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Newsletter June 2010: Accounting crisis could break G20 reform deal

World leaders must make accounting problems a priority or global financial reforms will fail. Top banker voices concern

By David Keefe

The split between standard-setters over global accounting rules could well be a “deal-breaker” for the entire Group of Twenty effort to reform financial regulation, according to top banking industry figure Bill Rhodes.

Rhodes, the much-respected senior advisor to the American Citigroup banking giant and a leading light in the international banking industry’s primary lobbying organisation, says G20 leaders must make resolving the split a top priority at their Toronto summit at the end of June.

“Without globally agreed rules on how to measure the value of bank assets and liabilities and other aspects of the banking business, any other agreements aimed at increasing the resilience of the financial system will be virtually meaningless,” Rhodes, a former Citigroup vice-chairman, told GRR.

Amid signs that the G20’s target of achieving a convergence of accounting rules by June 2011 has already gone by the board (see box), Rhodes says long-awaited proposals on financial instrument accounting from the Financial Accounting Standards Board (FASB), America’s accounting rule-maker, have widened the international split.

Rhodes’s remarks were made on the sidelines of the annual spring meeting in Vienna of the Institute of International Finance (IIF), the influential Washington-based body that represents leading international banks and of which Rhodes is first vice chairman.

He had earlier told delegates to the meeting that the gap on accounting issues between FASB and its international counterpart, the International Accounting Standards Board (IASB), is getting wider not closer. The two boards have clearly not come together and “are wider than they were at this point a year ago.”

Rhodes cited German central bank president Axel Weber in support of his concerns. Weber reminded an IIF meeting in Washington recently that it’s impossible to have international regulatory standards without international accounting standards.

The differences cover many issues, including the way provisions for loan losses are dealt with as well as “the famous point” about to what extent fair value, or mark-to-market, accounting should be used. Fair value rules require firms to measure their assets and liabilities at current, or market, prices when making their financial reports. Critics blame mark-to-market rules for exacerbating the financial crisis by requiring banks to measure assets at knock-down, fire-sale prices quoted in markets frozen by the turmoil.

The G20 must keep pressing for a single set of high-quality global accounting standards, Rhodes urged. The Financial Stability Board (FSB), the body coordinating implementation of the G20 reforms, and the Basel Committee of global banking supervisors must put more pressure on the G20 heads on this particular point when they meet in Toronto. If the differences aren’t resolved in Toronto, then they must be at the next G20 leaders’ summit in Seoul in November. G20 finance ministers, meeting in Busan, South Korea in early June ahead of the Toronto summit, called on the standard-setters to redouble their efforts to achieve convergence.

The accounting split is also yet another example of the worrying tendency to fragmentation of the G20’s global reform efforts, Rhodes said. He added that unilateral national actions such as the ring-fencing of bank deposits, the imposition of special taxes, and the initiation of regulatory reforms that aren’t consistent with the thrust of international measures will further damage the financial system.

However, FASB chairman Robert Herz seemingly downplayed differences with the IASB when the US standard-setter announced in late May its long-awaited proposals for improving accounting for financial instruments, the loans, bonds, derivatives and investments that feature on bank balance sheets.

As expected, the Norwalk, Connecticut-based FASB released a single package of proposals that would controversially extend the use of fair value to cover a much greater portion of bank loans and securities than is currently the case while also accelerating the recognition of loan losses. Banks would have to report the cost of loans on the basis of both fair value and amortised cost, a method of depreciating the value of an asset over time. The implementation date has yet to be decided, although January 2013 is given as a sort of working hypothesis. The comment deadline is September 30.

FASB believes the extension of fair value measurement to most financial instruments would help provide the most useful, transparent and relevant information to investors about a financial firm’s assets and liabilities.

By presenting both fair value and amortised cost information, investors would more easily incorporate either approach or both in their analysis of a firm. Fair value would provide more information about the market’s assessment of a firm’s expectation of its future cash flows, discounted to reflect both current interest rates and the market’s assessment of the risk that the cash flows will not occur. Amortised cost would provide users with information about the instrument’s contractual cash flows.

However, Rhodes is highly critical of the dual fair value-amortised cost reporting approach. “Two columns don’t make a lot of sense,” he says.

And he strongly deprecates the extension of the fair value rule. “Anything that’s traded should be marked to market. But that shouldn’t apply to loans held for the long term. Fair value would result in unnecessary year-to-year volatility in the balance-sheet valuation of such securities.”

Meanwhile Edward Yingling, who heads America’s leading banking industry trade body, said the FASB proposal imperils “the potential for convergence of international accounting rules”.

“The mark-to-market principles in the proposal…conflict with the recommendations of the G20 and the Basel Committee, and the proposal is also dramatically different from the new International Accounting Standards Board rules, which are based on an entity’s business model,” said Yingling who is chief executive of the American Bankers Association.

And on the other side of the Atlantic Nigel Sleigh-Johnson, head of the financial reporting faculty at the Institute of Chartered Accountants in England and Wales (ICAEW), said FASB and the IASB need to make every effort to resolve their differences over the next few months. Otherwise, he said, the fully converged global standards called for by the G20 are unlikely to happen in the next year or so.

But he urged the IASB not to waver “from its central mission of ensuring that investors in global capital markets get the high quality and transparent financial information they deserve.”

“In the debate over which direction the standard setters should move, it is the interests of investors, not regulators or politicians or preparers, that should determine the outcome, subject only to cost benefit considerations. In particular, the distinctive interests of banking and other regulators should not derail efforts to improve the quality and transparency of financial reporting for this paramount stakeholder group,” Sleigh-Johnson said.

He noted that a study by leading accounting firm PricewaterhouseCoopers shows that the majority of investment professionals around the world do not support the fair value model for financial instruments put forward by FASB (see page 17).

The ICAEW isn’t convinced that FASB’s approach, “which seems complex and potentially confusing, is necessary to provide more timely fair value information” on financial instruments.

Three-phase reform

The London-based IASB, which is responsible for the International Financial Reporting Standards (IFRS) now accepted in more than 100 countries although not yet in the US, is engaged in a three-phase reform of accounting rules for financial instruments. The first stage, which has already been rolled out, covers classification and measurement and uses a mixed fair value/amortised cost model. Proposals for loan-loss accounting are currently out for comment and the IASB is expected shortly to issue its plans for hedge accounting.

The IASB limits the use of fair value to trading activities involving items such as derivatives, while using amortised cost for bonds held to maturity, for instance, thus shielding long-term holdings from the accounting impact of short-term market fluctuations.

“Ideally, this (FASB) proposal would have been issued jointly with the IASB and contain convergence guidance,” the FASB document said. The two boards are committed to reducing their differences over the issue.

Herz acknowledged there were differences of timing and approach – FASB’s single package versus the IASB’s three-phrased effort and the IASB’s amortised-cost only approach, for instance – but said the dividing lines in respect of the classifications made were fairly similar. He agreed the two boards differed over the crucial issue of loan loss recognition with the IASB’s expected loss, or through-the-cycle, approach contrasting with FASB’s proposal.

Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities – FASB exposure draft

(Volume:8 Issue: 6)

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