The Accounting Standards Debate: The CFO

As markets tumbled, chief financial officer at ING Direct UK, Feike Brouwers, recalled Robert Shiller’s book whose title ‘Irrational Exuberance’ came from the prescient words of then Fed chairman Alan Greenspan. Shiller argued that sometimes the prices markets generated were very far from fair value but were driven rather by greed, fear and liquidity.

"We have seen many examples in recent months where asset prices have been completely out of whack" says Brouwers, citing Volkswagen’s surge last October giving it, at $129 billion, briefly the largest market cap of any world car maker. This anomaly arose purely because wrong-footed hedge funds were rushing to cover short positions. Any institution holding VW shares and marking to market at that time would, he maintains, have been giving completely false information.

"It is far better to use an historical price or an average price as a certainty at a point in time, and then explain in the notes or in the financial statement the underlying story and what prices could be under a stress test and things like that," Brouwers explains.

Measuring fair value has proved as difficult to execute in practice as it has been easy for everyone to accept in principle. Many were leery of the impact of IAS 39’s attempt to nail it down. In advance of the introduction of IAS 39 rules on fair value accounting, Brouwers was part of the ING project examining the financial statement impact.

"At the time we thought it was the biggest threat to our whole business model. Now we have a more moderate view and we’ve coped with it. But I still seriously think that the introduction of these accounting rules has driven the wrong kind of behaviour. I talk to practitioners, for example, who have decided to hedge certain positions simply because of the expected negative consequences on the accounting and the possible volatility to the P&L."

Companies are shying away from certain asset classes simply because of accounting complications.

"For example, if you’re a savings bank, your liabilities on the balance sheet are linked to interest rates and interest rates are driven by inflation. If you follow that line of thinking it might be a good idea to actually invest in assets that are also linked to interest rates that are linked to inflation, for example, in real estate. However, a lot of banks now shy away from investing in real estate because of the mark-to-market consequences and the short term P&L volatility, although in the long-term, it’s probably the best thing to do. I think accounting now also drives investment decisions and it also drives hedging decisions, whereas normally this should not be the case. Your decision about whether to hedge or not to hedge, to invest or not to invest should be driven by economic arguments and not by accounting arguments."

Brouwers believes that such distortions can only be avoided by rule changes on fair value accounting.

"I don’t mean change the rules completely but more their application in terms of determining asset prices. And it is important that this change should last for the duration of the crisis, and then we can all move back to the old situation again. I think we need to have more permanency."

If the argument for accounting with average or historic prices prevails, the notes to financial statements will have to be extensive. Brouwers accepts this brings it
own challenges.

"I think for smaller companies it will be a problem. However larger companies who have a listing, will have to make sure they have the capabilities, the knowledge and expertise in their business to actually apply those rules and produce the necessary notes." Such notes, adds Brouwers, would include an explanation of what the value of the asset would be under various stress tests.

Stress position

Finance directors may have found a way to cope with IAS 39 in normal markets, but they have not managed to handle the current crisis.

"Accounting has to show certainty. Volatility, as captured by IAS 39, doesn’t reflect the true economic underlying performance of the business,’ Brouwers says, ‘and then the reporting can even exacerbate the financial crisis or the market turmoil, because people see those financial statements and they see the volatility and they act upon it. It can almost become a self-fulfilling prophesy. You see the number and decide to sell the shares and it causes a downwards spiral."

But, despite his unhappiness with the IAS 39 as an efficient measure of fair value, Brouwers counsels that when changes are made, the baby is not thrown out with the bath water.

"Some people may be using the current downturn opportunistically to push forward their original wider objections towards IFRS but I think that would be a step back in time. That’s not what I think you should do. We have this set of rules now. In normal market circumstances they seem to work quite well and companies have learnt to adapt to and live with those rules.

"However I think it’s clear now that in situations of stress, those rules really don’t work and they can even be pro-cyclical and make the situation even worse. I’m not blaming current accounting rules for the crisis but certainly they haven’t helped to slow it down. The consequences of accounting have only made things worse. So we’ve learnt that it doesn’t work under stress. Therefore I think we need to move forward and see what we can to do to fix it. Those changes I believe need to come not so much in revision of the rules but more from a review of their application."

The test of a standard believes Brouwers is rigour.

"If it is way too loose and way too open to interpretation, if it gives companies too much room for earnings management for example, to manage their results based by picking and interpreting the rules the way you want to interpret them, then that is a standard that is clearly no longer acceptable."

IFRS timeline

2001: Formation of the IASC Foundation and IASB

2002: European Union passes regulation to adopt IFRSs for listed businesses in 2005. IASB and FASB plan to achieve compatibility in reporting standards

2003: IASB issues first new standard – IFRS 1. Australia, Hong Kong and New Zealand commit to adoption of IFRSs

2005: In Europe nearly 7,000 listed businesses in 25 countries switch to IFRSs

2006: IASB and FASB agree roadmap for convergence between IFRSs and US GAAP. China adopts standards substantially in line with IFRSs

2007: Brazil, Canada, Chile, India, Japan and Korea establish timelines to adopt or converge with IFRS. US SEC removes reconciliation requirement for non-US companies reporting under IFRSs

June 2008: IASB forms expert advisory panel to discuss the valuation of financial instruments in inactive markets

October 2008: IASB proposes improvements to financial instruments disclosures

December 2008: IASB proposes additional disclosures for investments in debt instruments

March 2009: IASB enhances financial instruments disclosures

April 2009: IASB responds to G20 recommendations and US GAAP Guidance

Source: IASB

Counting the same beans

The financial meltdown has, believes Feike Brouwers, increased the chances of the acceptance a single global accounting standard. ‘It would be a huge blessing for the preparers of financial statements if you have one worldwide system of accounting regulations; to say nothing of the major cost savings that would also come about as a consequence of a single system.’

In such an environment a company could seek a listing on any stock exchange. Brouwers regards as very good news the Obama administration’s interest in driving the IFRS as opposed to US GAP as the global accounting standard. However, he sees the problem that some jurisdictions, particularly in the US recoil, (arguably with some justice given recent bank failures), from the principles-based framework of accounting rules as applied in the UK.

‘My view is that before people will accept a global set of accounting standards, their application will need to become more rules-based than principles-based. Without this they will just not be recognised by some of the stock exchanges in the world, like in the US.’

The test of a standard believes Brouwers is rigour. ‘If it is way too loose and way too open to interpretation, if it gives companies too much room for earnings management for example, to manage their results based by picking and interpreting the rules the way you want to interpret them, then that is a standard that is clearly no longer acceptable.’