Fair Value Banking Crisis

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Fair Value Accounting and the Banking Crisis in 2008: Shooting theMessengerPaul Andra; Anne Cazavan-Jenya; Wolfgang Dicka; Chrystelle Richarda; Peter Waltonaa ESSEC Business School, France

To cite this Article Andr, Paul , Cazavan-Jeny, Anne , Dick, Wolfgang , Richard, Chrystelle and Walton, Peter(2009) 'FairValue Accounting and the Banking Crisis in 2008: Shooting the Messenger', Accounting in Europe, 6: 1, 3 24To link to this Article: DOI: 10.1080/17449480902896346URL: http://dx.doi.org/10.1080/17449480902896346

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Fair Value Accounting and theBanking Crisis in 2008: Shootingthe Messenger

PAUL ANDRE, ANNE CAZAVAN-JENY, WOLFGANG DICK,CHRYSTELLE RICHARD & PETER WALTON

ESSEC Business School, France

ABSTRACT The paper sets out to analyse the effects of the financial crisis on theinternational standard-setter in 2008 and the attempts made to shoot the messenger toblame IAS 39 for creating the crisis for reporting unrealised losses, rather than thecause being bankers making bad investment decisions. It first provides a brief analysisof IAS 39 and fair value accounting for financial instruments. It then sets out therelationship with the Basel II banking regulatory regime. The main part of the paper isa chronological presentation of the events of 2008 as they impact upon the internationalstandard-setting institution. In particular, we analyse the impact of the G20requirements and the blunt intervention of the European Commission that led toamendments to IAS 39. The final part of the paper looks at the consequences as theyare so far discernible and the damage done to the IASB by shooting the messenger.

Introduction

Responsible and guilty as charged? Since fairly early in the negative cycle, the

International Accounting Standards Board (IASB) has been put in the dock,

accused of having intensified the effects of the financial crisis. To hear the com-

ments of some banks, businesses and even politicians, International Financial

Reporting Standards (IFRS) have not only been ineffective during the period

of the crisis but they have also precipitated the fall of some major financial

institutions. Criticised and destabilised, accounting has been considered one of

the key factors of the crisis. But is that really the case?

Accounting in Europe

Vol. 6, No. 1, 324, 2009

Correspondence Address: Chrystelle Richard, ESSEC Business School, Avenue Bernard Hirsch,

BP 50105, 95021 Cergy Pontoise Cedex, France. Email: [email protected]

Accounting in Europe

Vol. 6, No. 1, 324, 2009

1744-9480 Print/1744-9499 Online/09/01000322# 2009 European Accounting AssociationDOI: 10.1080/17449480902896346Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA

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During 2007, financial institutions began to need to recognise a drop in value of

some of their financial assets, generally linked to sub-prime loans. The financial

press first focused on the amounts of the impairment write-downs and the doubt-

ful quality of the related assets. However, bit by bit, the financial institutions

started to blame fair value accounting. Their management argued that they had

no intention to sell these assets and there was no point in measuring them at

their market value. In March 2008, the chief executive of the American Insurance

Group (AIG) was cited in the Financial Times as suggesting that management

should estimate the likely losses and recognise those, rather than reflect market

prices by measuring at fair value.1 This position began to be heard by politicians

and banking regulators who started to review the situation. The IASB and FASB

started to come under pressure to reconsider the fair value rules. This was to lead

to a crisis for the international standard-setter and a possible loss of any chance of

being adopted in the US. The messenger was certainly shot, but not to death. It

remains to see how much it was wounded.

In this paper we will first set out what is the linkage between fair value account-

ing and banking regulation, then look at the unrolling in 2008 of political pressure

on the IASB, and finally we will review the consequences, actual and potential of

the fair value crisis.

Fair Value under IFRS

Fair value is defined in IAS 39, the recognition and measurement standard for

financial instruments, as the amount for which an asset could be exchanged, or

a liability settled, between knowledgeable, willing parties in an arms length trans-

action. The concept of fair value measurement is to show assets and liabilities at

their market value at balance sheet date rather than at historical cost. Gains and

losses are recognised immediately in the financial statements rather than being

smoothed over the life of the instrument. Accounting for assets at fair value can

be seen as a general application of the financial logic that sees the business as a

portfolio of assets whose value depends on their expected cash flows and risk.

The way in which standards require fair value to be measured is still evolving.

The FASB published a standard, SFAS 157 Fair Value Measurement, which

formalises how fair value should be applied when another standard calls for

that as a measurement basis. The IASB plans to issue its own convergent fair

value measurement standard before 2011. SFAS 157 recognises three levels of

fair value measurement: Level 1 is the current price in a liquid market for

exactly the same instrument, Level 2 is the current price in a liquid market for

a similar instrument, which can be adjusted to obtain the fair value of the instru-

ment being valued, Level 3 uses valuation models based on assumptions that a

market participant would use. Level 3 should not directly use the entitys own

assumptions without modifying them to reflect the market.

The application guidance of IAS 39 (developed several years earlier) implicitly

also has three levels but it mainly draws a distinction between fair value based on

4 P. Andre et al.

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market data (what SFAS 157 would call observable inputs) and fair value based

on a valuation model (unobservable inputs). These are also referred to as mark

to market and mark to model. The US three-level hierarchy has become widely

used outside of a US GAAP environment, and is significant in that standard-

setters usually ask for more stringent disclosures related to Level 3 (mark to

model) as opposed to Level 1 (mark to market).

Under IAS 39 financial instruments are classified under four headings, which

have different accounting consequences:

. financial assets held for trading

. held-to-maturity investments

. available-for-sale financial assets

. loans and receivables

Held for trading financial assets are valued at fair value at each balance sheet

date, and changes flow directly through the income statement. All derivatives

are treated this way. Held to maturity investments are held at amortised cost.

