Accounting: Beast within

One of the biggest battles being fought amid the financial crisis is over the
role of fair value. On one side, the banks have been consistently lobbying
governments to remove or suspend fair value, while an alliance of standard
setters, investor groups and the accountancy profession at large has
consistently defended the accounting practice.

Bankers think fair value is responsible for a spiral of doom that has seen
assets that still carry intrinsic value being written off, the casualty of
theoretical pricing models irrelevant to real financial markets. But those in
favour of fair value say what the market needs now is more, not less, relevant
information, disclosure and transparency, and that fair value rules provide
this. Either way, it is clear there is more pain in store for the financial
system ­ US Treasury secretary Hank Paulson has said as much, predicting more US
financial institutions would fail despite the $700bn bailout. So, the sooner
investors can start feeling the nadir has been reached, the sooner market
confidence can be rebuilt, and the sooner the volatility and price crashes that
have characterised autumn 2008 could recede.

Accounting standard setters across the globe seem determined to hold their
nerve while also being prepared to alter their course slightly. This financial
crisis has been a stern test for politicians and bankers alike, but the standard
setters are in the firing line as never before. In pre-crunch days, the plan to
create a global system of accounting standards looked like a nice-to-have part
of the previously inexorable move to open up access to capital markets across
the world. With those markets in tatters and beset by mistrust, this objective
now seems naïve.

Despite dysfunctional markets, crippling controversy and endless
finger-of-blame-pointing, there is crucial work to be done by the accountancy
profession now. The 2008 year-end audits of financial institutions will be vital
steps towards restoring confidence. That work is starting now and both client
and auditor will need to be certain of the rules. The latter will need nerves of
steel to exercise judgement and stand up to clients. The International Auditing
and Assurance Standards Board has released additional guidance to help them deal
with fair value auditing at this trying time, not least in the area of
accounting estimates at times of market uncertainty.

While that audit process starts, International Accounting Standards Board
trustees are attempting to convince politicians that they are conscious of their
responsibilities as part of the global financial infrastructure. They are keenly
aware of the damage that may be caused to standard setting in the long term by
the accusation that sticking to a theoretical basis of accounting has either
caused, or is prolonging, the financial crisis. They need to prove the
accusation unfounded.

One way to do this may be to employ pragmatism to defuse the row. Through its
discussions and working parties with banks over fair value, the IASB has tried
to prove it is taking part in the response to the credit crisis and that it is
prepared to change, remove or even suspend accounting rules if it is clear there
is good cause. However, the pressure to alter unpopular or misunderstood rules
must be balanced with the IASB’s responsibility to ensure there is no loss of
confidence in the actual numbers that are reported: there is a key distinction
between not liking the numbers that a company presents and not believing them.
The idea following the collapse of Enron that finance professionals were part of
a conspiracy to deceive engulfed the accountancy profession, including the
standard setters. No such accusation has yet been made amid this latest crisis
and the profession is working hard to ensure it stays that way.

While there are many unknowns, one of the few statements we can confidently
make is that many individuals, companies, institutions and regulatory
authorities will, in the long run, be fundamentally changed by what is happening
now. The 2008 banking crisis will define the future of standard setting for a
generation just as the 2001 Enron scandal helped define the current one. If
accounting standards are perceived by politicians to have been a contributory
factor, then the process of integrating standards will be halted for years. The
most likely outcome would be some sort of regional standard-setting process. If,
on the other hand, accounting standards are seen to have helped to maintain some
semblance of order amid this collapse, then this most worthy of projects could
emerge with strengthened raison d’être and enhanced authority. That verdict
could come with the study the Securities and Exchange Commission is currently
working on at the behest of the US Congress.

While the present crisis has focused attention on fair value as never before,
the irony for finance directors who have worked in the accountancy profession
for years is that this is an argument as old as the hills. Is it best to record
assets at their cost, or at their present value? A simple question throttled by
the complexity of modern financial instruments and market meltdown. However we
emerge from the maelstrom, that fundamental argument is unlikely to go away.