Capital Markets

U.K. Lawmakers Defend Fair Value

A report from a House of Commons Treasury Committee says bad decisions at banks — not accounting rules — created the credit crunch.
Marie LeoneMay 15, 2009

The U.K. House of Commons has gone to bat for fair-value accounting — and the International Accounting Standards Board — saying it was “a bridge too far” to expect accounting rules to compensate for bad decision-making by banks.

The report by the House Treasury Committee, released last week, delved into the banking crisis as it relates to reforming corporate-governance policy and pay issues. Fair-value accounting was one of eight topics covered, along with credit-rating agencies, auditors, and the role of the media.

In a stinging critique of banks’ role in the global credit crisis, the report asserted: “The uncomfortable truth for banks is that market participants had over-inflated asset prices which have subsequently corrected dramatically. Fair value accounting has actually exposed this correction, and done so more quickly than an alternative method would have done…. We do not consider fair value accounting to be a suitable scapegoat for the hubris, poor risk controls and bad decisions of the banking sector.”

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Bankers on both sides of the Atlantic have argued that fair-value accounting does not reflect the underlying economics and cash flows of investments that are held to maturity. In fact, the British Bankers Assn. and the American Bankers Assn. insist that the value of securities held to maturity should be carried at historical cost, and not written down on balance sheets and income statements as fair-value accounting prescribes.

According to the report, Paul Chisnall, representing the BBA, testified that historical cost accounting is a better way to value securities that are held over the long term. That’s because, he said, unlike fair value, “the historical cost model did not require a spot price, which was of little relevance unless the instrument was being sold.”

The BBA contends that fair-value accounting exacerbated the credit crisis, creating a “spiral of write-downs” and damaged banks’ capital ratios at a time when the markets had “effectively broken down.” Indeed, fair-value accounting forced companies, particularly financial institutions, to write down the value of billions of dollars of financial assets whose worth sunk as the markets for them dried up. In turn, the reported loss of value also drove down banks’ regulatory capital to the point where they didn’t have enough of a cushion to continue lending money.

But the Treasury Committee and representatives of the Chartered Financial Analyst Institute, the Association of British Insurers, and the Investment Management Assn. agreed that while fair-value accounting has a procyclical element that links it to banking capital requirements, it is not the culprit behind the credit crisis.

To be sure, the Treasury Committee noted that the link is not the fault of the accounting standards, but rather of financial statements being used “too crudely” in calculating regulatory capital requirements. The committee continued that the primary audience of financials is the shareholders, who want to see the true worth of their firm.

The committee also defended the International Accounting Standards Board’s decision last fall to forgo due process and rush out new fair-value rules that put European companies on the same footing as their American counterparts by reclassifying certain financial assets so that they are not subject to fair-value accounting. The IASB was under pressure from the European Union, as well as some heads of state — in particular Nicolas Sarkozy of France and Angela Merkel of Germany — to make a rule change under threat that the EU would pass its own rule that leveled the playing field.

The IASB “had little choice but to accept the [European Commission’s] demands” to produce a rule change or so-called carve-out, Charles Cronin of the CFA told the U.K. committee. Cronin emphasized that this incident marked the first time there had been “a direct threat to the independence of IASB through pressure from the European Union.” What’s more, Michael Izza, chief executive of the Institute of Chartered Accountants of England and Wales, noted that the IASB had been “damaged by the episode.”

“The existence of the European Commission’s carve-out power seriously undermines the ability of [the IASB] to project itself as a truly global setter of accounting standards, and indeed threatens the integrity of published accounts. Both are profoundly regrettable,” wrote the Treasury Committee in its report. The committee said it was concerned that the IASB “has already become tarnished by the accusation that it gave in too easily to the Commission’s demands.” It therefore recommended that the U.K. Treasury Department consider the effect of the European Commission’s carve-out power on the IASB’s reputation and continuing work on standards.

Across the pond on Capitol Hill, American lawmakers took a different view of fair-value accounting, demonizing the practice and falling in line behind bank lobbyists to claim that the mark-to-market methodology exacerbated the credit crisis. In March, members of the House Financial Services subcommittee threatened to suspend fair-value accounting if the Financial Accounting Standards Board didn’t do so itself. While most of the lawmakers refrained from proposing legislative changes, two subcommittee members promoted a recently introduced bill that would create a new oversight body to monitor FASB.

More recently, on Wednesday the ABA and other organizations sent a letter to House Financial Services Committee chairman Barney Frank (D-Mass.) asking for more work to be done on the standard related to “other than temporary impairment.” The banking group has taken issue with that accounting convention, saying it “continues to result in higher losses for U.S. companies versus companies that follow international accounting standards.”

FASB has already released a rule tweak to address OTTI issues (FAS 11502 and FAS 124-2) to amend the way companies record impairments for debt and equity securities that they have no current plans to sell. The amended rule, which goes into effect for periods ending after June 15, 2009, could cut the OTTI charges firms have been taking in their income statements, since it allows them to split credit losses from noncredit losses such as declines in value because of changing interest rates or a lack of liquidity.

The noncredit charges would be recorded in other comprehensive income (OCI) and no longer be a part of a company’s total earnings calculation. The result: possibly higher profits and fewer write-downs than have been seen in recent months.

But the ABA-led group — which includes the American Council of Life Insurance, the American Insurance Assn., the Council of Federal Home Loan Banks, and the Financial Services Roundtable — wants more changes. They claim that the rule may still allow an unintentional increase in the number of bonds that become subject to OTTI charges.

In the same letter, the groups took yet another swipe at fair-value accounting, saying that “FASB has publicly stated its view that [mark-to-market] accounting should be required for all financial instruments, including loans.” FASB spokesperson Neal McGarity said that statement was “incorrect” and that FASB “absolutely disagrees.” In fact, a FASB board member recently met with the ABA to explain the rules to the association leadership, according to McGarity.