Accounting – Hands off: political pressure will not deter standard setters

Accounting standard setters are trying to face down continuing pressure from politicians to ensure accounting standards contribute to global financial stability. Alongside the main G20 communiqué published in April, an annex, Declaration on strengthening the financial system, states, “We have agreed that accounting standard setters should take action by the end of 2009 (within the framework of the independent accounting standard setting process) to improve involvement of stakeholders, including prudential regulators and emerging markets, through the IASB’s constitutional review.”

The IASB is determinedly relaxed about the call of the world’s leaders to help create stability. But others are equally determined to warn politicians and regulators in more forthright tones about the dangers of muddying the waters over the primary purpose of financial statements. Maybe Paul Boyle feels less restrained now he has announced he will step down as chief executive of the Financial Reporting Council.

A speech given by Boyle as the G20 bandwagon rolled into London delivered a clear warning to politicians not to pervert the use of reports and accounts. While financial statements are designed for various end-users, there are special users – such as tax authorities and financial regulators – with legal powers to compel companies to provide them with the information they require. As Boyle puts it, they can insist on tailor-made suits while most of us have to get by with off-the-peg.

The present financial reporting product, shaped by the application of accounting standards, is unsuitable for raising taxes or determining how prudent a bank should be in its lending practices.

While Boyle acknowledges that politicians have a responsibility to ensure there is an effective system for setting accounting standards, he says the choices as to the most appropriate accounting methods should not be made on political grounds, but rather, by standard setters free of all vested interests, relying on their skills and experience. If the purpose of reports and accounts was to be significantly diverted to a financial stability role, there would be implications for the current use of accounting that would need debating.

Of course, there are good reasons why the IASB can’t be quite as outspoken as financial professionals might wish. Since this current financial crisis emerged, it has had to engage with panicked world leaders working on a list of demands since the previous G20 in Washington in November 2008, as well as dealing with the Americans who have had a mini-crisis over whether to keep on with their ‘roadmap’ to global standards. While the rhetoric may differ, the IASB shares a determination not to let the reporting and recording of regulatory capital be confused with accounting capital.

Accounting standards cannot be allowed to return to a situation of profit and loss smoothing and poor disclosure. That shouldn’t stop regulators from demanding financial institutions should have capital requirements over a level of non-distributable reserves and rules over the size and timings of capital restructurings, such as share buybacks and dividend payments. But that should not be confused with reports and accounts following cookie-jar accounting, when a company uses generous reserves from good years against losses that might be incurred in bad years. If that were to happen, it would be more difficult for all users of financial statements to make meaningful assessments about the performance of the company and the management. As far as the accountancy profession is concerned, smoothing through the cycle is just not on.

However, the question is whether standard setters can fulfill the primary role of reports and accounts – transparent communication of the current financial position – while allowing those reports to be used to calculate and demonstrate prudential capital requirements.

Boyle suggests one course that may answer the concerns of this ménage à trois of politician, regulator and accounting standard setter. Standard setters have been under constant political pressure for the past four years to abandon fair value accounting because it was giving the “wrong” answer, with assets worth more than the market says they are. The irony is, argues Boyle, market prices have indeed been wrong, only the assets are proving to be worth even less than the market first indicated. His answer is to consider whether investors would find it useful to have disclosure of both market and model valuations.

Given the uncertainty around the valuation bases, investors would be able to assess which is the more reliable measurement basis. This could be done, for example, by requiring the disclosure in subsequent years of the difference between the proceeds for assets which have been sold and the market and model valuations at the previous year-end.

Whatever the merits of Boyle’s suggestion, the IASB is quietly confident it can make a contribution. It does have a delicate path to tread. However, there is already too much uncertainty in the global financial system over issues such as ‘toxic’ assets. Increasing uncertainty would be folly. So the key point remains: any attempt to curb accounting transparency must be resisted.