by Francois Masquelier, Head of Treasury, Corporate Finance and ERM, RTL Group, and Honorary Chairman, EACT
Bankers recently criticised accounting rules, blaming them for deepening the financial crisis. Can an accounting standard be responsible for a credit crisis? How can the IASB respond to this situation? The CESR has its own view on these IFRS issues based on research amongst top European companies.
Bankers call for review of financial rules
In January 2009, the Chairman of HSBC, Stephen Green said that the current financial rules must be “fundamentally revised”, as they had deepened the financial crisis. He continues that the capital adequacy regulations and fair value accounting were “well intentioned” but had proved to be inadequate. Some even said that these rules encourage banks to build up their capital instead of lending money to their customers. He thinks, as many fellow bankers do, that “Fair value accounting has added considerable volatility to results, only part of which is economic…” Many bankers have said that that financial rules have worsened the crisis by using fair value accounting to determine the value of assets whose market price cannot be determined.
Logically, the accounting translation of a financial instrument should not be responsible for its quality and current valuation.
Although this position is understandable, it is too easy to blame an accounting rule when bankers may also have manipulated instruments they did not understand, and did not fully assess risks and potential volatility.
Christopher Cox, Chairman of the SEC at the time, (Dec 2008), said accounting rules must be neutral. He explained, “Accounting rules should not be bent to help soothe the battered US economy. Accounting rules must be neutral and aren’t just another financial rudder to be pulled when the economy ship drifts in the wrong direction”. He added that they are “the rivets in the hull and you risk the integrity of the entire economy by removing them”. Mr. Cox indicated that constructive revisions could be made to improve a rule that the banking industry had been pressing to be suspended in the crisis. An SEC study has found that most investors agree the rules provide a meaningful way to measure assets. He concluded by saying that, the more serious the stresses on the market, the more important it is to maintain investor confidence with neutral, independent accounting standards”. The standard setters must endeavour to continue developing robust best practice guidance for auditors and preparers – particularly for fair value measurements of securities traded in inactive markets.
How could an accounting standard setter respond to a credit crisis?
This is a very complex question. Accounting rules are formal ways to translate financial operations. It is a sort of blood test. However, although a blood test is not the cause of a disease, some consider that IAS rules were somehow responsible for the crisis, or at least have not helped to maintain financial stability. Following these criticisms, demands from the European Union (EU) and stakeholder pressures, the IASB decided to react.
A the end of 2008, the IASB decided to provide the EU with an update of its response to the credit crisis, and how they planned to address the various issues raised. The IASB wanted to take a number of significant steps to improve accounting guidance based on the FSF (Financial Stability Forum). One of the main issues was the fair value measurement when markets are no longer active. Logically, the accounting translation of a financial instrument should not be responsible for its quality and current valuation. However, during an economic crisis, people feared it could drive further market deterioration. The first answer from the IASB was to organise roundtables with experts to address the issues which had arisen (1)1. Both international accounting boards (IASB & FASB) were committed to urgently respond to this unprecedented situation facing financial markets. [[[PAGE]]]
The IASB made an amendment to IAS 39 to permit certain reclassifications out of the HfT (Held-for-Trading) and AfS (Available-for-Sale) categories. Many financial institutions in Europe have used the fair value option to eliminate or significantly reduce measurement mismatches. However, a virtual disappearance of some markets may have had an impact on the way instruments are managed. The problem comes if you opt for the fair value option and no subsequent change in the classification is permitted.
The need for further guidance in application of the fair value in illiquid markets was identified by the EU, notably on the use of mark-to-model.
In summary, there were four EU issues:
1. Ensuring that financial assets presently classified under the fair value option can be classified into other categories and not measured at fair value;
2. Clarification whether CDO’s (collateralised debt obligations) include embedded derivatives;
3. Adjustments to impairment rules applicable for A-f-S assets;
4. Need for guidance on fair value in illiquid markets.
IASB and CESR were requested by the European Commission to start working on appropriate solutions specifically on the fair value option, embedded derivatives and insurance issues.
