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Reasons for choosing the above topic and organisation
The credit crunch has become the most talked about event in 2008/09. The collapse of Lehman Brothers one of Wall Street's biggest investment banks, raised several questions on how and what went wrong with the world financial system. It is only appropriate to therefore focus on the largest accounting standard that has been issued by the International Accounting Standards Board (IASB) and how its new proposed amendments will impact banks over the course of 2008/09 financial year.
The specific standard that I would like to focus on in my research report is IAS 39 - Financial Instruments: Recognition and Measurement and the possible effects that the proposed amendments would have on organisations financial statements and its business activities. The specific organisation that I have chosen is Royal bank of Scotland (RBS Group).
I fined financial instruments extremely fascinating especially derivatives, from their mathematical complexity to the manner that they are bought and sold by financial institutions. The main reasons for selecting this particular topic is not only to show my enthusiasm over financial instruments but also to demonstrate their volatility in the abnormal profits and losses they can create which ultimately played a major part in the current financial crisis. Banks were at the centre of the financial meltdown. Many questions and suspicions have been raised by major investors and politicians alike over what exactly caused the near collapse of RBS.
Previous editions of IAS 39 was favourably applied by banks and financial institutions in general, the relevant classifications of assets and liabilities did not raise any concerns during prosperous times when the financial markets showed great stability, but due to the demise and near collapse of many major financial institutions, IAS 39 has received major criticism from business leaders and politicians.
Further reason on why I choose this particular topic was to not only investigate the effects that financial instruments has on a bank but also to learn more about an area of financial reporting which is not taught to the full extent compared to the other financial reporting standards. Furthermore the reason for selection RBS as an organisation is that the bank came under immense scrutiny by the Banking Crisis Committee lead by Rt Hon John McFall MP (Commons, 2009)whereby the previous Chief Executive Sir Fred Goodwin and Chairman Sir Tom McKillop were asked to give an explanations of way RBS incurred such heavy losses during 2008.
The main question of this research project is to identify the impacts a proposed accounting standard would have on the organisations business activities and how they will affect their financial statements. In answering the main research question, first other smaller but important question needs to answered such as;
- Why proposed amendments were drafted for IAS 39?
- What did IAS 39 state before the proposal where drafted?
- What are the new proposed amendments?
- How will they address the issues identified?
- Have the new proposals successfully addressed the issues identified.
- How will the proposals affect the organisations business activities and how will the presentation of the company's financial statements be effected?
It is also important to identify what RBS's business activities would in entail. Royal Bank of Scotland provided a wide variety of services such as corporate banking to large business entities normally quoted or listed on the stock exchange; private banking services in which they provide wealth management services to high net worth individuals. Investment banking is the business activity which is the most affected by financial instruments, especially derivatives. Derivatives such as credit default swaps, put and call options, currency forward contracts and etc. are used to trade and hedge against risk on the financial markets. RBS would use its own capital for these activities
After formulating the above research questions, the following objectives were set out to provide reasonable answers to those questions.
- To gain more knowledge and understanding about the current accounting issues affecting banks and issues that could change ways banks do business in the future.
- Exercise the opportunity to gain a comprehensive understanding of how financial instruments function.
- To gain a more complete and wider understanding of IAS 39, since the standard is not taught in its entirety on the ACCA syllabus.
- Satisfy the requirements set by my mentor.
- Deliver the research report on time.
The following conceptual framework was developed with the use of research methodologies to best apply the information found to achieve projects objectives and answering research questions.
The research methodology that was adopted in gathering information from primary and secondary sources was the scientific method as discussed by (O'Leary, 2004). This methodology describes the use of methodical procedures that consists of the development of a theory that is consistent with using observations and secondly to use this theory t o make future predictions or assumptions to test those predictions.
(O'Leary, 2004) Further demonstrates that with use of interviewing and document analysis, qualitative and quantitative data can be collected to answer research questions. The scientific method was used to identify the new proposed amendments; how they were developed; implemented and the effect that they will have on Royal Bank of Scotland financial statements. Based on these proposals, predictions could be developed on how they would impact the business activities of the bank. This methodology would best help answering the research questions and meet the project objectives identified.