Available-for-sale financial assets are valued at fair value at each balance sheet

date, but the change in fair value goes to equity and is now reported in

Other Comprehensive Income, with gains and losses recycled through the

income statement when the asset is sold. Loans and receivables may not

include derivatives nor be quoted on an active market. They are measured at

amortised cost using the effective interest rate method. In 2003, the IASB modi-

fied IAS 39 to add an option to use fair value through income for subsequent

measurement of any asset or liability in order to correct an accounting mismatch

(i.e. where matching assets and liabilities that were held to offset risk were

accounted for on two different measurement bases, giving an accounting

mismatch that did not reflect the underlying economics).

A key anti-abuse requirement is that entities had to determine at inception into

which category the asset fell, and were not subsequently able to re-classify it.

This, and the hedging rules, were primarily driven by the perception that if

entities were able to re-classify, at any balance sheet date all loss-making

assets would be transferred to amortised cost, while those showing a market

profit would be at fair value through profit and loss.

Fair value is not a new concept. Richard (2004) points out that market value

was used in France in the 19th century. It has existed in an Anglo-Saxon legal

context for at least 200 years (Walton, 2007). Broadly, the courts have used

the term to mean a price at which buyer and seller both receive an appropriate

benefit from a transaction i.e. a price that is fair to both parties. It has long

been used in accounting as a means of fixing a financial value when a transaction

does not contain an explicit financial value. This happens, for example, when a

promoter of a company gives up non-cash assets against shares in the

company. A fair value for the non-cash assets has to be determined to fix a

financial value for the transaction. Barter transactions also use it. Similarly, it

Fair Value Accounting and the Banking Crisis in 2008 5

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is used as an allocation device when a transaction needs to be broken down into

smaller components, such as when the purchase price for a business is broken

down into individual assets and liabilities in a business combination.

The potential danger of fair value accounting has been underlined by empirical

studies. Gonedes and Dopuch (1974) explained that the empirical association

between accounting figures and stock prices and returns is not a proof of the

relevance of an accounting rule. Holthausen and Watts (2001) also state that,

the value relevance literature seems to forget the questions of accounting

standard-setting.

However, its use in the context of financial instruments started to be widely

considered in the 1990s. As Casta (2003) explains, the emergence of fair value

in the last two decades can be related to several factors. It springs initially

from the problem of recognition: the rapidly expanding use of financial instru-

ments posed a problem as to how to recognise them in the balance sheet.

There was also a desire, notably on the part of the Securities and Exchange

Commission (SEC) in the US to reduce managements discretion in manipulating

earnings, given that the use of historical cost permitted them to defer the

revelation of problems. Finally, the principle of fair value is consistent with

the Conceptual Framework in terms of providing decision-useful information

to investors which met the requirements to be relevant and reliable.

The qualities attributed to fair value in relation to financial instruments are

numerous. This corresponds with the methods used by investors in forecasting

cash flows. In terms of comparability of financial statements, it removes the

possibility of opportunistic management of the result and ensures the neutrality

of the measure of performance, based on disposing of an instrument rather

than keeping it, and using an external benchmark. Finally it ensures the comple-

teness of the accounting information by recognising derivatives that are without

any historical cost.

All the same, the use of fair value is not exempt from criticism. There are, of

course, risks in using a valuation model for instruments for which there is no

liquid market in which prices can be observed. There is above all a short-term

orientation that can considerably increase the volatility of balance sheet values.

There is also the cost of applying such a system. At the end of the day, any

accounting measurement system implies a number of choices. The quality of a

system is assessed based on its capacity to facilitate the taking of decisions by

users, the relevance and reliability of the information and the systems capacity

to permit comparison over time and between companies.

Fair Value in the Banking Sector

Walton (2004, p. 6) notes that the banks are unhappy about having to value

available for sale and held for trading assets and liabilities at fair value and

believe this will cause great fluctuations on a period-to-period basis as a reflection

of short term shifts in the market. From the same perspective Aubin and Gil

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(2003) underline that the application of fair value to the banking sector leads to a

great heterogeneity in the content of the balance sheets of banking groups and the

computation of their results. Credit institutions have the discretion to value their

loans at historical cost when made to clients, a fair value for those eligible under

the fair value option or those bought on the secondary market. As far as hedging

is concerned, Aubin and Gil consider that the accounting rules do not translate the

reality of banks management of assets and liabilities, which is aimed at protect-

ing themselves from variations in rates, and not at netting off the variations in

value of the financial instruments concerned.

Colmant et al. (2007) also affirm that the IFRS that address financial instru-

ments (IAS 32, IAS 39 and IFRS 7) pose application problems in the banking

sector, notably in the way they interact with the New Basel Agreement on

Equity (known as Basel II). Basel II organises the prudential supervision of

banks by regulators into three pillars: a first pillar (Tier One) relative to the

minimum capital requirements, a second pillar (Tier Two) dealing with pru-

dential surveillance, and a third pillar (Tier Three) requiring publication of

certain information by banks. Moving to IFRS has modified the calculation

of the solvency ratio for banks, in particular as regards the re-measurement

of available for sale financial instruments and the unrealised results of cash

flow hedges.

The European criticism has only amplified the echo of the American criticism

made a few years earlier. In the face of the negative comments of the American

banks as well as the major audit firms at the time that SFAS 115 Accounting for

Certain Investments in Debt and Equity Securities was issued in 1993, Barth et al.

(1995) tried to respond to these and defend fair value as the measurement basis

for financial instruments held by financial institutions. Several of the affirmations

of opponents of SFAS 115 were tested to verify their validity and their veracity. It

is interesting to note that two of these were confirmed. In the first place, the earn-

ings numbers published by the banks were indeed more volatile under fair value

than under historical cost. In the second, the credit institutions more often

infringed regulatory requirements when they measured at fair value rather than

historical cost. There is, therefore, a fundamental inconsistency between account-

ing measurement and prudential valuation, as these two methods are seeking to

satisfy different objectives. Accounting information should be relevant to inves-

tors needs, while prudential information should be prudent from the regulators

perspective (Matherat, 2008).

