Fair value under pressure
The International Accounting Standards Board has yielded to intense pressure from European Union governments and United States regulators to allow some distressed financial instruments to be reclassified, removing them from the requirement to report at fair value. Many banking and insurance executives have blamed the use of fair value and mark to market valuations for the global financial crisis.
An emergency meeting of the IASB agreed that volatile and distressed financial instruments can, exceptionally, be moved from banks’ trading books to their banking books – provided there is an intention to hold them to maturity or for the long-term. This brings practice under IFRS more closely into line with US Generally Accepted Accounting Practice, addressing the concern of many European bankers and insurers who feel disadvantaged compared to their US counterparts.
Assets held on the banking books will be reported at amortised cost, rather than current market value. However, the baseline for the amortised cost will be current market value, rather than initial cost. The move will therefore have a limited impact on current valuations of banks and insurers, but will mean that future rises and falls in asset values will be reported on a gradualised basis – reducing the future volatility of banks and insurers’ share prices and capital requirements.
The IASB has made clear that it is uncomfortable with the concessions it has made, but felt obliged to agree them. Sir David Tweedie, the IASB chairman, said that it was better that changes were made by accountants than under the direct control of politicians. To help investors and other report users understand the impact of the asset reclassifications on individual banks and insurers, new disclosure requirements have simultaneously been introduced by the IASB, with companies having to report in footnotes which assets have been reclassified.
Banks and insurers will be permitted and not required to reclassify financial instruments. The IASB’s move was unanimously endorsed a day after its emergency meeting by a session of the European Union’s regulators committee. Companies will able to use the IASB’s amended versions of IAS 39 and IFRS 7 for reporting from July this year.
It has been reported that auditors fear that the rule change is likely to make it extremely difficult to approve current year accounts. However, Pauline Wallace, a partner at PricewaterhouseCoopers, said: “I don’t believe that the process of reclassification itself will present specific difficulties for auditors. The challenge will be for companies that choose to reclassify who will need to ensure that they are able to track the reclassified assets in the future in order to meet the extensive disclosure requirements in the amendments.”
Mark to market reviewed
A review of mark to market valuations has been initiated by the US Securities and Exchange Commission. The move was required under the federal government’s emergency legislation designed to rescue the US banking system.
Under the Emergency Economic Stabilization Act, the SEC must complete its mark to market study by the beginning of January. It is required to consider the impact of mark to market valuations on financial institutions’ balance sheets; the role of this in bank failures this year; how mark to market affects financial information for investors; the process by which the Federal Accounting Standards Board develops accounting standards; whether accounting standards should be modified; and what alternatives there are to FAS 157, which implements mark to market valuations in the US.
The study will be led by James Kroeker, deputy chief accountant for accounting at the SEC. Round table discussions involving accountants, standard setters, investors and business leaders will feed into the review.
Lord Turner, the recently appointed chair of the UK’s Financial Services Authority, has said he would support a wider review of the use of mark to market valuations. He added that other priorities for the FSA in the wake of the meltdown in financial markets were re-evaluation of banks’ capital adequacy requirements, more monitoring of financial institutions’ liquidity and looking at systematic assessment of banks’ remuneration policies, to prevent them being based on short-term profit positions that subsequently turn into losses.
Banking regulation tightens
Leaders of the G7 major industrial nations are set to strengthen global banking regulation in response to the crisis in the financial markets. Moves likely to be adopted including an international oversight panel that brings together representatives of the main financial regulators.
A report from the Financial Stability Forum presented to G7 finance ministers and central bank governors recommended a series of steps to tighten and co-ordinate market regulation. These include strengthened prudential oversight of capital, liquidity and risk management, greater transparency in accounts and in asset valuations, reform of credit ratings agencies, more focus on how regulators respond to emerging risks and more robust arrangements for dealing with stress in the financial system.
The FSF’s paper provides additional impetus for reforms being driven by UK prime minister Gordon Brown. The position of Brown amongst international leaders has been signficantly strengthened because the UK government’s reforms have been regarded as a template for action by other major developed nations.
Speaking in Brussels after a meeting of European leaders, Brown said that decisive action was necessary to tackle what he termed the “irresponsibilities and excesses” of the financial system. He added that it was necessary to have rules that provide “international global cooperation to deal with the management of the international financial system, a proper early warning system, proper coordination in crises and of course an agreement that we can work together to keep through macro-economic policy as well as proper supervisory arrangements the world economy moving forward”.
Brown also called for reform of the International Monetary Fund. “So the IMF has got to be rebuilt as fit for purpose for the modern world,” continued Brown, “we need an early warning system for the world economy that can involve the supervisors in different countries, where international or multinational companies work in a whole series of different countries, they themselves are agreeing that instead of having 15 different supervisors meeting separately, that you have a college of supervisors to deal with these issues.”
