Fair Value Banking Crisis

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Fair Value Accounting and the Banking Crisis in 2008: Shooting the
Messenger
Paul Andra; Anne Cazavan-Jenya; Wolfgang Dicka; Chrystelle Richarda; Peter Waltona
a
ESSEC Business School, France
To cite this Article Andr, Paul , Cazavan-Jeny, Anne , Dick, Wolfgang , Richard, Chrystelle and Walton, Peter(2009) 'Fair
Value Accounting and the Banking Crisis in 2008: Shooting the Messenger', Accounting in Europe, 6: 1, 3 24
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Accounting in Europe
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Fair Value Accounting and the

Banking Crisis in 2008: Shooting
the Messenger
PAUL ANDRE, ANNE CAZAVAN-JENY, WOLFGANG DICK,
CHRYSTELLE RICHARD & PETER WALTON
ESSEC Business School, France
ABSTRACT The paper sets out to analyse the effects of the financial crisis on the
international standard-setter in 2008 and the attempts made to shoot the messenger to
blame IAS 39 for creating the crisis for reporting unrealised losses, rather than the
cause being bankers making bad investment decisions. It first provides a brief analysis
of IAS 39 and fair value accounting for financial instruments. It then sets out the
relationship with the Basel II banking regulatory regime. The main part of the paper is
a chronological presentation of the events of 2008 as they impact upon the international
standard-setting institution. In particular, we analyse the impact of the G20
requirements and the blunt intervention of the European Commission that led to
amendments to IAS 39. The final part of the paper looks at the consequences as they
are so far discernible and the damage done to the IASB by shooting the messenger.
Introduction
Responsible and guilty as charged? Since fairly early in the negative cycle, the
International Accounting Standards Board (IASB) has been put in the dock,
accused of having intensified the effects of the financial crisis. To hear the comments of some banks, businesses and even politicians, International Financial
Reporting Standards (IFRS) have not only been ineffective during the period
of the crisis but they have also precipitated the fall of some major financial
institutions. Criticised and destabilised, accounting has been considered one of
the key factors of the crisis. But is that really the case?
Correspondence Address: Chrystelle Richard, ESSEC Business School, Avenue Bernard Hirsch,
BP 50105, 95021 Cergy Pontoise Cedex, France. Email: richard@essec.fr
1744-9480 Print/1744-9499 Online/09/01000322 # 2009 European Accounting Association
DOI: 10.1080/17449480902896346
Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA
P. Andre et al.
During 2007, financial institutions began to need to recognise a drop in value of

some of their financial assets, generally linked to sub-prime loans. The financial
press first focused on the amounts of the impairment write-downs and the doubtful quality of the related assets. However, bit by bit, the financial institutions
started to blame fair value accounting. Their management argued that they had
no intention to sell these assets and there was no point in measuring them at
their market value. In March 2008, the chief executive of the American Insurance
Group (AIG) was cited in the Financial Times as suggesting that management
should estimate the likely losses and recognise those, rather than reflect market
prices by measuring at fair value.1 This position began to be heard by politicians
and banking regulators who started to review the situation. The IASB and FASB
started to come under pressure to reconsider the fair value rules. This was to lead
to a crisis for the international standard-setter and a possible loss of any chance of
being adopted in the US. The messenger was certainly shot, but not to death. It
remains to see how much it was wounded.
In this paper we will first set out what is the linkage between fair value accounting and banking regulation, then look at the unrolling in 2008 of political pressure
on the IASB, and finally we will review the consequences, actual and potential of
the fair value crisis.
Fair Value under IFRS
Fair value is defined in IAS 39, the recognition and measurement standard for
financial instruments, as the amount for which an asset could be exchanged, or
a liability settled, between knowledgeable, willing parties in an arms length transaction. The concept of fair value measurement is to show assets and liabilities at
their market value at balance sheet date rather than at historical cost. Gains and
losses are recognised immediately in the financial statements rather than being
smoothed over the life of the instrument. Accounting for assets at fair value can
be seen as a general application of the financial logic that sees the business as a
portfolio of assets whose value depends on their expected cash flows and risk.
The way in which standards require fair value to be measured is still evolving.
The FASB published a standard, SFAS 157 Fair Value Measurement, which
formalises how fair value should be applied when another standard calls for
that as a measurement basis. The IASB plans to issue its own convergent fair
value measurement standard before 2011. SFAS 157 recognises three levels of
fair value measurement: Level 1 is the current price in a liquid market for
exactly the same instrument, Level 2 is the current price in a liquid market for
a similar instrument, which can be adjusted to obtain the fair value of the instrument being valued, Level 3 uses valuation models based on assumptions that a
market participant would use. Level 3 should not directly use the entitys own
assumptions without modifying them to reflect the market.
The application guidance of IAS 39 (developed several years earlier) implicitly
also has three levels but it mainly draws a distinction between fair value based on
Fair Value Accounting and the Banking Crisis in 2008 5
market data (what SFAS 157 would call observable inputs) and fair value based
on a valuation model (unobservable inputs). These are also referred to as mark
to market and mark to model. The US three-level hierarchy has become widely
used outside of a US GAAP environment, and is significant in that standardsetters usually ask for more stringent disclosures related to Level 3 (mark to
model) as opposed to Level 1 (mark to market).
Under IAS 39 financial instruments are classified under four headings, which
have different accounting consequences:
.
.
.
.
financial assets held for trading

