Accounting rules are boring, technical and understood by only a very few people. That makes them the perfect target for bankers and politicians scrambling around for a credit crunch scapegoat. It wasn’t our greed, stupidity or complacency that caused the crisis, they can argue, it was those idiotic accounting rules. Or rather, it was one particular accounting principle that pushed share markets and the financial sector to the brink of meltdown: the idea that financial assets should be reported at the “fair value” they could achieve in a market, rather than the price the company paid for them. This, of course, is rubbish, but the clamour for reform of fair value accounting has grown nonetheless.
The Institute of International Finance, a group of 375 financial services companies, was one of the first bodies to call for a fair value rethink, in a report it published in April. At the time, Lehman Brothers was still a respected name on Wall Street and you could argue that the worst of the crunch was over without someone laughing in your face. The situation has grown rather worse since then. The IIF’s report on the crunch pointed the finger at risk-management standards, disclosure practices and compensation policies – and also at fair value accounting.
In a statement that it released in May, the organisation said fair value accounting had been very useful in promoting transparency and market discipline and was still generally reliable in liquid markets. But there should be an open debate about the methods used to calculate fair values that are “useful, relevant, accurate and transparent.” In other words, when markets are highly volatile – or when the market for a particular security has dried up entirely – fair value does not work.
One could counter that the difficulty of arriving at a fair value for some of these assets reflects the simple fact that they no longer have any value: the bubble has been burst; the ruse rumbled. But the banking industry insists that as the markets recover these assets will have a “fair value”, but forcing financial firms to recognise a massive loss now will further destabilise the industry and make any recovery less likely.
Distinct lack of confidence
The Bank of England showed that it had some sympathy for this view when, in April, it published its Financial Stability Report. Loss estimates based on market prices were likely to overstate significantly banks’ losses as they will reflect factors such as illiquidity and uncertainty, which are unrelated to credit fundamentals and should ease over time, it said. Likewise, the Financial Stability Forum – a grouping of central bankers and regulators – has published a report stating that financial institutions and auditors were working together to improve valuation approaches and related disclosures in end-year financial accounts, “But further work is needed to provide confidence that valuation methodologies and related loss estimates are adequate, to clearly highlight the uncertainties associated with valuations, and to allow for more meaningful comparisons across firms.”
Some of the improvements it wanted to see were alternative valuation methodologies for illiquid market conditions, more consistency on this point between US accounting rules and the International Financial Reporting Standards used in most of the rest of the world, and more flexibility in allowing firms to shift certain assets from the “trading” category in their accounts to the “held to maturity” category, which would in effect protect these assets from fair value fluctuations.
The IIF was careful not to threaten the principle of fair value accounting. Its managing director, Charles Dallara, said it “remains an essential element of global capital markets as it fosters transparency, discipline and accountability.” He also accepted that accounting standards already give financial firms the flexibility to “mark-to-model” – which means basing a value on a theoretical calculation, rather than a market price – where there was no useable market data. “Appropriate use of such latitude is fully consistent with fair value accounting and has been embraced by accounting standard-setters,” said Mr Dallara.
The problem is that it is difficult for banks to use this latitude, especially when it comes to shifting assets beyond the scope of fair value. For one, their regulators have, in the past, not allowed it. Furthermore, it sends a worrying signal to investors: “what is the bank trying to hide by shunting assets around?” they might rightly ask. Dallara accepts that this is a problem. “There is the risk that, however well-framed the proposals, the intentions of those advocating changes could be misunderstood by investors at this stage,” he said.
That was the position in May; by October, with banks facing the prospect of punishing third-quarter fair value write-offs, the pressure to ease the accounting rules had become intense. Eventually, the banks got the changes they were asking for.
First, the US Financial Accounting Standards Board issued guidance to banks that wanted to use a fair-value opt out on the basis that there was no active market for their assets. This was reported as an easing of the rules, but those in the standard-setting community insisted that the board was simply explaining how to apply an existing rule.
Then the International Accounting Standards Board (IASB) responded to pressure and eased its rules. This was a far more significant move. At a meeting on October 13 the board rushed through amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures. The changes gave banks what they were asking for – the ability to reclassify some of their financial assets, which in practice meant they can avoid carrying them in their books at fair value. The board had earlier voted to suspend its due process rules so that it could implement the change with immediate effect.
By this time the IASB was under intense pressure from European Union politicians, who had complained that international accounting rules were putting the trading bloc’s banks at a disadvantage to their US rivals. Banks reporting under IFRS were unable to reclassify assets in a way permitted under US GAAP, they argued.
