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Fair Value Accounting and the Banking Crisis in 2008: Shooting
theMessengerPaul Andra; Anne Cazavan-Jenya; Wolfgang Dicka;
Chrystelle Richarda; Peter Waltonaa ESSEC Business School,
France
To cite this Article Andr, Paul , Cazavan-Jeny, Anne , Dick,
Wolfgang , Richard, Chrystelle and Walton, Peter(2009) 'FairValue
Accounting and the Banking Crisis in 2008: Shooting the Messenger',
Accounting in Europe, 6: 1, 3 24To link to this Article: DOI:
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Fair Value Accounting and theBanking Crisis in 2008: Shootingthe
Messenger
PAUL ANDRE, ANNE CAZAVAN-JENY, WOLFGANG DICK,CHRYSTELLE RICHARD
& PETER WALTON
ESSEC Business School, France
ABSTRACT The paper sets out to analyse the effects of the
financial crisis on theinternational standard-setter in 2008 and
the attempts made to shoot the messenger toblame IAS 39 for
creating the crisis for reporting unrealised losses, rather than
thecause being bankers making bad investment decisions. It first
provides a brief analysisof IAS 39 and fair value accounting for
financial instruments. It then sets out therelationship with the
Basel II banking regulatory regime. The main part of the paper isa
chronological presentation of the events of 2008 as they impact
upon the internationalstandard-setting institution. In particular,
we analyse the impact of the G20requirements and the blunt
intervention of the European Commission that led toamendments to
IAS 39. The final part of the paper looks at the consequences as
theyare so far discernible and the damage done to the IASB by
shooting the messenger.
Introduction
Responsible and guilty as charged? Since fairly early in the
negative cycle, the
International Accounting Standards Board (IASB) has been put in
the dock,
accused of having intensified the effects of the financial
crisis. To hear the com-
ments of some banks, businesses and even politicians,
International Financial
Reporting Standards (IFRS) have not only been ineffective during
the period
of the crisis but they have also precipitated the fall of some
major financial
institutions. Criticised and destabilised, accounting has been
considered one of
the key factors of the crisis. But is that really the case?
Accounting in Europe
Vol. 6, No. 1, 324, 2009
Correspondence Address: Chrystelle Richard, ESSEC Business
School, Avenue Bernard Hirsch,
BP 50105, 95021 Cergy Pontoise Cedex, France. Email:
[email protected]
Accounting in Europe
Vol. 6, No. 1, 324, 2009
1744-9480 Print/1744-9499 Online/09/01000322# 2009 European
Accounting AssociationDOI: 10.1080/17449480902896346Published by
Routledge Journals, Taylor & Francis Ltd on behalf of the
EAA
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During 2007, financial institutions began to need to recognise a
drop in value of
some of their financial assets, generally linked to sub-prime
loans. The financial
press first focused on the amounts of the impairment write-downs
and the doubt-
ful quality of the related assets. However, bit by bit, the
financial institutions
started to blame fair value accounting. Their management argued
that they had
no intention to sell these assets and there was no point in
measuring them at
their market value. In March 2008, the chief executive of the
American Insurance
Group (AIG) was cited in the Financial Times as suggesting that
management
should estimate the likely losses and recognise those, rather
than reflect market
prices by measuring at fair value.1 This position began to be
heard by politicians
and banking regulators who started to review the situation. The
IASB and FASB
started to come under pressure to reconsider the fair value
rules. This was to lead
to a crisis for the international standard-setter and a possible
loss of any chance of
being adopted in the US. The messenger was certainly shot, but
not to death. It
remains to see how much it was wounded.
In this paper we will first set out what is the linkage between
fair value account-
ing and banking regulation, then look at the unrolling in 2008
of political pressure
on the IASB, and finally we will review the consequences, actual
and potential of
the fair value crisis.
Fair Value under IFRS
Fair value is defined in IAS 39, the recognition and measurement
standard for
financial instruments, as the amount for which an asset could be
exchanged, or
a liability settled, between knowledgeable, willing parties in
an arms length trans-
action. The concept of fair value measurement is to show assets
and liabilities at
their market value at balance sheet date rather than at
historical cost. Gains and
losses are recognised immediately in the financial statements
rather than being
smoothed over the life of the instrument. Accounting for assets
at fair value can
be seen as a general application of the financial logic that
sees the business as a
portfolio of assets whose value depends on their expected cash
flows and risk.
The way in which standards require fair value to be measured is
still evolving.
The FASB published a standard, SFAS 157 Fair Value Measurement,
which
formalises how fair value should be applied when another
standard calls for
that as a measurement basis. The IASB plans to issue its own
convergent fair
value measurement standard before 2011. SFAS 157 recognises
three levels of
fair value measurement: Level 1 is the current price in a liquid
market for
exactly the same instrument, Level 2 is the current price in a
liquid market for
a similar instrument, which can be adjusted to obtain the fair
value of the instru-
ment being valued, Level 3 uses valuation models based on
assumptions that a
market participant would use. Level 3 should not directly use
the entitys own
assumptions without modifying them to reflect the market.
The application guidance of IAS 39 (developed several years
earlier) implicitly
also has three levels but it mainly draws a distinction between
fair value based on
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market data (what SFAS 157 would call observable inputs) and
fair value based
on a valuation model (unobservable inputs). These are also
referred to as mark
to market and mark to model. The US three-level hierarchy has
become widely
used outside of a US GAAP environment, and is significant in
that standard-
setters usually ask for more stringent disclosures related to
Level 3 (mark to
model) as opposed to Level 1 (mark to market).
Under IAS 39 financial instruments are classified under four
headings, which
have different accounting consequences:
. financial assets held for trading
. held-to-maturity investments
. available-for-sale financial assets
. loans and receivables
Held for trading financial assets are valued at fair value at
each balance sheet
date, and changes flow directly through the income statement.
All derivatives
are treated this way. Held to maturity investments are held at
amortised cost.
