(First of four parts)
There is a view, especially among the non-accountants, that accounting should never be the driver of economic activity nor should it determine business decisions. For much of its existence, accounting has been relegated to the role of merely being the “language of business”, a communication tool that should only “reflect economic reality” but not create it. Standard-setting bodies such as the International Accounting Standards Board (IASB) for International Financial Reporting Standards (IFRS) and the Financial Accounting Standards Board (FASB) for Generally Accepted Accounting Principles in the United States and most Northern American countries (US GAAP) have been fully cognizant of accounting’s place in modern financial markets and have responded by introducing new accounting standards or revising existing ones to better “reflect economic reality.”
During the incubation stage of IFRS and the massive wave of improvements made to US GAAP, the standard setters found no other much needed and overwhelming change than the adoption of fair value accounting. What’s a better way to reflect economic reality other than to use the prevailing fair market values in reporting an entity’s financial condition? While the IASB and FASB retained historical cost as the overall benchmark measurement basis, fair value accounting took on a more dominant role, particularly in the case of financial instruments (which comprise mostly the balance sheet of banks and similar institutions). Under IFRS, quoted financial assets are always carried at their fair values, unless the entity has both the positive intent and ability to hold these assets until maturity. As will be explained later, these are very difficult requirements.
In much of Europe and Asia, IFRS and subsequent improvements thereto were met with so much “enthusiasm” that countries lined up for their adoption. Apparently, the Philippines have gone well ahead of most of its neighboring countries and even some European countries by fully adopting IFRS-based standards in 2005. In the years leading to the global financial crisis, not too many business leaders asked this question — “how do we account for this transaction under the new accounting standards?” The deal makers didn’t care. Accounting has been thought of to come after the transaction, not before it, and normally involves only “those back office guys.” Apparently, since the new accounting standards reported nothing but good news, nobody complained at that time.
All these kindhearted reaction and frenzy quickly evaporated into thin air as the most horrifying financial crisis since the Great Depression in the 1930s gripped to submission, not only the US economy, but the rest of the world. As stock and asset prices spiraled into a free fall, the business and investment sectors are clamoring for heads to roll — most notably that of fair value accounting. A lot of prominent regulators and government officials have joined the foray in putting a stop to the bloodbath that has been widely blamed on fair value accounting. Former US Federal Deposit Insurance Corporation Chairman William Isaac was unequivocal about the ill effects of fair value accounting and why it should be blamed for much of the crisis. House Financial Services Committee Chairman Barney Frank said in March 2008 that the problem is that “mark-to-market accounting is dragging down financial institutions and the US economy.” Chief economist Brian S. Wesbury and colleague Bob Stein at First Trust Portfolios of Chicago commented that “it is true that the root of this crisis is bad mortgage loans, but probably 70 percent of the real crisis that we face today is caused by mark-to-market accounting in an illiquid market.
What’s most fascinating is that the Treasury is selling its plan as a way to put a bottom in mortgage pool prices, tipping its hat to the problem of mark-to-market accounting without acknowledging it. It is a real shame that there is so little discussion of this reality.” The messenger of economic reality may have just become reality itself — albeit sad reality.
Reclassification
In the Philippines, fair value accounting is not short of critics. While not much negative material has been publicized about the reactions of various industries to fair value accounting (probably because the media have focused too much attention on politics and showbiz), aversion to it can be seen from the number of banks and similar financial institutions which retroactively reclassified their financial assets previously marked to market through profit or loss or directly through equity to a category that allows the use of amortized cost, thereby avoiding huge unrealized losses and diminution of their capital.
The reclassification was allowed by the Philippine SEC and the Bangko Sentral ng Pilipinas based on the recent Amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures made effective by the IASB on October 13, 2008. The Amendments allowed the reclassification of debt securities carried at fair value to categories using amortized cost under “rare circumstances.” The global financial crisis, which has adversely affected even the local prices of debt securities, was considered by Philippine regulators and standard setters as a “rare circumstance” within the purview of the Amendments. The locally adopted Amendments allowed Philippine banks to retroactively book reclassification entries to any date on or after July 1, 2008. However, any reclassification on or after November 15, 2008 cannot be applied retrospectively. Most banks viewed this as an opportunity to reduce previously recognized MTM losses on their significant holdings of securities and preserve their regulatory capital. The beauty of the reclassification lies in the fact that the reclassified securities are protected from any further deterioration in prices because these are now carried at amortized cost, subject only to impairment and not to marking to market (which is bearable for most entities since impairment ignores any temporary decline in the value of the securities).
While the IASB attributes the adoption of the reclassification window to its recent advocacy of IFRS and US GAAP convergence (this option was already permitted under US GAAP), it can be seen that the IASB may have yielded to the immense pressure not only from various business groups and industry sectors in countries over which it has jurisdiction, but also from their governments and regulators which have become increasingly critical of fair value accounting. For instance, EU leaders, finance ministers through the ECOFIN Council, and the Financial Stability Forum, among others, wanted to ensure that “European financial institutions are not disadvantaged vis-à-vis their international competitors in terms of accounting rules and of their interpretation.”
Sir David Tweedie, Chairman of the IASB, commented on the IASB’s reaction to the clamor to make changes to IFRS to address the distressed market conditions: “In addressing the rare circumstances of the current credit crisis, the IASB is committed to taking urgent action to ensure that transparency and confidence are restored to financial markets. The IASB has acted quickly to address the concerns raised by EU leaders and others regarding the issue of reclassification. Our response is consistent with the request made by European leaders and finance ministers; it is important that these amendments are permitted for use rapidly and without modification.”
(Paul D. Causon is a Partner for Audit Services of Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email manila@kpmg.com.ph or pcauson@kpmg.com).