A V Rajwade: The unfairness of fair values

WORLD MONEY

The French are incensed; so are many other members of the European Union (EU). The EU is threatening not to back the Anglo-Saxon initiative that many critics see as yet another example of American hegemony.

No, the dispute is not about Iraq, or the Kyoto Protocol on environment or the international criminal court. It is on a more mundane, if not dull, subject "" accounting standard IAS 39, prepared by the International Accounting Standards Board (IASB).

IAS 39 is about accounting for financial instruments and it is envisaged that once the EU authorities bless it, it will be used for all accounts published in Europe from the next year.

Ninety other countries are also expected to adopt the IAS accounting rules. American regulators have accepted that EU companies conforming to IAS 39 need not publish separate sets of accounts under the US GAAP (generally-accepted accounting principles) for the purpose of accessing the American capital market.

Clearly, there are obvious advantages in a single world standard. The accounts of companies from Shanghai to Stuttgart to Mumbai to Moscow are comparable.

Howsoever attractive the objective, critics of IAS 39 contend that in trying to meet with the wishes of American regulators, IAS 39 has gone too far on the lines of the corresponding US standard FAS 133.

The dispute is not merely about the rules prescribed but more about the architecture of accounting standards on the two sides of the Atlantic. The US standards are famously rule-based, highly prescriptive and detailed.

On the other hand, the European rules have traditionally been more principles-based, leaving it to the company management and auditors to decide whether particular practices conform to the principles or not.

Thus, such standards emphasise the substance of the underlying transactions rather than looking merely at mechanical adherence to rules.

Supporters of principles-based standards point to the pitfalls of the American approach, citing the series of accounting scandals in the country over the past couple of years. (To be sure, European righteousness has been besmirched by Parmalat).

France is the principal and most vehement critic of IAS 39 as it stands, contending that the new rules about "fair value" accounting of derivatives may lead to volatility in reported profits, and that convergence of the standard with US practices has, in effect, meant accepting the US rules.

Critics also contend that the qualifications prescribed for a particular derivative transaction to become eligible for hedge accounting are too tough and, therefore, difficult to meet. European insurers are also opposed, arguing that IAS 39 may lead to "misrepresentation of profits".

In response to representations, the IASB did make some changes in the standards in August 2003 and later. But the banking and insurance industries are still unhappy and discussions on the subject continue.

The charge that fair value accounting rules on derivatives, whether under FAS 133 or IAS 39, can lead to profit volatility is evidenced by the restatement of profits by Freddie Mac, the giant US housing finance company.

It may be recalled that with the approval of its auditors, the company was valuing derivatives in order to "massage" earnings to create an impression of steady, consistent and predictable financial results.

When the auditors were changed, the new firm insisted on strict valuation as per FAS 133, which led to a significant restatement of income for the 2000, 2001 and 2002. In the case of Freddie Mac, the restatement resulted in increased profits.

The volatility of the restated numbers is evident. The changes were principally in non-interest income, and "largely due to the amount of derivatives, mortgage securities and guarantee assets, and guarantee obligations marked to fair value through earnings, with the most significant driver being derivatives gains and losses."

It should also be noted that this increase means that the profits in subsequent years would be correspondingly lower. The volatility arises from the fact that, even where derivative transactions like swaps have been undertaken to hedge the interest rate risk, for instance, if they do not conform to the hedge accounting criteria, they have to be marked to market while the underlying assets and liabilities in the books continue to be carried at historical cost.

To an extent, this does cloud the "true and fair" presentation of the accounts. The Freddie Mac experience does prove that there is substance to the charge that the standard would lead to profit volatility.

Meanwhile, European banks like Credit Suisse, UBS, Dresdner and HSBC have already agreed to conform voluntarily to the new rules, or to US GAAP, howsoever unfair the fair valuation rule may be.

Still on the subject of accounts and accountants, FASB has recently come out with rules for expensing equity options, and a US judge has barred Ernst and Young from taking new audit clients for six months "" the firm's sin was that its consulting wing earned huge fees from implementing a software product developed by a company it was auditing.

E-mail: avrco@vsnl.com