held-to-maturity investments
available-for-sale financial assets
loans and receivables
Held for trading financial assets are valued at fair value at each balance sheet
date, and changes flow directly through the income statement. All derivatives
are treated this way. Held to maturity investments are held at amortised cost.
Available-for-sale financial assets are valued at fair value at each balance sheet
date, but the change in fair value goes to equity and is now reported in
Other Comprehensive Income, with gains and losses recycled through the
income statement when the asset is sold. Loans and receivables may not
include derivatives nor be quoted on an active market. They are measured at
amortised cost using the effective interest rate method. In 2003, the IASB modified IAS 39 to add an option to use fair value through income for subsequent
measurement of any asset or liability in order to correct an accounting mismatch
(i.e. where matching assets and liabilities that were held to offset risk were
accounted for on two different measurement bases, giving an accounting
mismatch that did not reflect the underlying economics).
A key anti-abuse requirement is that entities had to determine at inception into
which category the asset fell, and were not subsequently able to re-classify it.
This, and the hedging rules, were primarily driven by the perception that if
entities were able to re-classify, at any balance sheet date all loss-making
assets would be transferred to amortised cost, while those showing a market
profit would be at fair value through profit and loss.
Fair value is not a new concept. Richard (2004) points out that market value
was used in France in the 19th century. It has existed in an Anglo-Saxon legal
context for at least 200 years (Walton, 2007). Broadly, the courts have used
the term to mean a price at which buyer and seller both receive an appropriate
benefit from a transaction i.e. a price that is fair to both parties. It has long
been used in accounting as a means of fixing a financial value when a transaction
does not contain an explicit financial value. This happens, for example, when a
promoter of a company gives up non-cash assets against shares in the
company. A fair value for the non-cash assets has to be determined to fix a
financial value for the transaction. Barter transactions also use it. Similarly, it
P. Andre et al.
is used as an allocation device when a transaction needs to be broken down into

smaller components, such as when the purchase price for a business is broken
down into individual assets and liabilities in a business combination.
The potential danger of fair value accounting has been underlined by empirical
studies. Gonedes and Dopuch (1974) explained that the empirical association
between accounting figures and stock prices and returns is not a proof of the
relevance of an accounting rule. Holthausen and Watts (2001) also state that,
the value relevance literature seems to forget the questions of accounting
standard-setting.
However, its use in the context of financial instruments started to be widely
considered in the 1990s. As Casta (2003) explains, the emergence of fair value
in the last two decades can be related to several factors. It springs initially
from the problem of recognition: the rapidly expanding use of financial instruments posed a problem as to how to recognise them in the balance sheet.
There was also a desire, notably on the part of the Securities and Exchange
Commission (SEC) in the US to reduce managements discretion in manipulating
earnings, given that the use of historical cost permitted them to defer the
revelation of problems. Finally, the principle of fair value is consistent with
the Conceptual Framework in terms of providing decision-useful information
to investors which met the requirements to be relevant and reliable.
The qualities attributed to fair value in relation to financial instruments are
numerous. This corresponds with the methods used by investors in forecasting
cash flows. In terms of comparability of financial statements, it removes the
possibility of opportunistic management of the result and ensures the neutrality
of the measure of performance, based on disposing of an instrument rather
than keeping it, and using an external benchmark. Finally it ensures the completeness of the accounting information by recognising derivatives that are without
any historical cost.
All the same, the use of fair value is not exempt from criticism. There are, of
course, risks in using a valuation model for instruments for which there is no
liquid market in which prices can be observed. There is above all a short-term
orientation that can considerably increase the volatility of balance sheet values.
There is also the cost of applying such a system. At the end of the day, any
accounting measurement system implies a number of choices. The quality of a
system is assessed based on its capacity to facilitate the taking of decisions by
users, the relevance and reliability of the information and the systems capacity
to permit comparison over time and between companies.
Fair Value in the Banking Sector
Walton (2004, p. 6) notes that the banks are unhappy about having to value
available for sale and held for trading assets and liabilities at fair value and
believe this will cause great fluctuations on a period-to-period basis as a reflection
of short term shifts in the market. From the same perspective Aubin and Gil

