Accounting: Interference into accounting standards moves up a notch

Bank regulators are nagging accounting standard setters. The proposed level of interference into accounting standards is ramping up. And while the accountancy profession has professed itself keen to play its full part in sorting out the banking crisis, there is still a clear and growing expectation gap between what the financial regulators want the accountants to do and how far they are prepared to go. Accountants are adamant that financial accounts are primarily aimed at investors: bank regulators are dismissive of that purpose and are keen for them to be subsumed into a vigorous prudential regulatory framework.

The latest assault on these lines came from the intellectually rigorous and charmingly persuasive chairman of the Financial Services Authority. And Adair Turner was confident enough of his ground to put his argument at the heart of the accountancy establishment in a speech to the Institute of Chartered Accountants in England and Wales.

One of the arguments bankers are deploying in the ‘it’s not my fault, guv’ analysis is that, if the standards had been better, they would have reined in their behaviour and the crisis would not have come to pass. According to Turner, before the crisis, there was concern among banks at board level about how low their commercial loan loss provisions had to be to comply with accounting standards. This would stand further investigation ­ but it does not seem to be a point that has been brought out clearly to date.

The argument of regulators is that the standard induced pro-cyclicality in credit provision and pricing. Prudential regulators say this cannot happen again so standards must reflect the belief that banks are different because, unlike any other sector, bank failures topple the world economy into recession.

The financial sector is unique, argues Turner, because it deals in financial instruments which link the present to the future: they have value in markets which are ‘inherently intertemporal’. He explains that, in contrast to say, bananas, a loan or equity contract has value today determined by future events and by opportunities to trade future for present value by way of other financial instruments.
The resulting inherent uncertainty over how to value long-term and contingent assets and liabilities introduces specific problems and complexities into the regulation and the accounting of all financial intuitions.

Banks have two other peculiar characteristics which could influence the accounting regime, however. First, the maturity transformation function in lending at longer-term than their liabilities. Second, extending credit to the real economy. Swings in the credit supply matter far more to the macro economy than over supply and contraction in bananas.

If you accept banks are different, can that difference be dealt with through a prudential approach, or does accounting have a part to play ­ especially in what Turner has identified as the two most contentious areas, the treatment of loan losses and the valuation of financial instruments? Yes, says Turner, because the present accounting approach makes the problem worse.

He says the way accounting standards should be distorted to allow the banking book to reflect a more forward-looking approach to loans losses and second, much more contentiously, to limit the use of fair value accounting in the income statement to highly liquid instruments.

So where should the balance be struck between other users of banks’ financial statement and the prudential regulators? It is tempting to be as helpful as possible to the major players and it would be possible for the accounting standard setters to convince themselves that what was good for the prudential regulators was, by definition, good for all.

A few years ago, standard setters may well have crumbled in the face of the persistent regulatory attack. But the global approach of the last few years has made standard setters a more cohesive and tougher bunch. As Bob Herz, chairman of the Financial Accounting Standards Board puts it, the feeling among standard setters remains that handcuffing regulators to Generally Accepted Accounting Principles or distorting them to always fit the needs of regulators is inconsistent with the different roles of financial reporting and prudential regulation.

Where the needs of regulators deviate from the perceived information requirement of investors, the reporting to investors should not be subordinated. To do so degrades the financial information available to investors and reduces public trust and confidence in capital markets.

Standard setters should continue to work with regulators on specific areas such as extra disclosure and possible recasting of information, but fundamental issues over measurement or more carve outs are off limits. Turner’s argument is already familiar; perhaps regulators believe if they repeat it often enough they will win the day. That, in the long run, would be a retrograde step. The accounting profession needs to politely but firmly make it clear to Lord Turner and his colleagues: nice try on accounting standards, sunshine ­ but we’re not giving in.

Peter Williams is a chartered accountant and freelance journalist