Available-for-sale financial assets are valued at fair value at
each balance sheet
date, but the change in fair value goes to equity and is now
reported in
Other Comprehensive Income, with gains and losses recycled
through the
income statement when the asset is sold. Loans and receivables
may not
include derivatives nor be quoted on an active market. They are
measured at
amortised cost using the effective interest rate method. In
2003, the IASB modi-
fied IAS 39 to add an option to use fair value through income
for subsequent
measurement of any asset or liability in order to correct an
accounting mismatch
(i.e. where matching assets and liabilities that were held to
offset risk were
accounted for on two different measurement bases, giving an
accounting
mismatch that did not reflect the underlying economics).
A key anti-abuse requirement is that entities had to determine
at inception into
which category the asset fell, and were not subsequently able to
re-classify it.
This, and the hedging rules, were primarily driven by the
perception that if
entities were able to re-classify, at any balance sheet date all
loss-making
assets would be transferred to amortised cost, while those
showing a market
profit would be at fair value through profit and loss.
Fair value is not a new concept. Richard (2004) points out that
market value
was used in France in the 19th century. It has existed in an
Anglo-Saxon legal
context for at least 200 years (Walton, 2007). Broadly, the
courts have used
the term to mean a price at which buyer and seller both receive
an appropriate
benefit from a transaction i.e. a price that is fair to both
parties. It has long
been used in accounting as a means of fixing a financial value
when a transaction
does not contain an explicit financial value. This happens, for
example, when a
promoter of a company gives up non-cash assets against shares in
the
company. A fair value for the non-cash assets has to be
determined to fix a
financial value for the transaction. Barter transactions also
use it. Similarly, it
Fair Value Accounting and the Banking Crisis in 2008 5
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is used as an allocation device when a transaction needs to be
broken down into
smaller components, such as when the purchase price for a
business is broken
down into individual assets and liabilities in a business
combination.
The potential danger of fair value accounting has been
underlined by empirical
studies. Gonedes and Dopuch (1974) explained that the empirical
association
between accounting figures and stock prices and returns is not a
proof of the
relevance of an accounting rule. Holthausen and Watts (2001)
also state that,
the value relevance literature seems to forget the questions of
accounting
standard-setting.
However, its use in the context of financial instruments started
to be widely
considered in the 1990s. As Casta (2003) explains, the emergence
of fair value
in the last two decades can be related to several factors. It
springs initially
from the problem of recognition: the rapidly expanding use of
financial instru-
ments posed a problem as to how to recognise them in the balance
sheet.
There was also a desire, notably on the part of the Securities
and Exchange
Commission (SEC) in the US to reduce managements discretion in
manipulating
earnings, given that the use of historical cost permitted them
to defer the
revelation of problems. Finally, the principle of fair value is
consistent with
the Conceptual Framework in terms of providing decision-useful
information
to investors which met the requirements to be relevant and
reliable.
The qualities attributed to fair value in relation to financial
instruments are
numerous. This corresponds with the methods used by investors in
forecasting
cash flows. In terms of comparability of financial statements,
it removes the
possibility of opportunistic management of the result and
ensures the neutrality
of the measure of performance, based on disposing of an
instrument rather
than keeping it, and using an external benchmark. Finally it
ensures the comple-
teness of the accounting information by recognising derivatives
that are without
any historical cost.
All the same, the use of fair value is not exempt from
criticism. There are, of
course, risks in using a valuation model for instruments for
which there is no
liquid market in which prices can be observed. There is above
all a short-term
orientation that can considerably increase the volatility of
balance sheet values.
There is also the cost of applying such a system. At the end of
the day, any
accounting measurement system implies a number of choices. The
quality of a
system is assessed based on its capacity to facilitate the
taking of decisions by
users, the relevance and reliability of the information and the
systems capacity
to permit comparison over time and between companies.
Fair Value in the Banking Sector
Walton (2004, p. 6) notes that the banks are unhappy about
having to value
available for sale and held for trading assets and liabilities
at fair value and
believe this will cause great fluctuations on a period-to-period
basis as a reflection
of short term shifts in the market. From the same perspective
Aubin and Gil
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(2003) underline that the application of fair value to the
banking sector leads to a
great heterogeneity in the content of the balance sheets of
banking groups and the
computation of their results. Credit institutions have the
discretion to value their
loans at historical cost when made to clients, a fair value for
those eligible under
the fair value option or those bought on the secondary market.
As far as hedging
is concerned, Aubin and Gil consider that the accounting rules
do not translate the
reality of banks management of assets and liabilities, which is
aimed at protect-
ing themselves from variations in rates, and not at netting off
the variations in
value of the financial instruments concerned.
Colmant et al. (2007) also affirm that the IFRS that address
financial instru-
ments (IAS 32, IAS 39 and IFRS 7) pose application problems in
the banking
sector, notably in the way they interact with the New Basel
Agreement on
Equity (known as Basel II). Basel II organises the prudential
supervision of
banks by regulators into three pillars: a first pillar (Tier
One) relative to the
minimum capital requirements, a second pillar (Tier Two) dealing
with pru-
dential surveillance, and a third pillar (Tier Three) requiring
publication of
certain information by banks. Moving to IFRS has modified the
calculation
of the solvency ratio for banks, in particular as regards the
re-measurement
of available for sale financial instruments and the unrealised
results of cash
flow hedges.
The European criticism has only amplified the echo of the
American criticism
made a few years earlier. In the face of the negative comments
of the American
banks as well as the major audit firms at the time that SFAS 115
Accounting for
Certain Investments in Debt and Equity Securities was issued in
1993, Barth et al.
(1995) tried to respond to these and defend fair value as the
measurement basis
for financial instruments held by financial institutions.
Several of the affirmations
of opponents of SFAS 115 were tested to verify their validity
and their veracity. It
is interesting to note that two of these were confirmed. In the
first place, the earn-
ings numbers published by the banks were indeed more volatile
under fair value
than under historical cost. In the second, the credit
institutions more often
infringed regulatory requirements when they measured at fair
value rather than
historical cost. There is, therefore, a fundamental
inconsistency between account-
ing measurement and prudential valuation, as these two methods
are seeking to
satisfy different objectives. Accounting information should be
relevant to inves-
tors needs, while prudential information should be prudent from
the regulators
perspective (Matherat, 2008).
