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Accounting: Seconds out

The long-simmering row between the international accounting standard setters
and the world’s leading banks appears to have ended in a victory for the former.
But has the International Accounting Standards Board won the war, or just one
small battle?

The grumblings of the banking industry over fair value came to a head in late
spring. The Institute of International Finance ­ faced with members
haemorrhaging huge writedowns stemming from the credit crisis ­ proposed
scrapping the IASB’s fair value policies in favour of valuing illiquid assets
using historical, rather than market prices.

It was the clearest possible call for a change to accounting rules which
forced the banking industry to mark-to-market even when markets are illiquid.
The result has been billions written off banks’ balance sheets in the past few
months.

If the banking industry was hoping to get a sympathetic hearing it was sadly
mistaken. Too many people saw the banking crisis as one of its own making and
one which now threatens to drag the world into a recession. The idea they could
walk away from well-established disclosure rules appeared to be a non-starter.
The industry’s cause was not helped by a well-publicised threat from Goldman
Sachs to walk away from the IIF, after the bank labelled the proposals as “Alice
in Wonderland accounting”.

In a bid to retrieve control, Charles Dallara, IIF’s managing director,
issued a statement that tried to explain the background to his organisation’s
thinking and actions. In October 2007, the IIF established the Committee on
Market Best Practice (CMBP), tasked with looking at the problem of valuing
banking assets.

The CMBP was concerned with the declining availability and quality of market
inputs for valuations and the difficulty of making model assumptions when
underlying economics are changing rapidly.

Following on from the CMBP’s work the IIF said it then engaged in “informal
consultations” involving market participants, central banks, securities and
banking regulators, auditors and accounting standard setters on how to apply
fair value accounting in illiquid conditions.

According to the IIF, one of the key points that emerged from this
consultation is that “fair value accounting remains an essential element of
global capital markets as it fosters transparency, discipline and
accountability.” Such a statement has to be seen as a significant admission that
the banking industry now accepts fair value as the way forward. However, the
acknowledgement does come with one or two caveats. The IIF is keen to maintain
what it calls “latitude” to use mark-to-model approaches where observable market
inputs are not available.

It insists that such latitude has been “embraced by accounting standard
setters.”

Despite this battering, the IIF is holding its corner, demanding from the
IASB further clarification on a number of fronts, such as pricing inputs in
illiquid markets. For some financial instruments it also wants refinements in
valuation methodologies and greater flexibility regarding the transfer of assets
between accounting categories ­ for example, from trading to held to maturity.

While warning that applying new techniques should not undermine the already
fragile confidence of investors at this nervy time, the banking industry has put
forward some tentative ideas on alternative valuation methodologies for illiquid
market conditions. This involves the use of underlying discounted cash flow, a
concept which is already present in existing accounting standards. It also has
called for greater consistency between international accounting standards and US
standards ­ a plea which close reading of international accounting standard
setting would lead you to believe is already on the cards. A final report on
these ideas is expected to be published over the summer.

While the headline call for the repeal of fair value appears to have
retreated, it is significant that the IASB seems to have met all the demands of
the banking industry. Shortly after the IIF issued Dallara’s statement, the IASB
announced it was forming an expert advisory panel to discuss the valuation of
financial instruments in inactive markets. The panel ­ a roll call of the
corporate great and good from the banking, accounting and regulatory worlds,
including Goldman Sachs ­ met privately in June to review valuation techniques
and help the IASB decide if additional guidance is required.

The work of this panel deserves close scrutiny over the coming months. Not
easy if it continues to meet in private. The banking industry, for all its
current problems, remains powerful and influential. It has resource, capability
and capacity. Just because it so publicly lost a row over fair value doesn’t
mean it won’t try again by the back door. In the late 1980s and 1990s the legal
profession in the UK tried to break the power of accounting standard setters in
a struggle over the concept of substance over form. The lawyers eventually lost,
much to the delight of Sir David Tweedie, then in charge of UK standard setting.
Now chairman of the IASB, he will take equal pleasure if he defeats bankers over
fair value. But victory is not yet assured.

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