The Accounting Standards Debate: The Reporting Council

Fair value has proved to be a bête noire for standards setters. It’s central to International Financial Reporting Standards (IFRS) and has divided regulators, auditors and accounts preparers for some time. It has even been fingered by some as a contributing cause of the recent banking crisis.

Nonsense, argues Finanicial Reporting Council CEO Paul Boyle.

"If you go back twelve months, there was a lot of criticism out there about fair value. And the critics were mostly the management of banks and other financial services organisations," he says.

The criticism of the fair value method can be summed up thus: it is flawed because it attaches incorrect market values to assets. Critics argue the real value of the complex securities and derivatives they were dealing in was higher than market value, which was artificially low in their view.

"Things look rather different now," says Boyle. "It is true that the market values were wrong. But rather than too low, they were too high and we’ve had more write-offs in the months since."

Boyle believes that, while fair value doesn’t offer a cast iron guarantee of accounting accuracy, it does represent the best option.

"If you don’t like mark to market and fair value, what shall we have instead?" he asks. "Who would vote for mark-to-management accounting?"

Fair dues

So what should be used to provide accurate valuations of assets on the balance sheet? In Boyle’s view, it’s unrealistic to expect a humble accounting technique to solve all problems and guarantee no repeat of the devastating slumps to hit Northern Rock, HBOS or indeed Enron.

"I testified to the Commons Select Committee back in October 2008 when they were talking about fair value and I said what we probably needed was a combination of fair value accounting plus intelligent decision making and what I mean by that was this: ‘How do you interpret these assets on the up cycle, when you’ve got a boom?’ Because if asset prices are rising fast, it seems right from an accounting point of view to reflect those rises in the balance sheet.

"Once again, if you don’t believe in fair value, shall we allow the banks to report only a portion of the increases, or allow them to hold back a portion and post a bit more next year or the next time they need to boost profits? So when we see the value of the assets rising fast and large profits being created, what people need to recognise when they interpret those numbers is this: be aware that markets can go down as well as up."

Boyle argues that companies need to change their approach, to become aware that, while they continue to hold large positions in these assets, it would be unwise to regard all of that profit that has been created by market rises as available for distribution or profits that it’s wise to pay bonuses on.

"So let’s have fair value accounting plus good decision making," Boyle says. "And that includes changing the design of remuneration policies and not trying to solve the problem by juggling the numbers."

That number juggling has become the talk of boardrooms and dinner parties across the developed world. How could the banks get away with such lopsided balance sheets? Why didn’t analysts, shareholders and the press pick up on the impending implosion when it was there in the accounts?

It is this that has led to so many legislators across the world to demand greater transparency and clarity in financial accounts. Recently, MPs in Westminster grilled institute heads as well as auditors over the issue of complexity. Now is the time, the MPs said, to end baffling financial statements and return to basic principles and easily decipherable accounts.

If only it were that simple, says Boyle. "There are plenty of ideas that appear straightforward and easy to understand but are also wrong," he says. "The fact is, the major banks in the US and Europe are incredibly complex organisations performing and offering a wide variety of services across a lot of markets. So why does anyone think that it’s at all appropriate to present simple financial statements?"

In Boyle’s view, the calls for financial statements to be shortened so that are readily understood by all stakeholders should be resisted.

"One of my favourite quotes from Einstein is this: things should be made as simple as possible, but not simpler," he says, pointing out that complex organisations, whether they report under US GAAP or IFRS, require expert understanding.

"So if you are an investor who finds banks financial statements confusing, maybe the conclusion you should draw from that is that investing in banks is not for you. If you think you can’t understand the accounts, you probably can’t understand the business either, so maybe this is not the best place to invest."

However, he does agree that there is a case for producing different versions of annual reports for different users.

The third degree

Boyle’s suggestion to square this circle is a three pronged approach to reporting: a basic summary in the chairman’s statement, a longer financial statement for interested readers, and a fully detailed version for analysts to use.

The issue of complexity has been raised as a possible reason for the US’s reluctance to adopt IFRS. It’s hard to escape the fact that US companies and legislators have shown little enthusiasm for the project so far. For Boyle, looking on from London, the issue is still alive but far from settled.

"In Europe, we had 25 different sets of accounting standards and jointly made a decision on a European level to go to a single set," Boyle explains. "The cost benefit equation of replacing 25 sets of standards with one isn’t too hard to work out. For the US, they’ve already got their own unified set of standards and are being asked to do a straight one for one swap. So the cost benefit equation of that doesn’t look so simple."

To counter this reluctance, the FRC chief executive favours a more incentive-led approach. Forcing companies to meet a strict deadline would produce serious problems of resourcing, he believes, so offering encouragement to gradually switch over on a voluntary basis would in his view be preferable.

"Maybe the best thing to hope for would be to extend the option that foreign companies in the US have of using IFRS, to allow US companies the option of doing the same. So, those US companies that judge it to be in their best interest to report under IFRS could do so, provided they are competent to do that. If the regulators say to firms, ‘you’ve got the option’, then those with global operations and investors can switch to IFRS."

Boyle believes this gradual phasing in, and demonstrating the benefits of using an internationally recognised standard, would go a long way to countering US suspicion. And it could also help in getting Japan and China on board the convergence train.