Nonetheless, in the course of the last few years, as long as the
market was
rising, no one was too shocked by fair value accounting, be they
management
or politicians. Fair value started to be stigmatised when the
market began to
decline, because neither regulators nor banks welcomed the
reflection of the
market downturn in the banks balance sheets. All the same, at
the beginning,
the crisis was classic in nature: financial institutions, some
of them hardly regu-
lated at all, had made loans on poor quality criteria, and the
loans had been used in
complex operations that were poorly securitised (Matherat,
2008).
Fair Value Accounting and the Banking Crisis in 2008 7
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However, as Vinals (2008) explains, the valuation models had
been conceived
in a favourable economic context, without taking into account
all the risks that
were present. Numerous models did not sufficiently take account
of the fact
that the underlying assets for many complex products were risky
American
mortgages, sensitive to variations in the interest rate, in the
price of property
and to the persuasions of lenders. The correlations between the
defaults in the
portfolios of sub-prime mortgages on which the instruments were
based had
largely been underestimated (Vinals, 2008, p. 135).
At the same time, fair value accounting results in more volatile
earnings (e.g.
Barth et al., 1995). One example, developed by Michel Magnan
(2009), illus-
trates the impact of fair value accounting on reported
earnings.
In its last reported financial statements before it went
bankrupt, Lehman
Brothers reported a loss of US$ 2.4 billion for the first six
months ending
May 31, 2008 (vs. a net income of US$ 2.4 billion for the first
six
months ending May 31, 2007). The shift of US$ 4.8 billion is
largely
driven by a dramatic fall of US$ 8.5 billion in Lehmans revenues
from
principal transactions, which include realized and unrealized
gains or
losses from financial instruments and other inventory positions
owned.
[. . .] Thus accounting for fair value for some financial assets
amplifiedLehmans downward earnings performance.
Measurement at fair value obliged the banks to recognise losses,
which were
accompanied by a reduction of their equity. From then on, in
order to maintain
their solvency ratio, the banks had to raise extra capital in
conditions where the
market was going down rapidly or were obliged to reduce their
new lending, a
disastrous policy in an economically depressed context (Veron,
2008). On top
of that, the same banks had brought back into their balance
sheets the toxic
assets of special purpose entities whose risks they thought they
had transferred
to others. For commercial reasons linked to their reputation,
the financial insti-
tutions chose to take back responsibility for many off balance
sheet items. This
required the consolidation of these entities and their
re-measurement triggered
further losses. It also called into question another area of
accounting standards:
the rules for consolidating subsidiaries and the relationship
between a company
and special purposes entities that it had created, as well as
disclosures of risk
associated with such vehicles.
Financial reporting is bearing messages: the audited,
consolidated accounts
have the objective of presenting the financial situation at
balance sheet date as
well as the economic performance and any change in the financial
situation
during the reporting period. These accounts serve in the
decision-making of
several users, but principally investors. Amongst other things
they serve as a
basis, after analysis and adjustment, for measuring future
profitability. If one
wants to use the accounts for other ends, such as for
establishing the level of regu-
latory capital (such as the Basel II ratio), one must provide
for special treatments
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and adjustments intended to achieve this objective. That was not
done, and led to
accusations that fair value had caused the problem of
under-capitalisation of
financial institutions.
By contrast, other non-investor users have adopted such
techniques: for
example, the tax authorities in many countries require specified
adjustments to
get to taxable profit. The fact of having directly linked the
prudential require-
ments for equity capital to the accounting rules generated an
effect described
as pro-cyclical: the financial institutions had to sell assets
to maintain their
regulatory capital and had thereby fuelled the downward trend of
the markets, gen-
erating a further need to sell assets, and so on. The question
that presents itself is
the following: should we change the general accounting model or
should we
modify the way in which the regulators determine the level of
equity capital
required (a level that could conceivably change in different
market conditions)?
When the Accounting Thing became a Political Thing: The IASBand
the Crisis
In the end, would it have been better to leave the assets in the
balance sheet and
not recognise the potential losses? In Japan in the 1990s, or
again in the US in the
savings and Loan crisis of the 1980s, conservative accounting
practices poten-
tially delayed recognition of serious problems and thus their
resolution. Many
users consider that, however difficult it may be, it is
important in the interests
of greater transparency and also to permit the markets to
adjust, to value the
assets and liabilities at balance sheet date and reveal the
level of risk to which
society is exposed. One could try to improve this approach and
present the
results better, but to do nothing is not to serve the users
interests.
The two sets of accounting standards that require systematic use
of fair value
for financial instruments are US GAAP and IFRS. By the end of
2007, IFRS had
been adopted by the European Union for all listed companies and
were used in
more than 100 countries round the world. As a consequence of the
quarter by
quarter fair value impairments, regulators and governments
started to ask was
there a real financial crisis or was the use of fair value
creating a crisis?
In the US, overt interference in accounting standard-setting has
most often
come from Congress. Politicians who receive election funding
from large corpor-
ations are also inclined to listen to their concerns, and so it
was in this case. An
attempt was made by politicians to have fair value suspended,
which was
eventually turned into a requirement that the SEC investigate
the role of fair
value in the financial crisis.
At an international level, it was the international regulators
that first took
action. In particular, both the International Organisation of
Securities Commis-
sions (IOSCO), which is the international umbrella organisation
for stock
market regulators, and the Financial Stability Forum (FSF),
which is part of
the international bank regulatory system based in Basel, set up
working parties
to report on fair value. The FSF report was submitted to the
meeting of G7
Fair Value Accounting and the Banking Crisis in 2008 9
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governments in April 2008. It is implicit in the reports that
the IASB was
involved in discussions with these bodies.
The IOSCO report, prepared by its Technical Committee (IOSCO,
2008), high-
lighted a number of problems. It said (IOSCO, 2008, p. 17):
Broadly speaking, accounting principles are designed to provide
investors
with an understanding of the overall financial position and
performance of
the firm. In this sense, internal firm valuation and external
financial report-
ing accounting can be seen as offering critical information to
two different
sets of interested parties: on one hand, to the firms themselves
and to
regulators interested in the stability of the firm itself; and
to investors, inter-
ested in the firms performance. Ultimately, in both instances,
valuation
methodologies and accounting principles exist to benefit
investors.
