Quite often, a basic reason for differences of opinion between central bankers and regulators is one of mission. Accounting standards setters and regulators are tasked with protecting the interests of investors and the general public from all sorts of fraud. Central bankers, on the other hand, see this as only one of their obligations, often subordinate to:
● Preserving intact the financial fabric, and
● Avoiding the need of having to use taxpayers money to salvage defunct credit institutions from bankruptcy.
Seen under this perspective, one can appreciate why, while testifying on behalf of Fed Chairman Alan Greenspan, Federal Reserve Board Governor Susan Phillips said during the 1997 US Senate hearings that ‘the desirability of meaningful
disclosure is not the issue’, adding right after that: ‘These problems can be mini- mized by placing market values in meaningful supplemental disclosure, rather than by forcing their use in the primary financial statements ...’
● This essentially meant continuing the reporting of huge derivatives expo- sure off-balance sheet, and
● Keeping the torrents of red ink a closely guarded secret from investors and regulators rather than promoting transparency.
What the Fed and the banks had been fearing from on balance sheet reporting of derivatives gains and losses is that this would uncover their large derivatives losses, and put an end to their hide-and-seek game. Similar silly arguments, which border on lack of business ethics, have been heard in 2004, in Europe, with IASB’s decision to make recognized but not realized derivatives gains and losses transparent. ‘Replacing historical cost with fair value accounting will lead to uncertainty in financial statements,’ warned a senior partner of a Big Four accountants firm. A sweet answer to such a statement is: ‘Don’t make me laugh.’
More to the point, however, is the fact that certified public accountants should not be pulling dirty tricks.
Speaking at a conference in London, in late 2004, Allister Wilson, senior techni- cal partner at Ernst & Young, raised doubts about the ‘practical impact’ of accounts prepared in accordance with International Financial Reporting Standards (IFRS). In his words: ‘Income statements will now be the residual whereas previously the balance sheet was the residual. Historical costs have been replaced with fair value.’3
This was the ‘right sort’ of music to the ears of executives of companies who wish to keep their derivatives losses hidden from the public eye. But Wilson should have known better about the importance of revealing recognized but not yet realized gains and losses. He works for a global certified public accountant who has years of experience with SFAS 133 in the United States. And he should have been aware not only of Jenkins’ testimony, but also of Levitt’s.
Faced with rapidly developing financial markets, a surge in the number of unknowns, fast and wide product innovation, and mounting risk, regulators have been happily sticking to their guns. In 1997 in the United States, Arthur Levitt, then chairman of the Securities and Exchange Commission, testified at a Senate hearing that SEC will enforce the FASB accounting rules (outlined in section 2) for the 15 000 American companies which are public.
To make the reasons for this decision, as well as his point, clear to the US legis- lators, Arthur Levitt warned that FASB must remain independent, and that he was there ‘to shield it from political pressure’. ‘It is very inappropriate for the Congress to suggest any further delays. I believe that we would be playing Russian roulette with our markets,’ Levitt stated firmly – a statement that also applies with IFRS.
In 2004, David Tweedie, chairman of IASB, proved to be just as firm. Speaking at the same conference with Ernst & Young’s Wilson, he told the attendees that busi- nesses will find the transition to IFRS tough, but reiterated the need for a global set of accounting principles. Tweedie also added that 92 countries will permit financial statements produced in accordance with IFRS after the 1 January 2005 start date – and he described IAS 39, Financial Instruments: Recognition and Measurement(see Chapters 4 and 5), as ‘the bane of my life’.
Whether we talk of FASB or IASB, of SFAS 133 or of IAS 39, the long-term aim of bringing fair value into play, in the balance sheet and income statement, is transparency. The law of the land now is to actualize the financial reporting standard. As has been explained on several occasions, accrual accounting:
● No longer reflects rapidly evolving business conditions, and
● It fails to inform stakeholders on assumed mega risks.
Moreover, writing down derivatives losses in a ‘supplemental disclosure’, as Susan Phillips suggested to US legislators, might make sense if the amounts involved in these trades and portfolio positions were a trifle – a minor exception compared to the balance sheet. This, of course, is not the case. Derivatives deals, by all sorts of public companies and most particularly by big banks, are a mul- tipleof their assets and a high multipleof their equity. At that size:
● They eat up the entity’s balance sheet for breakfast, and
● Hiding them in ‘supplemental disclosures’ is tantamount to placing a nuclear bomb under the world’s financial fabric.
All managers and professionals should appreciate that the fundamental mission they have been entrusted with is to assure the survival of the enterprise for which they work; not just some temporary profit numbers. The problem of course lies in defining fair value in assets and liabilities, appreciating the fact that financial reporting:
● Is much more about predicting future staying power (see Chapter 12)
● Than massaging numbers to beautify the past.
Cognizant people in the derivatives business know very well that the fight over the FASB’s and IASB’s accounting standards is more than just an issue over ‘this’ or
‘that’ rule. Bringing to light the full exposure assumed by public companies might tell the world that the global financial system is not far from being bankrupt – a bankruptcy hidden by the old accounting framework, which has repeatedly failed to adequately reflect economic reality.
There is no wonder that the investor community increasingly demands greater transparency. The prerequisite is that firms provide information that really reflects the impact of their trades, and of prevailing economic conditions, on their financial position. Hence the need for fair value approaches, where valua- tion rules are applied depending on management’s intentionsin holding certain assets and liabilities.
● This is precisely the intentional process corporate raiders used to make their fortune.
● This is, also, the scope of management accounting information chief exec- utives and their immediate assistants should want to have for better gov- ernance reasons.
Ironically, it is precisely because of better governance that accounting reforms are likely to have a profound impact on business and industry, and most partic- ularly on the banking sector. Neither is IAS 39, which roughly corresponds to US GAAP’s SFAS 133, the only financial standard that needs to be enacted, in order to gain advantages in governance.
Much can be learned about further requirement from accounting standards applied in the United States during the past few years, as well as from Financial Accounting Standards Board Interpretations (FIN). FIN 45 ‘Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others’, was issued in November 2002. It addresses:
● Disclosures to be made by a guarantor in its interim and annual financial statements, about its obligations under certain guarantees that it has issued, and
● Clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for fair value of obligation(s) undertaken in issuing the guarantee.
For its part, FIN 46 ‘Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin 51 – Consolidated Financial Statements’, was issued in the United States in January 2003. It provides new criteria for determining
whether a company is required to record assets and liabilities on its balance sheet.
Notice that the more complex the accounting rules become, in order to reflect the greater sophistication of financial instruments, and of entities holding them or trad- ing in them, the greater the need for interpretations by supervisors so that compa- nies are not gaming the system, and it becomes feasible to maintain a level playing field for all entities. This is precisely what both US GAAP and IFRS are targeting.