Peeling away financial reporting issues one layer at a time

Amended IAS 39: Exploding the Myth of an Independent IASB

Although the FASB's record as accounting standard setter is far from spotless, I can't think of a single action taken where the quality of information provided to investors unambiguously diminished. That's what makes the IASB's amendments to IAS 39 so remarkable: the august body that is supposed to take over the FASB's role as principle standard setter for the U.S., the putative adherent to principles, the preacher of "true and fair view," just took a huge step down a very steep slippery slope.

By way of background, IAS 39, Financial Instruments: Recognition and Measurement, requires financial assets to be classified in one of the following categories, which determine how a particular financial asset is recognized and measured in the financial statements:

  • Financial assets at fair value through profit or loss (FVTPL);
  • Available-for-sale financial assets (AFS) – fair value through other comprehensive income;
  • Loans and receivables (L&R) – measurements based on contracted-for amounts;
  • Held-to-maturity investments (HTM) – measurements based on investment cost.

These categories are more or less the same as U.S. GAAP, so I should start by observing that everyone's accounting for financial assets could easily be a lot simpler all around: all financial assets should be measured at fair value (or preferably replacement cost) through profit or loss. The exceptions to FVTPL for equity and debt securities are the FASB's invention in SFAS 115, the original fair value standards.  Such a political compromise was made necessary to get the buy-in of issuers (who funded the FASB) fearful of the havoc that mark-to-market accounting of even some investments would wreak on their earnings (and presumably, executive compensation).

The IASB's press release announcing the IAS 39 amendments reminds me of the politician (everything reminds me of politics on this day) who will say anything with a straight face, no matter how false, just so long as it can possibly win votes:

"In responding to the crisis, the IASB notes the concern expressed by EU leaders and finance ministers through the ECOFIN Council to ensure that 'European financial institutions are not disadvantaged vis-à-vis their international [read U.S.] competitors in terms of accounting rules and of their interpretation.' The amendments today address the desire to reduce differences between IFRSs and US GAAP in a manner that produces high quality financial information for investors across the global capital markets." [emphasis supplied]

Taking these two sentences together, it appears that the IASB must have performed a miracle. Somehow, it has allayed concerns of the European financial institutions, while in the process, has come up with a new accounting treatment that still "produces high quality financial information for investors." I admit they didn't actually say that the quality of financial information has increased by their actions, but a diminishment in quality is the unambiguous and unprecedented result. In stark contrast to the press release propaganda, there is not even a whiff of consideration of investor needs in the document amending IAS 39; nowhere is the word "investor" to be found.

I don't have to deal here with all the ins and outs of the amendments to make my point; just two examples will suffice. First, loans (think mortgages) and receivables that were heretofore measured at fair value may be transferred to the HTM category. As explained above, this is a place where fair value measurement takes an indefinite leave of absence. Today, fair value; tomorrow, who knows.

Second, the effective date of the IAS 39 amendments is retroactive to July 1, 2008, i.e., before the proverbial you-know-what hit the fan. While permitting loan reclassification to HTM may be said by some to undo any "disadvantage" because the same accounting was already permitted in U.S. GAAP (though more narrowly than IAS 39 now permits), even an undergraduate student will immediately understand that the European banks are being given a mulligan. With the unprecedented benefit of hindsight, issuers will cherry pick financial assets with accumulated gains since July 1 to remain in AFS, and the loss securities will be transferred to HTM as of July 1. In other words, the accounting will look like the crash in value didn't happen—in fact, winners count and losers don't. That's not leveling the playing field, it's picking up your marbles and going home. Will any auditor in Europe challenge a client's statement of intent and ability to hold a toxic loan for the "foreseeable future," whatever the heck that means? Vive le Société Générale!

As to any "disadvantage" that may have existed prior to the IAS 39 amendments, the IASB is mute as to what it is, why it is, or how it works.  I have never understood the argument that real competition in business should be presumed to be affected by financial reporting. Take business combinations, for example. In order to eliminate pooling of interests accounting, the FASB had to overcome the objections of its constituents who argued (whether they believed it or not) that recognition and amortization of goodwill would put U.S. companies at a competitive disadvantage when making acquisitions of other companies. When I was at the SEC for just one year, at least one registrant per week would spend shareholders' good money machinating and politicking to get to the point where the SEC staff wouldn't object to pooling of interests accounting for an acquisition. One of Abe Briloff's most famous essays was about how MacDonald's Corp. (I think it was in More Debits Than Credits) would systematically pay far too much of its own stock to underperforming franchisees to reacquire their restaurants (if that's what you would call a MacDonald's), while qualifying for pooling of interests accounting. There was even one case where politicians must have leaned on the SEC to look the other way when AT&T used pooling of interests to account for its acquisition of NCR. AT&T overpaid, of course.

The point is, as I have made repeatedly before, that bad accounting, especially when lobbied for by management, begets decision making that may be good for management in the short-run, but will eventually destroy (lots of) shareholder value. The amendments to IAS 39 will be no exception. Will the toxic loans on the books of financial institutions be managed with a desired accounting result in mind? You betcha (more election blues)! Auf wiedersehen, shareholder value.

The distinctive feature of this story, however, is the blatant pandering to issuers by the IASB, without any pretense of due process and nary a flinch of concern for having robbed investors of current information at a time when they need it the most. If there ever was any notion of an independent IASB, it has now vanished.

2 Comments

  1. Reply kfizzle November 6, 2008

    “…even an undergraduate student will immediately understand that the European banks are being given a mulligan.”
    Just wanted to say that, as an accounting undergrad, this is the exact thought that popped into my head right before I reached this line in the post.

  2. Reply Eddie Thomas November 11, 2008

    Why wouldn’t hold to maturity be ok if coupled with some concept of impairment? I would think that standards for determining probabilities of default are as reliable as market values, if not more so.
    I fear that fair market valuations can create feedback loops where write-downs lead to an increase in selling pressure which leads to further write-downs and so on. This seems especially likely in the credit crunch we are in right now; buyers who once might have stabilized prices can’t raise the capital to take advantage of the drop in prices.
    Your idea of replacement cost as the standard for fair market valuation may be the right idea, but it is not the system we have. Given the system we have, I think hold to maturity has a place.

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