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The Bruce Column — Clarity and thought in Brussels

11 Feb 2011

Financial reporting should, everyone agrees, bring about maximum transparency.

But sadly transparency and clarity and the optimism which they can bring about are not often attributes of conferences dealing with financial reporting issues. But this week's European Commission conference on financial reporting and auditing in Brussels was different. There was a high quotient of clarity of thought clearly expressed.

One of the highlights was the first public speech from Hans Hoogervorst since it was announced that he would succeed Sir David Tweedie as Chairman of the IASB. He laid down some pretty unequivocal markers on the issues of who financial reporting was for and whether it should stray into the realms of financial stability as an objective. Not only was he forthright in his views but it was clear that they hadn't altered since his previous speeches on the subject given in his days as a regulator himself.

But before looking at his arguments in detail we should put them into the context of the day. Jonathan Faull, Director-General for Internal Market and Services with the EC set the scene. He said that 2011 was a crucial year for producing results on both convergence and governance. Looking back to 2005 and the European implementation of IFRS he said it had been the right decision and it had been a successful one. Now the G20 had called for global convergence and he looked forward to the US decision on the matter later in the year. He stressed the importance of this. All of the work being done around the world on capital requirements was predicated on accounting rules being the same. The crisis had highlighted the need for transparency. And he ended with the view that: 'Now is the time for change and now is the time for truth'.

Arthur Lindo, Senior Associate Director and Chief Accountant at the US Federal Reserve Board, made the point that stability and transparency are often complementary. And he said that on the question of the US decision he remained optimistic. The US needed to work through its issues with IFRS in the same way the Europeans had done when they took their decision. If the IASB and FASB have done what they need to do by the end of the year then the stage was set, he said, and the US would be ready to make its decision.

There were also encouraging remarks from Michel Prada, a veteran of the scene and former Chairman of the Autorite des Marches Financiers, (AMF), in France. He made the point that in his view accounting might have contributed to the crisis but the key issue had been the fragmented regulatory approach. It was a regulatory problem which had little to do with accounting.

All of this provided the surrounding detail to Hoogervorst's utterly clear exposition of the objectives of financial reporting. The key to his approach was that people should keep it simple. He talked of the intense debates on two accounting questions: at which audience should financial reporting be primarily directed, investors, regulators, or both; and whether accounting standards should only serve the goal of transparency, or whether they should also have a financial stability objective.

'I was often puzzled by the intensity of these debates', he said, 'given the fact that I think these questions can be answered in a fairly straightforward way'. And he then went on to do so. He pointed out that no one would disagree that the purpose of financial reporting is to provide as faithful a picture as possible of the financial position of a company or organisation and that the financial statements should contain information that is as unbiased and reliable as possible.

'It goes without saying that financial statements are most relevant to the investor', he continued. 'After all, financial reporting was born out of the necessity to give investors adequate information on the company they are providing capital for. The interest of the investor will always remain the main focus of accounting standard setting'. But if the aim of financial reporting is to be as faithful as possible then it is less relevant who the user of the financial statements is. 'If a financial statement of a company is as accurate as possible it cannot be accurate in 10 different ways', he said. 'It could not possibly become more or less faithful depending on the question whether an investor, a depositor or a regulator is using it'.

He then went on to relate this to the public interest. 'Moreover', he said, 'while it remains undeniable that financial statements are of primary importance to investors, in our modern economy so many entities are working with "other people's money" that financial reporting is of importance to much wider interests. High quality financial reporting is of essential importance to depositors and their protectors, the prudential regulators, to suppliers, to creditors in general.

'Indeed, reliable financial reporting is such an important ingredient for building trust in our global market economy, that it can be said to be of public interest. That is why the IFRS Foundation mentions in the first paragraph of its constitution that it works "in the public interest"'.

He then placed this public interest in context. 'It is hard to underestimate the public interest of IFRS', he said. 'IFRS is already the common business language of well over 100 nations. It is indeed the only set of standards that has the potential to be used all over the world. IFRS is an engine for economic modernisation, linking industrialized nations with growth markets around the world. Only IFRS can unleash the full potential of a truly global capital market. It can make an enormous contribution to economic growth by enhancing transparency and liquidity around the world. This is a global public interest which I will be proud to serve'.

He then turned to the perceived conflict between whether the purpose of financial reporting should be primarily to provide transparency or whether it should also serve the goal of stability. He thought the conflict was a false contradiction. Transparency, he said, is a necessary precondition of stability. 'The current credit crisis has to a large extent been caused by a lack of transparency in the financial markets', he said. 'Huge risks were allowed to build up on and off balance sheet without being noticed. Without proper transparency about risks, stability is bound to collapse in the end. Stability is not the same as transparency, but there can be no durable stability without transparency'.

So accounting standards can contribute to stability by enhancing transparency. 'There are plenty of recent examples of how accounting standard setters are doing just that', he said, 'often in close consultation with the prudential community'. He cited the tightening up of conditions for offbalance sheet financing, the proposed convergence to eliminate differences between US GAAP and IFRS in the netting of financial assets and liabilities, and the proposed introduction of the expected loss model to enhance loss recognition in the loan portfolio in a timely stage.