(2003) underline that the application of fair value to the banking sector leads to a
great heterogeneity in the content of the balance sheets of banking groups and the
computation of their results. Credit institutions have the discretion to value their
loans at historical cost when made to clients, a fair value for those eligible under
the fair value option or those bought on the secondary market. As far as hedging
is concerned, Aubin and Gil consider that the accounting rules do not translate the
reality of banks management of assets and liabilities, which is aimed at protecting themselves from variations in rates, and not at netting off the variations in
value of the financial instruments concerned.
Colmant et al. (2007) also affirm that the IFRS that address financial instruments (IAS 32, IAS 39 and IFRS 7) pose application problems in the banking
sector, notably in the way they interact with the New Basel Agreement on
Equity (known as Basel II). Basel II organises the prudential supervision of
banks by regulators into three pillars: a first pillar (Tier One) relative to the
minimum capital requirements, a second pillar (Tier Two) dealing with prudential surveillance, and a third pillar (Tier Three) requiring publication of
certain information by banks. Moving to IFRS has modified the calculation
of the solvency ratio for banks, in particular as regards the re-measurement
of available for sale financial instruments and the unrealised results of cash
flow hedges.
The European criticism has only amplified the echo of the American criticism
made a few years earlier. In the face of the negative comments of the American
banks as well as the major audit firms at the time that SFAS 115 Accounting for
Certain Investments in Debt and Equity Securities was issued in 1993, Barth et al.
(1995) tried to respond to these and defend fair value as the measurement basis
for financial instruments held by financial institutions. Several of the affirmations
of opponents of SFAS 115 were tested to verify their validity and their veracity. It
is interesting to note that two of these were confirmed. In the first place, the earnings numbers published by the banks were indeed more volatile under fair value
than under historical cost. In the second, the credit institutions more often
infringed regulatory requirements when they measured at fair value rather than
historical cost. There is, therefore, a fundamental inconsistency between accounting measurement and prudential valuation, as these two methods are seeking to
satisfy different objectives. Accounting information should be relevant to investors needs, while prudential information should be prudent from the regulators
perspective (Matherat, 2008).
Nonetheless, in the course of the last few years, as long as the market was
rising, no one was too shocked by fair value accounting, be they management
or politicians. Fair value started to be stigmatised when the market began to
decline, because neither regulators nor banks welcomed the reflection of the
market downturn in the banks balance sheets. All the same, at the beginning,
the crisis was classic in nature: financial institutions, some of them hardly regulated at all, had made loans on poor quality criteria, and the loans had been used in
complex operations that were poorly securitised (Matherat, 2008).
P. Andre et al.
However, as Vinals (2008) explains, the valuation models had been conceived
in a favourable economic context, without taking into account all the risks that
were present. Numerous models did not sufficiently take account of the fact
that the underlying assets for many complex products were risky American
mortgages, sensitive to variations in the interest rate, in the price of property
and to the persuasions of lenders. The correlations between the defaults in the
portfolios of sub-prime mortgages on which the instruments were based had
largely been underestimated (Vinals, 2008, p. 135).
At the same time, fair value accounting results in more volatile earnings (e.g.
Barth et al., 1995). One example, developed by Michel Magnan (2009), illustrates the impact of fair value accounting on reported earnings.
In its last reported financial statements before it went bankrupt, Lehman
Brothers reported a loss of US$ 2.4 billion for the first six months ending
May 31, 2008 (vs. a net income of US$ 2.4 billion for the first six
months ending May 31, 2007). The shift of US$ 4.8 billion is largely
driven by a dramatic fall of US$ 8.5 billion in Lehmans revenues from
principal transactions, which include realized and unrealized gains or
losses from financial instruments and other inventory positions owned.
[. . .] Thus accounting for fair value for some financial assets amplified
Lehmans downward earnings performance.
Measurement at fair value obliged the banks to recognise losses, which were
accompanied by a reduction of their equity. From then on, in order to maintain
their solvency ratio, the banks had to raise extra capital in conditions where the
market was going down rapidly or were obliged to reduce their new lending, a
disastrous policy in an economically depressed context (Veron, 2008). On top
of that, the same banks had brought back into their balance sheets the toxic
assets of special purpose entities whose risks they thought they had transferred
to others. For commercial reasons linked to their reputation, the financial institutions chose to take back responsibility for many off balance sheet items. This
required the consolidation of these entities and their re-measurement triggered
further losses. It also called into question another area of accounting standards:
the rules for consolidating subsidiaries and the relationship between a company
and special purposes entities that it had created, as well as disclosures of risk
associated with such vehicles.
Financial reporting is bearing messages: the audited, consolidated accounts
have the objective of presenting the financial situation at balance sheet date as
well as the economic performance and any change in the financial situation
during the reporting period. These accounts serve in the decision-making of
several users, but principally investors. Amongst other things they serve as a
basis, after analysis and adjustment, for measuring future profitability. If one
wants to use the accounts for other ends, such as for establishing the level of regulatory capital (such as the Basel II ratio), one must provide for special treatments

