A thought leadership issue

Governments across the world have reacted to the credit crisis by committing to large scale economic stimulus packages, which include bringing forward infrastructure projects, making tax cuts, providing liquidity to key industrial sectors, guaranteeing bank loans, purchasing assets, injecting capital and, in some cases, nationalising banks or insurance companies.

Stimulus packages on this scale are unheard of in modern times, and they raise challenging questions for public sector accounting. While South Africa may have so far avoided the worst of the credit crisis, it has adopted and is implementing public sector accounting standards based on International Public Sector Accounting Standards (IPSAS) at a time when the credit crisis is demonstrating the limitations of the standards.

While private sector financial statements are predominantly aimed at providers of capital such as lenders and investors, public sector financial statements are used by a wide a range of users, including taxpayers, citizens, elected officials, buyers of government debt and the media. Public sector financial statements are used to make economic, social and political decisions, and they could affect electoral outcomes.

To consolidate or not to consolidate
Accounting standards that deal with control and consolidation (IAS 27, GRAP 6 and IPSAS 6) require reporting entities to include all controlled entities into the scope of consolidation. Control for financial reporting purposes means having the power to govern the financial and operating policies of an entity so as to benefit from its activities.

One country has already announced a departure from GAAP in relation to control and consolidation. In the Netherlands, the Ministry of Finance now controls a number of banks; however, it intends to disclose separately, rather than consolidate, its newly acquired banking interests. The Ministry argues that its newly acquired banking interests would have a distorting effect on its financial statements that would last for years.

While this approach may not follow GAAP, it is logical if you look towards the respective IPSAS Board’s and IASB’s consultative conceptual frameworks, which define the qualitative characteristics of financial information to include relevance, understandability, and comparability. A problem is that both the IPSAS Board and the IASB believe that their respective conceptual frameworks should not override existing standards.

Bad banks and illiquid asset insurance schemes
Many countries are now actively considering setting up “bad banks” to buy the illiquid assets in their banking sectors, or are offering to insure the illiquid assets in their banking sector. Both types of scheme are high risk because the most illiquid of assets have no active markets to set prices, and banks, often aware that they will not be allowed to fail, may try to negotiate unrealistic valuations for their assets.

Insurance schemes: off-balance sheet or on-balance sheet?
To deal with the credit crisis, many governments are seeking ways to encourage banks to increase their lending. One of the methods being used to achieve this is through governments guaranteeing the illiquid assets of banks. These schemes typically protect banks against credit risk, such as when the issuer of an illiquid asset defaults on payment. These schemes do not typically protect banks from losses incurred on the sale of an illiquid asset or for changes in the market value of the illiquid asset.

Most governments have typically treated financial guarantees as contingent liabilities, and so they have appeared off the government’s balance sheet. However, considering the size of some of the guarantees currently being made by governments, and the uncertainty attached to them, this treatment is not optimal.
IPSAS and GRAP do not currently cover the measurement of financial instruments, which include financial guarantees. In the absence of IPSAS or GRAP one must look towards IFRS for guidance on accounting for financial guarantees, and this allows a choice between accounting under IAS 39: Financial Instruments: Recognition and Measurement or under IFRS 4: Insurance Contracts.

Accounting under IAS 39 requires that the guarantees will appear as a financial liability on the balance sheet; initially at fair value and then at the higher of a value measured in accordance with IAS 37: Provisions, Contingent Liabilities and Contingent Assets or amortising the initial fair value in accordance with IAS 18: Revenue. However, this raises the problem of how to measure guarantees at fair value when the governments and banks involved in the transaction may not necessarily be knowledgeable or willing parties to the transactions.

Under certain conditions, IFRS allows financial guarantees to be accounted for as insurance contracts under IFRS 4. While such accounting should still allow for governments to provide against guarantees, there may be a measurement difference between the IAS 39 and IFRS 4 options.

Unfortunately, considering the amount of uncertainty at the current time, it is unlikely that any accounting treatment adopted will be able to reflect the true risk exposure to which taxpayers are exposed.

Bad banks: on-balance sheet
Under the “bad bank” option, the illiquid assets of a bank may be bought by a government and will typically find their way onto the balance sheet of either the reserve bank or the Ministry of Finance, which are the most likely entities to intervene in a market.