Then he went on to say that accounting standards also helped stability by avoiding artificial noise in the balance sheet and the income statement. 'This was an important reason for the IASB to continue with a mixed attribute system with regards to financial instruments', he said. 'Financial instruments that have basic loan features and which are managed on a contractual yield basis are valued at amortized cost. For such instruments, cost is deemed to provide more relevant information than short term market fluctuations'. And he continued: 'Income is another example of accounting standards being sensitive to preventing noise in the income statement. While the definition of OCI is in need of a firmer theoretical underpinning, it is a pragmatic way of shielding the P&L from volatility in the balance sheet that does not truly reflect the financial performance of the entity'.

But he stressed that this should be kept in perspective. 'Stability should be a consequence of greater transparency, rather than a primary goal of accounting standard-setters', he said. 'For this, accounting standard setters simply lack the tools. For example, they cannot set capital requirements for the banking industry. This instrument belongs to the prudential regulators who do have stability as their main mission. What accounting standard setters can also not do is to pretend that things are stable which are not. And, quite frankly, this is where their relationship with prudential regulators sometimes becomes testy'.

And why this conflict? 'Accounting standard setters are sometimes suspicious that they are being asked to put a veneer of stability on instruments which are inherently volatile in value', he said. And how does this come about? 'Whereas the search for transparency is the natural focus of accounting standard setters, this is not necessarily the case for prudential regulators. They are bound to strict confidentiality rules and often feel an understandable need to work out problems behind closed doors', he said. 'After all, maximum transparency may not always be the best way to prevent a bank run'.

This, for Hoogervorst, is where the real problems lie. 'Transparency does not always come spontaneously to an industry that is as vulnerable as the financial sector. It is indeed hard to imagine a riskier business model than the current banking industry. Both sides of a bank's balance sheet are prone to volatility. Its assets can be very sensitive to the economic cycle, whether they are based on derivatives, bricks and mortar or sovereign risk. Goldplated triple A can turn sour very quickly, as we have seen in the case of Ireland. The banking industry's liability side is also notoriously vulnerable. Funding can evaporate with the speed of a mouseclick.

'As if this is not risky enough, the banking industry has been allowed to run on the flimsiest of capital margins. The capital cushion of the banking industry has been allowed to shrink dramatically in the last century. Just before the crisis, tangible common equity of most banks was lower than 2% and in many cases close to zero' His conclusion was straightforward: 'It is no surprise that this business model experiences recurrent crises all around the world'.

He continued: 'One cannot envy the prudential authorities for being responsible for such an inherently unstable system. In these circumstances, it is also understandable that they can be uncomfortable with accounting rules that force problems into the open'. And this is where the arguments about independence start.

'When you look at the fundamentals of IFRS, it is striking that most of them are based on plain, economic sense', he said. 'Despite its complexity, IFRS is actually a quite elegant system of economic reasoning, firmly rooted in common sense. At the same time, we have to recognize that financial reporting is not an exact science. Asset valuation is in many respects more of an art than a science. Many assets are not homogenous and they often have no active or liquid markets that give reliable price signals. In many cases, asset valuation requires a lot of judgement and/or common sense. Often there is room for legitimate differences in opinion'.

But, as Hoogervorst made clear, it is also the matter of motivation which brings the independence issue into focus. 'But often', he said, 'accounting disputes are not fed by genuine intellectual debates, but by naked financial interests. It was not in the interest of CEOs to run share based payments through the P&L. That is why they fought it tooth and nail when accounting standards were forcing them to do so', he said.

'It was also not pleasant for companies to have their pension liabilities fully visible on their balance sheet and therefore IAS 19 on employee benefits met fierce resistance. Though these changes forced changes in some business practices, it is clear that they were for the good, bringing hidden costs or liabilities out into the open', he said.

Then he set out his independence stall, clearly and unequivocally: 'Accounting standard setting should therefore be sensitive to legitimate business concerns but be firm and independent in the face of special interests. Independence is an essential precondition for durable public trust in accounting standard setting'.

The other side of that were the responsibilities of the IASB. 'Independence will only be respected if there is a strong sense of ownership among the user community and among the public authorities that endorse the standards', he said. 'This is a huge challenge, especially for a young organisation that has conquered so much territory in a very short time'.

He saw four ways of strengthening the worldwide sense of ownership of IFRS: the quality of the standards should always be first rate, there should be a first-rate system of due process, the standard-setters needed to be fully aware of the challenges on implementation of standards, and there should be a strong sense of accountability.

This first speech from Hoogervorst has quite plainly set out the agenda. And it is positive, clear and unequivocal. Small wonder that people came away from the conference feeling better about the world. There was a good atmosphere surrounding the proceedings. 'It is a critical year', people were saying. There was a feeling that 2011 was the year, as one speaker said. 'This will be the year when we harvest', said another.

Robert Bruce February 2011

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