In fact, the IASB has better defined guidance on the application of fair value when markets become inactive. In December 2008, it also published proposals to strengthen and improve accounting requirements for off balance-sheet items. Furthermore, it published new disclosure requirements related to impairment. The two major accounting boards seemed to be cooperating to accelerate efforts towards harmonised positions and solutions. Finally, the IASB is considering other key issues related to financial instruments, including the fair value option, raised at recent roundtables and by the EU Commission in its letters to the Chairman of the IASB. This last issue is certainly more complex than it seems and some specialists are not fully convinced that reclassification from the fair value option would improve financial reporting and enhance investor confidence. The EACT will need to continue following the solutions that the IASB propose.
CESR statement on the reclassification of financial instruments
CESR (Committee of European Securities Regulators) has closely monitored the amendments proposed by the IASB regarding accounting for financial instruments. In particular, it has followed the discussions on fair value accounting.
The review followed the approval by the IASB in October 2008 to amend IAS 39 and IFRS 7 for the so-called “reclassification between categories of some financial instruments”. At the same time, this “crisis amendment” was endorsed by the EU to be used in all member countries. The CESR has expressed its support for the initiative taken by the IASB, which eventually avoided another EU carve out. The IASB and CESR were requested by the European Commission to start working on appropriate solutions specifically on the fair value option, embedded derivatives and insurance issues. The EU Commission stressed the urgency of finding solutions to the issues identified as they needed to be resolved by the end of 2008 (in order to be applied to 2008 figures and results)2. The IASB responded in December 2008. The CESR identified three issues as matters of particular importance which needed to be solved rapidly: (1) Fair value option, (2) Embedded derivatives, (3) Impairment of A-f-S items. [[[PAGE]]]
CESR’s views on main IASB issues
1. It is now possible to reclassify some financial instruments out of a category of instruments reported in the P&L to other categories. However, the new option does not apply if the financial instrument has been classified into this category using the fair value option. The EU Commission clearly stated that it should be possible. The CESR has therefore urged the IASB to re-examine the effects of the use of the fair value option in more detail as a matter of priority.
2. The EU Commission also reiterated its insistence on the issue of standards convergence (IFRS & US GAAP) in the area of embedded derivatives more specifically.
3. CESR is also concerned with the possible reclassification of the host contract (once split) to H-t-M category (not the derivative dis-embedded). CESR welcomed the publication of the European Directive on amendments to IFRIC 9 and IAS 39. It encourages both accounting boards to work closely together and FASB has recently expressed its agreement to work on ensuring US GAAP is applied in the same way as IFRS.
4. Finally, the CESR is concerned by EU Commission issues raised regarding A-f-S. For A-f-S debt items, if impairment is identified, unrealised reduction of fair value is treated as impairment. For A-f-S equity items, any impairment cannot subsequently be reversed. The EU is contemplating the appropriateness of these measures. It will recommend that IASB, in specific circumstances, should develop due process procedures with public hearings and consultation to enable standards to be amended when necessary in response to emergency circumstances.
Review of top European companies
The CESR ran a survey to analyse the 100 top EU financial companies (comprising 22 companies from the FTSE Euro Top 100 and 78 other financial companies).
The purpose was to check whether other amendments would be applied or not, and if so, the related disclosures (according to IFRS 7). More than 50% did not apply the reclassification of instruments. CESR is somewhat concerned by the disclosure of reclassifications, which should be transparent, clear and comprehensive.
CESR will continue to closely monitor future IFRS developments in the highly sensitive area of financial instruments and fair value accounting. It is particularly cautious of IFRS 7 developments and transparency of disclosures to protect users. By simply reading available public financial information, a reader (professional or not) should understand the reasons for reclassification and how it impacts on the accounts.
