The Subprime Crisis became noticeable first in the second half of 2006, when many subprime mortgage borrowers in the United States of America (U.S.) were no longer able to make their loan payments, and securities linked to those mortgages, that had been sold all over the world, turned out to be often worth quite less and in general substantially more risky than market partici-pants had expected. As the market tried to figure out the problems underlying the crisis, financial reporting, especially regarding derecognition of financial assets, special purpose entities and fair value measurement, became a matter of public concern. Consequently, the purpose of this work is to discuss these concerns in order to estimate whether and to what extent financial reporting might have contributed to the crisis and to present and assess the usefulness of actions taken by the U.S. Financial Reporting System in response to the crisis.
In order to meet this objective, the paper first provides a brief description of how the housing boom and the subsequent crisis evolved. The following chapter describes the U.S. Financial Reporting System, by providing basic information about U.S. institutions that authoritatively deal with the elements of the system, including their aims, basics about their work and how they interact. Afterwards, the paper examines the relevant reporting concepts and disclosure requirements, provides suggestions for improvements, and assesses concerns voiced by market participants with respect to financial reporting. Subsequently, the author analyzes and judges actions taken by authoritative institutions of the U.S. Financial Reporting Sytems in response to the crisis. This thesis considered publications issued until December 10, 2008.
Table of Contents
1 Introduction
2 History of the Subprime Crisis
2.1 The Term Subprime in Context of the Crisis
2.2 Key Causes and Development of the Subprime Mortgage Boom
2.2.1 Broader Economic Factors
2.2.2 Mortgage Securitization – Volume, Process and Participants
2.3 Development of the Subprime Crisis
2.3.1 Outbreak of the Subprime Crisis and Underlying Factors
2.3.2 Confidence and Liquidity Crisis
2.4 Intermediate Results: Key Causes of the Crisis
3 U.S. Financial Reporting System – Elements and Organizations
3.1 Reporting Standards and Authoritative Organizations
3.2 Auditing Standards, Ethic Code and the PCAOB
3.3 Examinations, Enforcement and Assigned Organizations
3.4 Education and Related Organizations
4 Critical Analysis of Reporting Standards Related to the Crisis
4.1 Fair Value Measurement in Context of the Crisis
4.1.1 Scope and Acceptance of Fair Value Accounting
4.1.2 Fair Value Measurement Pursuant to FAS 157 and Related Criticism
4.1.2.1 Fair Value Hierarchy Pursuant to FAS 157
4.1.2.2 Analysis of Public Criticism Related to the Fair Value Hierarchy
4.1.2.3 Critical Review of Disclosure Requirements Pursuant to FAS 157
4.1.3 Discussion of Allegations Regarding Procyclicality
4.2 Reporting for Off-Balance Sheet Arrangements and the Crisis
4.2.1 Assessment of Accounting Concepts and Disclosure Requirements
4.2.1.1 Derecognition of Financial Assets
4.2.1.2 Characteristics of Qualifying Special Purpose Entities
4.2.1.3 Concept and Consolidation of Variable Interest Entities
4.2.1.4 Related Key Disclosure Requirements
4.2.2 Evaluation of Public Criticism
5 Critical Evaluation of Actions Taken in Consequence of the Crisis
5.1 Clarifications and Planned Amendments to Accounting Standards
5.1.1 Clarification of Fair Value Measurement in Inactive Markets
5.1.2 Elimination of the Qualifying Special Purpose Entity Concept
5.1.3 Amendments to the Derecognition Model
5.1.4 Changes to Consolidation of Variable Interest Entities
5.1.5 Proposed Disclosure Amendments to FAS 140 and FIN 46(R)
5.1.5.1 Introduction of Overall Objectives and Aggregation Principles
5.1.5.2 Selective Disclosure Amendments Regarding Derecognition
5.1.5.3 Disclosure Amendments with Respect to Variable Interest Entities
5.1.5.4 Assessment of Disclosure Amendments to FAS 140 and FIN46(R)
5.1.6 Assessment of Effective Dates with Respect to Standard Setting
5.2 Findings Regarding Auditing and Ethic Standards
5.3 Actions with Respect to Examinations & Enforcement
5.4 Educational Proceedings and Considerations
5.4.1 Advising Letters of the SEC Regarding MD&A Disclosures
5.4.1.1 Advises for Disclosures about Off-Balance Sheet Arrangements
5.4.1.2 Advises for Disclosures Concerning Fair Value Measurements
5.4.2 Educational Publications Regarding Fair Value Measurement
5.4.2.1 Individual Publications of the FASB, AICPA and PCAOB
5.4.2.2 Joint SEC and FASB Clarifications on Fair Value Accounting
6 Conclusion
Research Objectives and Core Themes
The primary objective of this thesis is to discuss concerns regarding the U.S. financial reporting system during the subprime crisis, specifically in the areas of asset derecognition, special purpose entities, and fair value accounting, to assess if financial reporting contributed to the crisis and to evaluate the appropriateness of the systemic response.
- The role of fair value accounting and its potential procyclical effects.
- The impact of derecognition and consolidation rules for off-balance sheet arrangements.
