The financial crisis is turning many things upside down. Nevertheless, it is amazing to see how the positions of key market actors on financial reporting standards have changed since the crisis started. While investment banks, accounting firms, regulators and governments in the heyday of financial market capitalism stood firmly together in unanimous and unfettered support of fair value accounting, this front has been collapsing.
In April 2008, Neue Züricher Zeitung reported Claude Bébéar, president of the French Insurance Group Axa, as saying that mark-to-market rules which require firms to value assets according to (hypothetical) market prices had contributed to the financial crisis. Henri de Castries, CEO of the same group, was quoted as referring to a “conceptual mistake” which had forced companies and banks to write down billions of assets. In September 2008, Newt Gingrich commented on Forbes.com “Suspend Mark-to-Market Now!”, quoting Brian S. Webury, chief economist at First Trust Portfolios of Chicago:
“It is true that the root of this crisis is bad mortgage loan, but probably 70% of the real crisis that we face today is caused by mark-to-market accounting in an illiquid market.”
With the financial crisis lingering on and politicians, regulators and banks still searching for solutions, debates on the pros and cons of mark-to-market accounting have perked up again during the last weeks.
On March 11, 2009, investor Warren Buffet admitted in an CBNC interview that mark-to-market had been “gasoline on the fire” while remarkably equivocally maintaining that
“the best way to handle that (the crisis) is to have the mark-to-market figures but not have the regulator say we are going to force you to put up more capital based on these mark-to-market figures.”
Others have been more straight forward in their demands to suspend mark-to-market. On March 12, 2009 Edward L. Yingling, president and CEO of the American Bankers Association stated at the House of Representatives Subcommittee on Capital Markets that
“For months, we have specifically asked FASB to address the problem of marking assets to markets that were dysfunctional. …We hope that FASB and SEC will take the significant action that is needed and not merely tinker with the current rules.”
Subcommittee Chairman Republican Paul E. Kanjorski, according to CCH Financial Crisis News Center, warned that if regulators and standard setters “do not act now to improve the standards the Congress will have no other option but to act itself.”
From a Europan perspective, these are pretty strong words given that the US was long seen as the bastion of fair value accounting rules, with the SEC and the national standard setter FASB spreading its mark-to-market gospel to Europe and other continents. What does this mean then for the future development of the International Financial Reporting Standards produced by the London-based International Accounting Standards Board, adopted by the European Union on January 1st, 2005?
Prior to the implementation of IFRS by the European Union Committee, the IASB had undertaken so-called comparability and improvements projects which according to its critics moved the standards much closer to fair value accounting. Pro-cyclical and unintended consequences of mark-to-market accounting have been a longstanding concern in continental Europe and Asia, some of which Tomo Suzuki and colleagues at the Oxford Said Business School have surveyed in a research project on the Unexplored Impacts of IAS/IFRS on Wider Stakeholders.
Ironically, then, one of the beneficial side effects of the crisis could be that it is alerting the international community of experts and politicians involved in financial market and accounting regulation to a long overdue need to reform accounting standards. As the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, states in unequivocal terms in its report (PDF): “accounting standards should not bias business models, promote pro-cyclical behaviour or discourage long-term investment”.
One should be careful, however, to not accept the current outcry of banks, regulators and politicians at face value. Behind the same rhetoric, one can find very different interests, motivations and positions: insolvent banks lobbying the US congress for suspension of mark-to-market reporting; US politicians aiming to discontinue or modify accounting standards in an instrumental way to write off toxic assets and return to normality once the crisis is over; regulators in charge of financial reporting standards, such as FASB and IASB, trying to get themselves out of the line of fire while still defending the merits of fair value in “normal times”; Angela Merkel and Peter Steinbrück (Financial Times Deutschland, March 23, 2009, page 1) following their US colleagues to free banks from fair value for the period of the crisis.
