Accounting Standards Wilt Under Pressure
Saturday, December 27, 2008
World leaders have vowed to help prevent future financial meltdowns by creating international accounting standards so all companies would play by the same rules, but the effort has instead been mired in loopholes and political pressures.
In October, largely hidden from public view, the International Accounting Standards Board changed the rules so European banks could make their balance sheets look better. The action let the banks rewrite history, picking and choosing among their problem investments to essentially claim that some had been on a different set of books before the financial crisis started.
The results were dramatic. Deutsche Bank shifted $32 billion of troubled assets, turning a $970 million quarterly pretax loss into $120 million profit. And the securities markets were fooled, bidding Deutsche Bank's shares up nearly 19 percent on Oct. 30, the day it made the startling announcement that it had turned an unexpected profit.
The change has had dramatic consequences within the cloistered world of accounting, shattering the credibility of the IASB -- the very body whose rules have been adopted by 113 countries and is supposed to become the global standard-setter, including for the United States, within a few years.
Sir David Tweedie, chairman of the IASB, acknowledged that the body needs more protection from political manipulation before it can claim that it has become the global gold standard.
Tweedie said he nearly resigned over the rule change demanded by European politicians. "I was so frustrated by the whole thing," he said. "All the time when we are trying to build a global accounting system, and we are pretty close to it, and then suddenly out of left field this thing appears. It's just absolutely exasperating."
U.S. standards have been set by the Financial Accounting Standards Board since 1973. "Right now, there is no credibility," said Robert Denham, chairman of the Financial Accounting Foundation, which oversees the FASB. "If we are going to have global accounting standards, my view is that is not going to work if the IASB is going to be jerked around by the European Commission. That is the very real risk that is posed by the EC coercion and the IASB's response."
The episode exposes how small, incremental changes in arcane accounting rules can affect billions of dollars in market value and corporate profitability. In turn, the money at risk raises the political stakes, as desperate companies begin to lobby political leaders to insist on changes that normally would come about only after a careful discussion and evaluation by experts.
For years, there has been a disconnect between U.S. and international accounting rules. With the history of corporate litigation in the United States, U.S. standards tend to be exact and explicit, making it easier for companies to defend themselves in court.
International rules rely on broad principles, giving companies greater leeway to make their own judgments. An extensive review of international accounting standards published last month by Moody's Investors Service found significant differences between two French companies on one key issue -- even though they used the same accounting firm.
Nevertheless, more than 110 countries have already adopted international rules since the IASB was established in 2001, with Japan, South Korea, India and Canada soon to make the switch. Tweedie expects that 150 countries will have adopted IASB rules within the next three years. The Securities and Exchange Commission on Nov. 14 adopted a plan to have all U.S. companies prepare their statements using international standards for fiscal years ending after Dec. 15, 2016. More than 100 of the largest companies would be permitted to adopt the rules as soon as next year.
But the financial crisis demonstrated how vulnerable the fledgling system is to political pressure.
On Oct. 8, the leaders of France, Germany, Italy, Britain and the European Commission met in Paris to discuss the worldwide economic crisis. They issued a statement saying they were working together "within the European Union and with our international partners" to ensure the safety and stability of the worldwide banking system. But buried within the statement was a sentence warning that European banks should not face a competitive disadvantage with U.S. banks "in terms of accounting rules and their interpretation." The leaders added ominously: "This issue must be resolved by the end of the month."
At issue is an accounting standard known as fair value, or mark to market, in which companies disclose how much an asset could fetch on the open market. With the values of assets plummeting, banks were suddenly stuck with paper losses on assets they could no longer sell. With some critics saying the provision was forcing banks to take large write-downs, the SEC and FASB issued guidance in late September that companies could use their own internal models for assigning a value to assets -- in essence, a nod to the principles-based international rules.
But European officials smelled a rat. Under rare circumstances, U.S. companies are permitted to reclassify assets they were actively seeking to trade into long-term "loans," using an accounting rule that was considered weaker than the international equivalent. The international rules did not permit such transfers, and European officials feared that the new guidance was handing the Americans a competitive advantage.
Shortly after the European leaders' statement, Commissioner Charlie McCreevy of the European Commission, who was in charge of the European Union internal market, signaled he would introduce legal changes, overriding the international rules. McCreevy decided to exploit a loophole in the system -- that all accounting rules must be adopted as legislation by the E.U. So McCreevy was going to force the changes on the IASB by threatening to remove -- or carve out -- the existing regulation, leaving nothing in its place.
"We made it clear what the IASB should accept," said Oliver Drewes, a spokesman for McCreevy. "There is always the right, and threat and the pressure, that one could go for a carve-out for European companies."
Tweedie said the rulemaking body had only four days to act before McCreevy pushed through a change in the law, even though accounting changes of this magnitude would normally take months to achieve.
Unlike the U.S. board, the international board has no regulator like the SEC to help shield it from political pressure. So the IASB was at the mercy of the European Commission.
"There had been pressure on him, I suspect, from some of the European leaders," Tweedie said, referring to McCreevy. "It was quite clear it was going to be pushed through and that would have been a disaster. We were faced with this hole being blown in the European accounting, and we just wanted to step in and control it."
But the IASB bowed to demands to let the firms backdate the accounting shift to the beginning of July -- something not permitted under U.S. rules.
In a recent report, Moody's wrote that the backdating provision could distort a bank's earnings and capital position, since "it allows managements to 'cherry-pick' selected assets" and "distort their economic reality," making it more -- not less -- difficult to compare global bank performance.
"The measure does not make much sense in the first place," said J.F. Tremblay, a Moody's vice president. "But the fact that a board can be influenced like that is not good news."