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Research

Fair Value Accounting – Political Economy Hot Potato (Part 2)

We know that fair value accounting doesn’t make sense for derivative instruments. A derivative can be potentially extremely volatile in terms of its value at any given point in time owing to small fluctuations in its underlying risk factors and market conditions. Physical assets that are more traditionally held at book value are far less volatile. Until the financial crisis hit, an accounting treatment that seemed extremely sensible was that everything not held to maturity is assumed to be traded, for which it then makes sense to mark-to-market or mark-to-model. When the financial crisis hit and the value of those instruments tanked, market participants began to protest against writing unrealised losses to the income statement and the resulting impact on capital through burning into retained earnings. The rationale behind these protests was that market values were ‘wrong’. But as John Maynard Keynes once observed “The market can stay irrational [far] longer than you… can stay solvent”.

 

fair-value-2It would of course be absurd to completely do away with fair value accounting. It is absurd to be allowed to trade in instruments without being required to write unrealised losses and gains to the income statement. One could indefinitely manipulate one’s income statement, capital, and solvency by simply not trading in those instruments that would realise a loss.

 

To address these concerns the IASB embarked upon the IFRS 9 project with the ultimate aim of reducing the complexity in reporting financial instruments. Phase one of this project culminated in November 2009 with the release of the first part of IFRS 9 Financial Instruments, which introduced new requirements for the classification and measurement of financial assets. Phase two was finalised in October 2010 with the reissuance of IFRS 9, incorporating new requirements for the accounting of financial liabilities, and also existing requirements for the derecognition of financial instruments. The third and final phase for the impairment of financial assets and hedge accounting was to have been completed by the end of June 2011.

 

In a nutshell, what the standard setters had realised was that it would be appropriate to make the accounting standards more straightforward to follow and less prone to abuse. At the same time, the standards should continue to penalise the use of very thinly traded instruments at book value, and also force firms to recognise unrealised losses and gains on instruments that could intrinsically be extremely risky.

 

IFRS 9 allows only two primary measurement categories for financial assets – fair value and amortised cost. The existing IAS 39 categories of “Held-to-maturity”, “Available-for-sale”, and “Loans and Receivables” have been eliminated. An asset is assigned to the amortised cost measurement category if the business model within which it is held has the objective of holding assets to collect contractual cash flows, and the terms of which give rise to cash flows comprised of principal and interest on specified dates. All other financial assets are designated fair value. Given that an asset is measured at fair value, all changes in fair value are recognised in profit and loss, with the exception of equity. Entities may choose, on a case by case basis, to recognise gains and losses on equity holdings not held for trading in other comprehensive income, with no recycling of gains or losses or recognition of impairments in profit and loss.

 

Another fascinating development, one that is in alignment with Solvency II in the insurance industry, is that IFRS 9 now not only restates financial liabilities in terms of an economic or total balance sheet approach, but is also based on an extremely statistical, actuarial view. The proposal takes a principles-based approach to accounting for financial liabilities on the premise that an insurance contract creates a bundle of rights and obligations that generate cash inflows (premiums) and cash outflows (claims, benefits, and expenses). The uncertainty inherent to those cash flows is reflected in a risk margin which is determined on the basis of standard deviation (or VaR), conditional tail expectation (or TVaR), or the cost of capital. The application of these statistical tools is in fact far more in keeping with the nature of the insurance industry, and the predominant role played by actuaries therein, in which the estimation of forward looking probabilities play such a crucial role.

 

The new provisioning standard also (implicitly) incorporates a statistical approach with the move away from incurred loss provisioning by the introduction of expected loss provisioning. Incurred loss provisioning can be seen as akin to backward looking provisioning based on financial assets’ actual behaviour. The treatment of impaired assets under IFRS 9 now consists of a dual impairment model driven off the credit characteristics of the loan book, which is also consistent with how banks manage credit risk, often referred to as a “good book” / “bad book” approach. Impairments on the bad book are recognised immediately, whereas impairments on the good book are the expected losses amortised according to a “time-proportional amount” or over a “foreseeable future period”. The IASB does not prescribe any particular statistical methodology to calculate expected losses.

 

No less important than the reduction in complexity associated with the reporting of financial instruments is the move toward convergence between the IASB and FASB standards that IFRS 9 represents. The emergence of a truly international standard should substantially elevate the transparency and comparability of large international institutions’ financial reporting. This is of particular importance in respect of the size of banks’ balance sheets. US GAAP nets out derivative positions, unlike European IFRS which deals with gross exposures, resulting in higher reported assets under IFRS. The difference is non-trivial. For Deutsche Bank, which reports its balance sheet under both standards, 2008 assets on balance sheet were $2 trillion under IFRS and $1 trillion under US GAAP, but with the same reported equity under both standards. Such a difference makes international comparisons of leverage all but impossible, hampering investor risk assessments and supervisory assessments.

 

Our review of IFRS 9 suggests that the new standards hold the promise of accounting for financial instruments in future that is much more closely aligned to economic substance. While the apparent failure of the efficient markets hypothesis implies that the fair value debate will never be satisfactorily resolved, the IASB seems to have deftly side-stepped the issue. By implementing the business model approach it will at least be clear to accountants, investors, and regulators to which of either category fair value or amortised cost an asset belongs. Moreover the adoption of a provisioning standard based on expected losses means that the carrying value of assets will reflect actual, anticipated losses on a forward looking probabilistic basis.