Summary Fair Value Accounting and the Banking crisis in 2008: Shooting the messenger

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Summary - Fair Value Accounting and the Banking crisis in 2008: Shooting the messenger

  • 1 Introduction

  • This paper analyses the effects of the financial crisis on the international standard-setter in 2008 and the attempts made to shoot the messenger, to blame IAS 39 for creating the crisis for reporting unrelaised losses, rather than the cause being bankers making bad investment decisions. 
  • Some said IFRS have not only been ineffective during the period of the crisis but they have also precipitated the fall of some major financial institutions,

    Criticism about IFRS is that managers argued that they had no intention to sell these assets and there was no point in measuring them at the market value. 

  • 2 Fair Value under IFRS

  • Fair value in IAS 39 is The amount for which an assets could be exchanged, or a liability settled, between knowledgable, willing parties in an arm's length transaction.
  • Show assets and liabilities at their market value on the balance sheet and not at their historical costs. 

    Accounting for assets at fair value can be seen as a general application of the financial logic that sees the business as a portfolio of assets whose value depends on their expected cash flows and risk.
  • Mark to market - valuation is based on market data.
    Mark to model - valuation is based a valuation model.
  • Under IAS 39 financial instruments are classified under 4 headings:
    1. Financial assets held for trading - Assets are valued at FV on each balance sheet date and changes flow directly through the income statement.

    2. held-to-maturity in investments - Amortised cost.

    3. Available-for-sale financial assets - Valued at FV at each balance sheet date, changes in FV goes to equity and is now reported in Other Comprehensive Income, with gains and losses recycled through the income statement when the asset is sold.

    4. loans and receivables - Amortised cost using the effective rate method. Not include derivatives bor be quoted on an active market.
  • In 2003 the IASB modified IAS 39 to add an option to use FV through income for subsequent measurement of any asset or liability in order to correct an accounting mismatch.

    A key anti-abuse requirement is that entities had to determine at inception into which category the asset fell and were not subsequently able to re-classify it.
  • Fair value emerged because:
    • it springs initially from the problem of recognition
    • Reduce management's discretion in manipulating earnings, given that the use of historical cost permitted them to defer the revelation problems. 
    • It provides decision-usefullness of the conceptual framework.
  • Criticism:

    • A short-term orientation that can considerably increase the volatility of balance sheet values.
    • There is also the cost of appying such a system.
  • 3 Fair Value in the Banking sector

  • The banks are unhappy about having to value 'available for sale' and 'held for trading' assets and liabilities at FV and believe this will cause great fluctuations on a period-to-period basis as a reflection of short term shifts in the market.

    The application of FC to the banking sector leads to a great heterogeneity in the content of the balance sheets of banking groups and the computation of their results.
  • IFRS that adresses financial instruments pose application problems in the banking sector, notably in the way they interact with BASEL II.

    And the EU criticism has only amplified (vergroot) th echo of the USA criticism made a few years earlier. 
  • As long as the market was rising nobody was too shocked by FV. it started to be stigmatised when the market began to decline, because neither regulators nor banks welcomed the reflection of the market downturn in the banks' balance sheet. But the crisis was classic in nature, poor regulation and very bad loans. 
  • 4 When the accounting thing became a political thing: The IASB and the crisis

  • A report by the IOSCO found that some financial firms appear to have inadequate human and technological resources to model their financial positions using fair value accounting principles under illiquid market conditions. 

    The Financial Stability Forum report made a number of recommendations:

    III.4 - The IASB should improve the accounting and disclosure standards for off-balance sheet vehicles on an accelerated basis and work with other standard setters toward international convergence.

    III.5 - The IASB will strengthen its standards to achieve better disclosures about valuations, methodoogied and the uncertainty associated with valuations.

    III.6 - The IASB will enhance its guidance on valuing financial instruments when markets are no longer active. 
  • The G7 agreed with those recommendations. 
  • The IASB decided to appoint the Expert Advisory Panel as an IASB-only exercise, not involving the FASB. But they regret this later.
  • After a lobby of Sarkozy european banks said they were being disadvantaged by IFRS compared with their US counterparts. In the USA property mortages did not required to be held at FV.

    Because of this the IASB had to take action. 

    But this led to the fact that the US SEC was not pleased by the EU carve out because it was said to be the equivalent of US GAAP. 

    Furthermore the carve out would lead to a demise of the worldwide globalisation project. The credibility of IFRS and the IASB would fataly demaged if it became clear that europe did not accept its authority. 
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