The impact of international accounting standards changes on the UK regulator and the regulated community
Speech by Kari Hale, Director, Finance, Strategy & Risk, FSA
Association of Foreign Banks
12 October 2005
Introduction
I am delighted to be here today as I was a partner of this Firm before moving to the Financial Services Authority as Director of Finance, Strategy and Risk and Banking Sector Leader. I am now leader of the new Accounting and Audit Sector, having passed on my banking sector role to Thomas Huertas.
I have been asked to speak today about the impact of International Accounting Standards on the FSA and our regulated firms. Because of the wide remit that we have as a financial services regulator this talk could go on all night. However, you will be relieved to know that I will try to be brief and pull out only what we see as key issues arising from IFRS.
I'll also try my best not to follow in the footsteps of the accountant who when asked by a lost paraglider where he had just landed replied "You are three feet in front of me on a public footpath in the middle of a field".
The paraglider retorts "Oh good grief! Just my luck you must be an accountant".
"How did you know that?" asks the accountant.
"Well – its obvious (says the paraglider), what you have told me is 100% accurate but absolutely useless".
The impact on the regulator
I would like to start with the impact on the FSA's approach to calculating prudential capital requirements, and the changes that have come about to the way we regulate. I'll then go on to give a flavour of changes we see and expect to see to our regulated community and what I believe you should be focussing on and finally I'll talk about the longer term view of changes in the global financial markets.
From a regulator's point of view, this is a time of profound change. The introduction of IFRS for EU listed groups took effect from January this year and has affected all the larger banks, insurance companies and obviously all our listed companies. Although reporting standards have changed a great deal they are not set in stone and for this reason we, at the FSA, have taken the decision not to impose complex rule changes but to develop short-term solutions that meet our statutory objectives
A key factor in developing that approach is that, in two years time or less, we intend to review all the issues raised in the consultation paper that we put out in April "Implications of a changing accounting framework". It is our belief that changes to the standards could materially affect the way they are applied which will have a knock-on effect on the adjustments that we need to make for prudential purposes. When the review is undertaken in mid-2007 we will have had two years' experience of firms' application of the standards and should then be in a position to make sensible, pragmatic rule changes and hopefully not, in the words of another accountancy joke: "solved a problem you didn't know you had in a way you don't understand"
In assessing the relevant issues we took a number of issues, listed on the slide, into account. I don't intend going through all of these considerations but want to highlight that our main objective and concern is to promote the convergence of accounting, economic and regulatory measures of capital in order to create a measure that is comprehensive and clearly understood. Also I would note that one of our key objectives is to maintain market confidence and to that end we need to ensure that UK institutions are not put at a competitive disadvantage.
As a result, we decided not to change the way regulatory capital is defined or measured. Instead we adjusted some of the accounting treatments that underlie the accounting measure of capital on which the regulatory measure is based.
IAS 39 had been the most controversial of the new standards, particularly for our regulated firms. It is also still in the process of change and the potential changes expected over the next couple of years could materially affect the way the standards are applied. We believe that this will have an impact on the adjustments we will or may ultimately need to make for regulatory reporting purposes. In the meanwhile, on a tactical level, the adjustments that we require for banks when producing their figures are:
Firstly the treatment of cash flow hedges, where we have eliminated from the measurement of regulatory capital all fair value gains and losses arising from the fair valuation of derivatives that have been accumulated in equity. This measure is also available to investment firms and should aid in the capital planning process.
The second issue under IAS 39 is the treatment of available-for-sale assets. Here we have followed the US approach and have left equities at fair value but write available-for-sale assets, notably debt instruments, back to cost or amortised cost.
Third is the treatment of the fair value option. Unrealised gains or losses arising from the fair valuation of a firm's own credit risk should be eliminated from regulatory capital. This was seen as the most reasonable and pragmatic approach to own credit risk, particularly as noted above that IAS 39 is still under revision by the IASB and given that the issue of own credit risk may not be dealt with in the same way in the final standard.
In addition, we have also introduced a significant departure from the accounting requirements in respect of accounting for defined benefit pension schemes. The actuarial gains and losses that will be recorded under IASs and UK GAAP may be large and volatile. Experience of the last few years of FRS 17 suggests that many companies will be recording very large liabilities when the standards come into force. We do not believe that defined benefit pension deficits should be treated as if they were current liabilities that would have to be funded over the next 12 months or so. Therefore the accounting measure of actuarial losses has been eliminated for regulatory purposes, and replaced by the firm's best estimate of the level of additional funding it would need to provide for its pension scheme over the following five years. Firms, however, retain the option to incorporate the full effect of the accounting figures in their prudential capital calculations.
As I mentioned earlier, we intend reconsidering all these issues in two years' time when the accounting will have setting down. By then the final rules to implement CRD, implementing the revised Basel Framework, will have been made and institutions will have a better understanding of how the accounting affects them in practice. They will be able to provide the information we need to develop robust long-term solutions. It is our intention to announce a timetable for this review towards the end of 2005.
I would like to say a few words about how we see the regulated community dealing with the complexity of accounting for financial instruments. I hope that we all agree that the aim of accounting reform in general, and the revision to accounting standards on financial instruments in particular, should be to close the gap between the economic substance of transactions and how they are reported publicly by banks.
I am happy to note that the major disagreements over the application of fair-value accounting are now close to being removed, but also note that less progress appears to have been made in the other area – hedge accounting. I urge the banking industry to engage with the IASB on the hedge accounting issue in the same pragmatic way in which you engaged on the fair value issue.
The one area which concerns me a great deal from an accounting, regulatory and investor reporting point of view is the valuation of illiquid financial instruments, determining how and when to recognise profits or losses from such instruments and whether, when and how to adjust values for changes in market liquidity and price volatility. This is a very important and topical issue. We are in particular concerned that liquidity risk is properly reflected in the valuation. We will be doing further work on this subject in the coming months and will be speaking to the industry to hear your views about this.
