How much of the current financial crisis is a product of accounting standards? How can standards contribute to a timely recovery? What needs to happen to put the world's economies on an even keel and how radical should the changes be?
The Financial Crisis Advisory Group, a joint international effort by the Financial Accounting Standards Board and the International Accounting Standards Board, has been grappling with these and similarly fundamental questions in hopes of advising the standard-setters on how to react to the financial crisis.
FASB project manager Jeffrey Mechanick said that the FCAG is working against a perceived loss of confidence in financial reporting. "The group is looking into areas that they believe the boards need to focus their attention on to do their part to help restore investor confidence in the market," he said. "So making major global improvements, especially in the area of financial instruments, is an important part of making lasting change."
The group is made up of former finance ministers, national bank directors, and top-level banking, insurance and securities regulators, so discussions have drifted between the specifics of accounting standards and the potential (and failures) of regulation.
Searching for an even broader base of opinions, the FCAG issued a document asking constituents to offer comments on a variety of questions. The answers returned in an even wider variety, though few, Mechanick said, were especially surprising.
The respondents generally agreed on one thing: There's definitely a problem. The mechanisms implemented to prevent and foresee the problem have failed, and urgent, or even radical action, is needed.
While some constituent comment letters laid the blame on poor management, bad loans and greed, rather than on reporting standards, there was much comment and disagreement on the proper treatment of financial instruments, off-balance-sheet items, and the role of mark-to-market accounting.
A majority of the comments held that mark-to-market accounting only played a positive role, if any, in laying bare the reality of the crisis. They saw the solution not in different accounting rules, but in changes to the market infrastructure.
A large minority, however, held that mark-to-market accounting had helped cause the financial crisis because current market prices reflect speculation, which few companies engage in, though their books are subject to its whims. Because of accounting rules, companies had to assume that prices in inactive markets were following prices in active markets.
Among other causes of the crisis that constituents identified were the risks associated with off-balance-sheet vehicles and hedge accounting.
One big question was whether emergency situations justified shortcuts in the writing of responsive standards. Most felt that full due process was preferable, but also agreed that there are likely to be situations that call for urgent change. They acknowledged the need to define "emergency" and to establish appropriate expedited due process procedures.
GET BACK TO BASICS
R. Christopher Whalen, managing director of Institutional Risk Analytics, a Torrance, Calif.-based risk management consultancy, said that the group needs to advise the boards to go back to the basics of cash flow, to simplify accounting, and to acknowledge the impossibility of adequately prescriptive standards.
"The FCAG is an attempt by FASB to be responsive to the collapse of most of the assumptions behind financial economics," Whalen said. "If you have a problem with market structure or with market finance, go fix the problem, don't change the accounting rule to try to fix the problem indirectly."
Whalen praised the group for probing into problems with financial instrument valuation. He urged them to consider the difference between value and price and to compare the "real economy," which is where most accounting standards apply, and the "surreal financial economy" that standards-setters are now trying to write rules for.
The FCAG plans to draw up a list of recommendations for the accounting standards boards and issue them no later then July, at which point the group will become inactive. FASB's Mechanick said that the group may reconvene six months later to review how the boards have reacted and consider whether they can be of further help.
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