and adjustments intended to achieve this objective. That was not done, and led to
accusations that fair value had caused the problem of under-capitalisation of
financial institutions.
By contrast, other non-investor users have adopted such techniques: for
example, the tax authorities in many countries require specified adjustments to
get to taxable profit. The fact of having directly linked the prudential requirements for equity capital to the accounting rules generated an effect described
as pro-cyclical: the financial institutions had to sell assets to maintain their
regulatory capital and had thereby fuelled the downward trend of the markets, generating a further need to sell assets, and so on. The question that presents itself is
the following: should we change the general accounting model or should we
modify the way in which the regulators determine the level of equity capital
required (a level that could conceivably change in different market conditions)?
When the Accounting Thing became a Political Thing: The IASB
and the Crisis
In the end, would it have been better to leave the assets in the balance sheet and
not recognise the potential losses? In Japan in the 1990s, or again in the US in the
savings and Loan crisis of the 1980s, conservative accounting practices potentially delayed recognition of serious problems and thus their resolution. Many
users consider that, however difficult it may be, it is important in the interests
of greater transparency and also to permit the markets to adjust, to value the
assets and liabilities at balance sheet date and reveal the level of risk to which
society is exposed. One could try to improve this approach and present the
results better, but to do nothing is not to serve the users interests.
The two sets of accounting standards that require systematic use of fair value
for financial instruments are US GAAP and IFRS. By the end of 2007, IFRS had
been adopted by the European Union for all listed companies and were used in
more than 100 countries round the world. As a consequence of the quarter by
quarter fair value impairments, regulators and governments started to ask was
there a real financial crisis or was the use of fair value creating a crisis?
In the US, overt interference in accounting standard-setting has most often
come from Congress. Politicians who receive election funding from large corporations are also inclined to listen to their concerns, and so it was in this case. An
attempt was made by politicians to have fair value suspended, which was
eventually turned into a requirement that the SEC investigate the role of fair
value in the financial crisis.
At an international level, it was the international regulators that first took
action. In particular, both the International Organisation of Securities Commissions (IOSCO), which is the international umbrella organisation for stock
market regulators, and the Financial Stability Forum (FSF), which is part of
the international bank regulatory system based in Basel, set up working parties
to report on fair value. The FSF report was submitted to the meeting of G7
10
P. Andre et al.
governments in April 2008. It is implicit in the reports that the IASB was
involved in discussions with these bodies.
The IOSCO report, prepared by its Technical Committee (IOSCO, 2008), highlighted a number of problems. It said (IOSCO, 2008, p. 17):
Broadly speaking, accounting principles are designed to provide investors
with an understanding of the overall financial position and performance of
the firm. In this sense, internal firm valuation and external financial reporting accounting can be seen as offering critical information to two different
sets of interested parties: on one hand, to the firms themselves and to
regulators interested in the stability of the firm itself; and to investors, interested in the firms performance. Ultimately, in both instances, valuation
methodologies and accounting principles exist to benefit investors.
The report found: some financial firms appear to have inadequate human and
technological resources to model their financial positions using fair value
accounting principles under illiquid market conditions. It argued that once it
was clear that the market was illiquid, market prices were no longer an appropriate source of valuation under Level 1 of the SFAS 157 hierarchy or of IAS 39 and
companies should have moved to Level 3, using models.
The FSF report (Financial Stability Forum, 2008, p. 22) noted:
Accounting standards define the fundamental framework of financial
reporting, which permits the measurement of the financial condition and
performance of firms. Adherence to these standards is the cornerstone of
a well-functioning financial system. In addition, the quality of financial
reporting is enhanced by the efforts of market participants, auditors and
supervisory and regulatory authorities to strengthen the reliability of valuations and of risk disclosures. Sound disclosure, accounting and valuation
practices are essential to achieve transparency, to maintain market confidence and to promote effective market discipline
It made a number of recommendations:
III.4 The IASB should improve the accounting and disclosure standards for
off-balance sheet vehicles on an accelerated basis and work with other
standard setters toward international convergence. (Financial Stability
Forum, 2008, p. 25)
III.5 The IASB will strengthen its standards to achieve better disclosures
about valuations, methodologies and the uncertainty associated with valuations. (Financial Stability Forum, 2008, p. 27)
Fair Value Accounting and the Banking Crisis in 2008
11
III.6 The IASB will enhance its guidance on valuing financial instruments
when markets are no longer active. To this end, it will set up an expert
advisory panel in 2008. (Financial Stability Forum, 2008, p. 27)
These recommendations (and many others made by the FSF) were reflected in the
G7s communique of 11 April 2008:
The International Accounting Standards Board (IASB) and other relevant standard setters should initiate urgent action to improve the accounting and disclosure standards for off-balance sheet entities and enhance its guidance on fair value
accounting, particularly on valuing financial instruments in periods of stress.
The IASBs period of sudden visible activity dates from this time (their financial
crisis time line page on their website shows actions from June 2008). They took
action in three areas: they set up the Expert Advisory Panel on Fair Value in a
Declining Market (EAP), they decided to amend IFRS 7 to improve the disclosures related to financial instruments, and they asked the staff urgently to advance
the existing consolidations project and the de-recognition project.
Expert Advisory Panel (EAP)
The IASB decided to appoint the EAP as an IASB-only exercise, not involving
the FASB. They were to regret this later. At the May 2008 meeting of the
IASB, the staff brought forward a paper:
Ms Eastman said that the issue was limited to the question of the advisory
panel for the Financial Stability Forum. Their April 7 report had recommended
that the IASB provide enhanced guidance on determining fair values in a
declining market. The IASB was setting up an advisory panel which would
assist the Board in reviewing best practice and producing guidance on measuring fair value when the market is no longer active. The staff had contacted
financial institutions and the panel was to have its first meeting on 13 June
in London. This would probably be a two or three day session which would
discuss the form of the deliverable. She would give an update to the Board
at the June meeting. (International Standard-setting Report, May 2008, p. 12)
Asked about the terms of reference, Sir David Tweedie said:
it was pretty simple: what, if anything, needs to be done? They were asking
for people who had experience of doing this. They did not want it to be done
from 35,000 feet. (International Standard-setting Report, May 2008, p. 13)
The EAP consisted of representatives of a number of banks, including BNP
Paribas, Citigroup, HSBC and UBS, insurance companies, the Big Four audit
12
P. Andre et al.
firms, the Basel Committee, Insurance Supervisors and the Financial Stability
Forum. In August the EAP produced a draft report that addressed (a) valuation
issues and (b) disclosure issues. This was published in September on the IASB
website and comments were invited. A final report was published in October 2008.
Although the FASB had sent a staff observer along to the EAP, the US
standard-setter was not directly involved. However, a joint statement by the
SEC and the FASB on 30 September 2008 said There are a number of practice
issues where there is a need for immediate additional guidance and referred to
the EAPs draft document. The SEC statement had a series of questions and
answers on valuing financial instruments.2
The IASB put out a statement on 2 October saying that it had reviewed the
SEC/FASB guidance and considered it consistent with IAS 39. The press
release cites Sir David Tweedie: The SEC-FASB clarification on fair value
accounting is a useful contribution, and our staff believes that it is consistent
with IFRSs. We will continue to ensure that any IFRS guidance on fair value
measurement is consistent with the clarification that has been provided by the
US SEC staff and the FASB staff.
With the benefit of hindsight, it appears that this last sentence could be an
oblique reference to the European Commissions attempt, then in preparation,
to force the IASB to change IAS 39 to align with US GAAP.
The EAPs final report was welcomed in public pronouncements from the
European Commission and others (including the Committee of European Securities Regulators CESR), and preparers and auditors were urged to follow it
immediately.
IFRS 7 Disclosures
The EAPs view on disclosures was that IFRS 7 had worked quite well but that
there was room for improvement. The criticisms of it were that it was not specific
enough in some areas, notably in terms of a fair value hierarchy and in terms of
quantitative disclosures. The IASBs capital markets team took up these points
and brought proposed amendments to the Board, which were published as an
exposure draft in October 2008. The exposure draft proposed bringing in to
IFRS 7 the fair value hierarchy from IAS 39. This is virtually the same as the
SFAS 157 hierarchy but not set out so explicitly. The exposure draft mandated
greater disclosure about level 3 valuations and required quantitative disclosures
of the maturity of its derivatives in addition to a qualitative discussion of liquidity
risk. The IASB tentatively decided that the final amendment should be in force
from July 2009 with earlier application allowed.
Consolidation
Arguably the most difficult problem to address was that of off balance
sheet investment vehicles. The existing IASB literature on the subject was SIC
13
12. However, the Board had had a project to revise IAS 27, the basic standard
on consolidation, and incorporate SIC 12 into it (it is standing policy for the
IASB that whenever a standard is revised, any Interpretations issued subsequently
to the last version of the standard are incorporated into the revision). This project
had been on the active agenda for some time but had repeatedly been pushed to
one side by other projects. It now became a top priority.
The project was being led by Alan Teixeira, a senior project manager who had
joined the IASB from the New Zealand standard-setter, and became Director of
Technical Activities in April 2008. His view, which he was able to persuade the
Board to accept, was that something more flexible was needed than the on-off
switch that arose from the decision to consolidate or not a special purpose
entity. His solution was (a) to require a discussion of the non-consolidation
decision, and (b) to propose a series of disclosures about sponsored entities
and any with which the parent had a continuing involvement.
The exposure draft was published in December 2008. It called for companies to
disclose how many structured entities they have sponsored during the year and
what fee income they derive from these. They will also ask companies to give
details about vehicles that they have sponsored in the past and subsequently supplied any support to. These are an attempt to give investors an idea of the scale of
the companys activity in creating Structured Investment Vehicles (SIV). They
also try to address the possibility of a company deciding to take back onto its
balance sheet an SIV without there being any legal obligation because of the
risk to reputation. Situations arose during the initial sub-prime crisis where
banks that had sponsored such vehicles and had no further investment (but
were receiving management fees) took the view that they had to rescue the
vehicles or accept considerable damage to their standing with investors who
had participated in the SIVs.
The proposal goes a long way beyond SIC 12 and much of its requirements will
be the reaction to the financial crisis, addressing primarily structured entities set
up by banks.
Attack from Europe