What was needed, added the British prime minister, was nothing less than a “rebuilding of the financial international architecture” akin to the creation of the IMF, the World Bank and the United Nations after the Second World War. It was an “immediate task” to create modern institutions that are “relevant” today, he said.
Reporting to become clearer
Financial statements will have more coherence and greater disaggregation of figures, under proposals jointly made by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB).
The two standards boards said that the global financial crisis underlined the need for financial reports to be transparent and intelligible – a test that many reports currently fail. Financial statements should be cohesive, in the sense that a reader can follow a flow of information through a succession of different statements.
But figures would be disaggregated, so that it could clearly be seen which activities of an entity generated a profit or a loss. Financial information would be brought together in “reasonably homogenuous groups of items” that would also enable investors to predict future cash flows. Together, the new reporting structure would provide a clearer picture of an entity’s liquidity and financial flexibility, say the standards boards, enabling report users to understand the entity’s capacity to exploit future opportunities, make investments and respond to unexpected events.
Robert Herz, chairman of the US FASB, said: “Providing investors with the most transparent, consistent financial reporting possible is more critical than ever to the efficiency and soundness of our capital markets. By working together to create one common, high quality global standard for financial statement presentation, the boards are aiming to increase the usefulness of financial reports while enhancing their comparability across international capital markets.”
Sir David Tweedie, chairman of the IASB, said that the two boards had opted to build on established practice, rejecting the option of eliminating the ‘net income’ line.
In another initiative – one of a sequence in response to the financial crisis – the IASB has published for comment proposals to improve the information available to investors on the fair value measurements used for financial instruments. The proposals build on suggestions from the Financial Stability Forum, backed by the finance ministers of the G7 group of countries, on how to measure fair values when markets are not active and on the impact on liquidity risk.
FDs expect credit to stay tight
Chief finance officers of UK listed companies are increasingly gloomy about the financial outlook, a Deloitte survey has confirmed. CFOs reported that most of their companies intend to cut staff and capital expenditure.
The impact of the global financial market turmoil is already felt across companies, said the CFOs. Most, even in the non-financial sector, are engaged in reducing debt and restructuring their balance sheets. Nearly all said that credit had become more expensive and harder to obtain. There has been a big increase in the number of companies that are likely to reduce dividends and an even greater interest in moving capacity offshore.
Margaret Ewing, Deloitte partner and vice chairman, commented: “CFOs are preparing for a more prolonged period of distress in credit markets than they had earlier expected, with cost cutting and cash preservation coming to the fore. There is also a growing readiness to contemplate more radical options such as offshoring and dividend cuts, a reflection of the growing intensity of the slowdown. Non financial corporates appear to be following banks in cutting expenditure and strengthening their balance sheets.”
Deloitte reports that while credit availability has fallen, so has demand. It found that more companies intend to reduce gearing than increase it, contrary to all recent experience. It said that this finding was consistent with the results of the most recent Bank for England Credit Conditions Survey, which found that the only source of strong demand for credit came from corporates seeking to restructure their balance sheets.
However, there is a marked increase in interest in mergers and acquisitions, with a recognition that equity prices have become cheap. Almost half of CFOs expect merger and acquisition activity to increase in the near future.
Accountants urged – ‘just say no’
ACCA has opened the debate on where responsibility for the global financial crisis should lie – and says the profession needs to take a hard look at itself.
In a letter to The Guardian, ACCA president Richard Aitken-Davies argued that too often, remuneration was geared to short-term reported profits rather than improvements in cash flow and failed to take into account the risks in the long-term of these profits turning bad. This had happened in some instances because accountants had not “said no enough”. There needed to be a re-evaluation of ethics in business and professionalism, reflecting the fact that “something has gone seriously wrong with corporate governance”.
The theme of strengthening corporate governance has been developed by Steve Priddy, ACCA’s director of technical policy and research, in a discussion contribution to ACCA’s website. He suggested there needs to be a debate about producing an international standard for corporate governance. Questions should also be asked, he said, about whether the drive for non-executive directors has been a factor in the crisis – producing decision-makers who are unable to understand aspects of the technical nature of some businesses, particularly investment banks.
Priddy added that there should also be reconsideration of elements of the Combined Code and the emphasis on attracting non-executives to boards. “As business models become more complex – and nowhere have they become more complex than in the investment banking world – it is claimed that a fresh pair of eyes is vital to the health of the organisation,” explained Priddy. “The problem is that complexity, combined with quantum leaps in computing technology, has made understanding the investment bank business model incomprehensible to all but the most dedicated insider.”
