Memorandum by Professor Michael Page
1. There are substantial grounds for believing
that the financial reporting rules promulgated by the International
Accounting Standards Board (IASB) and the US Financial Accounting
Standards Board (FASB) contributed significantly to an excessive
growth in lending by financial institutions, and to the subsequent
near collapse of the financial markets. The most immediate issue
is the marking of financial instruments to so-called "fair-value".
The case against fair value is not so much that it requires entities
to record assets at below their "hold to maturity" values
after the market collapse, but that it contributed to the irrational
exuberance of the bubble that preceded the crash.
2. In this memorandum I contend that fair
value measurement contributed to the current crisis and that,
in pursuing their current objective of financial reporting, the
IASB is neglecting the important issues of financial stability
and corporate governance that are fundamental to a good system
of financial reporting. Before dealing with the particular issues
upon which the Committee has requested evidence I want to make
two fundamental points:
2.1 Fair value measurement can lead to financial
2.2 Accounting principles should take account
of wider economic concerns than decisions by capital providers.
3. The case for reporting market values
is based on the hypothesis that markets are informationally efficient,
so that the price recorded in a market reflects all publicly available
information. However, even if that hypothesis is approximately
correct averaged over a long period of time, market prices may
be very unreliable measures of value at any given time. Moreover,
market prices are "systemic" so that if the price of
one security is a poor reflection of future values, then the prices
of all securities are likely to be wrong. There is good evidence,
theoretical and observational, that market prices are excessively
volatile. Work by Schiller
among others has shown that variations in the level of stock market
prices are too great to be explained by subsequent variations
in dividends; and, theoretical work by Plantin, Sapra and Shin.
among others shows that marking to market can lead to excess volatility,
particularly where traders tend to copy each other, for example
because of bonus scheme arrangements or in reaction to rumours.
4. Advocates of marking to market frequently
assert that market values "tell things as they are"
or that "there is no better alternative". However, the
assets and liabilities to which the values are applied are usually
not going to be sold or transferred, and if they were, very different
amounts would be realised, because the markets from which the
prices are derived have substantial imperfections.
It would not be stating the case to strongly to say that the "fair-values"
that accounting standard setters currently aspire to are "guesses
of prices set by hypothetical market participants in markets that
don't exist for items that aren't going to be transferred".
5. As to the assertion that there is no
reasonable alternative, I contend amortised historical cost accounting
(HCA) is viable. HCA uses either the "lower of cost or recoverable
amount", for non-current assets, and "lower of cost
or market value", for current assets. Certain items have
zero initial cost, but zero is a perfectly good number.
6. This is not to say that current values
should not be reported in notes to financial statements; transparency
is a good thing. What it does say is that profits should not be
calculated on the basis of excessively volatile market prices,
since to do so gives companies, particularly financial companies,
incentives to borrow excessively and take other excessive financial
risks. Where individuals are remunerated on the basis of mark-to-market
based profits, excessive volatility is translated into an incentive
for enormous risk taking, since individuals can become independently
wealthy an the basis of a couple of good years and aren't required
to bear losses when the markets turn down.
7. Both the IASB and the FASB have "Conceptual
Frameworks"sets of principles that are supposed to
guide the setting of accounting standards. The current conceptual
frameworks have twin objectives of providing information useful
to people making economic decisions and showing the "stewardship"
that managers have exerted over entities. Not withstanding that
both bodies are tasked with broad economic objectives, the standard
setters have focused on providing information for participants
in financial markets. The bodies have recently published an exposure
draft (ED) of a new objective (see below paragraph 10) for a common
conceptual framework that focuses almost entirely on information
needs of "capital providers" and in which "stewardship"
disappears as a separate objective. The ED explicitly rejects
the notion that financial reporting should have a role in corporate
8. The investor focus is convenient for
the FASB and IASB because they can claim that accounting standards
are only providing information and do not affect the behaviour
of economic actors. This claim is invalid. Moreover the tradition
of UK company law is that the prime role of financial reporting
is as a governance device: its primary function is to guard against
dishonest or incompetent company managements making free with
investors' and creditors' money. Because of the safeguards financial
reporting has provided, many financial and commercial relationships
are possible that would not otherwise be possible, to the benefit
of the diversity and stability of the economy. By neglecting this
role of financial reporting the standard setters have done great
disservice to the national and global economy.
9. Like any complex activity financial reporting
has multiple purposes: it encourages management to act in the
interests of stakeholders; it contributes to the smooth running
of financial markets (except when it doesn't); it forms a basis
for a wide range of possible economic relationships that could
not otherwise exist; it assists competition to work in factor
markets; it is a source of information useful for regulation of
entities and control of the economy; it may help direct funds
to economically productive uses.
10. In their recent exposure draft of a
conceptual framework for financial reporting, the IASB and FASB
would have us believe that the objective of financial statements
To provide financial information about the reporting
entity that is useful to present and potential equity investors,
lenders and other creditors in making decisions in their capacity
as capital providers.
11. This is hardly a statement of "purpose"
and we are presumably meant to infer that the objective serves
the purpose of helping secondary financial markets run smoothly.
In my view this is a partial view of the purpose of financial
reporting. As stated above the current conceptual frameworks of
IASB and FASB have separate stewardship objectives that are to
be subsumed within the new objective of providing information
to equity holders in their capacity as owners. This misses the
point: the objective of stewardship reporting is encourage management
to act in the interests of stakeholders. In that respect financial
reporting has an objective of maintaining good corporate governance
and constraining the behaviour of management by encouraging managers
to be diligent and honest. The ED denies that financial reporting
has any role in corporate governance or in affecting the behaviour
of anyone in a predetermined way.
