EU's McCreevy, IASB's Smith On Financial Reporting in a Changing World

Yesterday and today (May 7-8), European Union Internal Markets Commissioner Charlie McCreevy (a chartered accountant by background), International Accounting Standards Board member John Smith, U.S. Securities and Exchange Commission Deputy Chief Accountant Julie Erhardt and others took part in a conference on: Financial Reporting in a Changing World. The conference was hosted by the European Commission in Brussels.

McCreevy's keynote address and Smith's remarks at the conference have been posted on the European Commission and IASB websites, respectively. Highlights from their remarks appear below. (NOTE: we have grouped excerpts from their remarks under certain common general topics, although the topic headings we use did not appear verbatim in their remarks, and in some cases only McCreevy or Smith spoke on a particular topic.)

Politics and Accounting
· McCreevy: Accounting is now a hot political topic. That is no bad thing... The calls for the IASB to get its house in order have grown louder. But let's be clear, this conference will not be a full frontal attack on the accounting rules and the standard setters. But the call for us to back off and leave it to the standard setters just misses the point. Although no one likes a messenger who brings bad news, we are not about to shoot the messenger. ...Accounting is now far too important to be left solely to ....accountants! Independence of standard-setters is important, but they must be fully accountable. When the IASB acts or desists from doing so, this can have significant economic consequences. The IASB cannot set an agenda oblivious to economic and financial developments or fail to deliver. We thus need to look at how the independence, quality and funding of the IASB can be improved and the reporting lines with public authorities strengthened.
· Smith: As the conference title suggests, the financial crisis has changed the world. It has served as a wake-up call to policymakers, regulators and standard-setters. It has exposed critical weaknesses in business practices and financial regulation. It has challenged beliefs that we once held, rightly or wrongly, as axiomatic. We will ultimately be judged on how we respond to this crisis. The result must be a more robust system of financial regulation suitable for the reality of integrated capital markets. The IASB is acutely aware of the attention that political leaders have given to accounting standards in recent months. We at the IASB have been and remain committed to responding in an urgent and responsible manner.

Global Set of Standards
· McCreevy: We remain committed to an international standard-setting system: falling back on national or regional solutions, even if sometimes tempting, is not the way forward. And this is not solely an EU view. The G20 has called for the creation of a single high-quality global accounting standard, as well as for co-operation among regulators, supervisors, and accounting standard setters to ensure their consistent application and enforcement. It is very important that all major jurisdictions sign up to the international system. For us, it is now crucial that the US come on board.
· Smith: Towards a global set of standards, the financial crisis has emphasised the relevance of the IASB’s mission. More than ever, there is a need for a single set of worldwide accounting standards. This is something that Europe recognised earlier than others. Clearly, the European Union has been a catalyst and the leader in that effort in deciding to adopt International Financial Reporting Standards (IFRSs) in 2005. Today, more than 100 countries require or permit the use of IFRSs and major economies in Asia-Oceania (Japan), North America (Canada and Mexico) and South America (Argentina, Brazil and Chile) have set out a time line towards the full adoption of IFRSs. As to the United States, it has created another catalyst to use IFRSs by removing the reconciliation to US GAAP for foreign filers using IFRSs. Clearly, the United States is on a path towards the adoption of IFRSs, the question is, when? We continue to work with the FASB, and in March, at our joint meeting in London, we reaffirmed our 2011 commitment under our Memorandum of Understanding. The completion of our joint work with the FASB will result in significant convergence with accounting standards in the United States. This will reduce the cost of transition. But will that be enough to get the United States over the line? I believe it is in the interest of the United States to adopt IFRSs in the next five years. With Brazil, Canada, China, India, Japan and Korea committed, with the European Union already using IFRSs, the cost to the United States of failing to adopt IFRSs will be high. If it doesn’t adopt, it will be the outlier and those countries already adopting and committing themselves to IFRSs will not accept a situation where the United States remains outside the system indefinitely, yet has a seat at the table. In the meantime, we continue to work with the FASB in advancing our projects under the MoU and we continue to strive to meet our end of the bargain.

