisis. There is also debate around the rules-based or
principles-based accounting standards to be implemented for the development of financial
reports. The IASB (International Accounting Standards Board) and Financial Accounting
Standards Board (FASB) are largely emphasizing on reviewing and resolving the accounting
issues that have developed from the crisis. This involves developing new and revised accounting
3

standards in order to replace the complex accounting standards that exist for stating the gains and
losses. This is essential for safeguarding the interest of the users of financial statements so that
they can develop a better understanding of accounting for financial instruments for their
decision-making. The main objective of the IASB and FASB in the development of new
accounting standards is to improve the relevance and decision-usefulness of the financial
information and reduce the complexity that exists for reporting the financial instruments. In this
context, the IASB is currently placing focus on replacing IAS 39 with the IFRS 9 that highlights
the measurement of financial assets through the adoption of two measurement categories. The
major financial instruments recorded during the financial reporting are assets, debt instruments,
derivatives and equity. All the financial instruments will be initially recognized at fair value and
then at amortized cost after the initial recognition. This will help in improving the accounting
practices adopted by businesses for managing the financial assets. The accounting for financial
instruments is an area of conflict for both IASB and FASB board and both want to achieve same
policies reading their recognition and measurement. The reconciliation of the accounting
standards is possible through modifying and replacing the IFRS 9 standards (Huian, 2012).
The development of new accounting standard aims at reducing the complexity that
involves in measurement of financial instruments. It also aims at aligning the management
strategies developing for monitoring and controlling the financial assets. The IFRS 9 standard
also aims at issues arising from financial crisis such as credit gains and fair value accounting.
The simplifies accounting rules as per the IFRS 9 standard also helps in preventing the
manipulation of financial data that can cause the occurrence of corporate scandals at later stage.
Also, it is highlighted from the global financial crisis of 2008 that business entities need to
implement and adopt proper risk management system for overcoming the instability in the
market. The financial institutions faced challenging competitive market conditions at the time of
financial crisis due to market fluctuations and regulatory environment (Kirkpatrick, 2009). Also,
the corporate governance system of business entities needs to be rigid so that management
follows standard policies and procures for valuing its assets and liabilities. Therefore, the
development of new approaches regarding the valuation of assets and liabilities need to be
developed for preventing the financial crisis occurrence (ACCA, 2011).
Conclusion
4

It can be summarized from the overall discussion held in the essay that accounting of
financial instruments is a major topic of debate in the accounting field. The overstatement of
assets and liabilities during the financial crisis of 2008 has lead to the collapse of large financial
institutions. However, the accounting professions need to develop new approaches for valuing
the financial instruments and should not only emphasize on improving the accounting standards.
5

References
ACCA. 2011. The future of financial reporting 2011: global crisis and accounting at a crossroad.
Retrieved 28 August, 2017 from
http://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/
tech-tp-farsig11.pdf
Huian, M.C. 2012. Accounting For Financial Assets and Financial Liabilities According To
IFRS 9. Economic Sciences 59 (1), pp.27-47.
Jarolim, N. and Oppinger, C. 2012. Fair value accounting in times of financial Crisis. ACRN
Journal of Finance and Risk Perspectives 1(1), pp. 67-90.
Kirkpatrick, G. 2009. The Corporate Governance Lessons from the Financial Crisis. Financial
Market Trends 1, pp. 1-30.
Pozen, R. 2009. It Fair to Blame Fair Value Accounting for the Financial Crisis? Retrieved 28
August, 2017 from https://hbr.org/2009/11/is-it-fair-to-blame-fair-value-accounting-for-
the-financial-crisis
Zadeh, A., Barth, M. and Landsman, W. 2013. Does Fair Value Accounting Contribute to
Procyclical Leverage? Retrieved 28 August, 2017 from
https://corpgov.law.harvard.edu/2013/11/13/does-fair-value-accounting-contribute-to-
procyclical-leverage/
6