Nonetheless, in the course of the last few years, as long as the market was

rising, no one was too shocked by fair value accounting, be they management

or politicians. Fair value started to be stigmatised when the market began to

decline, because neither regulators nor banks welcomed the reflection of the

market downturn in the banks balance sheets. All the same, at the beginning,

the crisis was classic in nature: financial institutions, some of them hardly regu-

lated at all, had made loans on poor quality criteria, and the loans had been used in

complex operations that were poorly securitised (Matherat, 2008).


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However, as Vinals (2008) explains, the valuation models had been conceived

in a favourable economic context, without taking into account all the risks that

were present. Numerous models did not sufficiently take account of the fact

that the underlying assets for many complex products were risky American

mortgages, sensitive to variations in the interest rate, in the price of property

and to the persuasions of lenders. The correlations between the defaults in the

portfolios of sub-prime mortgages on which the instruments were based had

largely been underestimated (Vinals, 2008, p. 135).

At the same time, fair value accounting results in more volatile earnings (e.g.

Barth et al., 1995). One example, developed by Michel Magnan (2009), illus-

trates the impact of fair value accounting on reported earnings.

In its last reported financial statements before it went bankrupt, Lehman

Brothers reported a loss of US$ 2.4 billion for the first six months ending

May 31, 2008 (vs. a net income of US$ 2.4 billion for the first six

months ending May 31, 2007). The shift of US$ 4.8 billion is largely

driven by a dramatic fall of US$ 8.5 billion in Lehmans revenues from

principal transactions, which include realized and unrealized gains or

losses from financial instruments and other inventory positions owned.

[. . .] Thus accounting for fair value for some financial assets amplifiedLehmans downward earnings performance.

Measurement at fair value obliged the banks to recognise losses, which were

accompanied by a reduction of their equity. From then on, in order to maintain

their solvency ratio, the banks had to raise extra capital in conditions where the

market was going down rapidly or were obliged to reduce their new lending, a

disastrous policy in an economically depressed context (Veron, 2008). On top

of that, the same banks had brought back into their balance sheets the toxic

assets of special purpose entities whose risks they thought they had transferred

to others. For commercial reasons linked to their reputation, the financial insti-

tutions chose to take back responsibility for many off balance sheet items. This

required the consolidation of these entities and their re-measurement triggered

further losses. It also called into question another area of accounting standards:

the rules for consolidating subsidiaries and the relationship between a company

and special purposes entities that it had created, as well as disclosures of risk

associated with such vehicles.

Financial reporting is bearing messages: the audited, consolidated accounts

have the objective of presenting the financial situation at balance sheet date as

well as the economic performance and any change in the financial situation

during the reporting period. These accounts serve in the decision-making of

several users, but principally investors. Amongst other things they serve as a

basis, after analysis and adjustment, for measuring future profitability. If one

wants to use the accounts for other ends, such as for establishing the level of regu-

latory capital (such as the Basel II ratio), one must provide for special treatments

8 P. Andre et al.

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and adjustments intended to achieve this objective. That was not done, and led to

accusations that fair value had caused the problem of under-capitalisation of

financial institutions.

By contrast, other non-investor users have adopted such techniques: for

example, the tax authorities in many countries require specified adjustments to

get to taxable profit. The fact of having directly linked the prudential require-

ments for equity capital to the accounting rules generated an effect described

as pro-cyclical: the financial institutions had to sell assets to maintain their

regulatory capital and had thereby fuelled the downward trend of the markets, gen-

erating a further need to sell assets, and so on. The question that presents itself is

the following: should we change the general accounting model or should we

modify the way in which the regulators determine the level of equity capital

required (a level that could conceivably change in different market conditions)?

When the Accounting Thing became a Political Thing: The IASBand the Crisis

In the end, would it have been better to leave the assets in the balance sheet and

not recognise the potential losses? In Japan in the 1990s, or again in the US in the

savings and Loan crisis of the 1980s, conservative accounting practices poten-

tially delayed recognition of serious problems and thus their resolution. Many

users consider that, however difficult it may be, it is important in the interests

of greater transparency and also to permit the markets to adjust, to value the

assets and liabilities at balance sheet date and reveal the level of risk to which

society is exposed. One could try to improve this approach and present the

results better, but to do nothing is not to serve the users interests.

The two sets of accounting standards that require systematic use of fair value

for financial instruments are US GAAP and IFRS. By the end of 2007, IFRS had

been adopted by the European Union for all listed companies and were used in

more than 100 countries round the world. As a consequence of the quarter by

quarter fair value impairments, regulators and governments started to ask was

there a real financial crisis or was the use of fair value creating a crisis?

In the US, overt interference in accounting standard-setting has most often

come from Congress. Politicians who receive election funding from large corpor-

ations are also inclined to listen to their concerns, and so it was in this case. An

attempt was made by politicians to have fair value suspended, which was

eventually turned into a requirement that the SEC investigate the role of fair

value in the financial crisis.

At an international level, it was the international regulators that first took

action. In particular, both the International Organisation of Securities Commis-

sions (IOSCO), which is the international umbrella organisation for stock

market regulators, and the Financial Stability Forum (FSF), which is part of

the international bank regulatory system based in Basel, set up working parties

to report on fair value. The FSF report was submitted to the meeting of G7


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governments in April 2008. It is implicit in the reports that the IASB was

involved in discussions with these bodies.

The IOSCO report, prepared by its Technical Committee (IOSCO, 2008), high-

lighted a number of problems. It said (IOSCO, 2008, p. 17):

Broadly speaking, accounting principles are designed to provide investors

with an understanding of the overall financial position and performance of

the firm. In this sense, internal firm valuation and external financial report-

ing accounting can be seen as offering critical information to two different

sets of interested parties: on one hand, to the firms themselves and to

regulators interested in the stability of the firm itself; and to investors, inter-

ested in the firms performance. Ultimately, in both instances, valuation

methodologies and accounting principles exist to benefit investors.

