IASB looks for the simple life

If timing is all, the
International
Accounting Standards Board has got it made. With the world’s
financial markets, regulators and governments pole-axed by the credit crunch, up
pipes the IASB with the suggestion to reduce the complexity crippling those
markets. It is a bit like asking a man who has just crawled out of the desert
whether he fancies a sip of water.

In what must rank as one of the best understatements in the history of
standard setting, the IASB admits that “the existing requirements for the
reporting of financial instruments are widely regarded as difficult to
understand, interpret and apply”.

Once and for all
So in a bid to reduce the complexity, the IASB has launched a discussion paper.
In the spirit of its International Financial Reporting Standards’ raison d’être,
the key argument in the paper examines a possible long-term approach that would
use one measurement method for all types of financial instruments in the scope
of a financial instruments standard.

“IAS 39, which the IASB inherited from its predecessor body, is far too
complex,” IASB chairman Sir David Tweedie says. “We are determined to simplify
and improve IAS 39 by creating a principles-based standard. Those who believe in
reducing complexity in accounting standards have now the opportunity to shape
the way ahead.”

The IASB is interested to hear from the market on possible alternative ways
to develop new standards for principles-based reporting that could minimise the
complexity inherent in financial instruments such as derivatives, and their
application.

One of the main causes of the complexity of financial instruments is the
number of ways to measure them and the rules associated with this. The US
Securities and Exchange Commission’s project committee on improving financial
reporting says this complexity impacts users, who fail to understand the
economic substance of the transactions, and hence the overall financial position
of the underlying company. It also says this affects finance directors and their
colleagues, who struggle to ensure that generally accepted accounting principles
are applied and others – notably regulators and auditors – who struggle to do
their jobs.

Stating the obvious
Of course, one of the reasons why financial instruments are complex is because
they are, er, complex. One amusing aftermath of the credit crunch has been the
outpouring of honesty – the admission that few of us understand these
instruments.

The term ‘financial instrument’ encompasses a variety of instruments, from
the relatively straightforward to the obscure. In the light of current events,
it is clear that credit risk may make even instruments with simple terms
difficult to analyse.

Think you understand
Even if you think you understand a financial instrument, there is no guarantee
you would understand the accounting treatment. The current accounting standards
contain many alternatives or exceptions that often obscure the underlying
principles.

These alternatives result in a host of accounting rules. One example is how
financial instruments should be measured, and when and how financial assets
measured using a cost-based method should be impaired. The IASB has named 17
ways in which financial instruments as assets can be measured, and says its list
is not comprehensive.

Regulators across the globe have been saying that one of the lessons to be
learned from the credit crunch is the need for transparency, governance and
accountability. This links into the presentation and disclosure of financial
instruments.

Disclosure is critical, says the IASB’s discussion paper, although the paper
is not about presentation and disclosure. Why critical? Because no single
number, regardless of the measurement attribute used, provides all the
information users need to understand financial instruments – such as the purpose
for which the company purchased the instrument. Clear presentation is also
critical in helping understand the effects of changes in measurements.

Of most interest is how the IASB sees possible long-term solutions for
reducing measurement-related complexity. Critics of fair value and of the IASB’s
perceived love affair with fair value will note with concern that the discussion
paper says fair value “seems to be the only measurement attribute that provides
relevant information for all types of financial instruments”.

Fair value is an example of current value. The definition of fair value
itself is crucial and the IASB has an ongoing project to establish general
principles in determining fair value. The criticism of fair value measurement
has been magnified by the market turmoil – volatility of earnings arising from
changes in fair values and presentation of unrealised gains and losses in
earnings.

But despite the drawback, it seems unimaginable that accounting for financial
instruments won’t be under a fair value regime. Ultimately, the IASB sticks to
its ideal of measuring in the same way all types of financial instruments within
the scope of a standard for financial instruments.
A single measurement attribute for all types of financial instruments would
facilitate comparisons between entities and between accounting periods for the
same business. If that can be achieved, it would be welcomed by users, preparers
and regulators. The credit crunch may have opened minds to the possibility of
change, but it still won’t make coming up with an accounting standard for
financial instruments that actually works well any less of a brain-ache.

The IASB invites comments on the discussion paper by 19 September 2008.