GAAP and IFRS

“Spineless?” UK Pressure Targets Fair Value Weakening

IASB's independence is questioned at a Parliamentary hearing today, as politicians look to soften mark-to-market accounting.
Marie LeoneNovember 11, 2008

Members of the Treasury Committee of Britain’s House of Commons asked razor-sharp questions about the independence of the International Accounting Standards Board today — and especially IASB’s relaxation of fair-value accounting rules to help banks weather the credit crisis.

“Spineless? Caved-in?” said Labor Party MP John McFall, the committee chair, as he crisply opened the hearing on “accountancy and the banking crisis.” He then made a one-word demand of the man being questioned, IASB Chairman David Tweedie: “Answer.”

Since early October, IASB has been under fire for reportedly submitting to political pressure in softening the accounting rules in the face of financial pressure on Britain’s banks. One complaint against IASB has been that it sidestepped due process to rush out a rule allowing financial institutions to reclassify some loans as a way of avoiding marking those assets to market. By eschewing fair value accounting, the banks also avoid losses generated by a drop in asset value.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Critics of the fair value accounting — which includes banks — blame the methodology for exacerbating the current credit by forcing companies to take unnecessary writedowns on illiquid financial assets.

Tweedie said that the board had little choice but to rush through the rule changes to IAS 39 and IFRS 7 because the European Commission was bearing down on the organization and threatening to pass legislation that would allow reclassification of loans without also requiring proper controls or disclosures. Tweedie asserted that IASB faced a standard-setting dilemma that he hoped he would never encounter again — “a blunt threat to blow the organization away … and that came very, very rapidly.”

Tweedie explained that IASB first heard about the draft legislation in a speech by the EC commissioner, in which he proposed mandating a “carve out” or exception to the existing rules. The legislation, if passed, would have allowed banks to reclassify “held for sale” or “held for trading” loans to “held to maturity,” effectively permitting banks to avoid losses associated with fair value accounting. The EC had a competitive reason for promoting the rule change. According to an Oct. 7 statement, the EC wanted to avoid “any distortion of treatment between U.S. and European banks due to a difference in accounting rules.”

Quickly, IASB decided to speed through the rule change by adopting its American counterpart: FAS 115, which places restrictions around the reclassification process and includes disclosure requirements. “I think accounting in Europe would have been totally out of control if they had taken the option to go with the [EC] carve out,” Tweedie told the HOC committee, which has oversight responsibilities for the UK Treasury, Revenue & Customs, and associated public bodies, including the Bank of England and the Financial Services Authority.

Originally, IASB expected to have at least a week to work through the EC draft to make sure it was aligned with U.S. generally accepted accounting principles and the ongoing convergence project between IASB and the U.S. Financial Accounting Standards Board. “But we didn’t have a week, only a matter of days,” noted Tweedie, who said it was important to investors to push through a rule change that included restrictions and disclosure requirements.

Although it did not have time to discuss the changes with constituents, IASB did consult with FASB, the U.S. Securities and Exchange Commission, and auditors, on whether the rule meshed with U.S. standards. Nevertheless, Tweedie insisted that the EC’s draft legislation was a “surprise” that “came out of nowhere,” and that the EC version would have brought about a “standard free for all” if IASB had not bypassed its due process.

Tweedie acknowledged that he could not guarantee that the EC would stay clear of the standards setting process in the future. In fact, Tweedie admitted that the independent status of the IASB had been damaged by the incident, and that he considered resigning.

But he stayed on because “I wanted win this one,” he said, referring to the board’s efforts to guarantee its independence against European political pressure. One way to fight back, opined Tweedie, is with the upcoming trio of roundtables that IASB has scheduled in conjunction with FASB, in which experts representing all constituents will come together to discuss accounting issues arising from the global credit crisis.

However, the reclassification controversy may have just been the opening salvo in the battle for IASB independence. On Oct. 27, Jorgen Holmquist, the EC director general for Internal Markets and Services, sent a letter to Tweedie noting that the commission welcomed the IASB’s “prompt response” to the reclassification rule change, and continued that: “We now expect that IASB clarify certain practical aspects to ensure the effective implementation of the recently adopted amendments to IAS 39.”

