One of the contributing factors to a successful financial system is the efficient flow of financial information to different stakeholders including regulators, investors and other financial market players. However, this information must be unbiased, transparent and relevant to facilitate decision making.
This third part of my journey involved a visit to a financial reporting standard setting body, the Financial Accounting Standards Board (FASB) to discuss the financial crisis. In the last two weeks, I have discussed visits made to key players in the financial system, namely two Federal Reserve Banks and an investment bank.
The FASB was established in 1973 and is the designated organisation in the private sector for establishing standards of financial accounting that govern the preparation of financial reports by nongovernmental entities in the United States. The FASB is based in Merritt, Norwalk, which is an hour’s journey on train from New York. As I travelled to meet an official from FASB, one of the questions I had was whether proper financial reporting would have better detected and averted the financial crisis.
The meeting at FASB was both interesting and informative. We covered the role and structure of FASB, including the standard setting process. We also discussed the cause of the financial crisis and improvements put in place over financial reporting in order to avoid future crisis. While accounting standards were not the root cause of the crisis, the crisis exposed weaknesses in accounting standards and their application.
These weaknesses reduced the credibility of financial reporting, which in part contributed to the general loss of confidence in the financial system. The weaknesses exposed the difficulty of applying fair value (“mark to market”) accounting in illiquid markets and the delayed recognition of losses associated with loans, structured credit products, and other financial instruments by banks, insurance companies and other financial institutions.
There are arguments that fair value accounting contributed to the instability in the financial system through resulting in significant overstatement of profits prior to the crisis and severe overstatement of losses during the crisis.
There were also a broad range of off-balance sheet financing structures that were not included in the financial statements of financial institutions nor adequately disclosed. In addition, the complexity of accounting standards for financial instruments led to differences in interpretation and application resulting in multiple approaches to recognizing asset impairment. The standards did not also adequately cover new and complex financial instruments that were the result of financial innovations by investment banks.
Hence, one of the key action points for the FASB was to simplify and improve financial reporting standards on financial instruments. However, improvements in financial reporting standards alone are not adequate to resolve the financial crisis and should be accompanied by improvements in other key areas such as regulation and risk management as discussed in the last two weeks to avoid overleveraging, excessive risk taking and undercapitalisation of the banking sector.
While recognising the improvements required over financial reporting, it also became clear that there are limitations in financial reporting that each financial market participant should be aware of. Financial reporting only provides information about the performance of a business at a particular point in time and when there is financial instability, the financial information may be outdated as soon as it is produced and hence market participants must make use of other information such as performance trends of the company and industry information. In addition, the quality of financial reporting is only as good as the underlying data used by the preparer.
Florence Gatome is Senior Manager at PwC Rwanda.