The response of the International Accounting Standards Board

If this question was asked to politicians and business leaders, the answer would be a resounding ‘YES’. The ‘grey men who sit in dimly lit rooms and dream up accounting standards’ are responsible for the current global financial crisis. The gluttony of criticism has been primarily focused on the method applied to accounting for financial instruments and the requirement to fair value them and, furthermore, that accounting standard setters have caused the financial crisis. Accounting standard setters have been seen as ‘lame ducks’ – the ones who make no business decisions – yet can cause a global financial crisis!

This article seeks to provide a further understanding as to what caused the financial crisis and the response of the International Accounting Standards Board (IASB).

In late 2007, when the sub-prime crisis had started to emerge, accountants and financial directors were hauled before boards to account for the reasons for the significant deterioration in earnings, mainly due to extensive losses being recognised on the remeasurement of the fair value of derivative instruments and having to make good losses that existed in special purpose vehicles. These same directors had themselves, in prior years, been paid significant bonuses based on the increases in fair value recognised in profit and loss.

In the US, home loans, housed in securitisation special purpose vehicles, started to default due to declining house prices. As a result, many financial institutions that held the lowest credit quality, mostly subordinated paper in these securitisation vehicles, started to report huge losses. In prior years, there had been a limited market and high demand for this low quality paper because of the high interest nominal returns attached to it.

This resulted in positive fair value adjustments being recognised in profit and loss. However, as the decline in housing prices gathered momentum, so the market for this low quality paper disappeared, and this led to a rapid decrease in the fair value of this paper.

The impact of the US sub-prime crisis reverberated throughout the world. At the height of the US housing boom, European financial institutions had purchased this low quality paper in order to participate in this ‘lucrative’ market. Therefore, as the effects of the sub-prime crisis accelerated, these institutions started to report extensive losses. Furthermore; European financial institutions had also securitised their own mortgages and, as a result of the world economic pressures, these vehicles also went into default, which resulted in further losses being reported.

This caused a global financial crisis that has had far reaching implications on the stability of world financial systems. Glaring examples of this crisis can be seen in the demise of well established entities, such as: Merrill Lynch being bought out by the Bank of America, Lehman Brothers being declared bankrupt, Bear Sterns slowly dissolving into nothing, the Royal Bank of Scotland reporting record losses and the demise of Northern Rock.

Probably, and most importantly, the ceding of control of many financial institutions to their respective national governments were sure signs of the times. Government assistance or bailouts for financial institutions became the ‘modus operandi’. The face of the financial institutions in the world as we had known it had changed forever. Never before has there been such intensive global focus on one accounting standard, not only from the business community, but also from global politicians.

Extensive political pressure, encouraged by the business community, from both the European Union and the US Congress have forced the arm of both the IASB and the Financial Accounting Standards Board (FASB) to accelerate urgently the timetable to rewrite the provisions of the financial instrument standards. One of the examples of political interference was the US Congress issuing a draft bill allowing Congress to withdraw any part of an accounting standard as it so wishes. A further example of political pressure was evident in Europe where the IASB yielded to European Union pressure to adopt the identical model adopted by the US, being the reclassification of financial instruments.

This was the first time that the IASB, in its current state, released a standard or amendment thereto without due process being followed. Statements by politicians, the Commissioner of the European Union, Commissioner Charlie McCreevy and, even by the then President of the US, George W Bush, constantly increased the political pressure on the IASB and the FASB urgently to take corrective action on certain aspects of financial instrument accounting that were thought to be the root cause of the global financial crisis.

The enormity of the pressure on the accounting standard setters can be likened to Atlas balancing the world on his shoulders. Numerous parties pounced and were quick to highlight the potential accounting-related issues that were seen to be the cause of this crisis. The parties involved, amongst others, included large business organisations, the Basel Committee for Banking Supervision (Basel), the Finance Ministers of the G7 group of countries (G7), the US Federal Reserve, the Financial Stability Forum (FSF), the European Commission (EC), the US Congress and the Securities & Exchange Commission (SEC). As time past, the pressure applied on the accounting standard setters to institute corrective action increased exponentially.

The result
The impact of the financial crisis, compounded by excessive political interference, has resulted in the IASB agreeing to an urgent and complete revision to the standards on financial instrument accounting. Many people were of the opinion that they would never see such drastic revisions to standards in their lifetime. The revision to the standards is considered to be quite remarkable, given that many entities were only just getting accustomed to reporting their business in terms of the current standards.

