While the clauses of IAS 39 have been applied in financial statements since January 2005, this was done in the understanding they were still tentative.
Negotiations were going on with the objective of finalizing them, and these nego- tiations were not easy because of widely varying viewpoints among stakeholders.
Mid-March 2005 it was reported that international accounting standards setters could endorse a revised version of the IAS 39 rule on financial instruments, after it won widespread support at a public meeting on 16 March. This rule proposes giving companies the discretion to show liabilities as well as assets at market value in accounts (what insurance companies asked for) – a choice that can have huge impact on:
● Earnings
● Balance sheets
● Credit ratings, and
● The ability to compare one balance sheet to another.
As stated in section 5, the European Commission objected to the original IAS 39 rules, and carved out parts from the international accounting standards which have been enforced in the European Union in 2005. The March 2005 version of IAS 39 threw the spotlight back on the Commission, as well as on the question of whether part of the carved-out clauses could or should be reinstated.
The final decision is a political one, and this is unfortunate because it means the balance would tilt to the position of the player who has more political clout. As it will be recalled, at the heart of the Commission’s objection to the original IAS 39 rules is that marking to market assets and taking at book value liabilities creates an accounting mismatch because historic cost is not matched to market value.
If this is really the European Commission’s thesis it is a self-defeating one, because its argument simply acknowledges that market prices, hence fair value, are better than historical costs. Presumably, under the pressure of covert inter- ests, the EU Commission was publicly supporting exactly the reverse, failing to take the proverbial long, hard look.
For their part, regulators have been worried that companies could use fair value accounting to manipulate earnings – which is nothing new, because through cre- ative accounting companies manipulate earnings anyway, EBITDA being an example.8 In spite of this concern, however, European regulators appeared to back the new version of IAS 39, though representatives from Australia expressed concern that earnings would not be comparable if some companies used fair val- ues and others chose not to.9
The Australians are right. There is much to say about the ills of cherry picking, as we will see in Chapter 10. For instance, ifVodafone was allowed to cherry pick (see the case study on Vodafone’s IFRS results at the end of Chapter 3), then it would surely retain the pre-IFRS consolidation in financial reporting while there is no doubt it would choose to benefit from the new rules regard- ing goodwill.
Different financial institutions will be affected in different ways by compliant IAS 39 reporting, depending on the type and amount of their exposure. For instance, Deutsche Bank let it be known that it has 500 billion euro off-balancing for its most important customers, a large amount of which may have to be brought on balance sheet.
The aftermath of IAS 39 as a result of special exposure characterizing the bank- ing sector, led the Basel Committee to take a good look at the new accounting standards. The July 2005 Basel document, mentioned in the Introduction, states that the purpose of the IAS 39 fair value optionwas to simplify its application which imposes a mixed-attribute measurement model on financial instruments because under IAS 39,
● Some financial assets and liabilities must be measured at fair value, and
● Other assets and liabilities must be measured under the method of amor- tized cost.
Basel’s supervisory guidance brings the banks’ attention to the fact that the mixed-attribute model of IAS 39 ‘requires derivatives to be recognized on the balance sheet as either assets or liabilities at their fair value, regardless of whether a hedged item is held at fair value.’
Many experts agree that the fact changes in fair value of derivatives are recorded directly in profit and loss is a sound principle. The July 2005 document by Basel impresses on bank management that in applying the fair value option to illiquid instruments credit institutions should employ a more rigorous valuation process than the one typically used for liquid instruments.
The Basel Committee on Banking Supervision is right to be concerned about the fine print, because starting in the go-go 1990s, banks have cornered themselves into trading book positions with no active reference market. As the histogram in Figure 4.3 shows, interest rate derivatives have the highest frequency closely fol- lowed by credit derivatives (mainly a 21st century huge market) and equity derivatives. How a highly paid (and skilled) top management in commercial
30%
10%
20%
40%
INTEREST
RATE CREDIT EQUITY FOREX OTHER
0%
Figure 4.3 Classes of trading book positions with no active reference market (Source: Statistics by Basel Committee on Banking Supervision)
banks, investment banks, and insurance companies committed that sort of blun- der is a mystery.
This blunder, however, does not mean that regulators and accounting standards setters could, or should, close their eyes to such ineptitude – and the Mount Everest of risk it has piled up. Even guarantees given by one derivatives gambler to another are rather meaningless because:
● Protection buyer, and
● Protection seller have exposure to nearly the same big risks.
AIS 39 includes rules for financial guarantees that provide for payments to be made in response to changes in a specified variable such as price, rate, or index.
These are derivatives within the scope of the new rules, but guarantees are not derivatives, and therefore are excluded from IAS 39 onlyif they provide for spec- ified payments, for instance, payments to be made to reimburse holders for a loss they incur because a specified debtor fails to make payment when due. IAS 39 states that such ‘excluded’ guarantees:
● Must be initially recognized at fair value, and
● Subsequently recognized at the higher of two alternatives.
By contrast, loan commitments are outside the scope of IAS 39 if they cannot be settled net in cash or another financial instrument; they are not designated as financial liabilities at fair value through profit or loss; and the credit institution does not have a past practice of selling the loans that resulted from the commit- ment shortly after origination. This will drop from the exclusion clause if the bank securitizes its loans – a fast-growing practice.
By contrast, contracts to buy or sell financial items and non-financial items are within the scope of IAS 39. Financial items are always under AIS 39. Non-financial items interest AIS 39 if they can be settled net in cash or another financial asset and some other conditions.
Notes
1 Basel Committee, ‘Supervisory Guidance on the Use of the Fair Value Option by Banks under IFRS’ (Consultative Document), BIS, July 2005, Basel.
2 The Economist, 6 March 2004.
3 D.N. Chorafas, Economic Capital Allocation with Basel II: Cost and Benefit Analysis, Butterworth-Heinemann, Oxford and Boston, 2004.
4 D.N. Chorafas, Chaos Theory in the Financial Markets, Probus, Chicago, 1994.
5 The Financial Times, 17 January 2005.
6 For evident reasons, a somewhat less nice answer would be that ‘political accountability’ is an unknown quantity.
7 Claude M. Fuess, Rufus Choate, the Wizard of the Law, Minton, Bald & Co, New York, 1928.
8 D.N. Chorafas, Management Risk. The Bottleneck Is at the Top of the Bottle, Macmillan/Palgrave, London, 2004.
9 The Financial Times, 17 March 2005.
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