The report found: some financial firms appear to have inadequate human and

technological resources to model their financial positions using fair value

accounting principles under illiquid market conditions. It argued that once it

was clear that the market was illiquid, market prices were no longer an appropri-

ate source of valuation under Level 1 of the SFAS 157 hierarchy or of IAS 39 and

companies should have moved to Level 3, using models.

The FSF report (Financial Stability Forum, 2008, p. 22) noted:

Accounting standards define the fundamental framework of financial

reporting, which permits the measurement of the financial condition and

performance of firms. Adherence to these standards is the cornerstone of

a well-functioning financial system. In addition, the quality of financial

reporting is enhanced by the efforts of market participants, auditors and

supervisory and regulatory authorities to strengthen the reliability of valua-

tions and of risk disclosures. Sound disclosure, accounting and valuation

practices are essential to achieve transparency, to maintain market confi-

dence and to promote effective market discipline

It made a number of recommendations:

III.4 The IASB should improve the accounting and disclosure standards for

off-balance sheet vehicles on an accelerated basis and work with other

standard setters toward international convergence. (Financial Stability

Forum, 2008, p. 25)

III.5 The IASB will strengthen its standards to achieve better disclosures

about valuations, methodologies and the uncertainty associated with valua-

tions. (Financial Stability Forum, 2008, p. 27)

10 P. Andre et al.

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III.6 The IASB will enhance its guidance on valuing financial instruments

when markets are no longer active. To this end, it will set up an expert

advisory panel in 2008. (Financial Stability Forum, 2008, p. 27)

These recommendations (and many others made by the FSF) were reflected in the

G7s communique of 11 April 2008:

The International Accounting Standards Board (IASB) and other relevant stan-

dard setters should initiate urgent action to improve the accounting and disclos-

ure standards for off-balance sheet entities and enhance its guidance on fair value

accounting, particularly on valuing financial instruments in periods of stress.

The IASBs period of sudden visible activity dates from this time (their financial

crisis time line page on their website shows actions from June 2008). They took

action in three areas: they set up the Expert Advisory Panel on Fair Value in a

Declining Market (EAP), they decided to amend IFRS 7 to improve the disclos-

ures related to financial instruments, and they asked the staff urgently to advance

the existing consolidations project and the de-recognition project.

Expert Advisory Panel (EAP)

The IASB decided to appoint the EAP as an IASB-only exercise, not involving

the FASB. They were to regret this later. At the May 2008 meeting of the

IASB, the staff brought forward a paper:

Ms Eastman said that the issue was limited to the question of the advisory

panel for the Financial Stability Forum. Their April 7 report had recommended

that the IASB provide enhanced guidance on determining fair values in a

declining market. The IASB was setting up an advisory panel which would

assist the Board in reviewing best practice and producing guidance on measur-

ing fair value when the market is no longer active. The staff had contacted

financial institutions and the panel was to have its first meeting on 13 June

in London. This would probably be a two or three day session which would

discuss the form of the deliverable. She would give an update to the Board

at the June meeting. (International Standard-setting Report, May 2008, p. 12)

Asked about the terms of reference, Sir David Tweedie said:

it was pretty simple: what, if anything, needs to be done? They were asking

for people who had experience of doing this. They did not want it to be done

from 35,000 feet. (International Standard-setting Report, May 2008, p. 13)

The EAP consisted of representatives of a number of banks, including BNP

Paribas, Citigroup, HSBC and UBS, insurance companies, the Big Four audit


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firms, the Basel Committee, Insurance Supervisors and the Financial Stability

Forum. In August the EAP produced a draft report that addressed (a) valuation

issues and (b) disclosure issues. This was published in September on the IASB

website and comments were invited. A final report was published in October 2008.

Although the FASB had sent a staff observer along to the EAP, the US

standard-setter was not directly involved. However, a joint statement by the

SEC and the FASB on 30 September 2008 said There are a number of practice

issues where there is a need for immediate additional guidance and referred to

the EAPs draft document. The SEC statement had a series of questions and

answers on valuing financial instruments.2

The IASB put out a statement on 2 October saying that it had reviewed the

SEC/FASB guidance and considered it consistent with IAS 39. The pressrelease cites Sir David Tweedie: The SEC-FASB clarification on fair value

accounting is a useful contribution, and our staff believes that it is consistent

with IFRSs. We will continue to ensure that any IFRS guidance on fair value

measurement is consistent with the clarification that has been provided by the

US SEC staff and the FASB staff.

With the benefit of hindsight, it appears that this last sentence could be an

oblique reference to the European Commissions attempt, then in preparation,

to force the IASB to change IAS 39 to align with US GAAP.

The EAPs final report was welcomed in public pronouncements from the

European Commission and others (including the Committee of European Securi-

ties Regulators CESR), and preparers and auditors were urged to follow it

immediately.

IFRS 7 Disclosures

The EAPs view on disclosures was that IFRS 7 had worked quite well but that

there was room for improvement. The criticisms of it were that it was not specific

enough in some areas, notably in terms of a fair value hierarchy and in terms of

quantitative disclosures. The IASBs capital markets team took up these points

and brought proposed amendments to the Board, which were published as an

exposure draft in October 2008. The exposure draft proposed bringing in to

IFRS 7 the fair value hierarchy from IAS 39. This is virtually the same as the

SFAS 157 hierarchy but not set out so explicitly. The exposure draft mandated

greater disclosure about level 3 valuations and required quantitative disclosures

of the maturity of its derivatives in addition to a qualitative discussion of liquidity

risk. The IASB tentatively decided that the final amendment should be in force

from July 2009 with earlier application allowed.