Turning to the listed community. Listed groups are required to report in IFRS and this means that interims and previous year comparatives have all had to be reported in IFRS. We wrote to all Chief Executives of listed companies in October 2004 and April this year to remind them of this and that they are required to announce price sensitive information, which may have arisen as a result of the changes to the financial reporting method, as soon as possible. We also urged them to embed the new requirements in their businesses rather than relying on short-term fixes, such as spreadsheet, at group level. We realised that this would considerably increase the workload of the companies' accountants and auditors, so we relaxed the 90 day listing rule reporting requirement to the 120 day EU limit. Having said that, companies are still required to inform the market that they intend to take advantage of the relaxation and to explain the reasons for the delay.
As for the direct impact of all of this on the FSA – well first and foremost we have needed an expert team to analyse the issues and develop appropriate responses. Richard Thorpe leads this team, whose agenda remains rather full! Secondly, we decided to create this new A+A sector to make sure we were looking at the bigger picture and thinking strategically about the opportunities and challenges of this unprecedented panel. And last but not least, we need to consider the amount of knowledge that our line regulators, in policy, supervision and enforcement, need to have about IFRS, and then we must ensure they have the training, or access to sufficient expert counsel, to be able to think critically and confidently about the way firms are adjusting to the transition.
International Developments
Transition to IFRS
I would now like to concentrate on international developments impacting financial markets more broadly. It is our belief that it is imperative that the transition to IFRS within the EU be handled properly to ensure market confidence is maintained and the vision of common financial reporting standards, interpreted, applied and enforced in a consistent manner across the EU, is realised. This will encourage the development of a single European capital market.
In the transition period, given IFRS is a principles-based system, open, to some extent, to interpretation and subject to cultural differences in the transition from country-specific accounting standards to a common financial reporting system, there is scope for significant differences in interpretation. One of the challenges of this period is distinguishing between those differences that flow from the strength of principles-based standards (which is the ability to cope with a myriad of economic circumstances and allow for slightly different accounting policies in detail) and those that flow from differing interpretations of the principles themselves. Such differences of interpretation do need to be addressed where they involve departures from economic substance.
We support the IASB's objective of setting standards, based on principles that do not seek to provide detailed answers for every accounting problem. The strength of principles-based standards is that they can deal with the financial reporting for many different economic situations. However the speed and breadth of the move to IFRS within Europe means that experience of applying the standards to particular circumstances is limited. Consistent interpretation which is necessary across jurisdictions is not yet available. We therefore need to cooperate, rather than compete, as preparers, auditors, regulators and standard setters. The major audit firms, which have practices across the EU and which audit the vast majority of the EU's 8000 listed companies, have a particularly key role in securing consistent interpretation across their EU listed clients.
The global context
Equivalence of other GAAP with IFRS
CESRFin (of which John Tiner, our CEO, is Chair) has been reviewing the equivalence to IFRS of three major GAAPs: Canada , Japan and the US with a view to advising the European Commission on whether third country issuers should be permitted to use the standards for Prospectuses and financial accounts issued in the EU. CESRfin is of the view that "equivalent" should not be defined as meaning "identical". A third country's GAAP can therefore be declared as equivalent when financial statements, prepared under such GAAP, enable investors to take similar decisions in terms of whether to invest, hold or divest, as they would using financial statements prepared on the basis of IAS/IFRS. Differences of detail between a third country's GAAP and IAS/IFRS which would not give rise to differing investment decisions are not relevant in defining equivalence. CESRfin's conclusion was that Canadian, Japanese and US GAAP, taken as a whole, are equivalent to IAS / IFRS with certain additional disclosures as a remedy for any significant differences between IAS / IFRS and the local GAAP.
Convergence
There is now a real opportunity to take a major step towards the prize and long term goal of having global financial reporting standards, consistently interpreted, applied and enforced, across all the major capital markets. Convergence of accounting between the three major capital markets of the world: EU , US and Japan is clearly heading in the right direction and this should lead to companies in one marketplace being able to access investors in other markets without incurring the costly exercise of performing reconciliations to the local GAAP.
In these ways companies will have access to a wider pool of capital, investors will benefit from access to equivalent financial reporting information, which will help ensure that financial resources flow to those firms where it is most appropriate, securities regulators can ensure more easily that financial reporting information reflects company activities and the whole of society gains form a lower cost of capital.
Under the Norwark agreement in 2002, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) pledged to use their best efforts to make their existing financial reporting standards fully compatible as soon as practicable. A roadmap is being developed by the US authorities and has been set out at a high level by the SEC Chief Accountant over the summer which will lead to the removal of the requirement to reconcile IFRS to US GAAP on the basis that IFRS is effectively and consistently applied across the EU. Recently, the IASB and the Accounting Standards Board of Japan (ASBJ) have also announced that they will launch a joint project to reduce differences between IFRSs and Japanese accounting standards.
Conclusion
To round up the FSA's approach – our objective is to maintain market confidence, which requires integrity and transparency in financial markets. That accounting remains the key facilitator of this is certain. In fact, it is the primary and only consistent and comparable means by which the users and providers of capital in markets communicate.
A great prize is in sight in this regard and we see an almost unprecedented opportunity in this regard.
However barriers and pit-falls abound and we are concerned that standard setters not let the search for the intellectually perfect be enemy of the practically good. Standards that can only be understood by a very few cogniescienti, the information produced under which can not be understood by management or investors, will not represent success in my view. Good enough standards, consistently applied and enforced, should in our view preferably be the immediate goal of the standard setters.