Let's look at two everyday situations.
In one, a bank lends money to someone to buy a house or to start a new business. In the second, a company raises debt financing to finance a new investment.
At first glance, these two situations seem pretty common and standard. Consequently, the general public could think that the accounting for these situations should be pretty uncontroversial and straightforward.
However, anyone who is familiar with recent accounting debates is aware that this is far from being the case. These are two of the most controversial items when the issue of accounting for financial instruments is examined. Moreover, they are at the heart of the conflicting areas of the convergence process put in place by the Financial Accounting Standards Board and the International Accounting Standards Board, which is due to be completed by 2011.
Two official documents have recently been released on the subject. In November 2009, the IASB issued International Financial Reporting Standard 9, Financial Instruments, the new international standard on financial instruments, which established the new rules to classify and account for financial assets. For financial liabilities, the old IAS 39, Financial Instruments: Recognition and Measurement, is still the valid standard. On the other side of the Atlantic, in May, FASB issued an exposure draft on Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities.
These documents contain important areas of disagreement on how to account for financial instruments. In particular, the two documents openly disagree in prescribing how to account for the situations described above.
THE CRISIS AND FAIR VALUE
Accounting for financial instruments has always been controversial. IAS 32 and IAS 39 were already the most controversial standards in the debate that preceded the official endorsements of International Accounting Standards by the European Union in 2005.
However, the financial crisis that began in 2007 further fueled the debate. At its heart lies the question of whether we want to account for financial instruments at historical cost or fair value. Many commentators have argued that the impact of the financial crisis on the markets was aggravated by the use of fair value accounting.
Was this the case?
On a theoretical basis, the argument can be solidly defended. An article by Guillaume Plantin of the London Business School, Haresh Sapra of the Booth School of Business, and Hyun Song Shin of Princeton University, published in the Journal of Accounting Research in 2008, has been frequently quoted to advocate this argument. In that article, the authors model a market where trading returns are also determined based, at least partially, on the behavior of the rest of the market and not only on the intrinsic feature of the asset traded.
In such a setting, fair value accounting may lead to high inefficiencies because of a sort of snowball effect that creates artificial volatility. This is true in particular when the assets traded are senior, illiquid and long-lived - three features shared by many of the so-called toxic assets involved in the crisis. More generally, fair value accounting, by creating a feedback-loop effect from the market price to the accounting system, can induce fire sales of assets that again affect the market price. The final consequence is a vicious circle that can potentially amplify any initially small outside shock to prices.
From an empirical point of view, it has been difficult to sustain this theoretical argument. Christian Leuz of the Booth School of Business and Christian Laux of Goethe-University Frankfurt provide a thorough analysis of the actual working of fair value accounting rules in the U.S. to provide evidence against this idea. They show that most of the assets that were accounted at fair value by banks before and after the start of the crisis were actually so-called Level 3 fair value assets. This means that their valuations were isolated from the behavior of the market prices and were conducted by using an internal model. They also provide a comprehensive review of other academic studies that question the empirical relevance of the theoretical vicious circle argument.
However, the debate about accounting for financial instruments has certainly played an important role in the drafting of the two recent regulatory documents.
ACCOUNTING AND FINANCIAL DECISION-MAKING
A related aspect of the debate has to do with the question of whether accounting regimes are "neutral" or have the power to influence the investment decisions of financial institutions. This question was addressed in a recent theoretical paper that I developed together with Silviu Glavan of the University of Navarra. We show that if accounting numbers are used as the contractual basis to distribute returns among shareholders, then the portfolio chosen by that financial institution is determined by the adopted accounting regime.
In particular, fair value induces a more conservative (less risky) portfolio choice than historical cost accounting. Is this good or bad? It depends on the ultimate objective of the regulators. If the aim is to reduce the level of risk in the system, then this is a desirable outcome.
However, in terms of consumption smoothing over time (an important aspect of the role played by the financial institutions in the system), the fair value outcome can be more inefficient than the historical cost outcome.
From an empirical point of view, again, it is difficult to establish a conclusive result. However, we can use Europe as a test. We can interpret the shift in 2005 from previous national standards to IFRS as a move towards a more extensive use of fair value. Looking at the resistance voiced by financial institutions before IFRS adoption in Europe, that seems to be how it was perceived in the financial world.
We studied a sample of European banks and analyzed the composition of their portfolios before and after 2005 and found preliminary evidence in favor of our theoretical predictions: The proportion of risky assets diminished after the adoption of IFRS.
In summary, academic research on accounting for financial instruments gives us a couple of insights.
First, the choice of the accounting regime for financial instruments may have real effects, but they seem to be more evident at the micro level of portfolio choice than at the macro level of the overall stability of financial markets. In other words, different accounting regimes may affect the composition of the investment choices made in the markets, but they are less likely to play an active role in the possible destabilization of the markets.
Second, long-term debt-type instruments may play a crucial role in determining the effects of different accounting regimes in the economy
Professor Marco Trombetta is vice dean of research at IE Business School in Madrid, Spain.
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