Consolidation

Arguably the most difficult problem to address was that of off balance

sheet investment vehicles. The existing IASB literature on the subject was SIC

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12. However, the Board had had a project to revise IAS 27, the basic standard

on consolidation, and incorporate SIC 12 into it (it is standing policy for the

IASB that whenever a standard is revised, any Interpretations issued subsequently

to the last version of the standard are incorporated into the revision). This project

had been on the active agenda for some time but had repeatedly been pushed to

one side by other projects. It now became a top priority.

The project was being led by Alan Teixeira, a senior project manager who had

joined the IASB from the New Zealand standard-setter, and became Director of

Technical Activities in April 2008. His view, which he was able to persuade the

Board to accept, was that something more flexible was needed than the on-off

switch that arose from the decision to consolidate or not a special purpose

entity. His solution was (a) to require a discussion of the non-consolidation

decision, and (b) to propose a series of disclosures about sponsored entities

and any with which the parent had a continuing involvement.

The exposure draft was published in December 2008. It called for companies to

disclose how many structured entities they have sponsored during the year and

what fee income they derive from these. They will also ask companies to give

details about vehicles that they have sponsored in the past and subsequently sup-

plied any support to. These are an attempt to give investors an idea of the scale of

the companys activity in creating Structured Investment Vehicles (SIV). They

also try to address the possibility of a company deciding to take back onto its

balance sheet an SIV without there being any legal obligation because of the

risk to reputation. Situations arose during the initial sub-prime crisis where

banks that had sponsored such vehicles and had no further investment (but

were receiving management fees) took the view that they had to rescue the

vehicles or accept considerable damage to their standing with investors who

had participated in the SIVs.

The proposal goes a long way beyond SIC 12 and much of its requirements will

be the reaction to the financial crisis, addressing primarily structured entities set

up by banks.

Attack from Europe

While the IASB was busy dealing with its responses to the FSF and G7, a separate

initiative was taking place in France. Rene Ricol, a Paris-based former small

practitioner who had served a term as president of the International Federation

of Accountants, was asked by the French President, Nicolas Sarkozy, reputedly

after lobbying by French banks, to give an opinion as to whether European

banks were being disadvantaged by IFRS as compared with their American

counterparts. Ricol came to the view that this was the case. SFAS 86, a relatively

old standard, did not require property mortgages to be held at fair value, and

SFAS 133, the substantive fair value standard, allowed available for sale financial

instruments to be re-classified under rare circumstances.


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The so-called EU IAS Regulation (2002/1606) which required all Europeanlisted companies to follow IFRS from 2005 includes a requirement that IFRS

endorsed by the EU must not disadvantage European companies as compared

to those in other major markets. The Internal Market Directorate General

(DGXV) which is responsible for capital markets, drew up a draft carve-out

to amend IAS 39 as endorsed by the European Union.

This was a very significant event, to understand which it is necessary to look

briefly at the history of EU endorsement of IAS 39. French banks have been

opposed to carrying financial instruments at fair value ever since this was

mooted in the 1990s. They persuaded the then French president, Jacques

Chirac, to write to the European Commission in 2003 (reproduced in Alexander,

2006, pp. 7980) to complain that this would destabilise the economy. French

banks tried to persuade the IASB to modify IAS 39 and negotiations took place

for many months. In the end, one sticking point was that IAS 39 says that no liab-

ility can be stated at less than the amount that may be required to be paid at

balance sheet date (known as the demand deposit floor). This was not accepta-

ble to French retail banks which discounted such liabilities below the floor on the

basis that customer current accounts in practice provided virtually permanent

funding. The IASB would not budge on this and the banks persuaded the

Accounting Regulatory Committee (the organ responsible for endorsing IFRS

into European law) to carve out the paragraph in IAS 39 that addresses this

issue.

This was a major blow to the IASB. It has meant that there are at least two var-

iants of IFRS used IFRS as issued by the IASB, and IFRS as endorsed by the

EU. This has in turn led to threats of carve-outs elsewhere. For example the

Australian Accounting Standards Board (AASB) threatened a carve-out if

the IASB did not allow the creation of new holding companies without revalua-

tion in 2007. The Indian standard-setter has also insisted in its document accept-

ing a plan to move to IFRS that it reserves the right to amend the standards

(although it later assured the Committee of European Securities Regulators

that any amendments would not be such as to prevent Indian companies asserting

compliance with IFRS as issued by the IASB).

The US Securities and Exchange Commission was not at all pleased by the EU

carve out. When it said in September 2007 that it recognised IFRS as equivalent

to US GAAP for the purposes of foreign companies listed in the US, it specified

that this applied only to IFRS as issued by the IASB. There has so far been only

the original carve-out, but many people, including Sir David Tweedie, IASB

president (testimony to House of Commons Select Treasury Committee 11

November 2008) believe that a second European carve out would lead to the

demise of the worldwide globalisation project. The credibility of IFRS and

the IASB would be fatally damaged if it became inescapably clear that Europe

did not accept its authority.

Matters came to a head when President Sarkozy called a meeting of the

European finance ministries of countries that are part of G7 (France, Germany,

14 P. Andre et al.

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Italy and the UK) on 4 October to discuss the credit crisis. He obtained agreement

that the IASB should be asked to amend IAS 39 to bring it in to line with US

GAAP by the end of October. This position was endorsed by a full meeting of

the EU Council of Finance Ministers (ECOFIN) a few days later. It seems

highly probable, given that the IASB has a well-documented due process that

involves lengthy exposure periods, that France and the European Commission

did not think that the IASB could remotely meet this deadline. A meeting of

the ARC was arranged for mid October to vote on the carve-out that the Commis-

sion had drafted.

However, the IASB had of course seen the Ricol report at an early stage and

the draft carve-out. Sir David Tweedie later gave evidence that the carve-out

would have been disastrous, and would have opened up a free for all in

accounting for financial instruments. The ARC can remove material from

standards, but it cannot add material. So in removing the paragraphs that

prevented re-classification, it would take away all safeguards on manipulation

of instrument categories without providing any new defences such as disclosures.