IASB Funding
· McCreevy: Clearly the IASB cannot do its job properly if it does not have the necessary resources. A stable source of public funding would make it more accountable. We in the EU now have an initiative to provide the IASB with some financial support. I am pleased to announce that only yesterday, both the Council and the European Parliament were able to agree to our funding proposal. The idea is that the funding we provide would be conditional upon further concrete improvements in governance. We would like to see other major jurisdictions set up similar funding arrangements.

Accounting and the Financial Crisis-Specific Concerns
Fair Value
· McCreevy: On fair value, my views on this are well known. Some degree of flexibility is needed especially on where and how to apply it. I am very encouraged that the IASB has announced that IAS 39 will be revised fundamentally to simplify the standard and to address known shortcomings and that this exercise will be finished this year.
· Smith: In response to concerns about fair value measurements in illiquid markets, we set up a panel of experts to identify best practices for estimating fair value in illiquid markets and for disclosure. We held a series of meetings during the summer last year and issued additional guidance on those topics based on the input from the panel. As we were issuing that guidance, we amended it to include the emphasis on significant judgement to coincide with the FASB and SEC interpretations. We looked at the FASB’s recent FSP on fair value measurement in illiquid markets and concluded that it does not differ from the guidance in our literature and in the [IASB Expert Advisory] Panel document. There is some confusion, however, because the initial draft of the FSP contained a presumption that transactions in illiquid markets could be ignored unless there was evidence to show those transactions were not distressed. That presumption was removed from the final FSP. So let me repeat, we think that the guidance in US GAAP and IFRSs is the same and we believe the emphasis on judgement is appropriate. That said, to reduce any continuing fears, the exposure draft we shall be publishing soon on Fair Value Measurement will include the FASB FSP language.

Loan loss provisioning
· McCreevy: As to loan-loss provisioning, this has served many banks well in the past and I would now like to see it used more broadly. A system that introduces significant counter-cyclicality, requiring banks to build up more substantial buffers in good times so that they can let them run down in bad times, makes obvious sense. It is true that there are several models on the table (e.g. dynamic provisioning, economic cycle reserve, expected loss approach) but we need to focus on the key objectives. The first is how to ensure that full account is taken of the credit risks involved in the business sector in which the entity is operating, and, secondly, how to balance the accounting and prudential rules that apply. I am extremely pleased that the IASB and FASB have already started discussing these ideas in their Financial Crisis Advisory Group and also with banking regulators. Again, this is a top priority for us.
· Smith: As part of our evaluation of impairment we will consider developing an expected loss model to replace the current incurred loss model. We are told that the incurred loss model provides too little too late. So we are exploring an expected loss model whereby provisions would be recognised for expected losses that have been identified on the basis of history and current expectations. There are other issues here about going beyond expected losses and recording additional amounts today to provide a buffer for the future to promote financial stability. This issue is more about the objective of financial reporting and a question about providing useful information to users. We have been and will continue to work with banking regulators through the Basel Accounting Committee to explore the expected loss model. We believe additional reserves beyond expected losses that might be required by regulators for capital purposes are more a regulatory issue than an accounting issue. However, we also will be exploring with the regulators what might be done to provide transparency around regulatory reserve requirements through a capital allocation

Consolidation and Derecognition
· Smith: We accelerated our consolidation and derecognition projects, both dealing with off balance sheet activities, and on each we published exposure drafts that include enhanced disclosures about off balance sheet .