The question that should be asked is; whether the amount of intensive pressure that is being applied by the politicians will result in a high quality set of accounting standards, or some mediocre, confusing, interim, stepping stone that will appease the politicians. A further point that should be examined is; whether complex issues will be simply overlooked for the overall result of expediency, or will a high quality set of standards be developed?

The IASB response
The response of the IASB to the imposed pressure has been the establishment of the Financial Crisis Advisory Group (FCAG) and further discussions on the following accounting technical issues, which are elaborated on below:

1. Fair value measurement
2. Enhanced disclosure of fair value measurement
3. Reclassification of financial instruments
4. Off-balance sheet structures
5. Measurement of own credit in financial liabilities
6. Measurement and classification of financial instruments
7. Impairment provisioning
8. Hedge accounting

Financial Crisis Advisory Group (FCAG)
The incessant criticism levelled at accounting standard setters resulted in the FASB and the IASB forming the FCAG. The African representative on this group is Professor Wiseman Nkhulu. The purpose of the group is to consider input from the business community regarding potential contributory causes to the financial crisis. The mandate of the FCAG included consideration of the accounting standard setting process, including potential improvements to accounting standards as well as the role, if any, that accounting standards played in respect of the financial crisis and the appropriateness of fair value measurement of financial instruments.

The FCAG has to date concluded that accounting standards should be set free from political influence. It further concluded that accounting standards did not cause the financial crisis, but did highlight certain issues of inappropriate risk management and incorrect decision-making processes within entities. The development of a high quality set of globally applicable accounting standards is a priority, with urgent improvements being required in respect of a simpler principle-based financial instruments accounting standard.

This revised standard should include an examination of impairment guidance, a review of fair value measurement guidance, and a review of hedging provisions. It was felt that the existing standard did not take into consideration whatever business model adopted by an entity. Furthermore, fair value measurement is an appropriate basis for the measurement of perhaps only certain financial instruments.

The FCAG was of the opinion that further guidance is required in terms of the determination of fair value in an illiquid market. The group concluded that the largest contributing factor was the lack of appropriate risk management strategies by companies, and an attitude of ‘legal’ compliance to accounting standards, rather than applying the principles contained in the standard.

1. Fair value measurement
In the early stages of the financial crisis, regulators and politicians looked to the accounting standard setters, principally the IASB and the FASB, regarding the contribution that the fair value measurement of financial instruments had on the financial crisis. Many studies have been conducted, with the overwhelming conclusion that fair value accounting highlighted, at an early stage, the turbulence in the financial markets, but did not de-facto contribute to the financial crisis. The abundance of exotic products, such as Collaterised Debt Obligations (CDOs), subordinated paper etc, which were either required to be measured at fair value or elected by management to be held at fair value resulted in huge volatility being recognised in profit and loss.

In the computation of fair value by companies, insufficient consideration was often given to the numerous factors that affected the fair value of these instruments. Practical difficulties arose in determining the fair value of these instruments, especially in the case where markets had either collapsed or disappeared overnight.

Many parties criticised the lack of fair value guidance, especially in the face of illiquid markets. This criticism was principally led by, amongst others, the Basel committee, the FSF, the G7 and the SEC. This criticism focused mainly on the risk management policies and procedures governing the processes for determining fair value. This included the insufficient review of the inputs and models used to determine fair value and the inadequate stress testing of the fair value of the instruments. Extensive guidance has been subsequently released on the determination of fair value in illiquid markets and the risk policies and procedures recommended for determining fair value.

2. Enhanced disclosure of fair value measurement
Criticism was levelled at the IASB because many stakeholders felt that insufficient disclosure was provided on various components of fair value measurement, including the sensitivities of inputs in the determination of the fair value and the effect of fair value measurements on profit and loss. The IASB has recently released amendments to the existing IFRS 7: Financial Instruments: Disclosures. These amended disclosures are required for entities with financial reporting periods commencing on or after 1 January 2009, and are based on the US GAAP standard, FAS 157, Fair Value Measurements.