The report found: some financial firms appear to have inadequate
human and
technological resources to model their financial positions using
fair value
accounting principles under illiquid market conditions. It
argued that once it
was clear that the market was illiquid, market prices were no
longer an appropri-
ate source of valuation under Level 1 of the SFAS 157 hierarchy
or of IAS 39 and
companies should have moved to Level 3, using models.
The FSF report (Financial Stability Forum, 2008, p. 22)
noted:
Accounting standards define the fundamental framework of
financial
reporting, which permits the measurement of the financial
condition and
performance of firms. Adherence to these standards is the
cornerstone of
a well-functioning financial system. In addition, the quality of
financial
reporting is enhanced by the efforts of market participants,
auditors and
supervisory and regulatory authorities to strengthen the
reliability of valua-
tions and of risk disclosures. Sound disclosure, accounting and
valuation
practices are essential to achieve transparency, to maintain
market confi-
dence and to promote effective market discipline
It made a number of recommendations:
III.4 The IASB should improve the accounting and disclosure
standards for
off-balance sheet vehicles on an accelerated basis and work with
other
standard setters toward international convergence. (Financial
Stability
Forum, 2008, p. 25)
III.5 The IASB will strengthen its standards to achieve better
disclosures
about valuations, methodologies and the uncertainty associated
with valua-
tions. (Financial Stability Forum, 2008, p. 27)
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III.6 The IASB will enhance its guidance on valuing financial
instruments
when markets are no longer active. To this end, it will set up
an expert
advisory panel in 2008. (Financial Stability Forum, 2008, p.
27)
These recommendations (and many others made by the FSF) were
reflected in the
G7s communique of 11 April 2008:
The International Accounting Standards Board (IASB) and other
relevant stan-
dard setters should initiate urgent action to improve the
accounting and disclos-
ure standards for off-balance sheet entities and enhance its
guidance on fair value
accounting, particularly on valuing financial instruments in
periods of stress.
The IASBs period of sudden visible activity dates from this time
(their financial
crisis time line page on their website shows actions from June
2008). They took
action in three areas: they set up the Expert Advisory Panel on
Fair Value in a
Declining Market (EAP), they decided to amend IFRS 7 to improve
the disclos-
ures related to financial instruments, and they asked the staff
urgently to advance
the existing consolidations project and the de-recognition
project.
Expert Advisory Panel (EAP)
The IASB decided to appoint the EAP as an IASB-only exercise,
not involving
the FASB. They were to regret this later. At the May 2008
meeting of the
IASB, the staff brought forward a paper:
Ms Eastman said that the issue was limited to the question of
the advisory
panel for the Financial Stability Forum. Their April 7 report
had recommended
that the IASB provide enhanced guidance on determining fair
values in a
declining market. The IASB was setting up an advisory panel
which would
assist the Board in reviewing best practice and producing
guidance on measur-
ing fair value when the market is no longer active. The staff
had contacted
financial institutions and the panel was to have its first
meeting on 13 June
in London. This would probably be a two or three day session
which would
discuss the form of the deliverable. She would give an update to
the Board
at the June meeting. (International Standard-setting Report, May
2008, p. 12)
Asked about the terms of reference, Sir David Tweedie said:
it was pretty simple: what, if anything, needs to be done? They
were asking
for people who had experience of doing this. They did not want
it to be done
from 35,000 feet. (International Standard-setting Report, May
2008, p. 13)
The EAP consisted of representatives of a number of banks,
including BNP
Paribas, Citigroup, HSBC and UBS, insurance companies, the Big
Four audit
Fair Value Accounting and the Banking Crisis in 2008 11
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firms, the Basel Committee, Insurance Supervisors and the
Financial Stability
Forum. In August the EAP produced a draft report that addressed
(a) valuation
issues and (b) disclosure issues. This was published in
September on the IASB
website and comments were invited. A final report was published
in October 2008.
Although the FASB had sent a staff observer along to the EAP,
the US
standard-setter was not directly involved. However, a joint
statement by the
SEC and the FASB on 30 September 2008 said There are a number of
practice
issues where there is a need for immediate additional guidance
and referred to
the EAPs draft document. The SEC statement had a series of
questions and
answers on valuing financial instruments.2
The IASB put out a statement on 2 October saying that it had
reviewed the
SEC/FASB guidance and considered it consistent with IAS 39. The
pressrelease cites Sir David Tweedie: The SEC-FASB clarification on
fair value
accounting is a useful contribution, and our staff believes that
it is consistent
with IFRSs. We will continue to ensure that any IFRS guidance on
fair value
measurement is consistent with the clarification that has been
provided by the
US SEC staff and the FASB staff.
With the benefit of hindsight, it appears that this last
sentence could be an
oblique reference to the European Commissions attempt, then in
preparation,
to force the IASB to change IAS 39 to align with US GAAP.
The EAPs final report was welcomed in public pronouncements from
the
European Commission and others (including the Committee of
European Securi-
ties Regulators CESR), and preparers and auditors were urged to
follow it
immediately.
IFRS 7 Disclosures
The EAPs view on disclosures was that IFRS 7 had worked quite
well but that
there was room for improvement. The criticisms of it were that
it was not specific
enough in some areas, notably in terms of a fair value hierarchy
and in terms of
quantitative disclosures. The IASBs capital markets team took up
these points
and brought proposed amendments to the Board, which were
published as an
exposure draft in October 2008. The exposure draft proposed
bringing in to
IFRS 7 the fair value hierarchy from IAS 39. This is virtually
the same as the
SFAS 157 hierarchy but not set out so explicitly. The exposure
draft mandated
greater disclosure about level 3 valuations and required
quantitative disclosures
of the maturity of its derivatives in addition to a qualitative
discussion of liquidity
risk. The IASB tentatively decided that the final amendment
should be in force
from July 2009 with earlier application allowed.