Financial Instruments
· Smith: We are accelerating our project on financial instruments to replace IAS 39, and intend to publish a proposal on classification and measurement within six months followed by a proposal on hedge accounting. ...Our project directly addresses the G20’s call for standard-setters to take action by the year-end ‘to reduce the complexity of accounting standards for financial instruments’. At a very high level we are all in agreement about the objectives for the project. We need to reduce complexity, increase comparability and transparency, rethink impairment rules to recognise losses more promptly and provide a basis for convergence worldwide, in other words a level playing field. Our six-month time frame is aggressive, but achievable if we attack the issues in an orderly way and sequentially. [IASB's Smith detailed:]
o We will start with classification and measurement alternatives. We understand the causes of complexity: We have 12 different measurement methods for financial instruments including three for impairment. We have 22+ ways of getting to one of the measurement methods based on a combination of criteria including type of instrument, its activity in the marketplace, management’s intentions by designation, and management’s intentions with various qualifying criteria. We can reduce complexity if we reduce the measurement alternatives and provide a better rationale for the alternatives that remain. Our goal would be to get to two measurements. Clearly, some instruments will be at fair value and others will not, but we have to decide how to make the cut. Is it the characteristics of the instrument, its activity in the marketplace or management’s intentions? Each of these alternatives can complement or conflict with each other, so we have to decide what trumps what, that is to say, what has primacy.
o As part of the project, we will address the issue of transfers out of fair value. The consideration here will depend on how we draw the line to distinguish the fair value and non-fair value categories. Impairment is clearly part of this project. We are trying to get to a single impairment method but first we have to sort out classification to determine if that is feasible. My inclination (me not other Board members) is that if the instrument was toxic from the start, that is to say, if it had highly volatile cash flows so that the investment was speculative in nature, the instrument should probably be at fair value. For plain vanilla, ordinary receivables, loans and investments with stable cash flow characteristics, a cost model seems appropriate, assuming that management is not trading the instrument, and impairment should be based on expected cash flows. But right now we include both extremes in the available-for-sale category and to some extent in loans and receivables, so we need first to sort out the classification of financial instruments and then try to get to a single impairment model.
o Concerns have been expressed about recognising gains on the reduction in the fair value of an entity’s own debt from credit deterioration. We will consider whether we should limit the use of fair value accounting in this regard as part of this project.
o The next step is hedge accounting and how to reduce complexity. We expect to issue a separate document on this subject following our proposal for the classification and measurement of financial instruments. Our objective is to reduce complexity and increase transparency of hedge accounting activities. But first we need to understand how hedge accounting would change if we introduced an expected loss methodology.
o Our staff have developed various alternatives they are considering for presentation to the Board in the next few months. The Board, in turn, will be deciding on which alternatives to propose for exposure. And, of course, we are working with the FASB on this project. We have a joint meeting with the FASB in July and I expect that after that meeting we will be in a position to start moving towards the exposure draft phase.
----
We have included additional topics McCreevy and Smith spoke about in our detailed FEI Summary (FEI members only can access the detailed summary.) Once again, reference should be made to McCreevy's keynote address and Smith's remarks for their complete remarks. If you received this blog post from 'a friend' and would like to receive our blog by email, send an email to blogs@financialexecutives.org and write in Subject line: Sign Up. You can also follow us on Twitter at @feiblog.

SEC Chair Outlines Principles Of Regulatory Reform; Proxy Access Proposal Coming Soon

In a speech before the Investment Company Institute earlier today (May 8) U.S. Securities and Exchange Commission Chairman Mary L. Schapiro provided her views on financial regulatory reform, and noted that a proposal on proxy access will be considered soon. (Specifically, she said: "Shortly, we will consider a proposal to enhance investor access to corporate proxies, to make real the promise of universal corporate suffrage, so shareholders can act as the owners the law says they are.") She also noted that proposed rulemaking concerning investment advisors will be taken up next week. (See Sunshine Act Notice for May 14 Open Commission Meeting.)

Schapiro's speech to the ICI, entitled, Building a Stable and Efficient Financial System, provided an outline of what she views as key principles of financial regulation, as well as her thoughts on moving to a new regulatory 'architecture' including a capital markets regulator, a banking institution(s) regulator(s), and a systemic risk regulator.

