Regulation - January 20, 2009

The changes to accounting standards are not a solution to the crisis - an interview with Philippe Foulquier

Philippe Foulquier, Professor of Finance, Director of the EDHEC Financial Analysis and Accounting Research Centre

You have just published a position paper on the debate around fair value and the changes to IAS 39. Could you tell us a bit about the context?

With the elaboration of measures to respond to the current financial crisis, the extent to which fair value accounting can be blamed for the intensification of the slump has been widely debated.

As the crisis worsened over the summer of 2008, there were more and more government interventions and the ranks of the critics of fair value grew apace. The critics focus on its pro-cyclical nature and the insufficient information provided by the standard-setting bodies on the means of valuing financial instruments in inactive markets.

On 30 September 2008, the SEC and the FASB issued additional guidelines for valuing assets in inactive markets. On 3 October, under pressure from the European Commission, which was threatening another carve out, the IASB prepared amendments to IAS 39 and IFRS 7, the intention of these amendments being to reduce divergences between US GAAP and IFRS when it comes to reclassifying assets. So as not to hold up the adoption of these amendments by the European Community, the trustees of the IASC Foundation went so far as to announce, on 9 October, that they would agree to suspend the usual due process (a first!). This permitted publication of the amendments by the IASB on 13 October, their approval the following day by the EFRAG (European Financial Reporting Advisory Group), and their adoption by the European Commission on 16 October.

Have these amendments met their ultimate objective, which is to restore investor confidence? Are they likely to reduce pro-cyclicality?

The pro-cyclical nature of accounting had already been denounced in the 2000-2003 financial crisis, as it had forced insurers to sell a part of their stock portfolios to comply with solvency requirements. At the time, in most European countries, the accounts were prepared at historical cost.

Besides, going back to historical cost, as is now possible on certain conditions, detracts from the role of accounting as a source of information. These amendments increase smoothing possibilities as well as the possibilities for discretionary management of the accounts. This is likely to hide companiesí real risk exposures and lead to mistrust in the financial community. As it happens, one wonders about the quality of the information that will be supplied by 2008 financial statements when they show in the balance sheets an amount for debt securities that is the same as it was in July 2008.

We have shown in our position paper that a debate that ignores the real issues has led to counterproductive amendments to IAS 39.

In what way does the debate on the relevance of fair value ignore the real issues?

Just as IFRS is becoming the global benchmark for accounting systems, the current crisis is serving as a testing grounds for the suitability of both the IASBís conceptual framework and the choices made in terms of accounting treatments. The debate ignores the real issues because it fails to make allowances for the role of accounting: the informative role of accounting should not be confused with the prudential role of Basel rules for capital.

The role of accounting is to provide as reliable description as possible of the net assets of a company, in the environment prevailing at the moment of the statement of the accounts. It cannot replace financial and prudential analysis. Accounting is but one of the means of studying the solvency of a financial institution.

Itís not the job of accounting to decide if the weakening of balance sheets should lead to a call for additional capital or a curtailment of business. That is the role of the regulator.

Some debt securities have been created to meet the demands of particular investors, and by design there is no secondary market for them. In the absence of active markets, it is worth asking the following question: how is it possible that putting these products in the trading book is allowed (by accounting standards and most of all by regulators)? Banks were given an incentive to make this choice by capital requirements that are lower in this category than they are in the banking book. The calling into question of fair value is thus altogether out of place: the problems caused by the opportunistic gaming of prudential rules and the relevance of fair value accounting are confused. The opportunistic gaming of prudential regulations with respect to the classification of some bank portfolios is no justification for calling into question fair value accounting.

Finally, that the measure of fair value and the choice of accounting treatments adopted by the IASB are highly debatable and need to undergo great reform, as EDHEC has been showing since 2006, doesnít necessarily mean that fair value accounting must be rejected. It is our belief fair value plays a role as a source of information better than any other system would and that it has permitted a swifter gauging of the depth of the crisis.

About Philippe Foulquier

Professor Philippe Foulquier began his career in 1990 in the Scientific Department of the French insurer UAP, as an internal consultant, notably in Asset Liability Management. He left UAP in 1996 and spent 10 years as a sell-side financial analyst in brokerage firms. He was head of the Pan-European insurance sector at Credit Lyonnais Securities Europe, at Enskilda in 2000 (nį1 Scandinavian broker) and at Exane BNP in 2003. During this time, he carried out several IPO and international M&A operations. He has been ranked top insurance sector financial analyst in the Extel/Thomson Financial and Agefi international surveys. He joined EDHEC in 2005 to teach financial analysis and accounting. He is Director of the EDHEC Financial Analysis and Accounting Research Centre. He is also actively involved in consulting in both IFRS-Solvency II and corporate valuation issues.

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