Consolidation
Arguably the most difficult problem to address was that of off
balance
sheet investment vehicles. The existing IASB literature on the
subject was SIC
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12. However, the Board had had a project to revise IAS 27, the
basic standard
on consolidation, and incorporate SIC 12 into it (it is standing
policy for the
IASB that whenever a standard is revised, any Interpretations
issued subsequently
to the last version of the standard are incorporated into the
revision). This project
had been on the active agenda for some time but had repeatedly
been pushed to
one side by other projects. It now became a top priority.
The project was being led by Alan Teixeira, a senior project
manager who had
joined the IASB from the New Zealand standard-setter, and became
Director of
Technical Activities in April 2008. His view, which he was able
to persuade the
Board to accept, was that something more flexible was needed
than the on-off
switch that arose from the decision to consolidate or not a
special purpose
entity. His solution was (a) to require a discussion of the
non-consolidation
decision, and (b) to propose a series of disclosures about
sponsored entities
and any with which the parent had a continuing involvement.
The exposure draft was published in December 2008. It called for
companies to
disclose how many structured entities they have sponsored during
the year and
what fee income they derive from these. They will also ask
companies to give
details about vehicles that they have sponsored in the past and
subsequently sup-
plied any support to. These are an attempt to give investors an
idea of the scale of
the companys activity in creating Structured Investment Vehicles
(SIV). They
also try to address the possibility of a company deciding to
take back onto its
balance sheet an SIV without there being any legal obligation
because of the
risk to reputation. Situations arose during the initial
sub-prime crisis where
banks that had sponsored such vehicles and had no further
investment (but
were receiving management fees) took the view that they had to
rescue the
vehicles or accept considerable damage to their standing with
investors who
had participated in the SIVs.
The proposal goes a long way beyond SIC 12 and much of its
requirements will
be the reaction to the financial crisis, addressing primarily
structured entities set
up by banks.
Attack from Europe
While the IASB was busy dealing with its responses to the FSF
and G7, a separate
initiative was taking place in France. Rene Ricol, a Paris-based
former small
practitioner who had served a term as president of the
International Federation
of Accountants, was asked by the French President, Nicolas
Sarkozy, reputedly
after lobbying by French banks, to give an opinion as to whether
European
banks were being disadvantaged by IFRS as compared with their
American
counterparts. Ricol came to the view that this was the case.
SFAS 86, a relatively
old standard, did not require property mortgages to be held at
fair value, and
SFAS 133, the substantive fair value standard, allowed available
for sale financial
instruments to be re-classified under rare circumstances.
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The so-called EU IAS Regulation (2002/1606) which required all
Europeanlisted companies to follow IFRS from 2005 includes a
requirement that IFRS
endorsed by the EU must not disadvantage European companies as
compared
to those in other major markets. The Internal Market Directorate
General
(DGXV) which is responsible for capital markets, drew up a draft
carve-out
to amend IAS 39 as endorsed by the European Union.
This was a very significant event, to understand which it is
necessary to look
briefly at the history of EU endorsement of IAS 39. French banks
have been
opposed to carrying financial instruments at fair value ever
since this was
mooted in the 1990s. They persuaded the then French president,
Jacques
Chirac, to write to the European Commission in 2003 (reproduced
in Alexander,
2006, pp. 7980) to complain that this would destabilise the
economy. French
banks tried to persuade the IASB to modify IAS 39 and
negotiations took place
for many months. In the end, one sticking point was that IAS 39
says that no liab-
ility can be stated at less than the amount that may be required
to be paid at
balance sheet date (known as the demand deposit floor). This was
not accepta-
ble to French retail banks which discounted such liabilities
below the floor on the
basis that customer current accounts in practice provided
virtually permanent
funding. The IASB would not budge on this and the banks
persuaded the
Accounting Regulatory Committee (the organ responsible for
endorsing IFRS
into European law) to carve out the paragraph in IAS 39 that
addresses this
issue.
This was a major blow to the IASB. It has meant that there are
at least two var-
iants of IFRS used IFRS as issued by the IASB, and IFRS as
endorsed by the
EU. This has in turn led to threats of carve-outs elsewhere. For
example the
Australian Accounting Standards Board (AASB) threatened a
carve-out if
the IASB did not allow the creation of new holding companies
without revalua-
tion in 2007. The Indian standard-setter has also insisted in
its document accept-
ing a plan to move to IFRS that it reserves the right to amend
the standards
(although it later assured the Committee of European Securities
Regulators
that any amendments would not be such as to prevent Indian
companies asserting
compliance with IFRS as issued by the IASB).
The US Securities and Exchange Commission was not at all pleased
by the EU
carve out. When it said in September 2007 that it recognised
IFRS as equivalent
to US GAAP for the purposes of foreign companies listed in the
US, it specified
that this applied only to IFRS as issued by the IASB. There has
so far been only
the original carve-out, but many people, including Sir David
Tweedie, IASB
president (testimony to House of Commons Select Treasury
Committee 11
November 2008) believe that a second European carve out would
lead to the
demise of the worldwide globalisation project. The credibility
of IFRS and
the IASB would be fatally damaged if it became inescapably clear
that Europe
did not accept its authority.
Matters came to a head when President Sarkozy called a meeting
of the
European finance ministries of countries that are part of G7
(France, Germany,
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Italy and the UK) on 4 October to discuss the credit crisis. He
obtained agreement
that the IASB should be asked to amend IAS 39 to bring it in to
line with US
GAAP by the end of October. This position was endorsed by a full
meeting of
the EU Council of Finance Ministers (ECOFIN) a few days later.
It seems
highly probable, given that the IASB has a well-documented due
process that
involves lengthy exposure periods, that France and the European
Commission
did not think that the IASB could remotely meet this deadline. A
meeting of
the ARC was arranged for mid October to vote on the carve-out
that the Commis-
sion had drafted.
However, the IASB had of course seen the Ricol report at an
early stage and
the draft carve-out. Sir David Tweedie later gave evidence that
the carve-out
would have been disastrous, and would have opened up a free for
all in
accounting for financial instruments. The ARC can remove
material from
standards, but it cannot add material. So in removing the
paragraphs that
prevented re-classification, it would take away all safeguards
on manipulation
of instrument categories without providing any new defences such
as disclosures.