Principles of Regulatory Reform
After reviewing some of the SEC's investor initiatives, "Topping our agenda is regulatory reform," said Schapiro. Following are the principles for regulatory reform which she outlined. (NOTE: headings below are provided for simplicity; the headings did not appear as such in the SEC Chairman's speech, although items shown in quotes are verbatim from her speech.)
1. Protect individuals. "At the SEC... we call it investor protection," said Schapiro. "We must and do attend to the safety of institutions, particularly those that are significant to our financial system, but as a means to an end and not as an end in itself.
2. Facilitate fair and efficient financial markets. However, Schapiro cautioned, do not "supplant" the markets. "A strong and steady regulatory hand is needed to assure [the markets'] continued survival," said Schapiro, "[b]ut that hand must not be so intrusive as to point to winners and losers, lest we lose the benefits of competition." She added, "Stable markets that manage risk and allocate capital effectively are essential for economic prosperity."
3. Promote and preserve public trust through transparency and disclosure. "Investors must know that the information upon which they base their investment decisions is the truth, the whole truth, and nothing but the truth," said Schapiro. She added, "Some may believe that there may well be extraordinary circumstances in which the truth is withheld from the markets when the very survival of indispensable financial institutions is at stake. But make no mistake, when the truth is withheld, we all pay a very high price. Without that essential confidence that they have truthful and complete information upon which to base their decisions, investors will avoid our financial markets for ones that are more transparent, or they will demand risk premiums for their continued participation. The efficient allocation of capital is simply impossible without transparency. To state the obvious, markets rely on words and numbers. They must both be true; and any new regulatory structure must preserve the integrity and independence of those charged with the responsibility for setting standards of financial disclosure."
4. Market architecture (e.g. pricing, processing and clearing). "Investors ... need to be confident that when they transact in markets the architecture will work," said Schapiro. She added, " Amidst all the economic devastation, it is understandable that we forget that over the last year, despite record volumes and enormous volatility, our markets have priced, processed, and cleared hundreds of billions of dollars in customer orders in an orderly and generally fair way.
5. Intermediaries. Schapiro noted: "When investors transact through intermediaries, they must be able to trust that those intermediaries deal with them honestly and fairly and with investors' well-being as their sole goal."

Architecture Would Include Four Regulatory Entities
Schapiro listed four entities that should be part of the new financial regulatory structure:
1. Capital Markets Regulator: responsible for regulating the markets for investment capital. Schapiro notes this regulator has historically been the SEC and she implies the SEC (or at least an 'independent agency' such as the SEC) should continue to serve this function. She emphasized: "Capital markets regulation is of a single piece. Splitting it into smaller pieces, I strongly believe, would be a disaster."
2. Banking regulator(s): responsible for regulating banking institutions. "For now, I leave it to others to describe precisely how [banks] should be regulated and who their regulators should be," said Schapiro, noting, "It is sufficient to acknowledge that, where banking institutions are public companies, there are sometimes different views among regulators about how safety and soundness concerns should intersect with concerns for the soundness of our capital markets and for investor protection." She added, "This may surprise you, but I regard this tension as healthy, creative even. Different regulators appropriately have different perspectives. It is important, I believe, to preserve these multiple perspectives. That is why I think it is useful to maintain the separation between market regulation and banking institution regulation. The best solutions come from the clash of legitimate, varying viewpoints."
3. Systemic risk regulator: responsible for monitoring and averting risks to the financial system as a whole. Shapiro observed there appears to be "substantial consensus" around the need for a systemic risk regulator and a regulator to resolve troubled institutions. However, she noted, "There is, though, rather less consensus about the precise form such a regulator should take — whether a single entity, a College of Regulators approach, or a hybrid as FDIC Chairman Sheila Bair proposed this week: a single regulator for systemically significant firms coupled with a systemic risk council to provide macro-prudential oversight of risk."
4. Regulator for resolving troubled institutions. Schapiro said: "we need to improve our capacity to wind up financial institutions that are no longer able to function."

Further details are in this FEI Summary; refer to Schapiro's speech for her complete remarks.

Bank Stress Test Results Released

Last night, as noted in this joint press release issued by the Federal Reserve, OCC and FDIC, the banking regulators released the results of their stress tests [more formally called the Supervisory Capital Assessment Program (SCAP)] on 19 of the largest bank holding companies in the U.S.

As noted on printed pg 3 (pdf pg 4) of the SCAP -Overview of Results , "[W]hile nearly all the firms have sufficient Tier 1 capital to absorb the unusually high losses of the more adverse scenario and still end 2010 with a Tier 1 risk‐based ratio in excess of 6 percent, 10 of these firms had capital structures that are too strongly tilted toward capital other than common equity. Thus, each of the 10 firms needing to augment their capital as a result of this exercise
must do so by increasing their Tier 1 Common capital."

