The Accounting Standards Debate: The Regulator

It has been a busy few months for the UK’s business regulator. Fresh from sending its chief executive to face questioning from MPs at Westminster, the Financial Services Authority (FSA) oversaw the publication of its "root and branch" review of financial regulation, produced by former CBI head Adair Turner.

A key plank of the review was the need for banks to accurately report their positions and to reflect the state of its balance sheet. Crucial to that are both the rules governing disclosure and reporting, as well as the standard used to best represent the banks’ position.

The benefits of fair value

Fair value has been at the centre of the debate, and the City watchdog is broadly in favour of its use in corporate accounts.

"If you don’t have items in the accounts at fair value then you won’t have derivatives of fair value," says Richard Thorpe, accounting sector leader and head of capital adequacy policy at the FSA. "And we’re all agreed on the need to have derivatives on the balance sheet at the value that reflects their importance to the business."

Thorpe also points to the dangers of not reporting assets and liabilities at fair value when it comes to lending – something very much in the spotlight on the back of the banking crisis.

"Furthermore if you don’t have fair value for receivables, then you can find yourself with sub-optimal lending, which is what happened in the savings and loans crisis in the US," Thorpe says. "If you’re lending at rates below the market which you’re not obliged to record at fair value then you can hide losses."

Given the storm over the banking sector’s perceived failure to provide accurate summaries of its position, the evidence in favour of fair value appear overwhelming. In Thorpe’s view, however, there are still parts of the debate that require clarification and that won’t be settled simply.

"Where things get more difficult is where assets continue to be held at fair value past inception," he says. "And on that issue, we’re not unhappy with where the accounting rules are now. But we do believe that standard setters need to address revenue recognition where assets are not being actively traded and where there are movements in fair value. Because ultimately they are still changing the balance sheet totals."

And that is where the Turner review comes in – ensuring that regulation keeps pace with revenue recognition techniques so that users of the accounts – investors, analysts, shareholders – are provided with the right information with which to make an informed decision. With the wind at its back, the FSA now has more of a mandate to make this a reality than ever before.

However, that does not extend to dictating to the relevant bodies on accounting standards. "If we want to get the accounting standards changed, and that would have big implications for the regulators, then we need the standard setters to do it," says Thorpe.

Almost global

Convergence towards a set of globally adopted accounting standards has been the holy grail for many in the regulatory community for the best part of a decade. And, while the FSA has no direct influence over what happens at the IASB’s, Thorpe makes it clear how the UK regulator feels about the issue.

"We have consistently said at the FSA that we want a global set of accounting standards. And we’re nearly there," he says.

"We’ve seen the SEC start to deliver on its roadmap to introduce the domestic use of IFRS in the US [despite the US regulator’s recent warning that it would miss its own deadline of 2014 for introduction of IFRS]. I never thought we’d get as far as we have and I’ve been working on this for ten years. So that’s fantastic and has achieved my personal objectives at least. And these sorts of crises do raise the opportunity to look at whether what you’ve got is giving you what you need."

For now, the FSA is focusing on making financial companies hold adequate capital reserves in case of another downturn.

"Dynamic provisioning is a way of setting aside reserves so that you can address those issues of fair value movement," explains Thorpe. "And while the classic model of dynamic provisioning doesn’t take assets at fair value – it deals with loans and receivables that are initially recorded at fair value but not subsequently so are effectively at amortised cost – you can argue that the principles of holding extra capital which are in our proposals for the economic cycle reserve could equally be applied to other assets that are at fair value where there are unrealised gains."

This has been met with a cautious welcome in the City, but it is surely sensible to question whether financial regulation should be led by the need to de-risk banks. Would the FSA be better to adopt a twin-track approach, regulating banks on the one hand, and non-banking companies on the other?

"You have to ask yourself who’s going to be affected." says Thorpe.

"And ask whether these issues are going to be material to anyone that has large portfolios of long-term receivables or has large portfolios of financial assets and liabilities and derivatives. Those firms tend to be in the financial services sector. They may not actually be deposit takers, they may not be banks, but they compete in the same market. So the key question should be: is it reasonable that these companies should be subject to the same market discipline as banks? I would argue that yes, it is. And if we come up with the right answers for the accounting conundrums, then I think that should applied more widely."

The needs of investors

The FSA, Thorpe says, has a number of constituencies to serve. So while corporates may lobby for less red tape, investors must also be taken into account.

"If we believe as regulators that there is a need for economic cycle reserve it’s because we have an interest in depositors," he says. "Of course, it may not be appropriate for those same requirements to be imposed on those that don’t have depositors. But on the other hand, if you’re a shareholder in a company then you would want to know that the company has enough capital set aside in case there is another downturn."

So, while setting sensible limits of regulation still drives the FSA team, guarding against Armageddon II can’t be ignored.

The American perspective

The prospects for wholesale adoption of international financial reporting standards in the US were clouded further in April. Despite the Securities & Exchange Commission reporting good progress on its "roadmap" for adoption, the recent financial crisis and the arrival of a new SEC chief executive has slowed down the process, according to reports.

Adding to the inertia is the new chief’s refusal to sign up to the roadmap’s timetable. Mary Shapiro is one of the new gaggle of legislator and committee heads to arrive in Washington as appointees of the Obama administration. It would seem Shapiro has less enthusiasm for the roadmap than her predecessor Christopher Cox.

According to several press reports the roadmap’s public consultation has drawn a lukewarm response in the US. The main contention appears to be reluctance to switch from a rules-driven approach which has long held sway in the US, to the European (and more specifically British) principles-led system.