The weekend before the IASB agreed the rule change, the European Commission said it would step in and rewrite the relevant reporting standards if the board failed to act.
The new rules allow banks to reclassify assets – apart from derivatives – which they no longer plan to sell or repurchase in the near term. They can then be reported in the financial statements at the fair value they held on July 1, before the latest crisis hit, with tests for impairment.
IASB chairman Sir David Tweedie described the reclassification rule change as a “short-term fix” and a “necessary evil”. The board was happy with its existing standard, he said, “but we did understand people saying ‘look, we are getting slaughtered compared to the American banks’.”
The board had not caved in to political pressure, insisted Tweedie, and its independence is intact. “What we’ve done is show that we are aware, in a crisis situation, that it is important that banks worldwide have exactly the same playing field and we’ve done our best to create that,” he said. “The board recognised that it had almost a duty to help other countries that felt they were at a big disadvantage.”
The politicians and bankers might be happy to see the rules eased, but investors should be “very concerned”, according to a research note issued by JP Morgan Securities analysts Sarah Deans and Dane Mott.
The board had decided to put political concerns ahead of accounting principles, they said, which established an “unfortunate precedent”. Moreover, the step would reduce the consistency and comparability of financial statements because not all banks would reclassify assets to the same extent.
A further concern raised in the JP Morgan note is whether the board’s revised standard is open to abuse. While banks can now reclassify certain assets, they can only do so in “rare” circumstances (although that restriction does not apply to loans). Tweedie says it is for a bank and its auditor to decide whether the business faces rare circumstances, but he made clear that the current financial turmoil clearly fitted the bill. The question is: what happens when – or if – the markets calm down?
Proposing new instruments
The IASB’s rule-change brings IFRS into line with US GAAP, which already allowed banks to reclassify certain assets in rare circumstances. However, until the recent crisis, the SEC had never allowed a bank to actually use this get-out. The SEC is allowing reclassifications now, but the assumption is that it would revert to its normal practice once markets stabilise. Banks outside the US would also need their national regulator to approve a reclassification and there is concern that not all of them would be as tough as the SEC about what “rare” means. The upshot is that some banks could carry on shoving assets beyond the reach of fair value measurement after others have been told to stop.
Tweedie said that the reclassification rule change comes with a heap of disclosure requirements so that investors can see exactly what banks are doing. “If you transfer assets you have to show the fair value of the amount you are transferring and the affect that there would have been in the profit and loss account had you not transferred,” he said: Any investor will be able to look at the financial statements and work out what the key figures would have been without the rule change.
Tweedie insisted that allowing banks to avoid fair value treatments in some areas did not mean its commitment to the principle was fading. “We put a discussion paper out in March where we talked about the complexity of accounting for financial instruments and in that we made it quite clear that we think the ultimate answer for all financial instruments is fair value,” he said. “That will probably take some time to get to, but in the medium and long term that is the answer.”
Pauline Wallace, a senior partner in the global IFRS team at PricewaterhouseCoopers and an expert in financial instruments accounting, described the rule change as “an incredible boost that will help banks a lot.” Critics of fair value accounting were wrong to blame it for the current turmoil she said: “This is not a problem around fair value. This is a problem of the markets deteriorating. All fair value does is report what the markets are doing. If what you are looking for is transparency, you need to know fair value.”
Wallace praised the IASB for acting quickly. “The board has not caved in, but it has recognised that for some banks this is an option that they might want to look at,” she said. There were drawbacks for banks considering a reclassification. If markets recover, they will not be able to recognise gains. “The other disadvantage is that there is masses of disclosure,” she said. “If you do this you are going to have to write loads about it. It is not an easy ride.” Nevertheless, there is concern that, having conceded this point, the IASB might be bullied into further concessions. The Corporate Reporting Users Forum, a pan European grouping of investment analysts, says that further changes would “risk severely undermining the confidence users have in the accounts produced by European companies.” Now especially, investors need comparability and transparency, not further uncertainty and inconsistency, it argued.
“The accounts should portray the situation facing companies as it is in reality, and the fair value approach is important to this,” says Peter Montagnon, director of investment affairs at shareholder group the Association of British Insurers. “We recognise that the application of fair value in very volatile conditions has exposed problems. These need to be addressed in a considered way, but now is not the moment for turning our backs on an important principle. If we are to have faith in accounting standards, fair value should be applied when the going is hard, as well as when it is fair.”
Abandoning the principle now would give banks some short-term comfort and strengthen their claim that fair value accounting was partly responsible for the crunch. But markets – especially when they are spooked – demand transparency. The banks need to be honest about what caused the crunch, and honest about how badly it has hurt them financially. Fair value must stay.