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This article focus on how to restore the confidence of investors on financial markets by improving the financial information, financial information should be more accurate and reliable so that investor can trust on them.
On November 15, there was meeting on that issue how to improve the financial system of the world after credit crisis. In that meeting finance ministers from 20 richest courtiers gathered to solve this burning issue.
The major issue that should be consider is financial information issued by public companies, there is an urgent need of strong rules and regulation regarding these financial statement's accuracy and reliability. Major reason of credit crunch was more risky investment by Banks and other insurance companies that lead to spoil balance sheets.
Investors still not showing their confidence in the companies due to poor financial information use by major companies around the globe. There is need of more clear and accurate financial information.
According to this article the major reason for this crisis is many companies provide poor and inaccurate information on their financial reports, they concealed there liabilities and other risk to mislead the investor and showing their statements stronger than that were.
Some banks have requested to eliminate fair-value accounting for weaker assets, fair-value of an asset is amount at which an asset can be purchased or sold in the market. Sometime assets current market value is very low but companies show them in their financial statement at higher cost. According to William Isaac a former chairman of FDIC Financial Accounting Standard Board is responsible for the credit crunch. According to the FASB assets should be valued at their market value. Financial service industry wants to change that rule of current market value of assets. That's why U.S security & Exchange Commission and the FASB introduce new rules and enables the companies and executive to use their own different financial methods for asset valuation.
According to this article relationship between the companies and capital market is very important for improving this situation of uncertainty. Companies are well aware of the fact of building more strong relation with their employees, suppliers, and customers. Companies need to build good relation with their customer for more market share and brand loyalty. More care should be given to their employees and suppliers. According to Miller, suppliers should have direct access to their supply system to build more confidence between them.
According to this article most companies have building good relation with above stated constituencies excluding capital market. We constantly ignore capital market; we never work with cooperation of capital market and provide them with wrong financial information. Its responsibility of management to provide accurate future cash flows and capital information.
Another major issue which is highlighted in this article more transparent derivatives (option, futures contract). According to Miller's view two important financial reporting practices under GAAP should be revised:
- Off-balance sheet financing
- Pension fund accounting
Off-balance sheet financing is a kind of financing in which major expenditure kept off from the balance sheet by using different methods. For example operating leases which are not shown in the balance sheet according to GAAP rule, that can be spoil balance sheet and mislead investors. Now FASB and IASB are jointly working on this issue of leases that would require to be shown in balance sheet.
FASB and IASB have already formed a new accounting standard about Pension fund assets. According to the new standard FAS 158 pension fund assets and liabilities are now mentioned in balance sheet of the company not mention as a foot note. Weaker assets which are shown in the balance sheet of the firms should be properly revealed.
Some strategist suggests that banks need to introduce new easy investment packages for two to three years to gain the confidence of investors and after that some typical investment packages. CMOs could be improved by improving the transparency of these assets. According to Scott, a data bank should be organised about securitized assets that were hobble around in the market although it's difficult but that can be done for more transparent financial system.
This report focuses on the electronic financial reporting, that combines all the managers report about assets and securities to generate more accurate information for the investor. That can do by using different computer base model by rating agencies.
According to Walter Pagano companies should follow more strict rules about capital requirement, now assets should be more liquid that would help to increase the confidence of investor. Electronic database of financial reporting should specially used in asset back securities so that its effect on investor's portfolio can be judge. EDGAR is an example that publishes financial data about SEC. XBLR is data protocol that enable analyst to compare data of different companies.
There is an 18 months conversation under the Washington-based Centre for Audit Quality which focuses on how to modify financial reporting to make it more specific and easy for investor and will present its report at the end of this year. According to CAQ's suggestion companies need to include key financial indicator of relevant industry in their financial reports that would allow investor to compare data among different companies.
According to Christine DeFabo, crisis can't fix only by focusing on reporting system but its required something broader like company's ability to access capital.
Substantive issues Raise
This report discusses the four main issues regarding the financial reporting; we will elaborate them step by step:
Short Shift to capital market
This issue focus on company's deep relation with capital market to provide them more specific and accurate information. In this section William Isaac blamed Accounting Standard Board for the asset valuation; according to this rule assets should be valued at their current market price/ fair value accounting. Most of the companies think that it should be suspended that can present misleading picture of the business. In accounting, fair value is use as an estimate of the market of an asset and liabilities for which market price is difficult to fix. According to the GAP (FAS 157), fair value is the amount at which the asset could be buy and sold, this can be used for assets whose carrying value is based on mark to market valuation. For those assets carried at historical cost, fair value of the asset is not used.
