Accountants are hoping to shore up investors’ confidence in financial markets with a move to let banks reclassify troubled assets in order to avoid writedowns.
“The intention is to try to provide something that will turn the tide in terms of the market perception of the safety and soundness of the financial system,” says Karen Higgins, national director of accounting services with Deloitte & Touche LLP in Toronto.
In mid-October, Canada’s Accounting Standards Board announced a temporary change in accounting rules concerning fair value accounting. Instead of requiring that assets be reported at current market value, the new provision will let financial services institutions move certain assets from one accounting category to another. As a result, the decreased value of plummeting bonds or stocks need not be reflected in the institution’s net income or earnings per share.
This is important, says Higgins, because analysts and investors tend to focus on earnings per share. She notes that the change could also have a positive impact on banks’ ability to manage their balance sheets and ease restrictions on credit.
Ian Hague, a principal of the Accounting Standards Board, says the move should provide “a little bit of relief” from the “vicious circle” of writedowns leading to decreases in reported earnings that, in turn, cause a lack of confidence in the market, thus pushing market prices down again.
Hague notes that the rule change applies specifically to assets that have been placed in an accounting category reserved for assets that are being held for trading in the market. “As the markets have dried up,” Hague says, “entities have said: ‘It’s pretty tough to force us to keep these things in the trading category, when they can’t be traded, and to value them at fair value when it’s difficult to get fair value from them because you can’t trade them’.”
While the regulations are not specifically directed toward banks and other financial services companies, the change is expected to affect only organizations that hold securities directly for the purpose of trading. As Higgins points out, many companies hold assets that they may trade in the marketplace, but few organizations other than financial services institutions hold assets exclusively for trading.
Hague says the decision to change the rules was partly driven by actions taken by other accounting bodies around the world.
“RARE CIRCUMSTANCES”
The rule change follows a similar move made last week by the International Accounting Standards Board and also reflects an existing rule under U.S. generally accepted accounting principles that allows this reclassification “in rare circumstances” — a condition that some U.S. companies have started to invoke on the grounds that the current market conditions represent rare circumstances.
“The change comes with full financial statement disclosure from an investor’s perspective,” adds Hague. “Investors are going to have fully transparent information.”
The assets governed by the rule change may include “some of the more esoteric debt securities,” such as collateralized debt obligations and mortgage-backed debt securities, but derivatives are not included, says Hague. He notes that loans and receivables are also outside the ambit of the regulation because Canadian accounting rules do not put them in a fair value reporting category in the first place.
Higgins notes that the regulations will apply only to assets that have lost value because of market conditions that are not intrinsic to the asset itself. In other words, it will still be necessary to write-down a stock or bond that is failing because the underlying investment is impaired.
The assets protected by the change in regulations will include those that have seen their value decline because of a lack of liquidity in the market. There are now so few transactions in the marketplace that the inputs to calculate fair value are making the fair value decline “because people are charging significant premiums to purchase these types of instruments.”
For example, Higgins says: “I might have purchased a bond at $100 and, only because of market information around credit spread and market information about liquidity, on a fair value basis that bond might now be worth only $75.”
CHANGING CATEGORIES
She explains that the rule change allows companies to move such bonds from a held-for-trading category, in which it is considered net income, into another category, in which it is considered an equity and does not have to be valued until it is sold or written down.
@page_break@If, on the other hand, a bond has been downgraded and there is real concern about ultimately being able to collect on that bond, the company would need to record the decline in value of the bond in net income, Higgins says. That’s because there is a demonstrated risk to ultimate recovery of the bond’s value, or to being able to sell it in the marketplace.
“Canadian companies need to take the time to understand the amendment,” Higgins says, “and determine whether or not it really applies to them.
“For those to which it does apply,” she adds, “it is helpful, not only because potentially it will have a helpful impact on their reported financial results in terms of net income, but also because it will retain some degree of consistency with international accounting standards.”
How much will it help in today’s volatile marketplace? “It’s too early to tell,” says Higgins. “But every piece of good news helps.” IE
Accounting standards eased for troubled assets
Temporary change will ease valuations for assets in markets with little liquidity
- By: Kevin Marron
- October 28, 2008 October 28, 2008
- 09:50