I think accounting in Europe would have been totally out of control if they had

used the option to take the carve-out.3

The IASB took action. Coincidentally, the Trustees of the IASC Foundation,

the IASBs oversight body, were meeting in Beijing just after the European min-

isters meeting and agreed to suspend due process. The Board then convened a

meeting on Monday 13 October to vote through an amendment to IAS 39. US

members complained that the reading of US practice was wrong and they

voted against but the amendment was passed. It was duly agreed by the ARC

two days later and the carve-out was averted but at some cost. Sir David

Tweedie told the UK parliamentary committee:

Others were asked Have we been damaged? I think the answer is yes we

have been by what happened a few weeks ago. I was in the United States a

fortnight ago and there were questions of Why did you do this? This is

European influence. Are you a European body? . . . Other countries werecompletely taken by surprise because all of this happened very, very

quickly . . . suddenly they were given something they had no knowledgewas coming. That was a major problem for us. It upset a great deal of

people. So it did damage the whole exercise.4

The political crisis for the IASB did not end there. DGXV wrote to the IASB later

in October5 setting out three further issues arising from a meeting with stake-

holders that it had called in the wake of the ARC vote. It raised the question of

re-classifying assets designated as held at fair value under the fair value

option, revising the impairment rules and clarifying that embedded derivatives

need not be bifurcated. The letter said these should be dealt with in time for

the year-end reporting season.


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The IASB chairman replied on 14 November 2008, pointing out that the IASB

was holding a series of round tables on the financial crisis, the last of which would

be in December. He also noted that the IASB needs to take proper account of the

views of all stakeholders in order to develop accounting standards that provide

transparent information to market participants. Sir David Tweedie wrote again

on 17 December. Commenting on the issues raised in the Commissions 14

November letter, he said:

it was a clear message of participants at these round tables that the IASB

should continue to take urgent action to improve the application of fair

value principles, where necessary, but such action must be in conjunction

with the FASB to ensure globally consistent conclusions. A further clear

message was that any steps taken to amend fair value accounting taken

without proper regard to the well-established and supported standard-

setting due process, would further undermine already scarce confidence

in the financial markets.

International Support

The IASB feared that the European attempts to interfere in the standard-setting

process would be continued at a meeting of the G20 heads of government on

15 November 2008 that had been called by the US to discuss the financial

crisis. The European members of the G20 met together on 7 November to

prepare for the Washington meeting. They put out a statement6 that called for

a more comprehensive information system, which no longer omits vast

swathes of financial activity from auditable, certifiable accounts and added:

Both prudential and accounting standards applicable to financial insti-

tutions will have to be revised to ensure that they do not contribute to creat-

ing speculative bubbles in periods of growth and make the crisis worse at

times of economic downturn.

Standards bodies, in particular in the area of accountancy, will have to

be reformed to allow a genuine dialogue with all the parties concerned,

in particular prudential authorities.

This was seen as a French attempt to make the IASB take account of

financial stability7 rather than privileging transparency for investors as the

main objective.

The Trustees of the IASC Foundation wrote to President Bush, asking that their

letter be transmitted to the G20 governments. The letter (dated 11 November and

published on the IASB website) underlined the importance of transparent and

comparable information and suggested that interference with the standard-

setting process undermined confidence in the markets. The letter cited support

from the Banque de France, the International Corporate Governance Network

16 P. Andre et al.

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and the CFA Institute. It also addressed the question of pro-cyclicality and agreed

that there was potentially a linkage if financial institutions had to sell assets to

meet liquidity ratios and added to the decline in the market. They suggested

that this should, however, be addressed by a dialogue between the IASB and

the bank supervisors as to how the latter used shareholder accounts.

IOSCO issued an open letter to the G 20 governments on 12 November 2008,8

saying that:

Accounting standards must provide clear, accurate and useful information

to investors to allow them to make informed investment decisions. Further-

ance of this goal promotes investor confidence in financial statements and

capital markets.

The statement also said: IOSCO strongly supports IFRS as developed by

the IASB.

Communique

The IOSCO letter was followed by a 14 November 2008 communique from 20

national standard-setters.9 These were all members of the loose grouping

known as the National Standard-Setters chaired by Ian Mackintosh of the UK

Accounting Standards Board, which meet twice a year to discuss technical

matters and to collaborate on technical research. The letter said: We continue

to support the IASB and its efforts to achieve true global accounting standards.

It added: It is important that the IASB follows appropriate due process It agreed

that in extraordinary times, it may be necessary for due process to be shortened.

But said it should not be abandoned, and the standard-setters were ready to help

achieve this. The letter was signed by the national standard-setters of the UK,

Germany, Austria, France, Sweden, the Netherlands and Italy from within the

EU, as well as Norway, Japan, Pakistan, New Zealand, Mexico, Canada, South

Africa, Taiwan, Hong Kong, Korea and India. The European Financial Reporting

Advisory Group (EFRAG) which provides technical advice to the European

Commission also signed the latter.

In the event, the G20 leaders issued a final communique from their summit

that largely supported the IASBs position. The communique repeated calls

for guidance on valuation of securities and attempts to address disclosures

related to off balance sheet vehicles and complex financial instruments. It also

said:

With a view toward promoting financial stability, the governance of the

international standard-setting body should be further enhanced, including

a review of its membership, in particular in order to ensure transparency,

accountability, and an appropriate relationship between this independent

body and the relevant authorities.


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This seems to be a reference to the changes in governance arrangements already

proposed by the Trustees, whereby a monitoring group including stock exchange

regulators, the European Commission, the World Bank and the International

Monetary Fund would be represented. The monitoring group will have oversight

of the Trustees governance of the standard-setter.

The communique continues:

The key global accounting standards bodies should work intensively

towards the objective of creating a single high-quality global standard.

Regulators, supervisors, and accounting standard-setters, as appropriate,

should work with each together and the private sector on an on-going

basis to ensure consistent application and enforcement of high-quality

accounting standards.

