Friday, May 8, 2009

EU's McCreevy, IASB's Smith On Financial Reporting in a Changing World

Yesterday and today (May 7-8), European Union Internal Markets Commissioner Charlie McCreevy (a chartered accountant by background), International Accounting Standards Board member John Smith, U.S. Securities and Exchange Commission Deputy Chief Accountant Julie Erhardt and others took part in a conference on: Financial Reporting in a Changing World. The conference was hosted by the European Commission in Brussels.

McCreevy's keynote address and Smith's remarks at the conference have been posted on the European Commission and IASB websites, respectively. Highlights from their remarks appear below. (NOTE: we have grouped excerpts from their remarks under certain common general topics, although the topic headings we use did not appear verbatim in their remarks, and in some cases only McCreevy or Smith spoke on a particular topic.)

Politics and Accounting
· McCreevy: Accounting is now a hot political topic. That is no bad thing... The calls for the IASB to get its house in order have grown louder. But let's be clear, this conference will not be a full frontal attack on the accounting rules and the standard setters. But the call for us to back off and leave it to the standard setters just misses the point. Although no one likes a messenger who brings bad news, we are not about to shoot the messenger. ...Accounting is now far too important to be left solely to! Independence of standard-setters is important, but they must be fully accountable. When the IASB acts or desists from doing so, this can have significant economic consequences. The IASB cannot set an agenda oblivious to economic and financial developments or fail to deliver. We thus need to look at how the independence, quality and funding of the IASB can be improved and the reporting lines with public authorities strengthened.
· Smith: As the conference title suggests, the financial crisis has changed the world. It has served as a wake-up call to policymakers, regulators and standard-setters. It has exposed critical weaknesses in business practices and financial regulation. It has challenged beliefs that we once held, rightly or wrongly, as axiomatic. We will ultimately be judged on how we respond to this crisis. The result must be a more robust system of financial regulation suitable for the reality of integrated capital markets. The IASB is acutely aware of the attention that political leaders have given to accounting standards in recent months. We at the IASB have been and remain committed to responding in an urgent and responsible manner.

Global Set of Standards
· McCreevy: We remain committed to an international standard-setting system: falling back on national or regional solutions, even if sometimes tempting, is not the way forward. And this is not solely an EU view. The G20 has called for the creation of a single high-quality global accounting standard, as well as for co-operation among regulators, supervisors, and accounting standard setters to ensure their consistent application and enforcement. It is very important that all major jurisdictions sign up to the international system. For us, it is now crucial that the US come on board.
· Smith: Towards a global set of standards, the financial crisis has emphasised the relevance of the IASB’s mission. More than ever, there is a need for a single set of worldwide accounting standards. This is something that Europe recognised earlier than others. Clearly, the European Union has been a catalyst and the leader in that effort in deciding to adopt International Financial Reporting Standards (IFRSs) in 2005. Today, more than 100 countries require or permit the use of IFRSs and major economies in Asia-Oceania (Japan), North America (Canada and Mexico) and South America (Argentina, Brazil and Chile) have set out a time line towards the full adoption of IFRSs. As to the United States, it has created another catalyst to use IFRSs by removing the reconciliation to US GAAP for foreign filers using IFRSs. Clearly, the United States is on a path towards the adoption of IFRSs, the question is, when? We continue to work with the FASB, and in March, at our joint meeting in London, we reaffirmed our 2011 commitment under our Memorandum of Understanding. The completion of our joint work with the FASB will result in significant convergence with accounting standards in the United States. This will reduce the cost of transition. But will that be enough to get the United States over the line? I believe it is in the interest of the United States to adopt IFRSs in the next five years. With Brazil, Canada, China, India, Japan and Korea committed, with the European Union already using IFRSs, the cost to the United States of failing to adopt IFRSs will be high. If it doesn’t adopt, it will be the outlier and those countries already adopting and committing themselves to IFRSs will not accept a situation where the United States remains outside the system indefinitely, yet has a seat at the table. In the meantime, we continue to work with the FASB in advancing our projects under the MoU and we continue to strive to meet our end of the bargain.

IASB Funding
· McCreevy: Clearly the IASB cannot do its job properly if it does not have the necessary resources. A stable source of public funding would make it more accountable. We in the EU now have an initiative to provide the IASB with some financial support. I am pleased to announce that only yesterday, both the Council and the European Parliament were able to agree to our funding proposal. The idea is that the funding we provide would be conditional upon further concrete improvements in governance. We would like to see other major jurisdictions set up similar funding arrangements.

Accounting and the Financial Crisis-Specific Concerns
Fair Value
· McCreevy: On fair value, my views on this are well known. Some degree of flexibility is needed especially on where and how to apply it. I am very encouraged that the IASB has announced that IAS 39 will be revised fundamentally to simplify the standard and to address known shortcomings and that this exercise will be finished this year.
· Smith: In response to concerns about fair value measurements in illiquid markets, we set up a panel of experts to identify best practices for estimating fair value in illiquid markets and for disclosure. We held a series of meetings during the summer last year and issued additional guidance on those topics based on the input from the panel. As we were issuing that guidance, we amended it to include the emphasis on significant judgement to coincide with the FASB and SEC interpretations. We looked at the FASB’s recent FSP on fair value measurement in illiquid markets and concluded that it does not differ from the guidance in our literature and in the [IASB Expert Advisory] Panel document. There is some confusion, however, because the initial draft of the FSP contained a presumption that transactions in illiquid markets could be ignored unless there was evidence to show those transactions were not distressed. That presumption was removed from the final FSP. So let me repeat, we think that the guidance in US GAAP and IFRSs is the same and we believe the emphasis on judgement is appropriate. That said, to reduce any continuing fears, the exposure draft we shall be publishing soon on Fair Value Measurement will include the FASB FSP language.