For quick reference, the list of the 10 bank holding companies directed to raise capital (and the other 9 bank holding companies in the SCAP program) can be found in the Dow Jones Newswire summary carried on CNN.com: At a Glance: Stress Tests Show 10 Banks Must Raise $75 Billion."

Those banks asked to raise capital as a result of the SCAP assessment have been given a specific timeframe to do so, as described in the banking regulators joint press release: "The estimates reported by the Federal Reserve represent values for a hypothetical 'what-if' scenario and are not forecasts of expected losses or revenues for the firms. Any BHC needing to augment its capital buffer at the conclusion of the SCAP will have until June 8th, 2009 to develop a detailed capital plan, and until November 9th, 2009 to implement that capital plan."

Besides the SCAP overview report released yesterday, additional context was provided in stress test methodology released prior to the release of the actual results, and in yesterday's Statement by Fed Chairman Ben Bernanke,

• These examinations were not tests of solvency; we knew already that all these institutions meet regulatory capital standards.
• Rather, the assessment program was a forward-looking, "what-if" exercise intended to help supervisors gauge the extent of the additional capital buffer necessary to keep these institutions strongly capitalized and lending, even if the economy performs worse than expected between now and the end of next year.
• Roughly half the firms... need to enhance their capital structure to put greater emphasis on common equity, which provides institutions the best protection during periods of stress.
• Many of the institutions have already taken actions to bolster their capital buffers and are well-positioned to raise capital from private sources over the next six months.
• However, our government, through the Treasury Department, stands ready to provide whatever additional capital may be necessary to ensure that our banking system is able to navigate a challenging economic downturn.

Further information can be found in statements issued by U.S. Treasury Secretary Tim Geithner , FDIC Chair Sheila Bair, and Comptroller of the Currency John Dugan (Dugan's statement in particular provides a high level summary of seven key points in connection with the stress tests).

SEC Enforcement Subject of Senate Hearing as GAO Issues Report

"Strengthening the SEC's Vital Enforcement Responsibilities" is the subject of a Senate Banking Committee hearing slated to take place at 2:30 pm EDT today. SEC Enforcement Director Robert Khuzami is scheduled to testify, along with Richard Hillman of GAO, Prof. Mercer Bullard of the Univ. of Mississippi School of Law, and Bruce Hiler of Cadwalader, Wickersham and Taft.

The hearing takes place one day after the public release of a GAO report entitled: "Greater Attention Needed to Enhance Communication and Utilization of Resources in the Division of Enforcement." According to GAO's Summary, GAO recommends: "To help ensure that SEC is effectively and efficiently using its resources in bringing enforcement actions, and that its enforcement policies are working effectively, the SEC Chairman should:

• consider an alternative organizational structure and reporting relationship for the [Office of Collections and Distributions], to address the organizational concerns identified.
• expand Enforcement's current examination of its methods to include the level and mix of resources available to investigative staff in the areas of administrative and paralegal support, specialized services and expertise, and information technology support; and include in the examination an evaluation of the impact of the case review process on organizational culture factors such as risk aversion and incentives to drop or narrow the scope of cases.
• examine the effects of the 2006 corporate penalty policy to determine whether the policy is achieving its stated goals and any other effects the policy may have had in adoption or implementation.
• take steps to ensure that the Commission, in creating, monitoring, and evaluating its policies, follows the agency strategic goal and other best practices for communication with, and involvement of, the staff affected by such changes

All of the recommended actions are currently "in process" at the Commission, GAO notes. (See our related Feb. 6 post on current SEC Chairman Mary L. Schapiro's initiatives.)

Additional coverage of GAO's report can be found in these articles:
Cox's SEC Hindered Probes, Slowed Cases, Shrank Fines, GAO Says (Jesse Westbrook and David Scheer, Bloomberg)
GAO: Cox's SEC Discouraged Corporate Punishment (Tim Reason, CFO.com)

What's New With Fair Value?

At its board meeting earlier today, the Financial Accounting Standards Board discussed approaches to determining the fair value of alternative investments, such as investments in hedge funds and private equity funds, in accordance with FASB Statement No. 157, Fair Value Measurement.