A short-sighted repeal of current standards for purely instrumental purposes of writing of toxic assets, however, does not seem the right way to prepare the ground for the necessary far reaching reforms. Interestingly enough, the Turner Review (PDF) of the UK Financial Services Authority published a few days ago, does indeed search to solve the financial crisis with more promising means.
Taking a critical stance on the public outcry for writing off toxic assets by means of suspending fair value does also not mean sharing the conservative view of the leading accounting firms which seem to be more concerned about avoiding any liabilities for ambiguities in their interpretation of reporting rules rather than worrying about how to bring the crisis to an end. On the contrary, I would say that the real test for a far-reaching reform of financial reporting standards towards rules that support economically sustainable development is still to come.
To work towards such a financial reporting system will, as suggested by the Larosière report (PDF), require opening up the standard-setting process of the FASB and IASB and including a variety of regulatory, supervisory and business communities. One might even go further and demand the inclusion of representatives of various stakeholder and civil society groups effected by accounting standards. This might not only prevent “group think” of the kind that we have seen enough of in the past, but it could also improve crisis management and lead the way to a substantially revised set of financial reporting standard which are neutral, non-cyclical and sustainable.
(sigrid)
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March 26, 2009 at 12:55
phil
I note Buffet’s humourous use of the expression “allow people to use their imagination” when it comes to balance sheets. Could this be the end of “creative accounting”? Assuming, of course, that accounting could ever be more of a science than an art. Alas, one wonders what will happen to all the thousands of financial engineers educated in the past years?
May 10, 2009 at 09:54
brittanica
JEREMY SHUM submission to IASB/ED10 Consolidated Financial’s
This is the submission to the International Accounting Standards Board’s new Exposure Draft (ED10) in relation to Consolidated Financial Statements, drafted by Jeremy Shum. Since the Special Purpose Entity (“SPE”) concept was one of the tools used by Enron to hide losses and fabricate earnings which eventually led to its collapse.
1. The converged definition of “control” of IAS 27 and SIC-12 is welcomed, with the exception of changing the semantic of “benefits” to “returns”
2. Scrap the idea of “structured entities” since that is just a reintroduction of “special purpose entities” which is merely an accounting loophole used by management to financially engineer corporate shells, which have caused the Enron collapse, and more recently, the banking sub-prime mortgage financial crisis
3. Assessing control of an entity is a case-by-case activity for an Accountant, which needs to give regards to options and convertible instruments; agency relationships; “risks and rewards” (although not as a separate test); reputational risk (although not as a separate test)
4. Disclosures should be extensive rather than contracted, since the purpose of note disclosures is to provide as much detailed information is required by the finance professional to understand underlying circumstances
info- http://jeremyshumofficial.com/wp-content/uploads/2009/04/submission-to-the-iasb-ed10-consolidated-financial-statements.pdf
June 4, 2009 at 19:03
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October 21, 2011 at 16:54
Solomon
The end is neither near nor is it bleak for fair value accounting. Neither the FASB nor the IASB believes that fair value accounting was the only cause of the financial crisis. Like the ICAEW put it, to blame fair value accounting is like shooting the messenger. There appear to be too much politics rather than accounting in the ensuing period post- financial crisis. Standard setters are making efforts to draw standards that will prevent future occurrences of this nature. But let us not lose sight of the fact that the complexity of todays business models is a great hindrance to drawing a complete standard that can resolve these problems.
Standards are drawn much more in a fire fighting mode and post crisis basis. It is difficult to predict the future let alone what will happen in the future. This is same for accounting standards as well. Standard setter must admit that the challenge of drawing standards to stop or prevent future catastrophes is not something they can have a goodnight sleep with.
Finally on Phils comment, I will like to mention that, creative accounting will still be with us for a very long time. Creative accounting which does not result in huge accounting scandals is perhaps what the question should be. With a lot of discretion in the current IFRS accounting standards, it is quite easy for accountants to live with creative accounting unnoticed. The use of discretion and assumptions in fair value accounting is among the flexible areas companies can still bend the rules to fit their purpose.
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