A deal at last - "fair value" formula wins backing
Accounting rule-makers remain cautious, but it looks like a done deal on the fair value option. Hopes rise for a cure to Europe's problems with IAS 39. By David Keefe
A solution that finds middle ground on limiting the use of the fair value option in new international accounting rules looks like a done deal, according to bankers, insurers and regulators attending a crucial mid-March round-table that revealed widespread assent to the compromise.
Global accounting rule-makers with the International Accounting Standards Board (IASB) were more cautious in their assessment. But they gave a sigh of relief as their latest idea for a "principles-based" resolution of the long-running dispute over the option cleared what they regarded as a major hurdle.
Fingers crossed
IASB staff had kept their fingers crossed that hopeful signs of agreement ahead of the round-table would not be dashed at the meeting by last-minute objections that would send them back to their desks to draft yet another proposal - a process that might mean year's worth of additional work and debate.
But with luck, a revised fair value option could come into effect in January 2006.
The banking and insurance industries and, crucially, their regulators, including the Basel Committee on Banking Supervision, signalled at the round-table their approval of a compromise that limits the use of the option to regulator satisfaction, but still enables firms to employ it to avoid distortions to their accounts caused by asset-liability mismatches. They were joined in assenting to the proposal by accountants and auditors attending the meeting.
Banking regulators in particular want to restrict the use of the option for fear that it might be used by weak banks to mask their problems and thereby possibly threaten financial stability.
Firms wanted to retain unfettered rights to use the option as originally envisaged in the context of the notorious IAS 39 mixed accounting rule for valuing financial assets and liabilities. IAS 39 is part of the new accounting rules, known as International Financial Reporting Standards or IFRS, that came into effect in January in many countries, including the 25 member states of the European Union.
And as IASB chairman David Tweedie says, curing the problem would remove a major reason for the European Commission's controversial partial adoption of the IAS 39 accounting rule for valuing financial assets and liabilities.
The Commission's decision last year to adopt, at least temporarily, a watered down version of IAS 39 threatens confusion in European Union company accounts as well as undermining the goal of eventually achieving a single set of global accounting rules, critics say.
The Brussels-based Commission's IAS 39 `carves out' from the original IASB version certain provisions relating to hedge accounting as well as the fair value option pending a resolution of the arguments.
Tweedie notes that the fair value option carve-out, which prohibits the use of the option in respect of liabilities, is binding on all the 7,000 or so companies listed on EU stock exchanges to which IFRS applies. This makes the option carve-out a greater problem than the hedge accounting carve-outs because the latter aren't so binding - firms and jurisdictions can opt to apply the full IAS 39 rules on hedge accounting if they so wish.
And agreement on the compromise over the fair value option will be good news for Danish mortgage banks, whose practice of issuing bonds to cover mortgage loans has been stymied by the block on using the option to measure liabilities at fair value, or current market prices. A representative of the Danish mortgage banks said the banks backed the IASB proposal, but want any amendment to be retroactive.
The tussle over IAS 39 has also helped fuel demands by the Commission, which as the EU's executive arm is responsible for initiating financial regulation across the bloc, for a greater say in the affairs of the IASB, the London-based standard setter that developed IFRS (see page 19).
Tweedie says IASB staff will now rewrite their proposals in the light of several technical points made at the round-table with the aim of putting them before the 14 international accounting experts who make up the IASB at their regular monthly meeting in April.
Regulators encouraged
If approved - and some Board members still favour an unfettered fair value option - a final version of an amendment to IAS 39 might be ready by June for implementation in January, 2006, but this can't be guaranteed. And the Commission's decision on whether to adopt it is outside the IASB's control.
Tweedie says much depends on the regulators. But he agrees that on the basis of the comments of regulator representatives at the round-table, the outlook is very hopeful.
Officials attached to the accounting task force of the Basel Committee on Banking Supervision told the meeting that they were very encouraged by the proposals and positive about the progress made. "It's all moving in the right direction," one added.
The Basel officials were reluctant to be quoted on the record. But they noted that Dutch central banker Arnold Schilder, chairman of the accounting task force, which develops the Committee's policies on the accounting aspects of bank capital adequacy, said in an immediate reaction in February to the IASB plan that it was a strong improvement on previous ideas.
The UK Financial Services Authority (FSA), Britain's principal financial services watchdog, welcomes the proposals, said Teddy Nyahasha, accounting policy adviser with the FSA's prudential standards division.