There was some discussion at today's board meeting about the staff recommendations in the board handout (pages 5-12), concerning the scope of this guidance, as well as the application of fair value methodology compared to (unadjusted) net asset value (NAV). In addition, some FASB board and staff members suggested considering disclosure requirements analogous to that provided in FASB Staff Position (FSP) No. FAS 132R-1, Employers’ Disclosures about Postretirement Benefit Plan Assets.

FASB Also Proceeds On Separate Project To Improve Fair Value Disclsoures
FASB Technical Director Russell Golden said the staff may bring the disclosure package for the alternative investments FSP back to the board together with separate proposed guidance on a broader project (included among the fair value guidance projects announced by FASB on Feb. 18) to improve (including by potentially requiring additional) disclosures about fair value measurements. Golden indicated staff currently plan to bring the broader disclosure project to the board at the May 18 board meeting (See FASB calendar).

FASB staff currently expect to be able to issue the proposed FSP on fair value of alternative investments on or about May 22, and with the 30-day comment period agreed to by the board, expect to be able to issue a final FSP in July. Read more in this FEI Summary; reference should be made to FASB's official Summary of Board Decisions, generally posted within a day of board meetings in FASB’s News Center. (Separately, we recently reported that FASB released for public comment Proposed FSP FAS 157-f , on Measuring Liabilities Under FAS 157.)

Rep. Bachus Requests Hearing To Review Mark-to-Market Application
In other news on the fair value front, Rep. Spencer Bachus (R-AL), ranking member on the House Financial Services Committee, recently sent a letter to Rep. Barney Frank (D-MA), chair of that committee, on the subject of fair value (also called mark-to-market) accounting.

Specifically, Bachus' April 27 letter to Frank references the committee's March 12 hearing on this subject, acknowledges related guidance issued by FASB and the PCAOB in April, and states: "While the FASB acted expeditiously to respond to many of the concerns raised by the Subcommittee Members," [i.e. the subcommittee on Capital Markets], "questions remain as to the ultimate effectiveness of the fair value accounting revisions. Therefore, I request that the Committee schedule a hearing at the first available opportunity to hear from the Securities and Exchange Commission, FASB and the [PCAOB] ... to review their actions and additioanlly receive testimony from those most affected by the FASB's actions." Bachus also posted this related press release and timeline.

NOTE: If you are new to our blog, among our recent posts relating to fair value, see also our recent post: FASB-IASB Advisory Group (FCAG) Updates, Cautions G-20.

Obama Proposes International Tax Reform

Yesterday, President Barack Obama presented his plan for international tax policy reform. This plan includes two major planks: 'getting tough on overseas tax havens,' and 'replacing tax advantages for creating jobs overseas with incentives to create them at home.' Read more in:

White House Fact Sheet: Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas
The President's Remarks
U.S. Treasury Department Press Release

Additionally, the White House Blog includes link to video of yesterday's press conference, and provides a link to the White House's account on Twitter www.twitter.com/WhiteHouse ! Did you know the FEI Financial Reporting Blog is now on Twitter? Follow us at www.twitter.com/FEIblog . If you'd like to receive our blog by email, send an email to blogs@financialexecutives.org and write in Subject line: Sign up.

CFO Compensation Trends Shown In FERF Report

Earlier this week, the Financial Executives Research Foundation (FERF), the research affiliate of Financial Executives International, released its 3rd annual Financial Executive Compensation Survey. According to the study, a growing percentage of respondents did not receive a salary increase. Those who did receive increases experienced a slight dip percentage-wise compared with the average salary increase they received in the previous year, while the breadth and depth of their responsibilities continues to expand. However, nearly all of financial executives still reported a bonus in 2008.

Cheryl de Mesa Graziano, Vice President, Research and Operations for FERF, said, "As the debate over salaries and cash-based bonuses continues to intensify, companies will be examining other types of compensation benefits as a means to award and retain professionals." She added, "Our survey results reveal this challenge as decreases in retirement and long-term cash pay come with increases in stock-based long-term awards. Also, though most companies are commonly using company goals to evaluate performance, this year's survey surprisingly reveals a decreased emphasis on individual goals, with more companies choosing EBITDA as a form of measurement." See further details in the press release, order the report from the FERF bookstore (free to FEI members).