By Steven Marcy
The Financial Crisis Advisory Group July 28 identified ways to enhance standard-setter independence and accountability and to make financial reporting more effective, in its report on the implications of the global financial crisis on the setting of accounting standards.
The report also spelled out the limits of financial reporting and discussed international accounting convergence.
The FCAG, formed by the Financial Accounting Standards Board and the International Accounting Standards Board in response to the crisis and which first met in January (5 APPR 80, 1/23/09), made recommendations to carry out its findings and preserve standard-setter independence.
Political and Constituent Pressures
The financial crisis and the subsequent takeover by some countries of some formerly private-sector financial institutions has brought standard setting under political pressure, as well as the more traditional pressure from special interests and constituent groups, all of which must be resisted despite the increased intensity, the report said.
“Because governments are more often now owners and guarantors of major industrial companies and financial institutions, it is particularly important that they support, and are seen to support, the independence of the standard setters,” the report said.
Pressures of the financial crisis to modify accounting standards also must not push standards setters into weakening their “due process” for deliberating and invoking any changes, although sometimes expedited action is warranted, the report said.
“During the last several months, we have become increasingly concerned about the excessive pressure placed on the two Boards to make rapid, piecemeal, uncoordinated and prescribed changes to standards, outside of their normal due process procedures,” the report said. “While it is appropriate for public authorities to voice their concerns and give input to standard setters, in doing so they should not seek to prescribe specific standard-setting outcomes.”
“At the same time,” the report continued, “we understand that at a time of acute crisis an expedited due process may be needed to make possible a timely response by the standard setters. For this reason it is important that the [FASB and IASB] define in advance the circumstances under which it is appropriate to act on the basis of expedited due process.”
Focus on Financial Industry
“Our focus has been primarily on issues relating to financial institutions because of their central place in the crisis,” the report said. “However, we believe that many of our conclusions and recommendations apply generally to all business entities.”
The report concluded that fair value accounting and other standards dealing with impaired financial assets did not—as some have charged—cause the crisis within the financial sector. Nonetheless, “it is clear that the crisis has exposed weaknesses in accounting standards and their application,” the report said. “These weaknesses reduced the credibility of financial reporting, which in part contributed to the general loss of confidence in the financial system.”
FCAG co-chairman, Dutch securities regulator Hans Hoogervorst, has blamed the financial crisis on the activities of the financial institution sector.
“My conclusion would be that [international financial reporting standards] had very little to do with the causes of the crisis. The real cause of the crisis was the massive overleveraging of the economy as a whole and the undercapitalizing of the banking sector in particular,” Hoogervorst said June 24 (5 APPR 635, 7/10/09).
Weaknesses Include Fair Value, Loss Delays
The weaknesses cited in the report involved:
• the difficulty of applying fair market value accounting, especially in illiquid markets;
• delayed recognition of losses;
• liability for off-balance-sheet financing structures; and
• the “extraordinary complexity of accounting standards for financial instruments.”
The FCAG report denied that fair value accounting created a “vicious cycle” in which falling asset prices led to writedowns, causing financial institutions to sell assets under duress to raise capital, which in turn caused further asset writedowns.
“Proponents of fair value accounting do not deny that indeed mark-to-market accounting shows the fluctuations of the market, but they maintain that these cycles are a fact of life and that the use of fair value accounting does not exacerbate these cycles,” the report said. “Moreover, they argue that fair value accounting standards provided ‘early warning' signals by revealing the market's discomfort with inflated asset values. In their view, this contributed to a more timely recognition of problems and mitigation of the crisis.”
Also, “the off-balance sheet standards, and the way they were applied, may have obscured losses associated with securitizations and other complex structured products,” the report said. “Thus, the overall effect of the current mixed attribute model by which assets of financial institutions have been measured, coupled with the obscurity of off-balance sheet exposures, has probably been to understate the losses that were embedded in the system.”
The report recommended that a combination of the current mixed attribute model of historic cost and fair value be used to measure assets, but in a simplified version.
“While some complexity may be inevitable because of the nature of the instruments and the diversity of business models, in our view the overall level of complexity is unwarranted,” the report said. “We believe that, for conceptual and/or practical reasons, a simplified mixed attribute model, rather than a full fair value-through-earnings model, is preferable. We have urged the [FASB and IASB] to accelerate and in some cases broaden their efforts to simplify and improve their standards in the vital financial instruments area.”
Among the major recommendations to make financial reporting more effective are:
• converging IFRS and U.S. GAAP on impairments and other areas, even though the two sets of standards sometimes have “different starting points”;
• exploring alternatives to the incurred-loss model for loan-loss provisioning and “the use of more forward looking information,” including a possible expected-loss or fair value model, while being careful to avoid encouragement of “earnings management:;
• reconsidering how an entity recognizes losses or gains from changes in the fair value measurement of its own debt and the impact of its own creditworthiness; and
• improving standards on consolidations and derecognition, including better, more transparent depiction of the risks involved when the standards are applied to complex financial instruments.
Limits of Financial Reporting
Financial reporting can never be made to capture all aspects of a company's financial and economic situation, especially in the midst of a financial crisis, the report said.
“Financial reporting only provides information about the performance of a business for a finite period and about the condition of a business at a point in time,” the report said. “Especially in turbulent times, financial information may be out of date when, or soon after, it is produced.”
“Accordingly, in making resource allocation decisions, financial market participants should ‘look beyond the numbers' in the financial statements that they have before them by also taking into account other relevant qualitative and quantitative information,” the report said.
The FCAG said it agreed with the Group of 20 nations that a strong, single set of international financial reporting standards is needed, and it urged that any individual exceptions to them for individual countries be disallowed.
Any exceptions or “carve-outs” would “perhaps irretrievably … dissuade countries on the verge of adopting or converging with [international financial reporting standards] from doing so, and it would halt the momentum that has been created for convergence between IFRS and US GAAP and, potentially, for adoption of IFRS in the United States,” the report said.
The FCAG will reconvene in December to review progress made on its recommendations, according to a joint FASB-IASB press release.
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