Financial institutions should provide enhanced risk disclosures in their

reporting and disclose all losses on an ongoing basis, consistent with inter-

national best practice, as appropriate. Regulators should work to ensure that

financial institutions financial statements include a complete, accurate, and

timely picture of the firms activities (including off balance sheet activities)

and are reported on a consistent and regular basis.

This seems to support the IASB and IOSCO position that losses should not be

hidden behind historical cost accounting.

The FASB gets support

Just as the IASB had been under fire in Europe, the FASB had been under

pressure from American banks, politicians and the SEC. The IASBs Expert

Advisory Panel had been organised independently of the FASB, but the FASB

had observed, and when the EAP produced its draft guidance on fair value

measurement, the SEC and FASB produced a joint statement clarifying similar

issues in the measurement of fair value10 and the FASB issued a staff position

(FSP FAS 1573) on determining the fair value of a financial asset when the

market for that asset is not active.

The US Emergency Economic Stabilization Act of 2008 had mandated an SEC

staff examination, along with the Federal Reserve and the Secretary of the Treas-

ury, of mark to market accounting. This was published on 30 December 2008. The

report (Report and Recommendations Pursuant to Section 133 of the Emergency

Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting)

noted that there was a debate between those who thought fair value accounting

was pro-cyclical and exaggerated the crisis and those who thought transparent

information was essential for investors. The credibility and experience of

parties on both sides of this debate demand careful attention to their points

18 P. Andre et al.

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and counterpoints on the effects of fair value accounting on financial markets

(p. 2).

The Report noted among other things (p. 4):

The Staff observes that fair value accounting did not appear to play a mean-

ingful role in bank failures occurring during 2008. Rather, bank failures in

the U.S. appeared to be the result of growing probable credit losses, con-

cerns about asset quality, and, in certain cases, eroding lender and investor

confidence. For the failed banks that did recognize sizable fair value losses,

it does not appear that the reporting of these losses was the reason the bank

failed.

It also noted (p. 5):

investors generally support measurements at fair value as providing the

most transparent financial reporting of an investment, thereby facilitating

better investment decision-making and more efficient capital allocation

amongst firms. While investors generally expressed support for existing

fair value requirements, many also indicated the need for improvements

to the application of existing standards. Improvements to the impairment

requirements, application in practice of SFAS No. 157 (particularly in

times of financial stress), fair value measurement of liabilities, and

improvements to the related presentation and disclosure requirements of

fair value measures were cited as areas warranting improvement

Support for fair value also came from Lloyd Blankfein, CEO of Goldman Sachs,

who wrote in the Financial Times, 8 February 2009. He blamed poor risk man-

agement for the crisis and noted:

Last, and perhaps most important, financial institutions did not account for

asset values accurately enough. I have heard some argue that fair value

accounting which assigns current values to financial assets and liabilities

is one of the main factors exacerbating the credit crisis. I see it differ-

ently. If more institutions had properly valued their positions and commit-

ments at the outset, they would have been in a much better position to

reduce their exposures.

The FASB has had some notorious clashes with Congress, notably over its

proposals for oil and gas exploration costs in the 1970s and its stock option

accounting in the early 1990s. In these cases it had to back down, but it seems

to have been luckier than the IASB this time and to have escaped wholesale

interference.


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Assessing the Consequences

It will take months if not years for the consequences of the events of 2008 for the

IASB to be assessed at that time, even if interference was to take place the next

year. What seems clear is that the IASBs credibility and independence have been

compromised by the European Commissions manoeuvres in October to force

the IASB to allow re-classification. The suggestion has been put forward that

the IASB contemplated a confrontation with the Commission but came to the

conclusion that if the Commission abandoned IFRS, it was probable that Japan

would follow suit, and potentially all the countries planning to adopt in 2011

might withdraw. It decided to trump the Commissions carve-out with a more

limited IAS 39 amendment and fight on.

However, the Commission intervention plays into the hands of those in the US

who do not wish to abandon US GAAP, as the SECs 2008 road map has pro-

posed. The change of government in the US has inevitably led to a change of per-

sonnel at the SEC. The new chairman, Mary Schapiro, said in her confirmation

hearing in front of the Senate banking committee that she thought a single set

of global standards would be a very beneficial thing but she expressed doubts

about the independence of the IASB and said she would not necessarily be

bound by the proposed roadmap (World Accounting Report, February 2009,

p. 7). The SEC Chief Accountant has also stepped down but no replacement

has yet been named. It seems likely that a switch to IFRS from US GAAP will

likely be delayed if not abandoned altogether.

Perceptions of the IASBs independence are not helped by things like Commis-

sioner McCreevy (DGXV) saying in a speech in Dublin in February 2009:

[accounting standards] have also exacerbated the markets recent problems

because of rules that are pro-cyclical . . . That is why I recently broughtforward a measure to provide firms with more flexibility on the mark to

market requirements and to facilitate asset transfer from the trading to

the banking book.11

This implies that the Commissioner still thinks he can change IFRS at will, which

is unlikely to play well in Beijing, Tokyo, Rio de Janeiro, Ottawa, Seoul, Delhi or

Washington, quite apart from London. This has to imply that more difficulties are

likely to be raised by the Commission. The April 2009 meeting of the G20 is

being indicated as the next showdown between those who want transparency

for investors and those who want to hide the losses because they believe it

creates stability.

In January 2009, the Trustees of the IASC Foundation finalised the new moni-

toring arrangements. A Monitoring Board was created. Its members included

the SEC, European Commission, Japanese Financial Services Agency and two

members from IOSCO. However, the World Bank and the International Monetary

20 P. Andre et al.

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Fund had disappeared from the original proposal, and the Basel Committee on

Banking Supervision came in as an observer. It seems likely that this shift came

about as a result of the 2008 debate.