The amendments to IFRS 7 include, amongst others, the requirement to categorise the fair value measurement of all financial instruments into three levels of measurement hierarchies. The three levels of fair value measurement hierarchies are:
• Level 1: fair value directly obtained from market prices;
• Level 2: fair value principally derived from market prices, but with minimal unobservable market inputs; and
• Level 3: fair value principally derived from unobservable market inputs (i.e. fair value of instruments valued off models)

The amendments to the standard also include disclosure of reasons for changes between the three levels of measurement hierarchies, as well as a detailed reconciliation of the amounts recognised for level 3 financial instruments recognised at fair value. It also requires disclosure of sensitivities to changes in inputs on the fair value measurement of financial instruments.

The amount of work required in order to comply with the amendments to this standard should not be underestimated, as it requires the classification and disclosure of all financial instruments. UBS, in its 2008 financial statements, provided certain disclosures as required by this amendment, which totalled twelve pages.

3. Reclassification of financial instruments
The IASB was subject to an enormous amount of political pressure with the European Union (EU) threatening to withdraw its endorsement of IFRSs if it did not permit the reclassification of certain financial instruments. Previously, the EU had required all EU publicly listed entities to adopt IFRS for reporting periods commencing on or after 1 January 2005.

In an unprecedented step, the IASB, without due process being followed, in October 2008, released an amendment to the existing standard allowing for the reclassification of financial assets previously carried at fair value to be carried at amortised cost, depending on various circumstances. This allowed entities not only to reverse previously recognised losses, but also allowed these instruments to be carried now at amortised cost. The amount of disclosure required for the reclassification is fairly onerous.

Interestingly, none of the French banks used the reclassification amendment, despite intense lobbying by the French Government to the IASB for this amendment. In South Africa, a limited number of companies reclassified certain of their foreign financial assets. Certain European financial institutions, including Deutsche Bank, Royal Bank of Scotland and Barclays Bank reclassified significant amounts of these financial assets. The prominence of this disclosure varied between entities, with certain entities including it in the last note of their financial statements.

The Accounting Practices Board in South Africa, when communicating this to the market indicated that, in its opinion, the ‘rare circumstances’ required to reclassify financial assets from fair value to amortised cost were ‘highly unlikely’ to exist in the South African environment, but could exist with regard to foreign financial assets and liabilities. The IASB subsequently indicated that ‘rare circumstances’ arise from a single event that is unusual and highly unlikely to recur in the near term, which supported the view taken by the APB.

4. Off-balance sheet structures and de-recognition
Standard setters have been criticised as to the reasons why accounting standards allowed for certain transactions to be derecognised from the balance sheet and for allowing special purpose vehicles, created by a group, not to be consolidated.

The existing accounting treatment of the consolidation of special purpose vehicles, including securitisation vehicles, when evaluated against the current accounting requirements may not have required such vehicles to be consolidated in the groups’ financial statements. The reason for the non consolidation of these vehicles was that the focus for the evaluation of control was on the legal obligations of the creator of the vehicle, with constructive obligations largely ignored.

This has resulted in loan obligations, related financial assets and profits or losses in these vehicles not being included in the financial results of the group. However, when these vehicles went into default, the group took ultimate responsibility for making good losses to investors and thereby, through their actions, acknowledged that they had indeed controlled these vehicles. In evaluating whether control existed, a legalistic approach was followed that resulted in constructive obligations being ignored in concluding whether these vehicles should be included in the group financial statements.

The US standards are currently more rule based in comparison to the IFRS. Studies have shown that if entities currently applying US Generally Accepted Accounting Practice (US GAAP) had applied the provisions contained in IFRS rather than that of US GAAP, it would have drastically increased the number of special purpose vehicles requiring consolidation. An exposure draft was released by the IASB in December 2008 that proposed that a control model should be applied when assessing whether a special purpose vehicle should be consolidated. Other requirements include the continual re-assessment of whether or not an entity controls another entity, including the potential consolidation of entitles where the consolidating entity does not hold a majority interest. Non-consolidation of an entity requires onerous disclosures.

With regard to derecognition of financial instruments, current standards written by the IASB and the FASB contain a complex set of rules against which entities have to evaluate specific transactions, in order to derecognise financial instruments off their balance sheet. The US standard contains more rules for de-recognition when compared to those contained in IFRSs. In the development of accounting standards, the IASB has always attempted to develop principle-based standards.

The existing standards have resulted in a ‘tick box’ methodology being applied when evaluating de-recognition transactions because of the combination of ‘risk & rewards’ and control approaches, which have not been historically well understood by preparers and auditors. The current proposals included in the exposure draft give name and say issued in … provide limited clarity on de-recognition. Many commentators, including four Board members, feel that the exposure draft still includes a mixture of the control and ‘risk & reward’ principles.

