Using the Balance Sheet Concept to Help Students Understand the Current Economic Crisis

Transcription

1 SUNY Plattsburgh From the SelectedWorks of Chuo-Hsuan Lee Spring 2010 Using the Balance Sheet Concept to Help Students Understand the Current Economic Crisis Chuo-Hsuan Lee Mohamed Gaber Available at:

2 USING THE BALANCE SHEET CONCEPT TO HELP STUDENTS UNDERSTAND THE CURRENT ECONOMIC CRISIS Chuo-Hsuan Lee*, Ph.D., CPA, CMA, CFM Associate Professor of Accounting School of Business & Economics State University of New York at Plattsburgh 101 Broad Street Plattsburgh, NY Tel: (518) Fax: (518) Mohamed Gaber, Ph.D. Professor of Accounting School of Business & Economics State University of New York at Plattsburgh 101 Broad Street Plattsburgh, NY Tel: (518) Fax: (518) Corresponding author

3 INTRODUCTION Teaching accounting has not been an easy task for most faculty and understanding accounting does not come naturally to students, especially in their first financial accounting course. Despite of the fact that many strategies have been devised in delivering financial accounting course materials to students including using many technological advances developed by publishers and embedded with each of their textbooks, many students taking the first course in financial accounting still question the relevance and the value of the knowledge learned in the course. In the Accounting Instructors Report (AIR) - Trends Column, Needles continued to address the characteristics of students that are the sources of dissatisfaction for accounting professors (Needles, 2006; 2007). One of such characteristics identified by Needles is Increase in Oral and Visual Learning of students. The main focus of this paper is to provide an example which applies the visual learning approach to enrich the first introductory accounting course by linking the concurrent events of economic crisis to the balance sheet concept. We present a simple approach to apply the balance sheet concept that students usually learn in the first two weeks of classes in an introductory financial accounting course to explain what has happened to our economy since mid Regardless of the diverse background of students taking the first course in accounting, she/he can relate to one or more aspects of the recent economic events started since mid-2008 that resulted in the economic meltdown in the United Stated as well as globally. Moreover, at each student personal level, she/he has felt the pinch of the current economic crisis when she/he applied for financial aid, borrowed money to finance college education, or acquired a loan to buy a new or used car. The idea behind this approach stems from our understanding that majority of American families do own homes, own one or more cars, have credit card(s), and borrow money for a variety of financing purposes. Majority, if not all, of students in our financial accounting course have known, or at least heard about the government bail-out to the financial sectors, financial trouble of U.S. car manufacturing companies, massive foreclosure in the housing market, employees/workers layoffs, and the persistence and steady rise in the unemployment rate. The aforementioned facts did give us the opportunity in initiating a dynamic class discussion to demonstrate the effects of such facts on the balance sheet. DEVISING AN EFFECTIVE TEACHING STRATEGY We started with a simple idea by introducing the accounting equation which has been discussed in the first two weeks of classes as follows: ASSETS = LIABILITIES + OWNERS EQUITY The simple, yet interactive, example we have used is related to a family or an individual who has purchased a house, with some of the financing coming from prior saving (down payment), and the rest borrowed from a local bank. The value of the purchased house is the total assets they have, and sources of financing can be decomposed into two areas: money from prior savings

4 (equity), and loans (debt or liability in a form of a mortgage payable) from a bank or a financial institution. To bring the accounting equation to life and to insure Visual Learning, as was mentioned in Needles Trends Column, we created the following slide (See Exhibit 1) to reinforce the relationship among assets, liabilities, and equity elements of the accounting equation as follows: Exhibit 1 Students now can make sense of why accounting equation is expressed in three major elements, and furthermore the two sides of the equation must be equal. In addition, students know the meaning of a simple capital structure which provides for two sources of financing namely equity and debt. Exhibit 2

5 Then, we expanded the discussion to the bigger picture, the economy (see Exhibit 2). Exhibit 2 gives an overview of the market structure, and shows students what is actually happening after their family buy a home, and have a mortgage on their home. This Exhibit, although seems overwhelming at first, with some discussion students started to understand the interrelationships among major players in the market as they relate to the simple idea of buying a home and creating an equity as well as liability. Exhibit 2 simply reflects the relationship among several parties. The amount of mortgage that a person borrows from a bank to finance the house is considered a liability to that person s balance sheet, while it is recorded as mortgage receivables (asset) under the bank s balance sheet (lender). The lender (bank) also finances itself from their customers deposits and in addition they borrow money from other financial institutions, most famously Fannie-Mae and Freddie Mac (FM & FM) that represent Banker of Bankers. (Reiss, 2009) When FM & FM lend money to banks, it is considered mortgage receivables (asset), and to the banks it is considered liability. Now, each individual bank as well as FM & FM have an asset called Mortgage receivables, which they can repackage and sell to other financial institutions in the securities markets as Mortgage-backed securities. Simply, they are selling one of their assets that are secured by mortgages on homes of individuals, and families. To that extent, students do understand that if an individual defaults in paying their periodic mortgage payment, her/his home can be taken away by banks and put up for foreclosure. Exhibit 3 When house pricing is heating up due to the low interest rate and federal policy, all parties identified earlier were getting excited and lending activities were extended to even individuals and families who cannot afford to buy homes at such scaled prices. For a person to purchase a new house, the increasing house price means more borrowing needed from the bank given limited equity. For a person who owns a house, the increasing house price makes this