I think accounting in Europe would have been totally out of
control if they had
used the option to take the carve-out.3
The IASB took action. Coincidentally, the Trustees of the IASC
Foundation,
the IASBs oversight body, were meeting in Beijing just after the
European min-
isters meeting and agreed to suspend due process. The Board then
convened a
meeting on Monday 13 October to vote through an amendment to IAS
39. US
members complained that the reading of US practice was wrong and
they
voted against but the amendment was passed. It was duly agreed
by the ARC
two days later and the carve-out was averted but at some cost.
Sir David
Tweedie told the UK parliamentary committee:
Others were asked Have we been damaged? I think the answer is
yes we
have been by what happened a few weeks ago. I was in the United
States a
fortnight ago and there were questions of Why did you do this?
This is
European influence. Are you a European body? . . . Other
countries werecompletely taken by surprise because all of this
happened very, very
quickly . . . suddenly they were given something they had no
knowledgewas coming. That was a major problem for us. It upset a
great deal of
people. So it did damage the whole exercise.4
The political crisis for the IASB did not end there. DGXV wrote
to the IASB later
in October5 setting out three further issues arising from a
meeting with stake-
holders that it had called in the wake of the ARC vote. It
raised the question of
re-classifying assets designated as held at fair value under the
fair value
option, revising the impairment rules and clarifying that
embedded derivatives
need not be bifurcated. The letter said these should be dealt
with in time for
the year-end reporting season.
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The IASB chairman replied on 14 November 2008, pointing out that
the IASB
was holding a series of round tables on the financial crisis,
the last of which would
be in December. He also noted that the IASB needs to take proper
account of the
views of all stakeholders in order to develop accounting
standards that provide
transparent information to market participants. Sir David
Tweedie wrote again
on 17 December. Commenting on the issues raised in the
Commissions 14
November letter, he said:
it was a clear message of participants at these round tables
that the IASB
should continue to take urgent action to improve the application
of fair
value principles, where necessary, but such action must be in
conjunction
with the FASB to ensure globally consistent conclusions. A
further clear
message was that any steps taken to amend fair value accounting
taken
without proper regard to the well-established and supported
standard-
setting due process, would further undermine already scarce
confidence
in the financial markets.
International Support
The IASB feared that the European attempts to interfere in the
standard-setting
process would be continued at a meeting of the G20 heads of
government on
15 November 2008 that had been called by the US to discuss the
financial
crisis. The European members of the G20 met together on 7
November to
prepare for the Washington meeting. They put out a statement6
that called for
a more comprehensive information system, which no longer omits
vast
swathes of financial activity from auditable, certifiable
accounts and added:
Both prudential and accounting standards applicable to financial
insti-
tutions will have to be revised to ensure that they do not
contribute to creat-
ing speculative bubbles in periods of growth and make the crisis
worse at
times of economic downturn.
Standards bodies, in particular in the area of accountancy, will
have to
be reformed to allow a genuine dialogue with all the parties
concerned,
in particular prudential authorities.
This was seen as a French attempt to make the IASB take account
of
financial stability7 rather than privileging transparency for
investors as the
main objective.
The Trustees of the IASC Foundation wrote to President Bush,
asking that their
letter be transmitted to the G20 governments. The letter (dated
11 November and
published on the IASB website) underlined the importance of
transparent and
comparable information and suggested that interference with the
standard-
setting process undermined confidence in the markets. The letter
cited support
from the Banque de France, the International Corporate
Governance Network
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and the CFA Institute. It also addressed the question of
pro-cyclicality and agreed
that there was potentially a linkage if financial institutions
had to sell assets to
meet liquidity ratios and added to the decline in the market.
They suggested
that this should, however, be addressed by a dialogue between
the IASB and
the bank supervisors as to how the latter used shareholder
accounts.
IOSCO issued an open letter to the G 20 governments on 12
November 2008,8
saying that:
Accounting standards must provide clear, accurate and useful
information
to investors to allow them to make informed investment
decisions. Further-
ance of this goal promotes investor confidence in financial
statements and
capital markets.
The statement also said: IOSCO strongly supports IFRS as
developed by
the IASB.
Communique
The IOSCO letter was followed by a 14 November 2008 communique
from 20
national standard-setters.9 These were all members of the loose
grouping
known as the National Standard-Setters chaired by Ian Mackintosh
of the UK
Accounting Standards Board, which meet twice a year to discuss
technical
matters and to collaborate on technical research. The letter
said: We continue
to support the IASB and its efforts to achieve true global
accounting standards.
It added: It is important that the IASB follows appropriate due
process It agreed
that in extraordinary times, it may be necessary for due process
to be shortened.
But said it should not be abandoned, and the standard-setters
were ready to help
achieve this. The letter was signed by the national
standard-setters of the UK,
Germany, Austria, France, Sweden, the Netherlands and Italy from
within the
EU, as well as Norway, Japan, Pakistan, New Zealand, Mexico,
Canada, South
Africa, Taiwan, Hong Kong, Korea and India. The European
Financial Reporting
Advisory Group (EFRAG) which provides technical advice to the
European
Commission also signed the latter.
In the event, the G20 leaders issued a final communique from
their summit
that largely supported the IASBs position. The communique
repeated calls
for guidance on valuation of securities and attempts to address
disclosures
related to off balance sheet vehicles and complex financial
instruments. It also
said:
With a view toward promoting financial stability, the governance
of the
international standard-setting body should be further enhanced,
including
a review of its membership, in particular in order to ensure
transparency,
accountability, and an appropriate relationship between this
independent
body and the relevant authorities.
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This seems to be a reference to the changes in governance
arrangements already
proposed by the Trustees, whereby a monitoring group including
stock exchange
regulators, the European Commission, the World Bank and the
International
Monetary Fund would be represented. The monitoring group will
have oversight
of the Trustees governance of the standard-setter.
The communique continues:
The key global accounting standards bodies should work
intensively
towards the objective of creating a single high-quality global
standard.
Regulators, supervisors, and accounting standard-setters, as
appropriate,
should work with each together and the private sector on an
on-going
basis to ensure consistent application and enforcement of
high-quality
accounting standards.
