Accounting Changes after Global

Financial Crisis: A Critical View

Written Report for ACCG 871: Advanced Corporate Accounting

Written by:
Ratna Yudhiyati
44047509
 Accounting Changes after Global Financial Crisis: A Critical View

Few years ago, business world faced one of the worst financial crisis in history. Now,
almost eight years after the collapse of Lehmann Brothers, business world is still recovering
from this Global Financial Crisis. This crisis brought many changes in economic and
business world. One of the major change it brought is new accounting standards. Many
people believe that these new accounting standards can prevent companies from ‘cooking
their books’ and increase financial statements’ quality. However, many people also believe
that these new standards have no impact to financial statements’ quality, while there are also
some people believe that these new standards are actually counter-productive. The objective
of this paper is to analyze these new accounting standards and compare them to expected
quality of financial statements.

Introduction: How Global Financial Crisis Happened

Many people believed that Global Financial Crisis started in 2007. There are many
causes of the crisis. However, The Economist (2013) explained how financiers’ attitude
toward risk is one of the main reason behind this crisis. They claimed that they were able to
manage and banish risk of investment, but actually they simply ignore and even lost track of
it. The problem was started by flood of ‘risky’ mortgage lending in US (The Economist
2013). This risky mortgage is sub-prime mortgage, a home loan given to risky and
questionable credentials.
Big banks turned all these risky mortgages into low-risk securities by combining all
these mortgages in pools. Then, these securities were used to back other security called
collateralised debt obligation (CDO). Credit rating agency, such as Moody’s and Standard
& Poor’s, assigned high safe rating to these securities. The Fed also declared low interest
rate in those years. This policy encouraged bank and financial institution to offer high-return
higher-risk investment and many investors were interested to buy them. Combining all these
situations, many investors bought these CDOs because they wanted more profitable
investment and they trust the ratings assigned by credit rating companies.
This financial engineering performed by these big banks might work if the risk of
securities were uncorrelated. However, these CDOs were backed by one kind of security;
sub-prime mortgage. When house price in US start declining is 2006, the problem rised. All
these investor suddenly found that their investments have lower value, or even worthless.
Investors started losing their trust to banks and financial institution. Bank started questioning
their counterpart’s and collegue’s credibility. Less people wanted to lend their money. Trust,
one of the most important factor in banking and financial system, started dissolving (The
Economist 2013). The final trigger is the bankrupcy of Lehmann Brothers in 2008. People
were panic. Financial crisis got worse and turned into commodities crisis.
Some experts and researchers believed that 2007-2009 crisis is a final result of
longstanding bubble economy. There was a possibility that Internet bubble in 1990s, asset
bubbles in 2005-2006, until sub-prime crisis in 2007 and commodity bubble in 2008 was all
related as one chain of events (Phillips & Yu 2011, p. 457). It means this crisis is not a

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sudden event, but a disaster waiting to happen since some time ago. It did not only happened
in US. An independent financial oversight group published a report which explained that
there was almost US$ 1 trillion ‘toxic debt’ in German financial system (Blakenburg &
Parma 2009, p. 532). It means that this problem exist in all Western economy, and its impact
was also experienced by Asian and African economic. It is not an exageration to conclude
that there is something terribly wrong in current system.

People want change. Regulators have to prevent this crisis from happening again.
There was a shift of business paradigm from free market and minimum regulation to control
of law (Davis 2011). New regulations were introduced. One of the changes is new accounting
standards.

New Accounting Standard: IFRS 9

Davis (2011) listed several accounting problems which might contribute to Global
Financial Crisis. First problem is the application of fair value accounting. Second problem
is how accounting method can be aplied to complex financial transaction and engineering,
such as repurchase agreement. Third problem is netting of financial instrument, such as
derivative. Fourth problem is impairment of financial assets.

IASB’s answer of global financial crisis is ammendment to IAS 39. IAS 39 is

accounting standard for recognising and measuring financial assets, financial liabilities,
contract, and derivative. After crisis, IASB announced IFRS 9 and declared that this new
standard would completely replace IAS 39.