Sources of information used in gathering the relevant data
This section of the report the various types and sources of information will be stated which were used in gathering information.
The basic categories of sources of information used where Primary and Secondary sources.
- Personal communication
- Email contact
- Internet access
Descriptions of methods used in gathering information
The primary sources are first hand information gathered such as discussions, interviews and email contact that was conducted with my previous Corporate Reporting lecturer and one other individual that wishes to remain anonymous. The other primary source includes internet access where the complete IAS 39 standard and published accounts of RBS were downloaded.
Online access was incredibly helpful on gathering information about a topic area on which information is not readily available in academic books and articles. The advantages of web access is the speed at which information can be obtained which in turn results in time being saved that could be spend on other more complex areas of the report.
All though the information gathering process wasn't strenuous, the following limitations where identified. Financial instruments have recently become a popular discussion point among accounting and business professionals, but it remains an area which is complex and not easily understood. Finding credible and relevant information on the topic area was challenging. The internet provides a gateway to information on financial instruments, but a large amount of it consist of 3rd hand information which difficult to reference and assure that the statements made by particular authors or writers are credible.
- Academic Books
- Journal Articles
- Reference material
These include sources edited from primary sources and second-hand version such as academic books, journal articles and reference material. Large amount of research material was acquired through the use of academic books already owned as well as books from the Said Business School library.
The following limitations in regards to secondary sources were identified. A vast amount of information on financial instruments exists but only in respect to mathematical formulation and not to how they are used in practice by banks. Banks are market players and also market creators when it comes to designing and trading financial instruments. As stated before a vast amount of information exists about financial instruments, this is only academic information not information that explains the practical and trading aspect of it.
Ethical issues that arose in gathering information and how they were resolved
The identification of ethical issues that arose in gathering information was based on the ACCA's Code of Ethics (ACCA, 2006).
The first ethical issue raised was whether the information found was unbalanced or biased towards a specific argument or point that was being proved. This issue was overcome by recognising biased information and finding a balanced view and also exploring opposing views and appreciating commercial interest in published information. The main challenge was to distinguish between factual and opinionated material and recognising the factual information and value added opinions by not being influenced by others.
When gathering accounting or financial information on a company some parts of the information could well initially be left out on purpose to disguise the truthful position or situation of the company. Milton Freedman stated that for the benefit of the shareholders and transparency, that all information about a company should be made public, if not the company's share price and overall value will not be truthfully be reflected. It is therefore important to identify missing information through further use of analytical skills to identify risk and accuracy of information.
Professional competence and due care
Are preparers of financial information experts or professional qualified? This will measure not only the accuracy but also give the information credibility. Although the information comes from a qualified source, it still needs to be assessed whether due care was taken in preparing the information. A good example in selecting creditable financial information is to use audited financial statements.
When gathering information on sensitive issues such as the use of financial instruments in practice, confidentiality starts to play a major role. (O'Leary, 2004) States that once a study or research project is conducted and it involves human participation, ethical approval is likely to be needed. The two interviews and numerous conversations that were performed with individuals all stated profoundly that they wish to remain anonymous in this research report. They where however glad to participate and explain certain technical issues in regards to derivatives and their practical uses. This obstacle was overcome by implanting the ACCA's strict code on confidentiality.
Accounting Techniques used in gathering information
Double Entry Accounting Method
This is one of the most useful methods of recording transactions in accounting. The method can be explained by the (CFA, 2008); this is an accounting system of recording transactions in which only two accounts so as to keep the basic accounting equation (Assets = Liabilities + Equity) in the Statement of Financial Position. The double entry or the debit credit method is the most useful way in analysing entries which are showing in the Statement of Financial Position and Statement of Comprehensive Income. It's also the foundation on which accounting was built and has a direct coloration with the SFP and the SCI.
Double entry accounting doesn't present itself as a helpful method for gathering information, but it does prove to be the most helpful method of all when comes to presenting complex accounting treatment even to the untrained eye.