Financial institutions should provide enhanced risk disclosures
in their
reporting and disclose all losses on an ongoing basis,
consistent with inter-
national best practice, as appropriate. Regulators should work
to ensure that
financial institutions financial statements include a complete,
accurate, and
timely picture of the firms activities (including off balance
sheet activities)
and are reported on a consistent and regular basis.
This seems to support the IASB and IOSCO position that losses
should not be
hidden behind historical cost accounting.
The FASB gets support
Just as the IASB had been under fire in Europe, the FASB had
been under
pressure from American banks, politicians and the SEC. The IASBs
Expert
Advisory Panel had been organised independently of the FASB, but
the FASB
had observed, and when the EAP produced its draft guidance on
fair value
measurement, the SEC and FASB produced a joint statement
clarifying similar
issues in the measurement of fair value10 and the FASB issued a
staff position
(FSP FAS 1573) on determining the fair value of a financial
asset when the
market for that asset is not active.
The US Emergency Economic Stabilization Act of 2008 had mandated
an SEC
staff examination, along with the Federal Reserve and the
Secretary of the Treas-
ury, of mark to market accounting. This was published on 30
December 2008. The
report (Report and Recommendations Pursuant to Section 133 of
the Emergency
Economic Stabilization Act of 2008: Study on Mark-To-Market
Accounting)
noted that there was a debate between those who thought fair
value accounting
was pro-cyclical and exaggerated the crisis and those who
thought transparent
information was essential for investors. The credibility and
experience of
parties on both sides of this debate demand careful attention to
their points
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and counterpoints on the effects of fair value accounting on
financial markets
(p. 2).
The Report noted among other things (p. 4):
The Staff observes that fair value accounting did not appear to
play a mean-
ingful role in bank failures occurring during 2008. Rather, bank
failures in
the U.S. appeared to be the result of growing probable credit
losses, con-
cerns about asset quality, and, in certain cases, eroding lender
and investor
confidence. For the failed banks that did recognize sizable fair
value losses,
it does not appear that the reporting of these losses was the
reason the bank
failed.
It also noted (p. 5):
investors generally support measurements at fair value as
providing the
most transparent financial reporting of an investment, thereby
facilitating
better investment decision-making and more efficient capital
allocation
amongst firms. While investors generally expressed support for
existing
fair value requirements, many also indicated the need for
improvements
to the application of existing standards. Improvements to the
impairment
requirements, application in practice of SFAS No. 157
(particularly in
times of financial stress), fair value measurement of
liabilities, and
improvements to the related presentation and disclosure
requirements of
fair value measures were cited as areas warranting
improvement
Support for fair value also came from Lloyd Blankfein, CEO of
Goldman Sachs,
who wrote in the Financial Times, 8 February 2009. He blamed
poor risk man-
agement for the crisis and noted:
Last, and perhaps most important, financial institutions did not
account for
asset values accurately enough. I have heard some argue that
fair value
accounting which assigns current values to financial assets and
liabilities
is one of the main factors exacerbating the credit crisis. I see
it differ-
ently. If more institutions had properly valued their positions
and commit-
ments at the outset, they would have been in a much better
position to
reduce their exposures.
The FASB has had some notorious clashes with Congress, notably
over its
proposals for oil and gas exploration costs in the 1970s and its
stock option
accounting in the early 1990s. In these cases it had to back
down, but it seems
to have been luckier than the IASB this time and to have escaped
wholesale
interference.
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Assessing the Consequences
It will take months if not years for the consequences of the
events of 2008 for the
IASB to be assessed at that time, even if interference was to
take place the next
year. What seems clear is that the IASBs credibility and
independence have been
compromised by the European Commissions manoeuvres in October to
force
the IASB to allow re-classification. The suggestion has been put
forward that
the IASB contemplated a confrontation with the Commission but
came to the
conclusion that if the Commission abandoned IFRS, it was
probable that Japan
would follow suit, and potentially all the countries planning to
adopt in 2011
might withdraw. It decided to trump the Commissions carve-out
with a more
limited IAS 39 amendment and fight on.
However, the Commission intervention plays into the hands of
those in the US
who do not wish to abandon US GAAP, as the SECs 2008 road map
has pro-
posed. The change of government in the US has inevitably led to
a change of per-
sonnel at the SEC. The new chairman, Mary Schapiro, said in her
confirmation
hearing in front of the Senate banking committee that she
thought a single set
of global standards would be a very beneficial thing but she
expressed doubts
about the independence of the IASB and said she would not
necessarily be
bound by the proposed roadmap (World Accounting Report, February
2009,
p. 7). The SEC Chief Accountant has also stepped down but no
replacement
has yet been named. It seems likely that a switch to IFRS from
US GAAP will
likely be delayed if not abandoned altogether.
Perceptions of the IASBs independence are not helped by things
like Commis-
sioner McCreevy (DGXV) saying in a speech in Dublin in February
2009:
[accounting standards] have also exacerbated the markets recent
problems
because of rules that are pro-cyclical . . . That is why I
recently broughtforward a measure to provide firms with more
flexibility on the mark to
market requirements and to facilitate asset transfer from the
trading to
the banking book.11
This implies that the Commissioner still thinks he can change
IFRS at will, which
is unlikely to play well in Beijing, Tokyo, Rio de Janeiro,
Ottawa, Seoul, Delhi or
Washington, quite apart from London. This has to imply that more
difficulties are
likely to be raised by the Commission. The April 2009 meeting of
the G20 is
being indicated as the next showdown between those who want
transparency
for investors and those who want to hide the losses because they
believe it
creates stability.
In January 2009, the Trustees of the IASC Foundation finalised
the new moni-
toring arrangements. A Monitoring Board was created. Its members
included
the SEC, European Commission, Japanese Financial Services Agency
and two
members from IOSCO. However, the World Bank and the
International Monetary
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Fund had disappeared from the original proposal, and the Basel
Committee on
Banking Supervision came in as an observer. It seems likely that
this shift came
about as a result of the 2008 debate.