There are three main topics and changes covered in IFRS 9. These three topics are
business model view in classification of financial assets and liabilities, forward-looking
impairment model, and improved hedge accounting. There is also additional topic about
treatment for profit and loss because of changes in entities’ own credit risk.

IFRS 9 introduces business-model view for classification of financial assets and

liabilities. There are three possible ways to recognise financial assets; amortised cost, fair
value through other comprehensive income (FVOCI), and fair value through profit or loss
(FVPL). According to IFRS 9, the classification is based on busines model of the entity
which hold the financial instrument. If the main objective of the business model is simply
holding assets and collecting contractual cash flows, the financial instruments hold by the
business model should be recognised in amortised cost. If the business model’s main
objectives are both collecting contractual cash flow and selling financial assets, the financial
instruments hold by the business model should be recognised in FVOCI. If the objective of
business model is trading and other activities which can not be included in two earlier
categories, the financial instruments will be recognised in FVPL (International Accounting
Standard Board 2014). This is the summary of classification standard.

IFRS 9 also introduces forward-looking impairment model. According to IFRS 9,

entities have to calculate and recognise 12-month expected credit loss when they recognise
financial instruments. They also need to establish loss allowance. If credit risk for the

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financial instruments increase significantly, entities also have to recognise full lifetime
expected credit losses (International Accounting Standard Board 2014).

An improvement was made in hedge accounting. IFRS 9 stated that hedge accounting
is applied to all kinds of risk management performed by company. Hedging for non-financial
items are included in new accounting standard. An example is fuel hedging performed by
airlines company.

Other topic covered by IFRS 9 is treatment for profit and loss because of changes in
entities’ own credit risk. According to IFRS 9, all gain or loss obtained by company because
of changes in its own credit risk will be stated in other comprehensive income (OCI), instead
of profit and loss (International Accounting Standard Board 2014).

Quality of Financial Statements

Quality of financial statements is difficult to define. In general, high quality financial
statements are financial statements which provide relevant and necessary information for
expectant investors, current shareholders, and regulators. However, different persons have
different definition of relevant and necessary information should be provided by financial
statements.

Iatridis (2010) used two indicators of financial quality in his research. First quality is
earning management. High quality financial statements should be free from possible earning
management. Accounting standards should be designed to prevent management from
manipulating company’s performance. Second quality is value relevance. Value relevance
can be defined as the ability of accounting measures to explain a company’s economic value,
reflected by its share price (Hung & Subramanyam 2007, p. 639). Hung & Subramanyam
(2007) explained that there are two accounting measure used to measure company’s market
value. They are book value and net income.

This paper would review IFRS 9 to find whether the standard can fulfill several
relevant indicators of high quality financial statements; (1) financial statement should be free
from earning management, (2) accounting number stated in financial statement should be
able to explain company’s market value and economic performance.

Analysis: New Standards and Financial Statement Quality

Earning Management
Financial instrument classification is one of the major changes brought by IFRS 9.
According to IFRS 9, financial instruments are classified based on the business model of the
entity which hold the financial instruments. Changes in business model is very rare. An
investment division will not change into a trading division. This kind of change can only be
caused by major change in company operation or other major reasons. If this kind of change
happened, it will raise red flag to auditors, regulators and other observers. Thus, financial
instrument reclassification is rare and there is clear explanation why it happened.
Old standards allow company to classify financial instruments based on
management’s judgment. There are some cases where company reclassify financial