In certain circumstances, IAS 39 permits choices as to how illiquid assets are measured, and the potential impacts of measurement methods can be demonstrated by an example from Switzerland.
One of the first countries to set up a bad bank during the current crisis was Switzerland, where the Swiss National Bank created a Stabilisation Fund to buy and dispose of the illiquid assets of UBS, one of Switzerland’s major banks.

When the Swiss National Bank set up its Stabilisation Fund, it was anticipated that it would buy $60 billion of the illiquid assets of UBS; however, as a result of amendments made to IAS 39 Financial Instruments: Recognition and Measurement in October 2008 it became possible for UBS to reclassify certain assets as loans and receivables without the need to value the assets at market prices. The result was that it became no longer imperative for the Swiss National Bank to buy $21 billion of the assets it originally intended to buy.

Many commentators have argued that fair value accounting has made the credit crisis worse because downward asset valuations erode the capital base of banks and weaken their ability to lend. The Swiss National Bank example does tend to support this view. The amendment to IAS 39 meant that it was no longer necessary for UBS to sell assets to the Swiss National Bank, which would previously have been marked-to-market and which would have had the potential to eradicate its capital base.

The question of who intervenes in the market affects whether interventions are on a government’s balance sheet
Who intervenes in the market affects whether interventions will appear on a government’s balance sheet or not. For example many reserve banks are not considered to be controlled by government, and therefore they appear off a government’s balance sheet.
Such a situation frequently arises because the reserve bank’s independence is enshrined in legislation. To prove control requires that the government has the power to govern the financial and operating policies of a central bank and that it can benefit from the activities of a central bank or be exposed to a financial burden as a result from its activities. However, the legal status of a reserve bank is rarely tested in substance.
The decision of who intervenes in the economy, whether it is a reserve bank or a Ministry of Finance affects how financial statements will be presented. If the reserve bank intervenes in the market, the intervention may appear off balance sheet, while if intervention is undertaken by a Ministry of Finance, which is typically a part of the government reporting entity, the results may appear on the government balance sheet.

Unfortunately, the different on-balance sheet/off-balance sheet results, which depend on who intervenes in the economy, may appear confusing, and confusion leads to questions about transparency; it is uncertain whether IFRS, IPSAS or GRAP can provide for the level of transparency necessary. Governments may consider it necessary to depart from the standards to ensure that their interventions are transparently accounted for in a way that is understandable to users of the financial statements.

The government: guarantor of strategic industries
Government bailouts have now created expectations that governments will ensure the liquidity of their banking and other strategic industries. This raises the question of just how far implied government guarantees go. If the auto industry is of strategic importance, then surely the defence industry is also strategic, as would be all privatised utility companies?

Consider the definition of a constructive obligation (IAS 37, GRAP 19 and IPSAS 19 are all titled Provisions, Contingent Liabilities and Contingent Assets) as “an obligation that derives from an entity’s actions where: (a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and (b) as a result, the entity has created a valued expectation on the part of those other parties that it will discharge those responsibilities.”
A strict reading of IAS 37, GRAP 19 and IPSAS 19 means that governments in some countries could legitimately provide for the likelihood of far more bailouts of their strategic industries on their balance sheets.

Is cash accounting information sufficient at the current time?
Cash accounting shows the cash flows of a period, and many countries, which include South Africa at the departmental level, use it for public sector financial reporting. However, the absence of a statement of financial position and a statement of financial performance means that cash information by itself is too limited to allow a reasonable assessment of the financial health of a government. Some governments that use cash accounting try to make up for the limited financial disclosures provided by cash accounting by providing supplementary information; however, this does not necessarily reconcile to the primary financial statements, and transparency is therefore lost.

The advantages of accrual accounting over cash accounting should be clear, as governments seek to stimulate their economies. However, some governments may be happy with their cash accounting systems at the current time because of the lack of financial transparency they provide. The problem at the current time is that accrual accounting also appears to offer many options on how to present financial information in a less than clear way.

Where next?
The unique nature of the credit crisis raises a number of challenges for public sector accounting. The credit crisis has evolved so quickly that it has not given standard setters sufficient time to consider fully and respond to emerging issues. Now governments have to decide how to account for unique events, which current accounting standards never anticipated.

The risks for public sector transparency across the world are clear for all to see.

Ian Sanderson FCA, is an expert in IFRS and IPSAS. He works for Deloitte in Geneva, Switzerland.