- The effectiveness of the U.S. financial reporting system and its authoritative bodies.
- Critical analysis of accounting standard amendments following the crisis.
- Evaluation of educational initiatives and enforcement actions by the SEC and PCAOB.
Extract from the Book
4.1.2.1 Fair Value Hierarchy pursuant to FAS 157
Although FV existed for about 50 years in the US, interestingly, the increased use of market prices to measure securities since 1993 is mainly a result of the U.S. savings and loan crisis, in which losses on loans had been hidden artificially by the use of historic cost accounting. The following text will explain FV measurement pursuant to FAS 157. This standard, entitled Fair Value Measurements, was issued in September 2006, and became effective for fiscal years beginning after November 15, 2007, i.e. during the crisis. Mentionable, FAS 157 does not create new uses for FV, i.e. it applies to those products already required to be measured at FV. Instead, it is designed to clarify existing standards and demands more rigor from companies in estimating FV. Beneath providing a unique definition of FV, FAS 157 furthermore establishes a framework for measuring FV and requires companies to expand their disclosures about those measurements.
Par. 5 of FAS 157 defines fair value as “…the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Pursuant to par. 7, the term price refers to an exit price from the perspective of a market participant that holds the asset or owes the liability. An orderly transaction is a transaction that is unforced, i.e. it is not a forced liquidation or distress sale. However, significantly decreased transaction volumes do not necessarily indicate that these represent distressed or forced sales. The SEC requires companies to provide convincing evidence that market prices (i.e. observable transactions) are driven by forced sales.
Summary of Chapters
1 Introduction: Summarizes the background of the subprime crisis and the scope of the thesis regarding financial reporting and the U.S. response.
2 History of the Subprime Crisis: Traces the origins of the subprime mortgage boom, the role of securitization, and the subsequent outbreak of the confidence and liquidity crisis.
3 U.S. Financial Reporting System – Elements and Organizations: Outlines the regulatory framework, including the roles of the FASB, SEC, and PCAOB in setting standards and enforcing compliance.
4 Critical Analysis of Reporting Standards Related to the Crisis: Evaluates fair value measurement and off-balance sheet accounting rules, addressing critiques regarding procyclicality and transparency.
5 Critical Evaluation of Actions Taken in Consequence of the Crisis: Reviews standard-setting amendments, enforcement changes, and educational outreach programs initiated in response to the crisis.
6 Conclusion: Synthesizes findings on the impact of financial reporting on the crisis and suggests improvements for future standard-setting.
Keywords
Subprime Crisis, Financial Reporting, Fair Value Accounting, FAS 157, Derecognition, Special Purpose Entities, Securitization, Mortgage Backed Securities, FASB, SEC, PCAOB, Off-Balance Sheet Arrangements, Procyclicality, Consolidation, Variable Interest Entities
Frequently Asked Questions
What is the core focus of this thesis?
The work examines the role and impact of U.S. financial reporting standards on the subprime crisis, specifically analyzing whether accounting rules for asset valuation and off-balance sheet activities contributed to or exacerbated the financial turmoil.
Which key areas of financial reporting are analyzed?
The research centers on three main accounting themes: the derecognition of financial assets, the use of special purpose entities (SPEs) and variable interest entities (VIEs), and the application of fair value (FV) accounting.
What is the main research objective?
The primary aim is to assess whether financial reporting standards contributed to the crisis and to analyze the effectiveness and usefulness of the regulatory and standard-setting actions taken by U.S. institutions in response.
What scientific methodology is employed?
The thesis adopts a descriptive and evaluative approach, examining existing accounting standards (such as FAS 140, FAS 157, and FIN 46(R)) and analyzing the critical debates, public criticism, and the subsequent standard-setting amendments and educational guidance issued by bodies like the FASB and SEC.
What topics are covered in the main body?
The main body covers the history of the crisis, an overview of the U.S. financial reporting infrastructure, a critical analysis of specific reporting standards related to the crisis, and an evaluation of the policy and standard-setting responses implemented by authoritative bodies.
Which keywords characterize the work?
The key concepts include subprime crisis, fair value accounting, derecognition, special purpose entities, FASB, SEC, PCAOB, and securitization.
Why did the FASB decide to eliminate the QSPE concept?
The FASB determined that the QSPE concept was no longer operational in practice because the securitization market had evolved beyond what was originally contemplated, and that intensive restructuring of assets—necessary during the crisis—was not compatible with the passive nature of a QSPE.
How does the thesis evaluate the procyclicality of fair value accounting?
The author argues that while some market participants believe fair value accounting fostered the crisis, the boom and subsequent crash were primarily consequences of the underestimation of risk and insufficient risk management, rather than a direct failure of the accounting standard itself.
What is the significance of the "linked-presentation" (LP) model discussed?
The author suggests that a linked-presentation model—where sold assets and related liabilities are presented together on the balance sheet—could provide more informative data for users of financial statements regarding a company's continuing involvement and risks, though she notes that such a model would be challenging to implement.
- Quote paper
- Miriam Janzen (Author), 2009, Effects of the Subprime Crisis on the U.S. American Financial Reporting System, Munich, GRIN Verlag, https://www.grin.com/document/132446
