Divine intervention
Jul 16th 2009
From The Economist print edition
Accounting rules for financial firms are a mess. New proposals go some way to cleaning them up
Illustration by David Simonds
FOR the past two years accounting has been engulfed in a religious war. On one side are those who want loans, securities and other financial assets to be carried at market prices. On the other are managers, backed by many politicians and regulators, who would prefer assets to be carried at cost and written down only when they say losses are likely.
There are problems with both approaches. Fans of “marking to market” are accused of being zealots who forced banks and insurance firms to book exaggerated losses as prices fell, in turn pushing them into insolvency and sending the financial system spiralling towards hell. Those in the second camp, meanwhile, are accused of cooking the books before the crisis, and then bullying standards-setters to ease the rules once the scale of bad debts became clear. To make matters worse, a long series of fudges means firms’ balance-sheets use a mix of both approaches. Different firms may hold identical assets at different prices, and recognise losses on them in several ways.
Into the mayhem has stepped the International Accounting Standards Board (IASB), which sets the rules in most of Europe and Asia and is eventually expected to have authority in America, too. Beaten up by furious politicians, and urged by investors to fight back, it has drafted new rules that should apply from the end of this year. The result is still a fudge, but a superior sort of fudge. With some tweaks it should deliver what both sides want: accounting that does not exacerbate the economic cycle, but which still allows investors to compare assets’ market prices with managers’ version of events.
Under the new proposals, there would be only two asset categories. Loans, and simple debt securities that are similar to loans, would be valued at their cost, provided banks can show they are being held for the long term—as most banks will try to. More complicated debt securities, including most of today’s toxic detritus, as well as derivatives and equities, would be carried at market prices. This categorisation is pretty arbitrary (see article), but the practical result should be a drastic simplification of the rules and far better comparability between firms. Bank regulators are rejigging their rules, too. This should mean firms that report marked-to-market losses are not immediately forced into capital raising or fire-sales of assets.
Carrot and stick
IASB still needs to be on its guard. First, it must police the boundary between the two categories with a big stick. However penitent today, managers will try to label opaque securities as loans to give themselves more discretion when valuing them. Anyone who doubts this should recall the frenzy of book-cooking after IASB modestly loosened the rules in October. Europe’s banks reclassified over half a trillion dollars of assets, boosting their 2008 profits by $29 billion in the process.
Second, IASB must ensure that investors can still find out the market price of any asset being carried at cost—a far better indicator of many assets’ toxicity than managers’ opinions. Banks today reveal this only in summary form. The disclosure needs to be fuller if investors are to be able to challenge managers’ valuations. Banks will complain about red tape, but if any information is important, it is surely this.
Finally, standards-setters must rebuild their independence after the political assault they have faced in both America and Europe. The best way to do this is to continue to merge their standards, including those for financial firms, into one global rulebook. That should help restore confidence by preventing regulatory arbitrage between jurisdictions and diluting the voices of powerful national lobbies. Investors need not trust in God, but they must be able to trust accounts.
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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