Questions on Financial Instrument Raised at Roundtables, by Fed Governor

By Stephen Bouvier

LONDON—Tensions between the International Accounting Standards Board and the European banking community surfaced Sept. 10 with IASB member Robert Garnett telling a French banking representative to be “careful what you ask for in future.”

The angry exchange came in the closing minutes of a roundtable meeting convened by IASB and the Financial Accounting Standards Board to hear constituent comments on separate IASB and FASB proposals to shake up financial instruments accounting. Roundtables were also held in Toyko Sept. 10 and in Norwalk, Conn., Sept. 14 (see related article in this issue on the Norwalk session).

“To be quite blunt about this, Bob [Herz] has said that the FASB is considering all of the issues together. That would be a preferable way of dealing with it,” Garnett told Frank Lafforgue, who attended the meeting as a representative of BNP Paribas.

Garnett continued, “I do hold you partly responsible, as a European banker, for insisting that we address some of these issues by the end of the year. You have forced on us the need to address this on a piecemeal basis.”

His outburst came in response to Lafforgue's call for the board to clarify its position on hedge accounting issues.

Garnett, who also chairs the board's interpretations committee, added, “So, I'm sorry, be careful what you ask for in future, because the result that you get is something that you found is not palatable.”

He concluded that, “If we had more time, we could address more of these issues jointly with FASB, [holding] joint deliberations with them. You have imposed this timetable on us, this is the consequence of coming back to us.”

John Smith, who sits alongside Garnett on the international board, told him, “You did well.”

Outline of IASB Plan

IASB published its proposals to replace IAS 39 on July 14 (5 APPR 811, 9/4/09). The sixty-day comment period closed on Sept. 14.

IASB has proposed two main measurement categories for financial instruments—fair value and amortized cost. That would reduce from the current four for financial assets and liabilities under the board's current literature, International Accounting Standard 39, Financial Instruments: Recognition and Measurement.

If confirmed, the proposals mean an entity would measure a financial asset or liability at amortized cost if the instrument meets two conditions:

• it has basic loan features, and
• the entity manages it on a contractual yield basis.

An instrument that fails to clear both hurdles must be measured at fair value through profit or loss.

IASB has said it will permit entities to hold certain equity instrument investments at what it calls “fair value through other comprehensive income.”
This exception will cover the situation where an entity takes an equity stake “for strategic purposes” and not “with the primary objective of realising a profit from increases in the value of the instrument and dividends.”

IASB expects to publish two further exposure drafts during the fourth quarter of 2009 addressing the separate issues of impairment and hedge accounting.

Modifications Proposed

Earlier, Lafforgue had argued that IASB should restrict the use of its proposed fair value through profit or loss category to cases where the instruments “are managed on the basis of the fair value.”

Moreover, Lafforgue said, “if we consider that fair value through profit or loss should be positively defined and amortized cost should also be positively [defined], there is a need for a third category, which could be fair value through OCI.”

This latter category, he noted, might include a “portfolio of equities for which there is no trading intent … and maybe also some debt instruments for which the trading intent is not assured.”

Proposal May Not Be Operational

Steering a much more politically cautious line, the chair of Germany's national standard setter Liesl Knorr, while praising the board's “starting point of having straight cashflows at something and having not so straight cashflows at fair value is a good one,” questioned the operationality of the proposals.

Knorr said it was “not clear if it is all that operational yet in the way you phrase it.” There was, she added, “room for improvement.”

Similarly, Russell Picot, group chief accounting officer of HSBC, declared himself “generally supportive of the two-category approach.” Picot noted that the debate around “what should be at amortized cost is an important one.”

The HSBC representative went on to remind the board that not only was it standard setting for a crisis but also for less crisis ridden times.

“We have a view that says people shouldn't just think about the here and now because obviously the financial system has a lot of assets within it which are heavily under water,” he said.

“There's quite a lot of those instruments that some would say are quite toxic, and so there's going to be a lot of focus on the very short-term issues, but I think there must be a longer-term focus that looks to the golden day when all that's flushed through the financial system.”

Where is the Dividing Line?

At that point in time, he explained, the fundamental question is: “If you have assets with leverage, should they be in the amortized cost or the fair value bucket. That is a very important question in terms of where you put the dividing line.”

And noting that the board's proposals currently include a bar on reclassification between the different categories, Picot added that reclassifications “are actually quite important, and we would say that they must be driven by fundamental changes in business model and not voluntary or at management discretion.”

Also calling for the board to give “more prominence to the business model” was French regulator Patrick Parent, who represented a committee of the International Organization of Securities Commissions.

Where he departed company from Picot, however, was in his claim that “the narrow definition of amortized cost category could lead consequently to an increase in the use of fair value through the P&L.”

This could lead to the conclusion, he argued, “that the lessons drawn from the crisis would not be taken into account.”

He cited as evidence for this assertion instruments “which according to the IASB amendment since 2008 have been [reclassified] to other categories will [now] be according to the current proposal reclassified at fair value through P&L.”

The Committee of European Banking Supervisors, he continued, has questioned this move because it could lead to entities reporting in the income statement “some elements which are not reliable,” with entities eventually distributing those elements.

And although, Parent said, CEBS believes “that the fair value through profit or loss category is very useful for liquid instruments which are traded actively,” a question mark hangs over the proposals in the case of non-traded instruments.

Summing up a common theme among European representatives—certainly among the non-Anglo-Saxons—Parent said, “There is a need for a third category which could be … the use of the OCI category.”

Questioning Assertions

Questioning the evidential basis for Parent's claims, Robert Garnett replied, “You have made a number of assertions in there [and] I'm not sure that they are all true.”

“The question of whether or not our approach increases the use of fair value is not something that I don't think we have evidence to support,” he noted.
Garnett added that he would be happy to consider any research that the Frenchman might have on the issue.

“Unless you have some evidence to say that it will result, definitely, in an increase in fair value, I think we must strike that off the record,” he said.
Garnett agreed that the proposals “may in some circumstances require more instruments to be at fair value.”

However, he also noted that, “In many cases … it will result in highly liquid instruments being able to be classified at amortized cost because of the nature of the instrument and the way in which they are managed.”

Indeed, in a dissenting opinion on the July 14 exposure draft, IASB member Jim Leisenring argued that “in the current crisis, instruments that have provided some of the most significant losses when measured at fair value would be eligible for amortised cost.”