Financial Accounting Standard Board 133 requisites US companies to value their derivatives at market price. This fair value accounting substitutes the practice of determine derivative at their historical cost (purchase price). According to critics of this system many instrument do not have a liquid market for manipulating fair value, in that situation it typical models are used to generate the fair value.
(6-12 Feb 2002/ vol 5 issue 5 . Enron hightlights fair value accounting problems by Mike topping).
U.S Securities & Exchange Commission and Financial Accounting Standards Board have issued new rules and enable managers and companies to value assets using their own various financial models.
According to Kawaller "Inconsistency of different models is the main concern". In most cases, firm's exposure change over time. As unfairness model could work in one direction. (mike topping)
It's very important for the companies to provide complete and fair information to capital market to build a strong relation with them. In the past companies raised money from the capital markets by providing them with bias financial statements that leads to financial crises in US.
More Transparent Derivatives
This issue mainly concerned with more clear derivatives, according to Millers's financial reporting methodology need to be altered that will improve the investors' confidence in financial markets. The two principles should be altered to provide more transparent and specific information about company's financial position, under the principles of GAAP these are as under:
- Off balance sheet financing
- Pension-fund accounting
Off balance sheet financing is an accounting practice in which debt the obligation of the company to pay does not appear in the balance sheet as a liability. That allowed the company to look more creditworthy. It is a form of financing in which large capital expenditure kept off from the balance sheet by using different methods. Off balance sheet includes:
- Joint venture
- Research and development
- Operating leases
Off balance sheet normally refers to separate authorized body, separate companies of which parent company have less than 100% ownership or contingent liabilities like letter of credit. GAAP sanctioned these items excluded from the parent company's financial statement but must be explained in footnotes. Off balance sheet were helpful to finance new venture. Parent company can finance new enterprise without diluting existing shareholders. Usage of off-balance sheet is better in a sense that it transfers the risk from parent's shareholders to others.
But in recent financial crises some companies used it negatively like Enron, in that case off-balance sheet items were used to enhance the financial results to mislead the investors. That situation becomes more disaster when the market penalizes a stock just because of off-balance sheet items.
Off-Balance-Sheet Entities: The Good, The Bad And The Ugly by Rick Wayman
In that case FASB and IASB jointly issue a new standard FAS 158, according to that issue Pension-fund assets now should be shown in balance sheet to provide more accurate and transparent information about companies.
Second issue under this head was discussed about collateralized mortgage obligation, and stress was given to restore the investor's confidence on them. CMO,s is financial debt that was build in June 1983 by the Investment Banks. CMOs a kind of mortgage-back security are bonds that characterize claims to exact cash flows for large pools of home mortgages.
CMOs effect started to take place when banks have been surpasses their poor performing loan to investors by selling CMO( including subprime mortgages). This default mortgage will affect many CDs and bonds that cause significant decrease in the value and investor have nothing at the end. In that crisis default loans valued around $400 billion, major companies were Merrill Lynch, Bear Stearns, UBS and Wachovia.
Investors confidence can be restore by improving the system regarding CMOs, according to Scott a data base need be build regarding CMOs to make them more transparent, that have complete information regarding different assets that hang in the market.
Need for Electronic Financial Reporting
To reduce the uncertainty among investors it is very important to introduce electronic financial reporting system. This type of system provides complete information about hedge funds and other assets how much risk involved in that. It is the obligation of Rating Agencies to develop such a system where all the financial report can be put into some data base model to generate accurate and real information about those companies.
Another way to create investor confidence on financial market is need of more liquid assets on the balance sheet of the companies. In the past most companies have more fixed assets than the current assets, this is another way to build investor confidence.
Traditional old fashioned report should be replaced by electronic financial reporting which should be accurate, transparent, and cost effective and timeliness. That will help investor to reach accurate financial reporting of the companies.
The new system specially need to be used in asset-back securities, so the genuine information would be provide to investor and help them to maintain their portfolio. XBRL is an electronic language that is already used in different countries of the world. The basic purpose of this provides information about corporate business reporting. This language is based on XML which is worldwide design for documents and data on the World Wide Web.
XBRL will lots of positive impacts on financial reporting:
- Financial reporting easy with XBRL
- You need to put information in computer once
- Generate Financial reports in different formats
- Reports can exchange independently
- Easily accessible by analyst
XBRL can help decision makers, professional accountants, analyst to organize and extort information they interested. (Jia Wu and Miklos Vasarhelyi)