A global advisory group released 37 pages of recommendations on Monday discussing how regulators, accounting standard–setters, and — to some extent — CFOs can help prevent the next financial crisis, and work to fix existing “weaknesses” in accounting standards
The report is the work of the Financial Crisis Advisory Group, an 18-member panel of experts assembled by the International Accounting Standards Board and the Financial Accounting Standards Board. In it, the group issued its final thoughts on financial reporting, the convergence of American and international accounting standards, and the independence and accountability of standard-setters. Donald Nicolaisen, an FCAG member and former chief accountant of the Securities and Exchange Commission, called the recommendations “sensible and sound,” noting the concepts won’t solve all the issues they address, but will “clearly identify strong support for an independent process of standard-setting.”
Independence was a hot-button issue during the past year, as standard-setters on both sides of the Atlantic were bullied by special interests and politicians to relax fair-value accounting rules. In interviews with CFO, both Nicolaisen and FCAG co-chairman Harvey Goldschmid focused on the importance of the independence issue.
“Accounting rules of the highest quality — written by independent standard-setters — will help to restore investor faith in the fairness and integrity of financial markets,” Goldschmid, a former SEC commissioner and currently a Columbia University law professor, told CFO. “This is now a national imperative and will prove a blessing for CFOs,” he added.
The FCAG recommendations range from asking companies to take more responsibility for “effective price verification” when valuing financial instruments, to developing robust disclosures around structured financial products, to developing a permanent funding mechanism for the IASB as a way to protect its independence from “undue influence.”
The reach of undue influence played out on the world stage last November, when German chancellor Angela Merkel, French president Nicolas Sarkozy, and other global policymakers jumped into the fray on fair-value accounting. As a result, the IASB ignored its normal rule-revision process and rushed out guidance that gave banks and other companies more flexibility to choose when to apply fair-value standards to financial instruments.
The expedited process came after banks lobbied heavily for the change — claiming that fair-value accounting led to excessive write-downs — and European policymakers threatened to pass laws that essentially would have given the banks the accounting treatment they sought. By March, members of Congress were vilifying fair-value accounting as the cause of the financial crisis, and FASB quickly pushed through its new guidance on valuing assets.
To address the independence issue, the FCAG suggests that before the next crisis, the IASB and FASB should define when it is appropriate to expedite the rulemaking due process, and how to inject into that rushed process the “maximum” amount of consultation that is practical. The group also wants to see policymakers “refrain” from writing, or rewriting, accounting rules.
“CFOs should recognize how important due process and independent, objective accounting standards–setting is to them,” said Nicolaisen. He noted that it is reasonable for all users of financial statements to ask whether the standard-setting process works, if decision making is biased, and whether standards fairly measure performance and valuation. “What would be wrong, however, would be to suspend due process and take direction from Congress or business interests who say, ‘use this accounting method because that’s what we want,'” asserted the former SEC official.
For the most part, the recommendations read like a roadmap of the most controversial accounting issues of the past year. In addition to fair-value accounting, the FCAG also outlined the “limitations of financial reporting,” writing that financial statements are dependent on the “generation of reliable data” from liquid markets, financial institutions, and companies. The group also wants investors and analysts to shoulder some responsibility for their own assumptions, saying “users of financial reporting…should never suspend their own judgment and due diligence.”
Addressing company management in general, the report insists that a corporation’s valuation of assets and liabilities should be done “completely independent of sales, trading, and other commercial functions.”
The recommendations were more specific about a handful of accounting-rule projects. For instance, with regard to financial instruments, the FCAG believes the IASB and FASB should seek ways to use more forward-looking information for calculating bad debts with respect to loan loss provisioning, and find ways to rein in so-called cookie-jar reserves that can be used to manage earnings.
Also, the FCAG asked the standard-setters to “reconsider” the appropriateness of including credit risk when measuring the fair value of a liability. At issue is an accounting rule oddity that allows companies to book a gain when their credit rating sinks. Further, the group is prodding the accounting boards to continue consulting with bank regulators concerning consolidation and derecognition issues, especially as they pertain to off-balance-sheet transactions. From the FCAG’s perspective, the way financial instruments are treated under accounting rules may also affect regulatory capital, and therefore robust risk disclosures should be made to investors.
“It seems clear that accounting standards were not a root cause of the financial crisis,” wrote the group. “At the same time, it is clear that the crisis has exposed weaknesses in accounting standards and their application.”
The best way to address those weaknesses, Nicolaisen told CFO, “is for IASB and FASB to work very closely and eliminate as many differences between international and U.S. accounting standards as possible, and to move toward a single global, high-quality set of standards as quickly as possible.”
Whether regulators and standard-setters will move to quickly implement the recommendations remains to be seen. Indeed, even members of the FCAG were on opposite sides on some of the issues addressed (likely by design in order to produce a balanced report), so it is unlikely that regulators and standard-setters will find it easy to reach agreement on the recommendations.
In some instances, the FCAG members representing regulators were pulling in different directions, pointed out Nicolaisen. For instance, the SEC focuses on investor protection and transparent disclosures of underlying economic events; meanwhile, the Federal Reserve, which is accountable for the safety and soundness of financial institutions, is examining capital requirements. Some members of the FCAG would like to see those two perspectives come closer together, said Nicolaisen. But, he said, they are unlikely to ever be completely in sync “because financial statement users are looking for different measures and metrics and may have differing time horizons for investing.”