12. Some idea of the scale of the impact
of fair value accounting can be gauged be the reported impact
on the financial results of Schroders of moving items from "marking
to market" to "held to maturity" as permitted by
the recent change to IAS 39 "Financial Instruments: Recognition
and Measurement". In the case of Schroders, eliminating
the market undervaluation turns £50 million loss into a profit.
Financial assets were overvalued on a similar scale before the
credit crunch. When markets are over-valued there are built-in
incentives for individuals to keep them that way. Moreover in
so far as overvalued markets lead to overvaluation of banks' reserves
for the purpose of calculating reserve ratios, then marking to
market leads to an expansion of lending many times the amount
of the overvaluation. If this lending then fuels further overvaluation,
a positive feedback loop is set up, leading to a bubble and to
a subsequent crash, when, eventually, logic reasserts itself.
13. Such events are considerably less likely
to occur if accounting measurement is done on a prudent basis
such as HCA, since gains are not recognised until they are realised,
but losses are recognised immediately. Recent events show the
losses from overvaluation are much greater than the costs of the
moderate undervaluation that can arise through prudent accounting.
14. The exact role that financial overvaluation
arising from fair value accounting played in the current crisis
is extremely complex and will take a long time to unravel. Because
the crisis is the product of the system rather any individual
entity, no on is in a position to say how the effects of overvaluation
were transmitted through the market. Nevertheless, after recent
events, and reflecting that marking to market was also a factor
in the Enron crisis, the onus of proof about the usefulness of
marking to market seems to be upon its proponents rather than
upon its critics.
15. Marking to market has also been damaging
to pension schemes and has been an important factor in the withdrawal
of defined benefit schemes.
16. Market values are too unreliable to
used in accounting measurements and accounting should revert to
an amortised historical cost basis of measurement, with very few
exceptions. This would have the advantage of forcing preparers
of financial statements and managers to evaluate the intrinsic
value of items rather than relying on market value.
17. The IASB is a private sector body and
largely self-perpetuating. Under the leadership of Sir David Tweedie
it has grown hugely in authority and influence. When the EU recognised
a version of the IASB's standards it did the IASB a great service
and added impetus to the IASB's ambition that its standards should
be accepted for the purpose of registration of securities on American
18. The main role the IASB should play in
EU financial reporting is that of saving the EU the trouble and
expense of setting its own standards. As an external body with
a representative council and extensive due process the IASB tries
to imbue its standards with legitimacy arising from independence
and intellectual and moral persuasion. One may surmise that it
is concern with legitimacy that makes the IASB reluctant to acknowledge
that setting standards for financial reporting necessarily advantages
some economic parties and disadvantages others. Focusing on market
values and the needs of investors is a great advantage to the
IASB since it can claim that it is only setting out to make people
better informed by requiring the provision of relevant and reliable
information. This claim does not stand up to examination, and
in attempting to claim that financial information can be neutral
as between parties the IASB ignores its wider responsibilities
to the economies of its client accounting regimes. In particular
the IASB does not examine the impact of its pronouncements on
the stability of markets or on corporate governance: it acts as
if its standards could not have unintended consequences.
19. There is reason for concern that the
IASB is insufficiently accountable. There are signs that the board
proceeds in a doctrinaire manner, (over the matter of valuation,
for example) and is at times insensitive to the views of respondents
to its consultations. For example, a large majority of respondents
to its initial discussion paper on the conceptual framework were
in favour of a separate stewardship objective for financial reporting,
but a separate objective has not appeared in the subsequent exposure
20. Some critics have observed that the
IASB has been acting as if it were preparing the way for a full
fair value measurement system. Although the Chair of IASB says
this is not the case, proposals for extension of fair value continue
21. The status quo whereby the IASB issues
standards and the EU endorses them is unlikely to persist. The
IASB can hardly make itself fully accountable to the EU and at
the same time the EU can hardly resign sovereignty in this area
to a private body. Particularly if extensions to fair value that
tend to destabilise company profits and financial markets continue,
the EU Accounting Regulatory Committee is likely to recommend
further amendments until a distinctive European set of generally
accepted accounting principles emerges.
22. The IASB has the appearance of adequate
due process but the process by which issues are added to the work
programme is somewhat opaque and, as mentioned above, the views
of respondents to its consultations do not seem, at times, to
be fully accepted.
23. Marking to market accounting should
be dropped, not just because it makes the crash worse, but because
it was a necessary condition for the bubble that preceded the
crash. Accounting standard setters should focus on setting standards
that lead to economic stability rather than reflecting back at
financial markets unreliable market prices.
24. The UK and the EU should adopt a more
critical view towards the proposals of the IASB and should seriously
consider reverting to amortised historical cost accounting wherever
fair value is currently mandated.
3 November 2008
3 Robert J Schiller (2000) Irrational Exuberance
Princeton University Press. Back
Gulliame Plantin, Haresh Sapra, Hyun Song Shin (2008) "Marking-to-Market:
Panacea or Pandora's Box?" Journal of Accounting Research
46,2 pp 435-460. Back
Page, M., & Whittington, G. (2007). The price of everything
and the value of nothing? Accountancy, 140(1369), 92-93. Back