Phew. That was close.
The Financial Crisis Advisory Group has come out and said it — accounting rules were not the root cause of the financial crisis.
In fact, the FCAG, jointly set up by the international and US accounting standards boards, the IASB and FASB, to examine financial reporting issues arising from the crisis, goes as far as to say it wasn’t fair-value accounting that exacerbated the crisis, but actually the use of its opposite, historical amortised cost.
Here are some excerpts from the FCAG report:While the post-mortems are still being written, it seems clear that accounting standards were not a root cause of the financial crisis.2 At the same time, it is clear that the crisis has exposed weaknesses in accounting standards and their application. These weaknesses reduced the credibility of financial reporting, which in part contributed to the general loss of confidence in the financial system. The weaknesses primarily involved (1) the difficulty of applying fair value (“mark-to- market”) accounting in illiquid markets; (2) the delayed recognition of losses associated with loans, structured credit products, and other financial instruments by banks, insurance companies and other financial institutions; (3) issues surrounding the broad range of off-balance sheet financing structures, especially in the US; and (4) the extraordinary complexity of accounting standards for financial instruments, including multiple approaches to recognizing asset impairment. Some of these weaknesses also highlighted areas in which International Financial Reporting Standards (“IFRS”) and US generally accepted accounting principles (“US GAAP”) diverged.
In the early part of the crisis, the principal criticism of financial reporting focused on fair value accounting. This criticism contended that fair value accounting contributed to the pro-cyclicality of the financial system. Prior to the crisis, it is argued, fair value accounting led to significant overstatement of profits; however, during the crisis, it was supposed to have led to a severe overstatement of losses and the consequent “destruction of capital.” Thus, the argument went, a vicious cycle ensued: falling asset prices led to accounting write-downs; the write-downs led to forced asset sales by institutions needing to meet capital adequacy requirements; and the forced sales exacerbated the fall in asset prices.3 In the US, moreover, critics singled out the other-thantemporary impairment standards for available-for-sale and held-to-maturity securities as being particularly “destructive” because institutions were forced to take charges against earnings as a consequence of what they believed to be temporary “market irrationality.”4
Proponents of fair value accounting do not deny that indeed mark-to-market accounting shows the fluctuations of the market, but they maintain that these cycles are a fact of life and that the use of fair value accounting does not exacerbate these cycles. Moreover, they argue that fair value accounting standards provided “early warning” signals by revealing the market’s discomfort with inflated asset values. In their view, this contributed to a more timely recognition of problems and mitigation of the crisis.
Whatever the final outcome of the debate over fair value accounting, it is unlikely that, on balance, accounting standards led to an understatement of the value of financial assets. While the crisis may have led to some understatement of the value of mark-to-market assets, it is important to recognize that, in most countries, a majority of bank assets are still valued at historic cost using the amortized cost basis.5 Those assets are not marked to market and are not adjusted for market liquidity. By now it seems clear that the overall value of these assets has not been understated — but overstated. The incurred loss model for loan loss provisioning and difficulties in applying the model — in particular, identifying appropriate trigger points for loss recognition — in many instances has delayed the recognition of losses on loan portfolios. (The results of the US stress tests seem to bear this out.) Moreover, the off-balance sheet standards, and the way they were applied, may have obscured losses associated with securitizations and other complex structured products. Thus, the overall effect of the current mixed attribute model by which assets of financial institutions have been measured, coupled with the obscurity of offbalance sheet exposures, has probably been to understate the losses that were embedded in the system.
Nevertheless, the FCAG seems to suggest that when it comes to fair value reporting of own credit — the accounting standard which allows companies to book gains from market declines in their own creditworthiness and to book losses on improvements — “seems counterintuitive and may not provide relevant, decision-useful information.” That’s an opinion that might end up being influential given the IASB is currently reviewing the option.
In fact, the whole report is rather important in the context of both the IASB and the FASB undertaking simultaneous reviews of fair value. While the IASB is looking at classifying assets according to their cash flows, the FASB wants everything valued at fair value. The not-so-subtle hint in the FCAG report is that the two accounting bodies should try to align their standards as closely as possible, while staying clear of political or business influence:
The joint and comprehensive financial instruments project now underway should be the focus and chief priority of both Boards for the balance of 2009. In conducting this project, the Boards should not compromise their due process procedures. We have committed to review the progress made by the Boards before year-end. We believe it is of critical importance that neither business nor political pressures divert the accounting standard setters from the financial instruments project, which is so important to the global financial system.
A summary of the IASB and FASB work being undertaken, sourced from the FCAG report, below.
Related links:
Sympathy for the ASBs - FT Alphaville
Accounting brinkmanship – FT Alphaville
Accountants gain courage to stand up to bankers – Bloomberg
Marketing mark-to-market changes to the FASB – FT Alphaville