Meanwhile, in a letter to the Financial Times, ACCA’s head of corporate governance and risk management, Paul Moxey, argued that it is not the use of fair value in itself that has driven the financial crisis, but rather the use of capital adequacy rules that as asset valuations fall determine that capital requirements increase. Equally, it is wrong that a bank should report a gain in its profit and loss account because the fair value of a debt declines and the credit worthiness of the bank is reduced. While the purpose of fair value is to improve transparency, in practice the associated accounting standards are not transparent, he argued.
News shorts
Audit committee guidance updated
Audit committees should pay more attention to the risk of their auditor leaving the market, according to the latest guidance from the FRC. Companies’ annual reports should provide more information on how and why auditors were selected, offering guidance on how firms from more than one network might work on an audit.
UK is tax competitive, says OECD
The UK charges less tax than many of its major competitor nations, including France and Germany, according to a survey by the OECD. Total tax revenue in the UK as a percentage of national income is 36.6%, against 43% in France and 43.6% in Germany. But the US charges much less, at 28.3% of GDP. Personal income tax and labour taxes tend to be lower in the UK than competitor nations, but taxes on corporations are higher.
More small firms excused audit
European Union member states will be permitted to excuse micro-businesses from the European Union’s Accounting Directives, internal market commissioner Charlie McCreevy has announced. A report prepared for the Commission found that savings of €5.7bn could be achieved if micro entities were exempted from the accounting framework and did not have to prepare annual accounts. Member states are already permitted to exempt some types of small businesses from the requirements of the Accounting Directives. The EU defines micro-businesses as employing less than 10 staff and a turnover or balance sheet value of less than €2m.
WPP joins tax defectors
The world’s second largest marketing group, WPP, has joined the growing flood of companies relocating their tax domiciles away from London to Dublin, to avoid UK corporation tax possibly being levied on overseas earnings. A new parent company is to be registered in Jersey, tax resident in Ireland and listed in London.
Accounts ‘must show liquidity risks’
The Financial Reporting Council has warned companies they must disclose any risk of having insufficient working capital, even if their profitability is not in doubt. It says that companies must be honest about liquidity risks in the current market conditions.
Balfour Beatty plea bargains
Balfour Beatty has settled a Serious Fraud Office investigation by agreeing to pay £2.25m against a civil recovery order, plus a costs contribution. Action was initiated over a subsidiary company’s failure to keep accurate records on the Bibliotheca Alexandrina construction project in Alexandria. Balfour Beatty says there is no suggestion of any improper commercial advantage accruing to the company or any individual. The SFO decided that no criminal proceedings should be instigated and that the matter could be settled by civil resolution.
Pre-death gift rules tightened
HM Revenue & Customs is to investigate inheritance tax liability more thoroughly, collecting evidence from a variety of sources and is willing to challenge estates much longer after death. It aims to stop estates excluding assets that were given away less than seven years prior to death. Helen Clark of accountants Dixon Wilson says: “By looking at returns of capital gains and other sources of information it will be much easier for the taxman to identify if cash and assets have been gifted away prior to taxpayers’ deaths.”
HMRC buy-to-let crackdown
HMRC is clamping down on buy-to-let landlords, checking whether they have fully declared rental income. From next April, tax officers will have new powers to visit landlords’ homes and inspect records. According to accountancy firm Target, HMRC is preparing for its use of its additional powers by collecting information on landlords with property in the UK or overseas. The firm warns that many landlords who believe they do not need to include information because they are making a loss on the rental of their homes could be affected.
First HMRC CEO
Lesley Strathie has been appointed the first ever chief executive at HM Revenue & Customs. She was previously chief executive of Jobcentre Plus and second permanent secretary at the Department for Work and Pensions. Dave Hartnett, who had been acting chief executive, becomes permanent secretary for tax at HMRC.
HMRC complaints rise
Complaints against HMRC criminal law enforcement operations have increased by 21% in the past year, according to analysis by accountants Wilkins Kennedy. Peter Goodman of the firm said: “There has been a lot of pressure on HMRC from the Treasury to improve the amount of money it takes in from its compliance work. As part of that HMRC has been granted tough new criminal investigation powers. It is not really surprising that we are now seeing an increase in complaints from taxpayers subject to these new powers.”
Banks’ remuneration controls strengthened
The FSA is clamping down on banks’ remuneration policies, alleging that they “may have been inconsistent with sound risk management”. It has written to regulated financial services firms saying that while the FSA will not become involved in setting remuneration levels, it wants evidence that boards have policies that ensure that remuneration policies do not encourage risk taking.