One of the ironies of the fair value crisis has been the emergence of pressure on

both the IASB and FASB to work closely together. In the 1990s there was still a

debate about whether US GAAP could become the worldwide standard for finan-

cial reporting. The European answer was that following US rules was completely

unacceptable. However, we find the Commission saying in 2008 that the IASB

must change its rules to give European companies the same position as under

US GAAP. This was followed by the IASB telling the Commission that it could

not accede to subsequent demands because constituents wanted it to work with

the FASB.

In fact, the two Boards also learned in this crisis that they needed to work very

closely together for political protection. After the IASBs creation of its Expert

Advisory Panel and the separate SEC/FASB publications on applying fairvalue, the two Boards met for their regular six-monthly meeting in October.

During the course of this meeting they issued a press release (20 October

2008) committing to work together to create a common solution to accounting

for financial instruments, to create a joint high-level advisory group on dealing

with the financial crisis, and to conducting a series of joint round tables.

The G7 statement of April 2008 has led to a rapid acceleration of the IASBs

work programme in related topics. Guidance has been given on applying fair

value in illiquid markets (Level 1 or Level 2 fair values require there to be a

liquid market, so only Level 3 mark to model fair values can be used). Steps

are being taken to improve IFRS 7 disclosures, although the IASBs initial pro-

posals have had to be modified. An exposure draft has been issued on consolida-

tion and special purpose entities. An exposure draft on de-recognition will be

issued in 2009.

Arguably, another irony in terms of outcomes is that in January 2009 the

Commission announced a fund to enable it to contribute directly both to the

IASBs costs and those of the European Financial Reporting Advisory Group

(EFRAG) which interacts on technical issues with the IASB on behalf of

European interests in general and the Commission in particular. The Commission

announced a fund ofE36.2 million to be made available for four years from 2010

to make contributions to the IASB, EFRAG and possibly others. Tentatively, the

IASB is expected to receive E5 million a year from this.

The Commission has been notorious over the years for being unwilling to

spend any money on accounting, not even paying for EFRAG, which is funded

by European lobbying bodies with an interest in accounting. The paper announ-

cing the proposal (COM 2009-14) says that this was being done as a result of the

October 2008 meetings where the Commission decided it should have more

involvement with the standard-setting process. The Commissions announcement

notes: Independence of the standard-setting process without any undue influence


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from parties with a stake in the outcome of the IASBs standard-setting process is

crucial.

The Committee of European Securities Regulators (CESR) carried out a survey

of the third quarter statements of 100 financial companies in Europe (of which 22

are included in the FTSE Eurotop 100 index) to see how they had reacted to the

IASBs emergency amendment to IAS 39.12 It found that 52% of the sample, and

64% of the FTSE Eurotop 100 companies had not re-classified any financial

instruments. Twenty-eight percent had made one re-classification (18% of the

FTSE Eurotop 100). Only one company had more than three re-classifications.

The majority of re-classifications were from fair value through profit and loss

to loans and receivables.

Conclusion

In our view, 2008 was a very unfortunate year for the international accounting

standard-setting institution. Fair value financial statements were telling banks

they had made disastrous investment decisions, but the banks, some governments

and the regulators preferred to believe the numbers were wrong (shooting the

messenger) rather than the investment decisions. At the time of writing

(March 2009) the US government has just voted almost $200 billion for AIG

to prop up the insurer, which might give an insight into the quality of the manage-

ments evaluations of their investments.

It seems to us that although the IASB was probably talking to IOSCO and the

Financial Stability Forum early in 2008, the fair value debate had started in 2007.

It took a long time, and a G7 announcement, before the IASB overtly recognised

that it had a political problem on its hands and started to react. Since then it has

worked decisively and rapidly to address the perceived problems, but it appears to

have been damaged. The focus on fair value reporting and pro-cyclicality has pre-

sented an opportunity for all those, such as the European Banking Federation,

who have strenuously opposed IAS 39 since drafting first started in the 1990s,

to try to kill the standard off permanently. It has also exposed the difference in

orientation between Anglo-Saxon regulators and those from the European code

law tradition (Walton, 2004) in terms of the objectives of financial reporting.

One group thinks it is to inform investors, the other that it is a tool that can be

used to regulate the economy.

The European Commission persists in behaving as though it controlled the

IASB, and a lot of progress will have to be made in 2009 to re-assure countries

adopting in 2011 (Canada, South Korea, India, China, and Brazil). It seems very

unlikely that the SEC will stick to the roadmap of making a decision in 2011 and

shifting progressively thereafter. There again, opponents of the shift are taking

the opportunity to point to lack of independence of the IASB and lack of

clarity in IFRS as arguments for staying with US GAAP. The IASB will need

to be luckier in 2009 than it was in 2008.

22 P. Andre et al.

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Notes

1AIG urges fair value re-think 14 March 2008.2This was followed on 10 October by an FASB Staff Position (FSP 157-3) on Determining the

Fair Value of a Financial Asset When the Market for that Asset Is Not Active.3Uncorrected transcript of the House of Commons Select Treasury Committee 11 November

2008, taken from www.parliamentlive.com.4Uncorrected transcript of the House of Commons Select Treasury Committee 11 November

2008, taken from www.parliamentlive.com.5Letter from the Director General of DGXV dated 27 October 2008, published on http://ec.europa.eu/internal_market.

6Informal Meeting of Heads of State or Government on 7 November 2008 Agreed Language

European Commission 7 November 2008.7For example Accountancy Age Sarkozy leads the charge towards IASB stability remit 13

November 2008.8Press release 12 November 2008 IOSCO open letter to G20 summit www.iosco.org.9Published by many of the participating standard-setters (not apparently by the Conseil national

de la comptabilite) but see for example the German Accounting Standards Board 17 November

2008 http://www.standardsetter.de/drsc/news.10SEC release 2008234 of 30 September 2008.11Speech 09/41: The Credit Crisis Looking Ahead 9 February 2009 downloaded from www.

ec.europa.eu/internal_market.12Announcement 08937 of CESR made on 7 January 2009.

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Fair Value Banking Crisis

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