In the 1960s I was invited for a meeting by the then president of Allgemene Bank Nederland (ABN). Prior to lunch, he showed me around the building, then said that it was 50 years old, but still functional. ‘I am now planning a new head- quarters,’ the president added, ‘and if I am going to be as successful as my pred- ecessor was, it should serve my bank well, for at least the next fifty years.’
Part of our discussion, as well as the reason for my having been invited, was the information technology (IT) supports which should be embedded into the projected headquarters of a global bank to keep it functional for at least five decades. By the
FREQUENCY
A α = 0.0007
AAA α = 0.0001 AA
α = 0.0003
CREDIT RATING IN FUNCTION OF SOLVENCY STANDARD
LEVEL OF CONFIDENCE
0.9993 0.9997 0.9999
Figure 2.3 Major risk management components are an exercise in reliability
1960s, IT was already a force in banking, and clear-eyed management wanted to take full account of state-of-the-art solutions, as well as of future developments.
At the time, both ABN and AMRO, Holland’s two big banks which were then two separate and competitor credit institutions, were ahead of the curve in informa- tion technology. The same was true of Citibank. In fact, some years later in the late 1970s, Walter Wriston, Citibank’s CEO, said that banking was information in motion– an excellent label. I bring up these two cases for two reasons:
● When we want the solution we are designing to live on, we must plan its life cycle at the drafting stage – not post-mortem, and
CORPORATE GOVERNANCE
RELIABLE FINANCIAL REPORTING
ADVANCED TECHNOLOGY
FINANCIAL ACCOUNTING
MANAGEMENT ACCOUNTING GENERAL
ACCOUNTING LOGISTICS
SUPPORT
GENERAL LEDGER
COMMAND AND CONTROL
MODELS
AUDITING INTERNAL
CONTROL
RISK MANAGEMENT BACK OFFICE
TRADE CONFIRMATIONS
Figure 2.4 Typical interactions of complex subsystems, targeting reliable financial reporting
● Today, integrating high technology requirements into any standard is a
‘must’; but at the same time the standard itself must be advanced. Anything short of that, and we are not doing our job properly.
As we will see in Chapters 4 and 5 (and in section 8), one of the most highly dis- puted issues of IFRS is IAS 39, the standard that covers marking to market finan- cial instruments. This happens because people do not like to change their habits and, at the same time, they are afraid of the unknown. Yet, IAS 39 is not just an alternative to accruals, it is a standard designed for our epoch, though it still needs to be analysed in its full multi-dimensional impact in:
● Judging company performance and assumed risk
● Satisfying regulatory and supervisory demands, and
● Stimulating business growth by providing a means to measure risk and return regarding products and customers.
The concept targeted by the first bullet point is the fair valuation issue and its importance in corporate governance. Valuing at market price is, no doubt, a chal- lenging concept and further work is indeed necessary to achieve transparency, consistency, and comparability in fair value accounting, as well as to:
● Gain a better understanding about what the direct and indirect conse- quences of implementing this not-so-radical concept are.
● Continue developing fair value methods, beyond the current rudimentary and open to manipulations accounting standards, by learning through real- life applications.
After all, what are our options? The obsolete book value? This is an approach that obliges senior management to run a company in a highly competitive and fast-changing business environment by looking through the rearview mirror. It is pretty clear to see that the pre-2005 accounting standards are no good.
Those who take the contrary view say that there are too many rules associated with the new standards. The answer is that there is no such thing as freedom without laws and rules, but neither are laws and rules written without a precise objective. The precise objective of IFRS is to provide a level playing field where:
● Deals being made are written in clear accounting terms, and
● Assets held in inventory are priced in a way commensurate with the mar- ket economy’s values.
The price attached to each position must represent current value – not an obso- lete or irrelevant reference which, among other ills, provides the means to game
the system. Responsible entrepreneurs, of which there are millions, do not look for short-term maximization of profits through creative accounting, but pursue a long-term objective, coherent with the reason why they are in business.
Nobody should doubt there will be winners and losers with the new accounting standards, as with any new system. It is widely expected that IAS 39’s greatest impact will be on banks and insurers (see section 8), but this is not necessarily true because the new standards will apply to allcompanies that:
● Do hedging, or
● Deal in derivative financial instruments.
Marking to market evidently affects all entities that use derivatives as part of their business. Therefore, all companies must carefully study the impact of International Financial Reporting Standards (IFRS) on their balance sheet and income statement. ‘All’ means plenty, because IFRS affects more than 7000-plus listed European companies and their financial reports which should:
● Provide reliable information about their financial position and perform- ance, and
● Help a wide range of users in making better-focused economic decisions, without book value ambiguities.
As is to be expected, there are changes from past practices. Chapter 3 will explain why profits will be affected by new numbers, such as stock option expenses and dynamic valuation of financial instruments. The IFRS statement will also have to accommodate charges for stock options. Moreover, numbers traditionally regarded as exceptional, like restructuring costs, or gains and losses on trading assets, will increasingly be seen as part of operating performance.
These changes are evolutionary, and they are necessary to reflect the switches which have taken, and continue to take place in the global business environ- ment. Another rather significant impact on the profit and loss statement will come from fair value estimates of items in assets and liabilities. Derivatives are a case in point. They have often been used for blurring the distinction between:
● Operating performance, and
● Changes to the balance sheet.
The experience of American companies with marking to market, in the 1999 after- math of Statement of Financial Accounting Standards 133, is that fair valuing the entity’s assets and liabilities is not easy – but it is doable. As mental compensation
for the added difficulty, at least in the first years, everybody should bear in mind that fair value of A&L is much more relevant than historical cost – and it is part of good governance.
A valid approach to business decisions always draws on market views of a com- pany’s value, based on forecasts of future cash flows. True enough, unlike his- toric cost, there is a question mark over the dependability of fair value measurements. A particular challenge is when there is no active market for many of the assets and liabilities. Models are used, but valuation models have to be carefully scrutinized because assumptions are usually subjective. As for the argument that hedge accounting makes company profits more volatile, just remember that:
● IAS 39 does not make the P&L ‘more volatile’.
● What it does is to make transparent its volatility.
It is up to the management of the company to see to it that its income is not volatile, as it is up to the entity’s board to accustom itself on how to handle changes like accounting for goodwill. Let’s face it – like historical costs, goodwill amortization has been an accounting function, and it is time it came to an end.