Mark to market accounting
This technique as explained by the (CFA, 2008) as method of revaluing the company's financial assets and liabilities to its current market value or fair value. Again it is not a technique that is used to gather information, but it's one of two very important techniques used to valuing derivatives. This method of fair valuation is beneficial to quoted companies during times when market price rise, but when market prices fall, millions to even billions of pounds can be erased from company's balance sheet as reported in the (FT, 2009)
This fair valuation method came under criticism from European politicians during the G20 summit, but during November 2008 the Institute of Chartered Accountants of Scotland defended fair value accounting in a written statement (Parliament, 2008) to the Treasury.
Look at Page 16 to 17 in Notes
Business Techniques used in gathering information
Qualitative and quantitative analysis was used to identify the most appropriate samples of information as discussed by (Maylor, 2005, pp. 167, 219). Quantitative analysis was used by focussing on those sections of the SFP and SCI that would be affected by the proposed amendments, where as qualitative analysis was used to identify what impact the proposals would have if enforced on the business activities for RBS.
O'Leary (2004) states the definition of interviewing as a method of data collecting where researchers responds by asking open ended questions. Interviewing was used in gathering information, but its first limitation a raised in that very few individuals outside the corporate banking industry has firsthand knowledge and experience on how they function. I was able to interview two individuals who both wished to remain anonymous. It was possible to gather not only useful information but also a better understanding on how financial instruments especially derivatives are used to hedge against risk and also to increase liquidity.
A further limitation of interviewing as discussed by O'Leary (2004) in gathering information with the use of interviewing is whether the information obtain is credible and is it specific to certain business only. Maylor et al. (2005) explains the best form of interviewing is face-to-face, as this method obtains more detail and benefits information gathering on technical subjects which involves understanding complex accounting treatment. He further discusses that face-to-face interviewing has its disadvantages whereby they are the most expensive to conduct, because of time, cost of travel and distance.
"Derivatives are financial weapons of mass destruction"
Very few individuals in the world of finance believed Warren Buffet when he made this statement in his is Shareholders Letter in (Buffet, 2003). Since 2003 the accounting standard on financial instruments namely IAS 39 has become the International Accounting Standards Boards achilles heel. This become apparent when in mid 2007 according to the (Bank of England, 2008) the world financial system was in a recession. The start of the financial turmoil was sudden but not unexpected, many global investors such as Buffet and Goerge Sorros predicted the events that followed 2007.
On June the 20th 2007 two major hedge funds of Bear Stearns collaps as reported in the
- ACCA. (2006, June). Code of Ethics and Conduct. Retrieved 2006, from ACCA Global: http://www.accaglobal.com/cec_doc.pdf?session=fffffffeffffffff0a0121384a7a6838ec5e09946c99f7b2f414894002a3d573
- Buffet, W. (2003, February 21). www.berkshirehathaway.com. Retrieved from Berkshire Hathaway: http://www.berkshirehathaway.com/letters/2002pdf.pdf
- CFA. (2008). Derivatives and Alternative Investments (Vol. 6). Boston: Pearson Custom Publishing.
- Commons, H. o. (2009, June 23). United Kingdom Parliament. Retrieved July 21, 2009, from UK Parliament Publications: http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/144/09021001.htm
- England, B. o. (2008, September 22). www.bankofengland.co.uk. Retrieved from Bank of England: http://www.bankofengland.co.uk/publications/news/2008/057.htm
- FT. (2009, July 16). www.ft.com. Retrieved July 16, 2009, from Financial Times: http://www.ft.com/cms/s/0/d43c6ae2-71a0-11de-a821-00144feabdc0.html?nclick_check=1/
- Maylor. (2005). Researching Business and Management. New York: Palgrave MacMillan.
- O'Leary. (2004). The Essential guide to doing research. London: Sage Publications.
- Parliament, U. (2008, November 3). www.parliament.uk. Retrieved from Pariaiment publlications: http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/144/144w103.htm