Ten years after the outbreak of the financial crisis, there are still persistent arguments about the role that accounting standards may have played in its genesis.
Some critics of International Financial Reporting Standards argue that they gave an overly rosy picture of banks’ balance sheets before the crisis and are still not prudent enough despite improvements since then. These same critics also argue that excessive reliance on fair value accounting, which reflects an asset’s current market value, has encouraged untimely recognition of unrealised profits.
They want to require banks to make upfront provisions for all expected lifetime losses on loans and, presumably, a return to good old historical cost accounting, which values assets at the price they were initially purchased.
Though superficially appealing, these changes would weaken prudent accounting, rather than strengthen it.
The British bank HBOS, which collapsed and was taken over by Lloyds Banking Group during the crisis, has been presented as an example of failing pre-crisis accounting standards. The truth is that HBOS met bank regulators’ capital requirements, and its financial statements clearly showed that its balance sheet was supported by no more than 3.3 per cent of equity. For investors who cared to look, the IFRS standards did a quite decent job of making crystal clear that many banks had wafer-thin capital levels and were accidents waiting to happen.
However, the crisis did reveal that the existing standards gave banks too much leeway to delay recognition of inevitable loan losses. In response, the International Accounting Standards Board developed an “expected loss model” that significantly lowered the thresholds for recognising loan losses. The new standard, IFRS 9, requires banks to initially set aside a moderate provision for loan losses on all loans. This prevents them from recognising too much profit up front. Then if a loan experiences a significant increase in credit risk, all the losses that can be expected over the lifetime of the loan must be recognised immediately. Normally, that will happen long before actual default.
In developing this standard, the IASB did consider whether to require banks to recognise full lifetime losses from day one. We rejected this approach for several reasons.
First, accounting standards are designed to reflect economic reality as closely as possible. Banks do not suffer losses on the very first day a loan has been made, so recording a full lifetime loss immediately is counter-intuitive. Moreover, in bad economic times, when earnings are already depressed, banks would have an incentive to cut back on new lending in order to avoid having to recognise large day one losses. Just when you need it most, the economy would probably be starved of credit.
Second, future losses are notoriously difficult to predict, so any model based on expected losses many years later would be subjective. Before the crisis, Spanish regulators required their banks to provision for bad times on the basis of lifetime expected losses. But their lenders underestimated and were still overwhelmed by the tide of bad loans. This kind of accounting also tempts banks to overstate losses in good times, creating reserves that could be released in bad times. That may seem prudent at first but could mask deteriorating performance in a later period, when investors are most in need of reliable information.
Critics also allege that IFRS has been too enamoured of fair value accounting. In fact, banks value almost all of their loan portfolios at cost, so the historical cost method remains much more pervasive.
Fears that fair value accounting lead to improper early profit recognition are also overblown. IFRS 9 prohibits companies from doing that when quoted prices in active markets are not available and the quality of earnings is highly uncertain. Moreover, fair value accounting is often quicker at identifying losses than cost accounting. That is why banks lobbied so actively against it during the crisis.
This does not mean that the accounting standards are infallible. Accounting is highly dependent on the exercise of judgement and is therefore more an art than a science. Good standards limit the room for mistakes or abuse, but can never entirely eliminate them. The capital markets are full of risks that accounting cannot possibly predict. This is certainly the case now, with markets swimming in debt and overpriced assets. For accounting standards to do their job properly, we need management to own up to the facts — and auditors, regulators and investors to be vigilant.
In developing this standard, the IASB did consider whether to require banks to recognise full lifetime losses from day one. We rejected this approach for several reasons.
First, accounting standards are designed to reflect economic reality as closely as possible. Banks do not suffer losses on the very first day a loan has been made, so recording a full lifetime loss immediately is counter-intuitive. Moreover, in bad economic times, when earnings are already depressed, banks would have an incentive to cut back on new lending in order to avoid having to recognise large day one losses. Just when you need it most, the economy would probably be starved of credit.
Second, future losses are notoriously difficult to predict, so any model based on expected losses many years later would be subjective. Before the crisis, Spanish regulators required their banks to provision for bad times on the basis of lifetime expected losses. But their lenders underestimated and were still overwhelmed by the tide of bad loans. This kind of accounting also tempts banks to overstate losses in good times, creating reserves that could be released in bad times. That may seem prudent at first but could mask deteriorating performance in a later period, when investors are most in need of reliable information.
Critics also allege that IFRS has been too enamoured of fair value accounting. In fact, banks value almost all of their loan portfolios at cost, so the historical cost method remains much more pervasive.
Fears that fair value accounting lead to improper early profit recognition are also overblown. IFRS 9 prohibits companies from doing that when quoted prices in active markets are not available and the quality of earnings is highly uncertain. Moreover, fair value accounting is often quicker at identifying losses than cost accounting. That is why banks lobbied so actively against it during the crisis.
This does not mean that the accounting standards are infallible. Accounting is highly dependent on the exercise of judgement and is therefore more an art than a science. Good standards limit the room for mistakes or abuse, but can never entirely eliminate them. The capital markets are full of risks that accounting cannot possibly predict. This is certainly the case now, with markets swimming in debt and overpriced assets. For accounting standards to do their job properly, we need management to own up to the facts — and auditors, regulators and investors to be vigilant.