Introduction
JP Morgan realized huge trading losses in 2012 owing to an investment transaction, which was carried out through its London office. Under the watch of Chief Investment Officer Ina Drew, who later stepped down, there were a series of unscrupulous statements made by this company with intent to induce unsuspecting customers into making investments regardless of considering the financial position of the company. Some of these machinations included credit default swaps (CDS) being entered and represented as part of the bank's "hedging" strategy. A trader, Bruno Iksil, famously known as the London Whale, accumulated many CDS positions in the market. It did not take long before the trading loss of approximately US$2 billion was announced, even though it was projected that the actual loss was larger than this. As a result, numerous investigations were launched in a bid to evaluate the risk management systems and internal controls established by the firm. In light of this background, the actions of JP Morgan clearly exhibited an example of FASB statements’ Violations. This paper will endeavor to highlight the precise rules that were flouted in a concise analysis.
FASB Statement No. 133
The essence of this statement is to demand that entities classify all derivatives either as assets or liabilities in all statements indicating financial positions and that they are indicated at a fair value. Such a derivative must always be cognizant of the following circumstances. First, it must factor in the exposure to changes that would be exhibited in the fair value of both a recognized asset and liability or an unknown commitment of the firm. Secondly, there has to be a hedge of the probable exposure to variable cash flows of a projected transaction. Finally, the foreign currency exposure of a certain investment in a foreign operation and an unknown firm commitment should also be factored in. JP Morgan, by concealing the likely risks associated with its hedging techniques and impending transaction; clearly violated this statement and that is why it was subjected to a lot of scrutiny by the authorities.
In light of this, the company adopted the valuation method that best suits its goals and interests in that particular accounting year. As such, it was easy to inflate the financial position of the company especially its projected gross profits in order to attract many investors and shareholders. These machinations amount to a clear affront to many international accounting standards including the principle of realization and accruals.
FASB Statement no. 157
Statement no. 157 elucidates the importance of fair value statements and establishes a framework within which fair value has to be disclosed in accordance with generally accepted accounting principles (GAAP). The import of this statement applies to both assets and liabilities, which have to be made clear according to the realization principle in order to give room for fair value measurements. There is a need to have consistency and comparability in fair value measurements, and that is why all firms are bound to state honestly the value of their assets and liabilities taking into account the best interests of all shareholders and potential users of accounting information. In relation to statement no. 133, this statement stipulates that a fair value measurement with respect to liability must reflect its nonperformance risk, which denotes the risk that the obligation may not be fulfilled. The hedging process is a financial speculator decision that is only reached at if a company intends to fix its interest rate of borrowing to a certain level. Therefore, presenting this in the books of accounts without indicating a warning or disclosing the fact that the interests are subject to the hedge being successful is tantamount to misleading every person who may rely on such statements of accounts.
JP Morgan should have envisioned the fact that nonperformance risk includes the presenting an entity’s credit risk, and therefore, it should have considered the effect of its credit risk or credit standing from the perspective of the fair value of the liability. Doing this would have introduced aspects of foreseeability in the operations of its major business relations like London Whale. JP Morgan violated the rules of expanded disclosures regarding the use of fair value to measure assets and liabilities and thus giving users of financial statements more information about the extent to which fair value has been used to measure recognized assets and liabilities, and this would ultimately obviate any cause of action from the users.
Statement no. 115
The essence of this Statement is to tackle the accounting and reporting practices for investments in equity securities, which already has determinable fair values for investments in debt securities. In this case, JP Morgan had an obligation to disclose the manner in which its equity trading is conducted. Debt securities of any enterprise, which have the ability to hold to maturity, are termed as held-to-maturity securities and are thus reported at an amortized cost. On the other hand, Debt and equity securities, which are bought and held essentially with a view of being sold again, soon are referred to as trading securities and reported at fair value, with unrealized gains and losses included in the earnings. In this case, all these assets are reported at fair value with unrealized gains and losses and ultimately excluded from earnings and as such, they are reported in a separate component of shareholders' equity.
A hedging plan was designed in a manner that clearly violated the market expectations. It turned out that JPMorgan was shorting the index by making huge trades. JPMorgan had projected that credit markets would get stronger. In the unfortunate finality, when investors became cognizant of the potential ramifications of the European financial crisis, the company suffered significant losses. This is reflective of the recklessness in the financial statements made by the company and being professionals relied upon by many people, the officials of JP Morgan were rightly held culpable for such malfeasance.
Statement No. 107
This Statement alludes to the existing fair value disclosure practices for all firms. As such, all entities must disclose the fair value of financial instruments with utmost honesty. All assets and liabilities realized and not realized must appear in the statement of financial position, making it more practicable to estimate the fair value in a manner that does not unduly advantage the company. However, if estimating fair value is not possible, descriptive information touching on estimating the value of a financial instrument should be disclosed to users of accounting information.
Given that JP Morgan had risk management officials who would ideally foresee a probable financial crisis if they released financial statements of unrealized assets, the firm clearly violated Statement 107 of FASB rules. If it had not done so, the investors would not have been held in a precarious situation, and thus, the firm would have avoided the many legal suits that followed it. The practice also out rightly violates the realization or prudence principles of accounting that require a company or financial institution to always account for assets that are within its grasp and leave out any projected profits before they ideally accrue.
Conclusion
Many companies have used Creative accounting to instrumentally cover up a lot of financial shenanigans at the expense of investors and shareholders recording huge financial losses. Such practices blatantly defy the spirit of standard accounting practices and rules, and should not be allowed to stand in this economic age. Owing to the despondency of certain personalities holding powerful positions in companies, significant amounts of money have been lost in an otherwise preventable way. This art of failing to observe or circumventing the already laid down rules is the one that led to the downfall of notable Multinationals such as Enron, Worldcom, and Parmalat. The real financial position of Companies is often concealed for a considerable duration after which the biggest looser is whoever innocently relies on financial accounting information.
In a nutshell, JP Morgan used many ingenuous ways that are often employed by present day accountants especially. The ultimate implications of such actions are that they often lead to an unjust eventuality. There must be enhanced scrutiny to cushion unsuspecting shareholders and investors from such overt operations. Such fraudulent conduct and activities should not be countenanced by financial regulators of today.
References
Singh, S. Corporate Governance: Global Concepts and Practices. New Delhi: Excel Books. 2005. Print
Stempel, Jonathan. JPMorgan ordered to face London Whale class action in U.S. Reuters 2015. Print.
Fleming, L. Excel HSC business studies. Glebe, N.S.W: Pascal Press. 2004. Print.
Jay, N., Saxena, A.K., Subrahmanyam, V., Best, R. “Is Accounting Fraud Predictable”, Review of Business Research, vol. 7, no. 4. 2007. Print
