Tuesday, July 28, 2009

The Economist on Politics and Accounting

Whenever The Economist writes about accounting, it is a good read. Here is a recent article.

Reforming finance: Accounting standards

Marks and sparks--Accountants draw up new rules for financial firms. The latest in our series

REWRITING laws in a hurry is never a great idea, but that is exactly what the International Accounting Standards Board (IASB), which sets rules for beancounters outside America, has been forced to do. One of the casualties of the credit crisis has been the idea of fair-value accounting—the practice of valuing financial assets, mainly securities, at market prices or the closest thing there is to them. The idea that accounting caused the crisis is specious, but Europe’s politicians, egged on by banks that took huge write-downs when market prices swooned, have nonetheless lashed out. The message has been pretty clear: make banks’ balance-sheets look better, or else. America’s rulemaker, the Financial Accounting Standards Board (FASB), has been excoriated by Congress and is back at the drawing-board too.

Unpleasant though the political mood music is, change is needed. The existing standards are a shambles, a patchwork of inherited rules riddled with escape clauses. They mix mark-to-market values with the more traditional practice of carrying assets at their cost and impairing them only when managers and auditors think fit. There are also several different ways of recognising losses. The result is that the balance-sheets of different banks are not always directly comparable.

IASB’s proposed solution, announced on July 14th, is to put all financial assets into two buckets. Loans and securities which share the characteristics of loans—in other words, assets that derive their value only from interest and repayment of principal—will be held at cost, provided banks can show they will hold them for the long term. Everything else, including equities, derivatives and more complicated securities, will be held at fair value. Companies will be allowed to start applying the new rules from the end of this year, and will be obliged to by 2012.

This is far simpler than the existing system. But according to one bank’s finance chief, defining the boundary between the two types of assets is likely to prove tricky. For example, IASB is likely to allow only the very top tranches of asset-backed securities to be classified as loans. That could reduce demand for tranches of nearly equivalent risk, as firms become less keen to hold them. Some insurance companies, meanwhile, are reported to be worried about holding all equities at market prices.

Any boundary will inevitably be somewhat arbitrary, however. The end result does look sensible: simple things will be held in more opaque loan books and fiddly things held at market prices. It is hard to judge whether the overall proportion of assets held at fair value will fall, but it seems highly likely. Anything else would result in an outright punch-up with some European governments.

It is this political tension which is the real problem now for standards-setters. Previous battles over accounting for pensions and share options were won in the face of great hostility. It would be hard to engage in such battles now. The best defence against politicking is to continue to merge international and American accounting into a single rulebook governed by an independent body. This is meant to happen over the next few years anyway, but American rulemakers have been dragging their heels. IASB’s pragmatic proposals may make consensus easier to reach.

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