While the IASB was busy dealing with its responses to the FSF and G7, a separate
initiative was taking place in France. Rene Ricol, a Paris-based former small
practitioner who had served a term as president of the International Federation
of Accountants, was asked by the French President, Nicolas Sarkozy, reputedly
after lobbying by French banks, to give an opinion as to whether European
banks were being disadvantaged by IFRS as compared with their American
counterparts. Ricol came to the view that this was the case. SFAS 86, a relatively
old standard, did not require property mortgages to be held at fair value, and
SFAS 133, the substantive fair value standard, allowed available for sale financial
instruments to be re-classified under rare circumstances.
14
P. Andre et al.
The so-called EU IAS Regulation (2002/1606) which required all European

listed companies to follow IFRS from 2005 includes a requirement that IFRS
endorsed by the EU must not disadvantage European companies as compared
to those in other major markets. The Internal Market Directorate General
(DGXV) which is responsible for capital markets, drew up a draft carve-out
to amend IAS 39 as endorsed by the European Union.
This was a very significant event, to understand which it is necessary to look
briefly at the history of EU endorsement of IAS 39. French banks have been
opposed to carrying financial instruments at fair value ever since this was
mooted in the 1990s. They persuaded the then French president, Jacques
Chirac, to write to the European Commission in 2003 (reproduced in Alexander,
2006, pp. 79 80) to complain that this would destabilise the economy. French
banks tried to persuade the IASB to modify IAS 39 and negotiations took place
for many months. In the end, one sticking point was that IAS 39 says that no liability can be stated at less than the amount that may be required to be paid at
balance sheet date (known as the demand deposit floor). This was not acceptable to French retail banks which discounted such liabilities below the floor on the
basis that customer current accounts in practice provided virtually permanent
funding. The IASB would not budge on this and the banks persuaded the
Accounting Regulatory Committee (the organ responsible for endorsing IFRS
into European law) to carve out the paragraph in IAS 39 that addresses this
issue.
This was a major blow to the IASB. It has meant that there are at least two variants of IFRS used IFRS as issued by the IASB, and IFRS as endorsed by the
EU. This has in turn led to threats of carve-outs elsewhere. For example the
Australian Accounting Standards Board (AASB) threatened a carve-out if
the IASB did not allow the creation of new holding companies without revaluation in 2007. The Indian standard-setter has also insisted in its document accepting a plan to move to IFRS that it reserves the right to amend the standards
(although it later assured the Committee of European Securities Regulators
that any amendments would not be such as to prevent Indian companies asserting
compliance with IFRS as issued by the IASB).
The US Securities and Exchange Commission was not at all pleased by the EU
carve out. When it said in September 2007 that it recognised IFRS as equivalent
to US GAAP for the purposes of foreign companies listed in the US, it specified
that this applied only to IFRS as issued by the IASB. There has so far been only
the original carve-out, but many people, including Sir David Tweedie, IASB
president (testimony to House of Commons Select Treasury Committee 11
November 2008) believe that a second European carve out would lead to the
demise of the worldwide globalisation project. The credibility of IFRS and
the IASB would be fatally damaged if it became inescapably clear that Europe
did not accept its authority.
Matters came to a head when President Sarkozy called a meeting of the
European finance ministries of countries that are part of G7 (France, Germany,
15
Italy and the UK) on 4 October to discuss the credit crisis. He obtained agreement
that the IASB should be asked to amend IAS 39 to bring it in to line with US
GAAP by the end of October. This position was endorsed by a full meeting of
the EU Council of Finance Ministers (ECOFIN) a few days later. It seems
highly probable, given that the IASB has a well-documented due process that
involves lengthy exposure periods, that France and the European Commission
did not think that the IASB could remotely meet this deadline. A meeting of
the ARC was arranged for mid October to vote on the carve-out that the Commission had drafted.
However, the IASB had of course seen the Ricol report at an early stage and
the draft carve-out. Sir David Tweedie later gave evidence that the carve-out
would have been disastrous, and would have opened up a free for all in
accounting for financial instruments. The ARC can remove material from
standards, but it cannot add material. So in removing the paragraphs that
prevented re-classification, it would take away all safeguards on manipulation
of instrument categories without providing any new defences such as disclosures.
I think accounting in Europe would have been totally out of control if they had
used the option to take the carve-out.3
The IASB took action. Coincidentally, the Trustees of the IASC Foundation,
the IASBs oversight body, were meeting in Beijing just after the European ministers meeting and agreed to suspend due process. The Board then convened a
meeting on Monday 13 October to vote through an amendment to IAS 39. US
members complained that the reading of US practice was wrong and they
voted against but the amendment was passed. It was duly agreed by the ARC
two days later and the carve-out was averted but at some cost. Sir David
Tweedie told the UK parliamentary committee:
Others were asked Have we been damaged? I think the answer is yes we
have been by what happened a few weeks ago. I was in the United States a
fortnight ago and there were questions of Why did you do this? This is
European influence. Are you a European body? . . . Other countries were
completely taken by surprise because all of this happened very, very
quickly . . . suddenly they were given something they had no knowledge
was coming. That was a major problem for us. It upset a great deal of
people. So it did damage the whole exercise.4
The political crisis for the IASB did not end there. DGXV wrote to the IASB later
in October5 setting out three further issues arising from a meeting with stakeholders that it had called in the wake of the ARC vote. It raised the question of
re-classifying assets designated as held at fair value under the fair value
option, revising the impairment rules and clarifying that embedded derivatives
need not be bifurcated. The letter said these should be dealt with in time for
the year-end reporting season.
16
P. Andre et al.
The IASB chairman replied on 14 November 2008, pointing out that the IASB
was holding a series of round tables on the financial crisis, the last of which would
be in December. He also noted that the IASB needs to take proper account of the
views of all stakeholders in order to develop accounting standards that provide
transparent information to market participants. Sir David Tweedie wrote again
on 17 December. Commenting on the issues raised in the Commissions 14
November letter, he said:
