Revised Fair-Value Rule Is Weaker: Moody’s

It's harder for investors to compare banks' financial statements now that IAS 39 lets them decide whether to reclassify "held for sale" assets as "...
Marie LeoneOctober 24, 2021

The effects of a fair-value accounting rule change are popping up in the third-quarter earnings reports of banks — and at least one credit-rating agency thinks investors were better off before the revision.

In a report issued Friday, Moody’s Investors Service analysts take issue with changes to IAS 39, the international accounting standard related to valuing financial assets. The changes, issued last month, allow companies to reclassify “held for sale” assets as “held to maturity.” The switch eliminates the need to record the instruments at fair value, and instead allows banks and other companies that reclassify financial assets under IAS 39 to carry related gain or loss at amortized cost, unless the asset is impaired.

The altered rule mirrors an existing U.S. standard, FAS 115, allowing financial assets to be reclassified “in rare circumstances.” According to the International Accounting Standards Board, rare circumstances may include the deterioration of the world’s financial markets during the past couple of months.

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Reclassifying assets could be a big boost for banks that hold in their trading books billions of dollars worth of illiquid securities that under fair-value accounting would have had to be written down.

The reason for the rule change, according to the IASB, was twofold. The board wanted to better align IAS 39 with U.S. generally accepted accounting principles, and it also was keen on changing the rule before officials at the European Commission pushed through their own revision that omitted important disclosure provisions.

Along with the reclassification rule, the IASB issued IFRS 7 — a disclosure rule — to make sure that any assets shifted to the “held to maturity” category are highlighted and explained in the financial-statement footnotes. U.S. GAAP also requires proper disclosures for reclassification.

But IAS 39 diverges from its American counterpart in one important way, says the Moody’s report: companies are permitted to retroactively reclassify financial assets at their July 1, 2008, value, in what the credit-rating agency calls a “look-back option.”

The look-back option “allows managements to essentially ‘cherry-pick’ which assets to reclassify and, in some instances, avoid the recognition of markdowns on assets that declined in value since that date,” notes senior accounting analyst Wallace Enman, a report co-author. Moody’s vice president J.F. Tremblay, another co-author, explains that the main difference between FAS 115 and IAS 39 is that the American standard requires companies to price the reclassified assets on the day the decision is made.

Moody’s laments the IASB change, saying that in some important respects IAS 39 was a better standard than FAS 115. “We believed that IAS 39 was moderately stronger regarding this particular issue, because no transfers were allowed, whereas under GAAP transfers were allowed in infrequent circumstances,” Enman tells He explains that allowing companies to move assets between categories “can potentially inhibit comparability and consistency.” In fact, Moody’s would rather see investment banks marking assets to market through the profit-and-loss statement, “as this treatment better matches the business model of the banks,” asserts Enman.

He points out that allowing the reclassification in “rare circumstances” is a relatively minor concern compared with allowing the retroactive pricing. “Had it not been for the look-back option, this would likely not have been a comment-worthy issue,” posits Enman.

To be sure, the retroactive pricing permits banks to “opportunistically” select assets “based on their performance during the most difficult period of the financial turmoil,” argues Tremblay. He reckons that under the IAS 39 rewrite, banks can probably avoid significant charges to equity — and possibly earnings — that would have been required under the original accounting treatment.

Banks that report under international financial reporting standards had until November 1 to commit to using the look-back option, which means the results of the rule change will appear in the third and fourth quarters, surmises Enman. Indeed, some of the impacts can already be seen.

In its report, Moody’s cites several financial institutions that used the look-back option, including Germany’s Deutsche Bank and Commerzbank, and the U.K.’s Royal Bank of Scotland, HSBC, Lloyds TSB, and HBOS. In Deutsche Bank’s third-quarter results, Germany’s largest bank applied the option to $32 billion of assets, on which it otherwise would have had to take more than $1 billion worth of markdowns.

Although choosing the look-back option did not affect the bank’s credit rating, notes the report, “Deutsche Bank’s 3Q results would have been more comparable to the results of other wholesale investment banks which did not use the look-back option if it had recognized the markdowns on these assets in the current period.”

In another example, the Royal Bank of Scotland reclassified some trading assets to avoid a $1.5 billion write-down in the third quarter. Of that amount, only $870 million was charged to equity through an “available for sale” reserve. Again, there was no immediate rating impact, but without shifting the assets, the bank’s results would have been more comparable to like banks that did not use the look-back.

As the results of the rule change trickle out, the IASB insists the revision was necessary, despite being criticized for bypassing due process in an effort to push out the amended version. In testimony before a Parliamentary treasury committee last week, IASB chairman David Tweedie said 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 the IASB faced a standard-setting dilemma that he hoped he would never encounter again — “a blunt threat to blow the organization away that came very, very rapidly.”

For its part, the European Commission was calling for quick action to avoid “any distortion of treatment between U.S. and European banks due to a difference in accounting rules,” according to an October 7 statement released by the group.

The Moody’s report acknowledges that the IASB disclosure rules went a long way to strengthen the revised rule. “Fortunately, the IASB also required disclosure with respect to reclassification that will enable investors to understand the impact” of the rule change on current and future financial statements, says the report. “The disclosures should facilitate ‘topside’ adjustments by investors who feel that the opportunistic use of the IAS 39 amendment is inappropriate given a bank’s particular business model,” it concluded.