6 person feel rich and ultimately this person spend more money with confidence via more borrowing from the bank. Exhibits 3 and 4 are two visual slides developed to insure students understanding of the above discussion. Exhibit 4 Since lending institutions had enough liquidity to lend to home borrowers, many individuals who have no prior equity, and even without any or very marginal down payment were encouraged to buy new homes with a very low starting variable rate, where in the first, and may be, the second year the interest rate on home mortgages are so low (teasing rates), however, the variable rate have gone up gradually and in some cases reached a very high rate that made the monthly mortgage payment unaffordable. At the time of lending most financial institutions and lenders did not factor that in their decision and the only thing that lending officers care about is to create those mortgage-backed loans. Financial markets were celebrating the vibrant economies around the globe (Friedland, 2009). Too good to be true! The moment of truth came to play with overheating economy and the strong signs for hiking interest rate. The Financial Bubbles is about to pop, resulting in an increase in interest rate and housing prices started to decline sharply. Individuals and families who owns homes with adjustable interest rate started to see their monthly mortgage payment goes up and the increasing monthly mortgage payment, in many cases, has led to unavoidable default. Remember that such defaulted monthly payments are what we have shown previously as Mortgage Receivables on the banks balance sheet. At this time of the presentation to our students, we started to introduce the concept of Uncollectible Receivables which are the banks

7 most valuable assets. If mortgage receivables become uncollectible, then the asset values on banks balance sheet are partially or totally devalued. To insure students visual understanding of the above discussion, we devised two slides to show the status of the economy and the reflections of recent economic events/crises on the balance sheet (see Exhibits 5 and 6). Exhibit 5 Based on the Exhibits 5 and 6, students are now aware of several facts that affect the balance sheet. First, there is a decline in asset values; second, there is an equal decline in owners equity to offset the decline in assets; and finally there is an increase in liability due to increase in mortgage interest rates that ultimately resulted in an increase in periodic monthly payments. On the other hand, banks, and financial lending institutions have mortgage receivable that became uncollectible.

8 Exhibit 6 Banks now do not have enough funding to lend, and the whole financial system in the United States as well as globally is near collapse (Hagerty, 2009). A government bailout seems evident and unavoidable to bring the heart of the economy beating again. Exhibit 7 is intended to give a visual picture of pumping money into the financial system to help the economy moving again. This is done in the United States, United Kingdom, Japan, Germany, France, and so many other countries worldwide.

9 Exhibit 7 The bailout was not a magic bullet to correct the wrong doing, and the financial crises spread through almost all other sectors of the economy. As credit market becomes extremely tight, it makes companies unable to secure new loans to finance their operating activities, and in turn results in massive layoff of employees and workers. Employees and workers losing their economic power resulted in massive cuts in household spending and inability of paying monthly mortgages, leading to foreclosure of their homes. Due to severe decline in consumers spending, companies were not able to sell their products, resulting in additional layoffs of employees and worker and the unemployment rate reached a new high. Another bailout was done by the government for car manufacturing companies including Car for Clunkers which intended to sell the current inventory of cars laid on car dealers lots nationwide. To depict the above economic scenario and link it to a typical American Company s Balance sheet, we developed Exhibit 8. Students now are convinced that an economic event, which they have seen in a typical definition of an accounting system, really has a meaning and such an economic event may have an effect on the financial statements.

10 Exhibit 8 It was also important to discuss the ethical issues that contributed to the economic crises and the financial meltdown at the end of the presentation. Now, students understand that unethical behavior not only affects the individual companies but also everyone in the entire economic system. We asked our students the following question: what should have been done to avoid or mitigate the economic crises if we could take the time machine back to the past. At the end of this presentation students were able to relate the ethical issues with the accounting concepts they have learned and presented some interesting points. CONCLUDING REMARKS In this paper, we present a visual learning approach to apply the balance sheet concept that students usually learn in the first two weeks of introductory financial accounting course to explain what has happened to our economy since mid By linking the concurrent events of economic crisis to the balance sheet, more specifically, the accounting equation, we were able to create an excitement in classroom discussion and enrich course materials in the first introductory financial accounting. We were encouraged by the favorable students feedback and comments in making a difficult concept easy to understand, and difficult to forget.

11 REFERENCES Friedland, J The subprime and financial crises. International Journal of Disclosure and Governance, 6 (1), Hagerty, J. R. Hit by mortgage Defaults, Fannie Needs $19 Billion. Wall Street Journal (Eastern edition), New York, N.Y.: May 9, Needles, B. E., 2006, Who are Our Students? Accounting Instructors Report: Trends, Winter, 1-2. Needles, B. E., 2007, Who are Our Students? Accounting Instructors Report: Trends, Spring, 1-6. Reiss, D The role of the Fannie Mae/Freddie Mac duopoly in the American Housing Market. Journal of Financial Regulation and Compliance, 17 (3), 336.