A consistent message from commentators on accounting standards is that the principles advocated in the standards on de-recognition and consolidation should be consistent in all material respects and should principally deal with the recognition and de-recognition of financial assets and liabilities.

5. Measurement of own credit in financial liabilities
Due to the existing stringent requirements contained in IAS 39, Financial Instruments: Recognition and Measurement for the hedging of financial instruments, many entities have been unable to apply hedge accounting due to incompatible policies and procedures. This has resulted in many entities applying the fair value option (FVO) to fixed rate financial liabilities in cases where interest rate derivatives are used to hedge interest rate risk.

The FVO requires entities to measure the full fair value of the liability, including the impact of own credit, when applying the fair value option. This has led to the ludicrous situation where an entity would recognise a profit on the deterioration of its credit rating. This is contradictory to the economic reality, as the deterioration in an entity’s credit rating indicates that the entity is not performing well and should by no means recognise a profit on the deterioration of its own credit.

An exposure draft was issued in June 2009 on how an entity’s own credit should be included in the determination of the fair value of financial liabilities.

6. Measurement and classification of financial instruments
The existing standards on financial instruments stretches over 750 pages in the Bound Volume of IFRS, and contain a combination of rules and principles that make it difficult to comprehend. The current version of IAS 39 includes four different categories of financial assets, two categories of financial liabilities and a further option for entities to designate financial instruments at fair value through profit and loss, if certain criteria are met.

The approach likely to be followed by the IASB is to mirror the principles contained in the International Financial Reporting Standard for Small and Medium Entities (IFRS for SMEs), which contains a more simple approach to the classification of financial instruments. This approach includes only two categories of financial instruments: those that are categorised at fair value and those measured at amortised cost. The IFRS for SMEs would be supplemented by the business overlay model when evaluating the appropriate classification of financial instruments.

The exposure draft states that financial instruments with the profile of interest yielding instruments may be measured at fair value, and with all other financial instruments recognised at fair value, and with changes recognised through the income statement. Changes in fair value can only be recognised in Other Comprehensive Income (OCI) for equity instruments that an entity holds for strategic business purposes. There will be no recycling of amounts recognised in OCI with regard to these instruments.

The amendments to the standard should prove to be easier for entities to apply, but there could be complications in the application of the final transitional provisions. Other complexities that the Board is currently grappling with include whether or not it should allow the reclassification of financial instruments. An exposure draft was issued at the end of July 2009, with a sixty day comment period.

7. Impairment provisioning
There is a great debate about whether or not the current accounting standards model for determining impairments is appropriate. Various European Central Banks have recommended different models that would allow entities effectively to spread impairment losses over the periods of prosperity. Alternatively, the Bank of Spain, which was the least affected European financial system during the crisis, has recommended the use of a complicated mathematical equation for the determination of impairment provisions.

Further questions surrounding this issue include whether the ‘incurred loss method’ of recognising impairment or the Basel II method of ‘expected losses’ is the correct method of recognising impairment. An exposure draft relating to impairments is expected to be released in September 2009.

8. Hedge accounting
Current provisions to apply hedge accounting are extremely onerous. Many simple transactions such as the hedging of simple inventory transactions or capital assets are disallowed, or are prohibitively too expensive to be implemented. The IASB has committed to re-evaluating the provisions of hedge accounting, which would hopefully ease the ability of entities to apply hedge accounting. An exposure draft on this is expected towards the end of 2009.

The pace of change of the requirements for the accounting of financial instruments is ever increasing. The question that all stakeholders, including politicians, need to answer is; whether, given in the short time constraints, a more simple high quality standard on financial instruments can be developed.

President Obama’s election slogan was ‘The time for change is NOW’, and the same statement can be applied to the rapid change in the accounting for financial instruments. The choice is ours: we can either be forward thinking and meaningfully contribute to the development of a high quality standard on financial instruments, or we can put blinkers over our eyes, pretending that nothing is happening – and then be left licking our wounds in the dirt, when the world of financial instrument accounting has changed before our eyes.

The role of Chartered Accountants in the current financial crisis is to ensure that the spirit in which the accounting standards are written is upheld, and that we persevere in presenting the financial information for which we are responsible, in a faithful manner.

David Castleden, Senior Manager: Financial and Management Reporting, Nedbank Group Limited.