05 July 2013

IASB: Submission to EU consultation on long-term financing

The IASB´s memorandum sets out the response of the IASB to the question (number 20) relating to accounting principles set out in the Green Paper ‘Long-term financing of the European Economy’ issued on 25 March 2013 by the European Commission.

Q20 – To what extent do you consider that the use of fair value accounting principles has led to short-termism in investor behaviour? What alternatives or other ways to compensate for such effects could be suggested?

The IASB does not believe that fair value accounting principles have of themselves led to short-termism in investment behaviour. As the Green Paper itself acknowledges, there is a wide range of factors that are conducive to short-termism and provide challenges for investors who want to take a long-term view.

It is also not the case, as some have claimed, that the IASB is seeking a full fair value model for financial instruments. Both the existing standard IAS 39 Financial Instruments: Recognition and Measurement and as well as its replacement IFRS 9 Financial Instruments provide for a mixed attribute model. IFRS 9 reflects the IASB’s view that fair value can provide the most relevant information depending on the nature of the instrument and how the reporting entity manages the asset. While fair value is an appropriate measurement attribute for financial instruments that are traded, in IFRS 9 Financial Instruments that have simple contractual cash flows (such as basic loans) and that are held to collect those cash flows are measured at amortised cost. For such instruments, amortised cost is deemed to provide the most relevant information. It is the case that the majority of banks’ financial assets, such as loans, are still valued on an amortised cost basis rather than fair value.

For many financial instruments that have complex cash flows, only fair value can capture meaningful information about those instruments. In some cases, there is no alternative to fair value. IAS 39 requires that derivative financial instruments be recognised and measured at fair value as they are typically issued at a small cost, or even at zero, but they may have a significant value subsequently and at settlement. Applying a cost approach to their measurement would not reveal that potential impact to investors. Similarly, if an entity’s business model is to trade or frequently sell its assets, measuring performance on the basis of the fair value of those assets provides the most relevant information about the entity’s performance to that entity’s investors irrespective of the investment strategy of those investors.

In May 2011, the IASB issued IFRS 13 Fair Value Measurement, which explains how to measure fair value for financial reporting. IFRS 13 will help increase transparency when entities use models to measure fair value, particularly when users need more information about measurement uncertainty, such as when a market becomes less active. The standard requires entities to disclose information about the valuation techniques and inputs used to measure fair value, as well as information about the uncertainty inherent in fair value measurements. The IASB believes that providing additional information about fair value measurements to users of financial statements will help improve confidence in those measurements, especially those at ‘Level 3’ of the fair-value hierarchy, which relies on inputs for the asset or liability when market data are not available, including an entity’s own data (referred to as ‘unobservable inputs’). That said, few banks make extensive use of Level 3. Research undertaken by JP Morgan Cazenove of the 2011 Annual Reports of European banks reveals that, on an unweighted average basis, Level 3 assets represented around 3 per cent of financial assets.

Concerns have been raised that fair value accounting principles create too much volatility, which in turn discourages investors from making long-term investments. IFRSs seek to report economic performance as it happens. While accounting should not be the source of volatility, it is not appropriate to hide or reduce volatility in an artificial way when that volatility reflects the actual economic conditions. As Hans Hoogervorst’s speech in April also makes clear, any proposals to hide the economic reality by smoothing out short-term volatility are fraught with difficulties and could reduce, rather than enhance, market confidence in financial reports. As well, the IASB places a high priority on transparency, so that the economic circumstances are clear to investors.

More widely, some critics argue that the removal of the term ‘stewardship’ from the IASB’s Conceptual Framework in 2010 is an indication that the IASB would no longer attach sufficient importance to the interests of the long-term investor. That is not the case. The concept of stewardship continues to underlie the Framework and IFRSs.

Finally, it is important for all users to recognise the limitations of financial reporting.This was a clear conclusion of the report of the Financial Crisis Advisory Group (FCAG) published in 2009, which emphasised that financial reporting “provides only a snapshot in time of economic performance”. Market participants need to “look beyond the numbers” in the financial statements and take into account other relevant qualitative and quantitative information.

Press release

Memorandum from the IASB

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