Loan loss provisioning
· McCreevy: As to loan-loss provisioning, this has served many banks well in the past and I would now like to see it used more broadly. A system that introduces significant counter-cyclicality, requiring banks to build up more substantial buffers in good times so that they can let them run down in bad times, makes obvious sense. It is true that there are several models on the table (e.g. dynamic provisioning, economic cycle reserve, expected loss approach) but we need to focus on the key objectives. The first is how to ensure that full account is taken of the credit risks involved in the business sector in which the entity is operating, and, secondly, how to balance the accounting and prudential rules that apply. I am extremely pleased that the IASB and FASB have already started discussing these ideas in their Financial Crisis Advisory Group and also with banking regulators. Again, this is a top priority for us.
· Smith: As part of our evaluation of impairment we will consider developing an expected loss model to replace the current incurred loss model. We are told that the incurred loss model provides too little too late. So we are exploring an expected loss model whereby provisions would be recognised for expected losses that have been identified on the basis of history and current expectations. There are other issues here about going beyond expected losses and recording additional amounts today to provide a buffer for the future to promote financial stability. This issue is more about the objective of financial reporting and a question about providing useful information to users. We have been and will continue to work with banking regulators through the Basel Accounting Committee to explore the expected loss model. We believe additional reserves beyond expected losses that might be required by regulators for capital purposes are more a regulatory issue than an accounting issue. However, we also will be exploring with the regulators what might be done to provide transparency around regulatory reserve requirements through a capital allocation

Consolidation and Derecognition
· Smith: We accelerated our consolidation and derecognition projects, both dealing with off balance sheet activities, and on each we published exposure drafts that include enhanced disclosures about off balance sheet .

Financial Instruments
· Smith: We are accelerating our project on financial instruments to replace IAS 39, and intend to publish a proposal on classification and measurement within six months followed by a proposal on hedge accounting. ...Our project directly addresses the G20’s call for standard-setters to take action by the year-end ‘to reduce the complexity of accounting standards for financial instruments’. At a very high level we are all in agreement about the objectives for the project. We need to reduce complexity, increase comparability and transparency, rethink impairment rules to recognise losses more promptly and provide a basis for convergence worldwide, in other words a level playing field. Our six-month time frame is aggressive, but achievable if we attack the issues in an orderly way and sequentially. [IASB's Smith detailed:]
o We will start with classification and measurement alternatives. We understand the causes of complexity: We have 12 different measurement methods for financial instruments including three for impairment. We have 22+ ways of getting to one of the measurement methods based on a combination of criteria including type of instrument, its activity in the marketplace, management’s intentions by designation, and management’s intentions with various qualifying criteria. We can reduce complexity if we reduce the measurement alternatives and provide a better rationale for the alternatives that remain. Our goal would be to get to two measurements. Clearly, some instruments will be at fair value and others will not, but we have to decide how to make the cut. Is it the characteristics of the instrument, its activity in the marketplace or management’s intentions? Each of these alternatives can complement or conflict with each other, so we have to decide what trumps what, that is to say, what has primacy.
o As part of the project, we will address the issue of transfers out of fair value. The consideration here will depend on how we draw the line to distinguish the fair value and non-fair value categories. Impairment is clearly part of this project. We are trying to get to a single impairment method but first we have to sort out classification to determine if that is feasible. My inclination (me not other Board members) is that if the instrument was toxic from the start, that is to say, if it had highly volatile cash flows so that the investment was speculative in nature, the instrument should probably be at fair value. For plain vanilla, ordinary receivables, loans and investments with stable cash flow characteristics, a cost model seems appropriate, assuming that management is not trading the instrument, and impairment should be based on expected cash flows. But right now we include both extremes in the available-for-sale category and to some extent in loans and receivables, so we need first to sort out the classification of financial instruments and then try to get to a single impairment model.
o Concerns have been expressed about recognising gains on the reduction in the fair value of an entity’s own debt from credit deterioration. We will consider whether we should limit the use of fair value accounting in this regard as part of this project.
o The next step is hedge accounting and how to reduce complexity. We expect to issue a separate document on this subject following our proposal for the classification and measurement of financial instruments. Our objective is to reduce complexity and increase transparency of hedge accounting activities. But first we need to understand how hedge accounting would change if we introduced an expected loss methodology.
o Our staff have developed various alternatives they are considering for presentation to the Board in the next few months. The Board, in turn, will be deciding on which alternatives to propose for exposure. And, of course, we are working with the FASB on this project. We have a joint meeting with the FASB in July and I expect that after that meeting we will be in a position to start moving towards the exposure draft phase.
We have included additional topics McCreevy and Smith spoke about in our detailed FEI Summary (FEI members only can access the detailed summary.) Once again, reference should be made to McCreevy's keynote address and Smith's remarks for their complete remarks. If you received this blog post from 'a friend' and would like to receive our blog by email, send an email to and write in Subject line: Sign Up. You can also follow us on Twitter at @feiblog.

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