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instrument from trading category to held-to-maturity. This reclassification was intended to
avoid recognising loss because of market value decline. IFRS 9 will greatly reduce earning
management by financial assets reclassification and other similar practices.
IFRS 9 also introduced new impairment model and rules. One of main changes in the
new rule is the effect of collateral to credit risk assesment. According to IFRS 9, collateral
attached to financial instruments should not affect credit risk for the financial instruments.
The credit risk assessment for the financial instruments should be free from consideration of
collaterals. This rules simplify credit risk assessment and provide relief to entities which
hold many financial instruments, such as financial insitutions (PwC 2014). This rule reduce
complexity of credit risk assement. When crisis happened or credit risk for certain
instrument increase, companies can not decide low credit risk because there are collaterals
attached to these financial instruments. Additional assesment and judgement for value and
risk of collateral is not necessary. The assessment is more straightforward. This rule reduce
earning management opportunities for credit risk.
However, new problem can rise because of the new classification requirements
described in IFRS 9. According to IFRS 9, financial instruments are recognised based on the
character of cash flow received. If the the cash flow received is solely payments of principals
and interest (SPPI), the financial instrument will be assesed further for its classification.
However, if the finacial instruments do not pass as SPPI, it will be automaticaly recognised
in fair value through profit and loss (FVPL). There are many hybrid financial instruments
as results of financial engineering. Sometimes, it requires difficult assessment and judgement
to define whether the received cash flow is SPPI or not. Different with previous standard,
IFRS 9 put FVPL classification as residual category (PwC 2014). If a company wants to put
its financial instruments as FVPL, it can simply engineer the financial instrument for failing
the requirements of SPPI. This rule bring new possibilities and methods to manipulate profit
and loss statements.
Value Relevance
IFRS 9 bring many improvements to hedge accounting. New standard accomodate
hedging accounting for non-financial items. Airlines companies are allowed to use hedge
accounting for fuel hedging. Other companies are also allowed to use this standard for other
commodities hedging. It means risk management performed by management will be more
accurately reflected in financial statements, both in balance sheets and income statements.
Forward-looking impairment model is a new concept introduced in IFRS 9. This
standard requires companies to recognise 12-month estimated credit loss when they
recognise financial instruments. They will have to recognise both possible credit lost and
provision. Financial instruments risk and possible loss of these instruments will be reflected
more accurately in financial statements.
IFRS 9 also address one of the major problem faced in Global Financial Crisis; gain
from changes of credit risk. During Global Financial Crisis, many companies have liquidity
problems and their credit rate decreased. Because of changes in their own credit risk, the
amount they owed to other companies which hold their debt instrument was decreased, too.

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This difference was recorded as gain. This treatment was greatly disliked by both investors
and regulators. IFRS 9 stated that gain and loss because of changes in company’s own credit
risk should be recorded as in other comprehensive income instead of profit and loss. This
new requirement will reduce volatility of company’s income. Profit and loss statement will
also reflect company’s business and economic condition more accurately.
However, there are several new problems which may rise from IFRS 9. IFRS 9
introduced business-model view as classification guideliness. IFRS 9 assumed that every
entity will only have one main objective. However, it is possible for entitiy to have two
business model. It can concentrate on both trading financial instruments and keep some other
instruments until maturity (PwC 2014). If IFRS 9 is fully implemented, company will have
to choose one kind of business model for accounting treatment when there is other business
model applicable for the entity. Financial statements will not fully explain the entity true
business operation. This is a possible problem for value relevance.
This business-model view classification also bring another question. Different
business model might have similar financial instrument, such as government bond. Consider
the following situation. Division A is a trading division. Most of the financial instruments
kept by the division will be resold to market. However, it also hold some government bonds
as part of diversification portfolio and this bond will be hold until maturity. Division B is an
investment division which concentrate on long-term financial instruments. Most of
instruments it helds will be kept until maturity. It also held some government bonds. This
condition will create complicated situation for IFRS 9. According to IFRS 9, all financial
instruments held by Division A should be recorded as fair value through profit or loss,
despite some of them will be held until maturity. The amount stated in financial statements
will be inaccurate and do not reflect company’s true objective for the financial instruments.
It wil also create inconsistency in accounting treatment.

Conclusion
IASB clearly consider Global Financial Crisis when developing this standard. IFRS
9 have its merits and solve some serious problems. However, these new standards also have
its own flaws and even create possibilities for new problems. This paper conclude that
despite its obvious merits, IFRS 9 does not greatly affect quality of financial statements. It
addressed problems in Global Financial Crisis but it might be not that usefull in general
situations. It also does not consider other problems which might give birth to different kinds
of crisis in future.

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