Accounting standards under attack

Standard-setters should defuse the argument by making clear that their job is not to regulate banks but to force them to reveal information. The banks, their capital-adequacy regulators and politicians seem to dream of a single, grown-up version of the truth, which enhances financial stability. Investors and accountants, however, think all valuations are subjective, doubt managers’ motives and judge that market prices are the least-bad option. They are right. A bank’s solvency is a matter of judgment for its regulators and for investors, not whatever a piece of paper signed by its auditors says it is. Accounts can inform that decision, but not make it.

The Economist.com, Messenger, shot (16/04/2009)

The Economist on April 16th 2009 has a piece (Messenger, shot) on banks and accounting standards in favour of the accounting standard-setters' independence and alerts that accounting rules are under attack by politicians and banks.

The centre of the problem is the 'mark-to-market' technique of pricing the fair value of the financial elements: assets and liabilities, income and expenses and the resulting equities.

Banks and other companies have been benefiting from this 'mark-to-market' pricing technique while the global economy was on the upbeat side of the credit cycle, since cheap credit allowed eager buyers and happy sellers inflate the asset price bubble while keeping the liabilities' side easy to service and re-fund if necessary. Thus banks and many other companies have been able to post ever-increasing profits in the past years since the dot-com crash in 2002.

Alas, what goes around comes around and bankers now face the problem of having to report big losses when that very same 'mark-to-market' pricing technique forces them to price down their assets uncovering many ill-fated investments and inefficiencies in many revenue models.

Now bankers and their purchased friends the politicians are whining that this 'mark-to-market' valuing of their assets is not fair because "market prices overstate losses, because they largely reflect the temporary illiquidity of markets, not the likely extent of bad debts." Well, indeed they are right, but they never complained when the market prices overstated profits and asset prices when they largely reflected the temporary cheap access to credit of markets!!

The Economist advises: "To get the system working again, losses must be recognised and dealt with. Standard-setters should defuse the argument by making clear that their job is not to regulate banks but to force them to reveal information. Banks’ regulators have to take responsibility. The FASB and IASB can help regulators to create whatever balance-sheet they want. But in doing so they must not compromise their duty to investors." I fully agree with this advice.

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As an auditor and trainee accountant, I learnt that the main objective of the financial reporting is the provision of true and fair information about the status and performance of the company. And central to this is the valuing of the financial elements at a fair value, defined by the International Accounting Standards Board as the value of an asset or liability in an arm's length transaction between unrelated willing and knowledgeable parties.

There is an interesting debate around the 'mark-to-market' pricing technique as a fair value method to be used for financial reporting. I will comment it in future posts, but in the end it comes down to the two school of thoughts on markets: the efficient markets hypothesis and the behavioural markets hypothesis.

This is one of the reasons why I sign with my typical:

Love and freedom.