it was a clear message of participants at these round tables that the IASB
should continue to take urgent action to improve the application of fair
value principles, where necessary, but such action must be in conjunction
with the FASB to ensure globally consistent conclusions. A further clear
message was that any steps taken to amend fair value accounting taken
without proper regard to the well-established and supported standardsetting due process, would further undermine already scarce confidence
in the financial markets.
International Support
The IASB feared that the European attempts to interfere in the standard-setting
process would be continued at a meeting of the G20 heads of government on
15 November 2008 that had been called by the US to discuss the financial
crisis. The European members of the G20 met together on 7 November to
prepare for the Washington meeting. They put out a statement6 that called for
a more comprehensive information system, which no longer omits vast
swathes of financial activity from auditable, certifiable accounts and added:
Both prudential and accounting standards applicable to financial institutions will have to be revised to ensure that they do not contribute to creating speculative bubbles in periods of growth and make the crisis worse at
times of economic downturn.
Standards bodies, in particular in the area of accountancy, will have to
be reformed to allow a genuine dialogue with all the parties concerned,
in particular prudential authorities.
This was seen as a French attempt to make the IASB take account of
financial stability7 rather than privileging transparency for investors as the
main objective.
The Trustees of the IASC Foundation wrote to President Bush, asking that their
letter be transmitted to the G20 governments. The letter (dated 11 November and
published on the IASB website) underlined the importance of transparent and
comparable information and suggested that interference with the standardsetting process undermined confidence in the markets. The letter cited support
from the Banque de France, the International Corporate Governance Network
17
and the CFA Institute. It also addressed the question of pro-cyclicality and agreed
that there was potentially a linkage if financial institutions had to sell assets to
meet liquidity ratios and added to the decline in the market. They suggested
that this should, however, be addressed by a dialogue between the IASB and
the bank supervisors as to how the latter used shareholder accounts.
IOSCO issued an open letter to the G 20 governments on 12 November 2008,8
saying that:
Accounting standards must provide clear, accurate and useful information
to investors to allow them to make informed investment decisions. Furtherance of this goal promotes investor confidence in financial statements and
capital markets.
The statement also said: IOSCO strongly supports IFRS as developed by
the IASB.
Communique
The IOSCO letter was followed by a 14 November 2008 communique from 20
national standard-setters.9 These were all members of the loose grouping
known as the National Standard-Setters chaired by Ian Mackintosh of the UK
Accounting Standards Board, which meet twice a year to discuss technical
matters and to collaborate on technical research. The letter said: We continue
to support the IASB and its efforts to achieve true global accounting standards.
It added: It is important that the IASB follows appropriate due process It agreed
that in extraordinary times, it may be necessary for due process to be shortened.
But said it should not be abandoned, and the standard-setters were ready to help
achieve this. The letter was signed by the national standard-setters of the UK,
Germany, Austria, France, Sweden, the Netherlands and Italy from within the
EU, as well as Norway, Japan, Pakistan, New Zealand, Mexico, Canada, South
Africa, Taiwan, Hong Kong, Korea and India. The European Financial Reporting
Advisory Group (EFRAG) which provides technical advice to the European
Commission also signed the latter.
In the event, the G20 leaders issued a final communique from their summit
that largely supported the IASBs position. The communique repeated calls
for guidance on valuation of securities and attempts to address disclosures
related to off balance sheet vehicles and complex financial instruments. It also
said:
With a view toward promoting financial stability, the governance of the
international standard-setting body should be further enhanced, including
a review of its membership, in particular in order to ensure transparency,
accountability, and an appropriate relationship between this independent
body and the relevant authorities.
18
P. Andre et al.
This seems to be a reference to the changes in governance arrangements already

proposed by the Trustees, whereby a monitoring group including stock exchange
regulators, the European Commission, the World Bank and the International
Monetary Fund would be represented. The monitoring group will have oversight
of the Trustees governance of the standard-setter.
The communique continues:
The key global accounting standards bodies should work intensively

towards the objective of creating a single high-quality global standard.
Regulators, supervisors, and accounting standard-setters, as appropriate,
should work with each together and the private sector on an on-going
basis to ensure consistent application and enforcement of high-quality
accounting standards.
Financial institutions should provide enhanced risk disclosures in their
reporting and disclose all losses on an ongoing basis, consistent with international best practice, as appropriate. Regulators should work to ensure that
financial institutions financial statements include a complete, accurate, and
timely picture of the firms activities (including off balance sheet activities)
and are reported on a consistent and regular basis.
This seems to support the IASB and IOSCO position that losses should not be
hidden behind historical cost accounting.
The FASB gets support
Just as the IASB had been under fire in Europe, the FASB had been under
pressure from American banks, politicians and the SEC. The IASBs Expert
Advisory Panel had been organised independently of the FASB, but the FASB
had observed, and when the EAP produced its draft guidance on fair value
measurement, the SEC and FASB produced a joint statement clarifying similar
issues in the measurement of fair value10 and the FASB issued a staff position
(FSP FAS 157 3) on determining the fair value of a financial asset when the
market for that asset is not active.
The US Emergency Economic Stabilization Act of 2008 had mandated an SEC
staff examination, along with the Federal Reserve and the Secretary of the Treasury, of mark to market accounting. This was published on 30 December 2008. The
report (Report and Recommendations Pursuant to Section 133 of the Emergency
Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting)
noted that there was a debate between those who thought fair value accounting
was pro-cyclical and exaggerated the crisis and those who thought transparent
information was essential for investors. The credibility and experience of
parties on both sides of this debate demand careful attention to their points
19
and counterpoints on the effects of fair value accounting on financial markets

