Off blance sheet reporting irretrievably broken

by admin on April 10, 2008

in General,Tax and Ethics

The FT reports that:

Rules regarding how banks account for off-balance sheet interests are “irretrievably broken”, a senior group of international rulemakers has warned…Accounting standard setters are already under pressure for their support of marking assets to current market prices – a practice that has resulted in billions in writedowns and affected banks’ profitability seriously.

To make matters worse, FASB and the IASB are saying:

“Completing a final standard by mid-2011 will be extremely difficult, perhaps impossible”

and that attempts to fix the problem:

…has lost momentum because of staff turnover and “relative inexperience.” It also urgently recommends that some senior figure be put in charge of the project, warning: “We cannot afford the luxury of waiting for the newly assigned staff to get up to speed.”

Marc Andreesson, he of Netscape and Ning fame ysas:

Remember Enron?

Imagine Enron times a hundred.

Marc is not wrong. We’re looking at potential losses on a colossal scale, running trillions of USD. Last month, the FT reported that:

Accounting rulemakers have defended the use of “fair value” accounting against attacks from bankers and insurers, who claim that applying it to financial instruments in the current turmoil risks undermining the financial system.

Fair value forces companies to mark assets and some liabilities to their market value, leading top banks and insurers to take heavy writedowns as markets seize up and values plummet…

“Fair value seems to be the only measure that is appropriate for all types of financial instrument,” the IASB says in its paper. But it acknowledges that “there are issues and concerns that have to be addressed before the boards can require general fair value measurement”.

Current rules allow a mix of fair value and old style “historical cost” accounting, where assets are booked at the price at which they were bought. But the explosion in the use of derivatives and other complex structured products has meant that increasing amounts of assets are reported at fair value.

Critics have said that because of current market dislocations companies’ profits have been dented by unrealised paper losses. Last week American International Group, the insurance company, said it had proposed to regulators that fair value should be suspended while the credit crunch was worked out…

“We are determined to simplify and improve IAS39 [the current standard] by creating a principle-based standard,” said Sir David Tweedie, chairman of the IASB.

The row over fair value is pitting executives against many investors and the accounting profession. Most alternative suggestions involve heavier reliance on subjective management estimates, which investors dislike.

As you can see, the banking world wants it all ways up and is resisting efforts to sort out a mess of its own making.

I don’t know how many times or over how many years I’ve written about this issue but I find the excuses given by FASB/IASB breathtaking. The problem of valuing what are in essence gambling chips is not going away any time soon.

Auditors should not have to deal with this problem. Right now they are expected to act as quasi actuaries for ‘assets’ that are notoriously difficult to value under a set of guidelines that represent a quagmire of legalese and which were written in favour of the financial institutions.

The simple solution is one the banks cannot stomach: All financial instruments should be the subject of actuarial assessment upon which auditors can rely as independently valued. Any actuary worth his salt will recognize the attendant legal risks of being over generous and therefore value at zero unless they have clear evidence that all counter party risks have been extinguished.

What we have now are the banks on one side strong arming the audit crews while the auditors are being forced to rely on an unworkable standard but falling back on ‘prudence’ as its get of jail free card. I can’t blame them.

If the IASB gets this right then the impact on the derivatives market will be significant. My guess is that it will pretty much kill off the practice of creating ever more exotic instruments. The banks won’t be happy but at least we might return to a bank lending system based on assets that have genuine value. That has to be the better way.

What I do not accept is that three more years are required to deal with the problem. The more time it takes, the more likely the banks are to obfuscate, prevaricate and obstruct attempts to resolve the issue.

In the meantime, ordinary people are suffering as banks take fright and clamp down on lending. If you’re advising clients on new business propositions, now is the time to be teaching them about cash flow management. They’re going to need it.

Comments on this entry are closed.

Francine McKenna April 10, 2008 at 4:58 pm

Dennis, You are spot on. The auditors not only aren't dealign with this well, they can't. They do not have to expertise and firepower. They are catching up to executives who are trusting some analyst in the back room with a model that no one can vet.

I suggest OTC and non-marketable securities be valued just as they are – non-marketable, at zero until someone makes a market, in a sanctioned marketplace, where regulators and other counterparties besides tow self-serving banks have influence.

Dennis Howlett April 10, 2008 at 5:16 pm

Francine – that has been my position for years. The banks will scream 'regulation by the back door' but they're the ones who created the situation as an attempt to get around rules they don't like.

Brian Clarke April 11, 2008 at 5:41 pm

I'm a UK Chartered Accountant and occasional auditor. I was taught long ago that, "if you don't understand it, you haven't audited it".

Enough said?

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