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RSM220H1 (54)
Xin Baohua (17)

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Rotman Commerce
Xin Baohua

The Role of Accounting in the Financial CrisisLessons for the Future SP Kothari kotharimitedu 6172530994andRebecca Lester rlestermiteduMIT Sloan School of Management E60382 30 Memorial Drive Cambridge MA 02421December 14 2011ABSTRACTThe advent of the Great Recession in 2008 was the culmination of a perfect storm of lax regulation a growing housing bubble rising popularity of derivatives instruments and questionable banking practicesIn addition to these causes management incentives as well as certain US accounting standards contributed to the financial crisisWe outline the significant effects of these incentive structures and the role of fair value accounting standards during the crisis and discuss implications and relevance of these rules to practitioners standardsetters and academics This article is based on a presentation by Deputy Dean and Professor SP Kothari of the Sloan School of Management Massachusetts Institute of Technology at Baruch College on October 25 2010 1Electronic copy available at httpssrncomabstract1972354The Role of Accounting in the Financial CrisisLessons for the Future I Introduction The Great Recession that started in 2008 has had significant effects on the US and global economy estimates of the amount of US wealth lost are approximately 14 trillion Luhby 2009Various causes of the financial crisis have been cited including lax regulation over mortgage lending a growing housing bubble the rise of derivatives instruments such as collaterized debt obligations and questionable banking practicesIn addition to these and many other reasons we explain two factors that partially contributed to the crisiscertain management incentives and fair value accounting standards This article discusses the causes of the financial crisis with particular focus on the debated role of the relevant US accounting standards and summarizes implications for accountants and accounting regulators based on the effect of these existing rules Following the dotcom bubble in 2000 and the September 11 2001 attacks the US economic policies of low interest rates coupled with easy credit lower taxes and the cheap dollar generated significant economic growth from 2000 to 2007Low interest rates motivated many in the United States to pursue home ownership a goal long propagated and encouraged by the government as a wise investment and worthy social objectiveEasy credit facilitated by agencies such as Fannie Mae and Freddie Mac enabled financial institutions to focus on the lucrative subprime mortgage marketMortgage lenders initiated a growing number of new home loans many of which were granted to individuals with a poor credit rating who would eventually be unable to service monthly mortgage payments once interest rates increasedUnfortunately gains generated from securitization of the home loans and from income on the servicing of the loans inflated financial profits motivating executives of mortgage origination firms to focus on quantity rather than quality of borrowersInvestors seeking new investment opportunities 2Electronic copy available at httpssrncomabstract1972354fueled the demand for mortgage backed securities that were created through securitization of the home loansSuch securities received high ratings from analysts who also did not correctly assess the underlying default risk In early 2005 interest rates begin to rise increasing up to 825 in 2007 from 4 in 2004In response a large number of homeowners particularly those with adjustable rate mortgages began to default on their monthly paymentsIn 2007 New Century Financial the second largest subprime mortgage originator in the US announced a restatement of its financial statements for the first three quarters of 2006 due to underreserving of certain loan loss provisionsThis announcement was followed shortly thereafter by large losses for firms with significant subprime positions including Bear Stearns Lehman Brothers Merrill Lynch and CitigroupThe market using the Dow Jones Industrial as a benchmark dropped precipitously from over 14000 points in October 2007 to under 7000 in March 2009 with a drop of almost 2000 points in one week alone in September 2008The subprime mortgage woes resulted in a significant and prolonged recession The companies engaged in the subprime mortgage business including both originatorssecuritizers of loans and purchasersinvestors in the securitized instruments were able to report certain gains on securitization of loans under US accounting standardsFurthermore companies followed US accounting standards to record loan servicing assets and residual interest assets as well as certain loan loss reserves using historical prime mortgage performance to estimate the appropriate valueFinally purchasersinvestors of the securitized instruments accounted for securities under the fair value accounting rules which permitted the firms to mark or not mark certain assets up to fair market value as measured based on classification of the instrument While the actual fair value standards themselves may not have been the culprit behind the financial crisis we believe that the inconsistent implementation and subsequent misapplication 3
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