(p. 2).
The Report noted among other things (p. 4):

The Staff observes that fair value accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in
the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor
confidence. For the failed banks that did recognize sizable fair value losses,
it does not appear that the reporting of these losses was the reason the bank
failed.
It also noted (p. 5):
investors generally support measurements at fair value as providing the
most transparent financial reporting of an investment, thereby facilitating
better investment decision-making and more efficient capital allocation
amongst firms. While investors generally expressed support for existing
fair value requirements, many also indicated the need for improvements
to the application of existing standards. Improvements to the impairment
requirements, application in practice of SFAS No. 157 (particularly in
times of financial stress), fair value measurement of liabilities, and
improvements to the related presentation and disclosure requirements of
fair value measures were cited as areas warranting improvement
Support for fair value also came from Lloyd Blankfein, CEO of Goldman Sachs,
who wrote in the Financial Times, 8 February 2009. He blamed poor risk management for the crisis and noted:
Last, and perhaps most important, financial institutions did not account for
asset values accurately enough. I have heard some argue that fair value
accounting which assigns current values to financial assets and liabilities
is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to
reduce their exposures.
The FASB has had some notorious clashes with Congress, notably over its
proposals for oil and gas exploration costs in the 1970s and its stock option
accounting in the early 1990s. In these cases it had to back down, but it seems
to have been luckier than the IASB this time and to have escaped wholesale
interference.
20
P. Andre et al.
Assessing the Consequences

It will take months if not years for the consequences of the events of 2008 for the
IASB to be assessed at that time, even if interference was to take place the next
year. What seems clear is that the IASBs credibility and independence have been
compromised by the European Commissions manoeuvres in October to force
the IASB to allow re-classification. The suggestion has been put forward that
the IASB contemplated a confrontation with the Commission but came to the
conclusion that if the Commission abandoned IFRS, it was probable that Japan
would follow suit, and potentially all the countries planning to adopt in 2011
might withdraw. It decided to trump the Commissions carve-out with a more
limited IAS 39 amendment and fight on.
However, the Commission intervention plays into the hands of those in the US
who do not wish to abandon US GAAP, as the SECs 2008 road map has proposed. The change of government in the US has inevitably led to a change of personnel at the SEC. The new chairman, Mary Schapiro, said in her confirmation
hearing in front of the Senate banking committee that she thought a single set
of global standards would be a very beneficial thing but she expressed doubts
about the independence of the IASB and said she would not necessarily be
bound by the proposed roadmap (World Accounting Report, February 2009,
p. 7). The SEC Chief Accountant has also stepped down but no replacement
has yet been named. It seems likely that a switch to IFRS from US GAAP will
likely be delayed if not abandoned altogether.
Perceptions of the IASBs independence are not helped by things like Commissioner McCreevy (DGXV) saying in a speech in Dublin in February 2009:
[accounting standards] have also exacerbated the markets recent problems
because of rules that are pro-cyclical . . . That is why I recently brought
forward a measure to provide firms with more flexibility on the mark to
market requirements and to facilitate asset transfer from the trading to
the banking book.11
This implies that the Commissioner still thinks he can change IFRS at will, which
is unlikely to play well in Beijing, Tokyo, Rio de Janeiro, Ottawa, Seoul, Delhi or
Washington, quite apart from London. This has to imply that more difficulties are
likely to be raised by the Commission. The April 2009 meeting of the G20 is
being indicated as the next showdown between those who want transparency
for investors and those who want to hide the losses because they believe it
creates stability.
In January 2009, the Trustees of the IASC Foundation finalised the new monitoring arrangements. A Monitoring Board was created. Its members included
the SEC, European Commission, Japanese Financial Services Agency and two
members from IOSCO. However, the World Bank and the International Monetary
21
Fund had disappeared from the original proposal, and the Basel Committee on
Banking Supervision came in as an observer. It seems likely that this shift came
about as a result of the 2008 debate.
One of the ironies of the fair value crisis has been the emergence of pressure on
both the IASB and FASB to work closely together. In the 1990s there was still a
debate about whether US GAAP could become the worldwide standard for financial reporting. The European answer was that following US rules was completely
unacceptable. However, we find the Commission saying in 2008 that the IASB
must change its rules to give European companies the same position as under
US GAAP. This was followed by the IASB telling the Commission that it could
not accede to subsequent demands because constituents wanted it to work with
the FASB.
In fact, the two Boards also learned in this crisis that they needed to work very
closely together for political protection. After the IASBs creation of its Expert
Advisory Panel and the separate SEC/FASB publications on applying fair
value, the two Boards met for their regular six-monthly meeting in October.
During the course of this meeting they issued a press release (20 October
2008) committing to work together to create a common solution to accounting
for financial instruments, to create a joint high-level advisory group on dealing
with the financial crisis, and to conducting a series of joint round tables.
The G7 statement of April 2008 has led to a rapid acceleration of the IASBs
work programme in related topics. Guidance has been given on applying fair
value in illiquid markets (Level 1 or Level 2 fair values require there to be a
liquid market, so only Level 3 mark to model fair values can be used). Steps
are being taken to improve IFRS 7 disclosures, although the IASBs initial proposals have had to be modified. An exposure draft has been issued on consolidation and special purpose entities. An exposure draft on de-recognition will be
issued in 2009.
Arguably, another irony in terms of outcomes is that in January 2009 the
Commission announced a fund to enable it to contribute directly both to the
IASBs costs and those of the European Financial Reporting Advisory Group
(EFRAG) which interacts on technical issues with the IASB on behalf of
European interests in general and the Commission in particular. The Commission
announced a fund of E36.2 million to be made available for four years from 2010
to make contributions to the IASB, EFRAG and possibly others. Tentatively, the
IASB is expected to receive E5 million a year from this.
The Commission has been notorious over the years for being unwilling to
spend any money on accounting, not even paying for EFRAG, which is funded
by European lobbying bodies with an interest in accounting. The paper announcing the proposal (COM 2009-14) says that this was being done as a result of the
October 2008 meetings where the Commission decided it should have more
involvement with the standard-setting process. The Commissions announcement
notes: Independence of the standard-setting process without any undue influence
22
P. Andre et al.
from parties with a stake in the outcome of the IASBs standard-setting process is
crucial.
The Committee of European Securities Regulators (CESR) carried out a survey
of the third quarter statements of 100 financial companies in Europe (of which 22
are included in the FTSE Eurotop 100 index) to see how they had reacted to the
IASBs emergency amendment to IAS 39.12 It found that 52% of the sample, and
64% of the FTSE Eurotop 100 companies had not re-classified any financial
instruments. Twenty-eight percent had made one re-classification (18% of the
FTSE Eurotop 100). Only one company had more than three re-classifications.
The majority of re-classifications were from fair value through profit and loss
to loans and receivables.
Conclusion
In our view, 2008 was a very unfortunate year for the international accounting
standard-setting institution. Fair value financial statements were telling banks
they had made disastrous investment decisions, but the banks, some governments
and the regulators preferred to believe the numbers were wrong (shooting the
messenger) rather than the investment decisions. At the time of writing
(March 2009) the US government has just voted almost $200 billion for AIG
to prop up the insurer, which might give an insight into the quality of the managements evaluations of their investments.
It seems to us that although the IASB was probably talking to IOSCO and the
Financial Stability Forum early in 2008, the fair value debate had started in 2007.
It took a long time, and a G7 announcement, before the IASB overtly recognised
that it had a political problem on its hands and started to react. Since then it has
worked decisively and rapidly to address the perceived problems, but it appears to
have been damaged. The focus on fair value reporting and pro-cyclicality has presented an opportunity for all those, such as the European Banking Federation,
who have strenuously opposed IAS 39 since drafting first started in the 1990s,
to try to kill the standard off permanently. It has also exposed the difference in
orientation between Anglo-Saxon regulators and those from the European code
law tradition (Walton, 2004) in terms of the objectives of financial reporting.
One group thinks it is to inform investors, the other that it is a tool that can be
used to regulate the economy.
The European Commission persists in behaving as though it controlled the
IASB, and a lot of progress will have to be made in 2009 to re-assure countries
adopting in 2011 (Canada, South Korea, India, China, and Brazil). It seems very
unlikely that the SEC will stick to the roadmap of making a decision in 2011 and
shifting progressively thereafter. There again, opponents of the shift are taking
the opportunity to point to lack of independence of the IASB and lack of
clarity in IFRS as arguments for staying with US GAAP. The IASB will need
to be luckier in 2009 than it was in 2008.
23
Notes
1
AIG urgesfair value re-think 14 March 2008.