One of the ironies of the fair value crisis has been the
emergence of pressure on
both the IASB and FASB to work closely together. In the 1990s
there was still a
debate about whether US GAAP could become the worldwide standard
for finan-
cial reporting. The European answer was that following US rules
was completely
unacceptable. However, we find the Commission saying in 2008
that the IASB
must change its rules to give European companies the same
position as under
US GAAP. This was followed by the IASB telling the Commission
that it could
not accede to subsequent demands because constituents wanted it
to work with
the FASB.
In fact, the two Boards also learned in this crisis that they
needed to work very
closely together for political protection. After the IASBs
creation of its Expert
Advisory Panel and the separate SEC/FASB publications on
applying fairvalue, the two Boards met for their regular
six-monthly meeting in October.
During the course of this meeting they issued a press release
(20 October
2008) committing to work together to create a common solution to
accounting
for financial instruments, to create a joint high-level advisory
group on dealing
with the financial crisis, and to conducting a series of joint
round tables.
The G7 statement of April 2008 has led to a rapid acceleration
of the IASBs
work programme in related topics. Guidance has been given on
applying fair
value in illiquid markets (Level 1 or Level 2 fair values
require there to be a
liquid market, so only Level 3 mark to model fair values can be
used). Steps
are being taken to improve IFRS 7 disclosures, although the
IASBs initial pro-
posals have had to be modified. An exposure draft has been
issued on consolida-
tion and special purpose entities. An exposure draft on
de-recognition will be
issued in 2009.
Arguably, another irony in terms of outcomes is that in January
2009 the
Commission announced a fund to enable it to contribute directly
both to the
IASBs costs and those of the European Financial Reporting
Advisory Group
(EFRAG) which interacts on technical issues with the IASB on
behalf of
European interests in general and the Commission in particular.
The Commission
announced a fund ofE36.2 million to be made available for four
years from 2010
to make contributions to the IASB, EFRAG and possibly others.
Tentatively, the
IASB is expected to receive E5 million a year from this.
The Commission has been notorious over the years for being
unwilling to
spend any money on accounting, not even paying for EFRAG, which
is funded
by European lobbying bodies with an interest in accounting. The
paper announ-
cing the proposal (COM 2009-14) says that this was being done as
a result of the
October 2008 meetings where the Commission decided it should
have more
involvement with the standard-setting process. The Commissions
announcement
notes: Independence of the standard-setting process without any
undue influence
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from parties with a stake in the outcome of the IASBs
standard-setting process is
crucial.
The Committee of European Securities Regulators (CESR) carried
out a survey
of the third quarter statements of 100 financial companies in
Europe (of which 22
are included in the FTSE Eurotop 100 index) to see how they had
reacted to the
IASBs emergency amendment to IAS 39.12 It found that 52% of the
sample, and
64% of the FTSE Eurotop 100 companies had not re-classified any
financial
instruments. Twenty-eight percent had made one re-classification
(18% of the
FTSE Eurotop 100). Only one company had more than three
re-classifications.
The majority of re-classifications were from fair value through
profit and loss
to loans and receivables.
Conclusion
In our view, 2008 was a very unfortunate year for the
international accounting
standard-setting institution. Fair value financial statements
were telling banks
they had made disastrous investment decisions, but the banks,
some governments
and the regulators preferred to believe the numbers were wrong
(shooting the
messenger) rather than the investment decisions. At the time of
writing
(March 2009) the US government has just voted almost $200
billion for AIG
to prop up the insurer, which might give an insight into the
quality of the manage-
ments evaluations of their investments.
It seems to us that although the IASB was probably talking to
IOSCO and the
Financial Stability Forum early in 2008, the fair value debate
had started in 2007.
It took a long time, and a G7 announcement, before the IASB
overtly recognised
that it had a political problem on its hands and started to
react. Since then it has
worked decisively and rapidly to address the perceived problems,
but it appears to
have been damaged. The focus on fair value reporting and
pro-cyclicality has pre-
sented an opportunity for all those, such as the European
Banking Federation,
who have strenuously opposed IAS 39 since drafting first started
in the 1990s,
to try to kill the standard off permanently. It has also exposed
the difference in
orientation between Anglo-Saxon regulators and those from the
European code
law tradition (Walton, 2004) in terms of the objectives of
financial reporting.
One group thinks it is to inform investors, the other that it is
a tool that can be
used to regulate the economy.
The European Commission persists in behaving as though it
controlled the
IASB, and a lot of progress will have to be made in 2009 to
re-assure countries
adopting in 2011 (Canada, South Korea, India, China, and
Brazil). It seems very
unlikely that the SEC will stick to the roadmap of making a
decision in 2011 and
shifting progressively thereafter. There again, opponents of the
shift are taking
the opportunity to point to lack of independence of the IASB and
lack of
clarity in IFRS as arguments for staying with US GAAP. The IASB
will need
to be luckier in 2009 than it was in 2008.
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Notes
1AIG urges fair value re-think 14 March 2008.2This was followed
on 10 October by an FASB Staff Position (FSP 157-3) on Determining
the
Fair Value of a Financial Asset When the Market for that Asset
Is Not Active.3Uncorrected transcript of the House of Commons
Select Treasury Committee 11 November
2008, taken from www.parliamentlive.com.4Uncorrected transcript
of the House of Commons Select Treasury Committee 11 November
2008, taken from www.parliamentlive.com.5Letter from the
Director General of DGXV dated 27 October 2008, published on
http://ec.europa.eu/internal_market.
6Informal Meeting of Heads of State or Government on 7 November
2008 Agreed Language
European Commission 7 November 2008.7For example Accountancy Age
Sarkozy leads the charge towards IASB stability remit 13
November 2008.8Press release 12 November 2008 IOSCO open letter
to G20 summit www.iosco.org.9Published by many of the participating
standard-setters (not apparently by the Conseil national
de la comptabilite) but see for example the German Accounting
Standards Board 17 November
2008 http://www.standardsetter.de/drsc/news.10SEC release
2008234 of 30 September 2008.11Speech 09/41: The Credit Crisis
Looking Ahead 9 February 2009 downloaded from www.
ec.europa.eu/internal_market.12Announcement 08937 of CESR made
on 7 January 2009.
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