Further, Holmquist wrote that the endorsement of the IASB’s recent amendments to IAS 39 and IFRS 7 on Oct. 15, “was only a first step in an ongoing process to comprehensively address accounting issues raised in the context of the financial turmoil.”

According to the letter, the EC wants the IASB to come up with solutions for three fair value issues in time to incorporate the accounting changes in end-of-year results. Broadly, the EC would like IASB to extend the reclassification of assets beyond “held for trading” loans, and apply it to other financial assets that are currently recorded at fair value. In addition, the commission is looking for clarification regarding whether synthetic collateralized debt obligations include embedded derivatives. Finally, the EC wants to see adjustments to impairment rules that apply to available-for-sale financial assets.

So far, IASB has not responded to the Oct. 27 letter, “and I think that’s right, because what we don’t want is politicization of this process,” noted Liz Murrall, director, Investment Management Association, who testified earlier in the day. Murrall explained that the first EC request made sense in light of aligning standards with American rules, but the second batch of changes diverge from U.S. GAAP, and is not consistent with convergence efforts that attempt to move the world toward one set of single accounting standards.

Russell Picot, a member of the British Bankers Association’s financial reporting advisory panel, who also testified on the early panel, said that while the EC wants IASB to consider the three new fair value rule changes, it also expects the board to address the changes using due process. “I think it is very important that we have an independent standard setter…[and] that due process is respected…not everyone is going to agree with what IASB says, but you have trust [its] due process and what they come out with in the [end].”

Others on the earlier panel agree that IASB independence is critical. “If the EC should be doing anything at the moment, it should be considering how to bolster independence of the body that is only global standard setter we have in this area,” opined Stephen Haddrill, director general of the Association of British Insurers. “But independence has to be based on legitimacy.”

Haddrill reckoned that IASB could “reinforce its own legitimacy,” by instituting several changes. For example, the board and trustees membership should be more representative of a wider group of interest, such as investors, users, and businesses. IASB could do a better job of explaining the economic affects of its proposals, said Haddrill.

Perhaps more important, the legal standing of the board needs to be reinforced. “It is coming up against real, democratic, legal authorities, but has grown up as a club — a private organization,” opined Haddrill. “We need to consider whether [IASB] needs to be given some kind of international or legal standing that would enable it to be robust and independent. He also suggested that IASB decisions should be reviewed through some legal process, rather than just asking countries to either adopt a rule, or reject it and create a carve out.

Still, Haddrill maintains that it is “inappropriate for the commission to be bullying the board.” But he thinks the IASB “is likely to be exposed to bullying until the board has some kind of solid international legal standing of it own.”

The idea that the EC’s meddling came as a surprise to the IASB prompted one Member of Parliament to ask whether being blindsided by politicians was a failure on the part of Tweedie, in that he was not able to understand “the mind of the commission.” Tweedie’s responded that IASB consults and works with the EC on a regular basis, but said the board just didn’t have an “inkling” about the proposed legislation related to the reclassification.

Paul Boyle, chief executive of the Financial Reporting Council, and a witness who testified alongside Tweedie, pointed out a structural oversight problem with IASB. By way of example, Boyle explained that politicians rarely, if ever, consider interfering with the authority of central banks to set interest rates, and that IASB must be granted the same kind of independence. “When the power was handed over [to IASB]…there was insufficient thought given to government interference.”

Indeed, the independence issues swirling around the reclassification rule “was a direct threat to IASB,” by the European Commission, testified Charles Cronin, who heads up the Chartered Financial Analyst Institute Centre. Cronin, who spoke during the earlier panel, also admitted that that the meddling had damaged the board’s independence. What’s more, the IMA’s Murrall said that while IASB “put on a brave face” and had good reason to react quickly to the EC’s first call for change, “the jury is still out on whether [IASB] will caved-in” to political pressure a second time.

For Tweedie’s part, when asked by a Treasury Committee member “at what point would the IASB stand up to the European Commission,” he replied: ” I think you should watch.”