As a prudential regulator the FSA can work with the current fair value option, he said. The agency's main concern is with the uncertainty created by the partial endorsement of IAS 39. The FSA wants the IASB to approve the proposal so that the European Commission can incorporate it by the end of the year, Nyahasha said.
Under IAS 39, financial instruments such as derivative contracts and bonds and shares held for trading must be measured at fair value rather than at original cost. Items that are less easy to value at current prices, such as loans and receivables, as well as long-term investments - bonds held to maturity, for instance - are measured at amortised cost.
But the IASB provided firms with an option - the fair value option - that allows them to nominate, once and for all, any financial item for fair value measurement. This is to avoid the distortions that could be caused by having economically matched assets and liabilities measured on different bases.
But the Basel supervisors and some other banking regulators feared that troubled banks could use the option to "cherry pick" the items they wanted to record at fair value with a view, for instance, to undervaluing their liabilities.
The IASB responded in April last year with an exposure draft that proposed restricting the use of the option to five detailed categories, essentially those where markets existed to provide pricing benchmarks, to meet regulator concerns about the difficulty of otherwise establishing fair value.
However, the exposure draft was overwhelmingly rejected by auditors, accounting bodies and firms, both financial and non-financial. Only regulators approved.
So the IASB issued a tentative paper in December promoting a principles-based approach aimed at getting firms using the fair value option to observe the spirit of its intent, which is to prevent accounting distortions and not to provide a means of masking weaknesses.
Banking regulators said the paper was a step in the right direction but didn't set out strongly enough the risk-management context in which firms might properly exercise the option.
So the IASB redrafted the December paper, producing in February a document proposing that firms using the option give clear reasons for doing so.
The paper suggested firms using the option state clearly why they are using it and how it fits into their asset-liability management policy. It sets out conditions for the acceptable use of the option.
It's this paper that industry representatives, accountants, auditors and regulators debated at the mid-March round-table.
On the insurance regulator front, Robert Esson, on behalf of the International of Insurance Supervisors (IAIS), said that out of the 13 IAIS jurisdictions taking a view on the February paper, 11 voted in favour of it. The IAIS is the Basel, Switzerland- based body that represents insurance supervisors in more than 160 jurisdictions. Esson is chairman of the IAIS's newly formed insurance contracts subcommittee. He is senior manager, global insurance markets with the National Association of Insurance Commissioners (NAIC) of the US, which represents the state insurance regulators that supervise the US industry.
Certainty needed
The NAIC prefers the latest IASB proposal, largely because it recognises that further modifications are unlikely to maintain a consensus on the issue.
Australian Prudential Regulation Authority (Apra) executive group member Steve Somogyi said by telephone link to the round-table that Apra backs the February proposal, but with the proviso that the Australian Accounting Standards Board can apply it "with certainty".
Bank and insurance industry representatives made it clear they would have preferred an unfettered fair value option as originally conceived by the IASB. But they accepted this is an unattainable goal and generally supported the compromise.
Insurers in particular had objected to the December paper, arguing that its wording prevented them using the option in several areas where they would regard its use as appropriate. The Comité Européen des Assurances (CEA), the Paris-based federation of Europe's national insurance trade bodies, argued that banking regulators' fears should be addressed through general accounting standards, rather than through specific supervisory tools such as restricting the use of the fair value option.
But CEA director Patricia Plas told the round-table that the consensus of the organisation's members favours the compromise. This follows a rewording, with examples, in the February document that enables insurers to use the option in respect, for instance, of assets backing general insurance liabilities and assets backing other non-linked, non-participating liabilities.
The Brussels-based European Banking Federation, representing more than 4,500 European banks, also backed the IASB compromise plan and wants an amendment to be issued as soon as possible.
Defining the terms
A number of largely technical issues remain to be resolved by IASB staff. These include transition questions - namely, how and when an agreed amendment would take affect for both existing and new users of IFRS - and the scope of the document.
The IASB's Tweedie argued against too many examples in a principles-based document with Apra's Somogyi noting "what's guidance for some is prescription for others".
Other tasks include refining what is meant by accounting mismatch and the term "significant reduction" used in the February document in connection with defining the appropriate use of the option. The treatment of embedded derivatives and the technicalities of designation are also on the list of things to be done before the amendment is finalised.
