International accounting standardisation and financial stability

The European Commission’s recent decision 1 to require the use of international accounting standards (IAS 2) for the preparation of the consolidated financial statements of listed companies is motivated by the very understandable and justifiable desire to improve the comparability of financial statements and achieve a level playing field. However, it raises a number of issues of principle, and some major practical difficulties. Looking beyond technical implementation issues, central bankers are faced with two crucial questions in terms of the maintenance of financial stability. – Are the standards sufficiently prudent in today’s climate of economic uncertainty and mistrust of the markets, and will they address the shortcomings that have recently been revealed? – Is there not a risk of the standards introducing artificial volatility into financial statements, impairing a proper understanding of the true position of economic agents? This article looks at the main changes proposed by the IASB in the light of these two questions, and in particular at changes which have a very significant impact on financial intermediaries, which oil the wheels of every economy. The changes in accounting for credit risk by credit institutions introduced by the revised IAS 39 3 are undoubtedly an advance in conceptual terms: by requiring the earlier recognition of risk in the accounts, they should reduce the cyclical nature (and hence the volatility) of the financial reporting of credit risk. They are also an advance in terms of regulatory convergence, in that they are closer to the prudential rules included in the new solvency ratio. As regards the determination of corporate risk exposures and the criteria for derecognition – an issue at the heart of recent accounting scandals – the IASB proposes a middle way between two contrasting approaches. On the one hand there is the view that favours form over the economic substance of risks; this has led some standard-setters to allow derecognitions that look excessive given the actual risk exposure. Other standard-setters define the concept of risk in very broad terms, prohibiting any transfer of assets and liabilities off balance sheet or any use of derecognition where the “transferor” retains the risks or rewards (i.e. profits) of a transferred asset. These two extreme positions lead to very different definitions of what should be in a balance sheet. The approach recommended by the IASB is a compromise. Although it undoubtedly needs to be made more effective, it does offer an interesting perspective. However, the concept of fair value, a key element in the IASB framework, and the proposed arrangements regarding risk management and hedging by banks, pose serious problems in terms of financial stability. Fair value accounting involves valuing as many balance and off balance sheet items as possible at market value, or where there is no market value, at a valuation calculated using modelling techniques. This appears to run counter to the principle of prudence, and to create artificial volatility in earnings and equity. Valuing all except held-to-maturity securities at market value, irrespective of liquidity or negotiability or of the intention of the owner, contravenes the principle of prudence in that some of the potential capital gains thus calculated may prove to be wholly illusory. Moreover, this approach will inevitably lead to unjustifiably high volatility in earnings and equity, which might actually aggravate the current confusion in the markets. The IASB proposals on risk hedging have similar negative effects to those on fair value accounting. The IASB requires mark-to-market valuation for all hedging instruments. The logical implication of this approach – if the principle of symmetrical treatment is to be preserved – is that the same valuation method should be used for hedged items as well. This proposal risks extending fair value accounting to intermediation banking (where the hedged item is generally accounted for), with all the attendant consequences in terms of prudence and volatility. Two other IASB proposals could also have significant consequences for the financial statements of companies in general, and not just those of banks: firstly the proposals on business combinations and the treatment of goodwill, and secondly the rules on employee benefits (pension liabilities and stock options). The effect of these two types of proposal on financial stability is not clear. If, as the IASB suggests, a purchase accounting approach is used for business combinations and goodwill is no longer amortised but subject to regular impairment reviews, this would seem to promote greater transparency and in future might even prevent some of the abuses surrounding corporate acquisitions. Similarly, the systematic recognition in the income statement of pension liabilities and of stock option grants would make corporate policies in these areas more transparent. However, a “big bang” application of these new standards would probably put many companies into a difficult position, which in turn might impair financial stability.