This was followed on 10 October by an FASB Staff Position (FSP 157-3) on Determining the
Fair Value of a Financial Asset When the Market for that Asset Is Not Active.
3
Uncorrected transcript of the House of Commons Select Treasury Committee 11 November
2008, taken from www.parliamentlive.com.
4
Uncorrected transcript of the House of Commons Select Treasury Committee 11 November
2008, taken from www.parliamentlive.com.
5
Letter from the Director General of DGXV dated 27 October 2008, published on http://ec.
europa.eu/internal_market.
6
Informal Meeting of Heads of State or Government on 7 November 2008 Agreed Language
European Commission 7 November 2008.
7
For example Accountancy Age Sarkozy leads the charge towards IASB stability remit 13
November 2008.
8
Press release 12 November 2008 IOSCO open letter to G20 summit www.iosco.org.
9
Published by many of the participating standard-setters (not apparently by the Conseil national
de la comptabilite) but see for example the German Accounting Standards Board 17 November
2008 http://www.standardsetter.de/drsc/news.
10
SEC release 2008234 of 30 September 2008.
11
Speech 09/41: The Credit Crisis Looking Ahead 9 February 2009 downloaded from www.
ec.europa.eu/internal_market.
12
Announcement 08937 of CESR made on 7 January 2009.
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Fair Value Accounting and the

During 2007, financial institutions began to need to recognise a drop in value of

Fair Value Accounting and the Banking Crisis in 2008 5

financial assets held for trading

is used as an allocation device when a transaction needs to be broken down into

Fair Value Accounting and the Banking Crisis in 2008 7

Fair Value Accounting and the Banking Crisis in 2008 9

Fair Value Accounting and the Banking Crisis in 2008

Fair Value Accounting and the Banking Crisis in 2008

Attack from Europe

The so-called EU IAS Regulation (2002/1606) which required all European

Fair Value Accounting and the Banking Crisis in 2008

Fair Value Accounting and the Banking Crisis in 2008

This seems to be a reference to the changes in governance arrangements already

The key global accounting standards bodies should work intensively

Fair Value Accounting and the Banking Crisis in 2008

and counterpoints on the effects of fair value accounting on financial markets

The Report noted among other things (p. 4):

Assessing the Consequences

Fair Value Accounting and the Banking Crisis in 2008

Fair Value Accounting and the Banking Crisis in 2008

AIG urgesfair value re-think 14 March 2008.

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