IFRS

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IFRS
Accounting for Confidence Brian
OKelly Principal, QED Equity Adjunct Professor
of Finance, DCU
2008 IFRS The Road Ahead
Wednesday 15th October 2008 Burlington Hotel
Sponsored By
Organised by
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2008 IFRS The Road Ahead
IFRS The Road Ahead
Overview

• Impact of accounting on business models
• Arguments for/against IFRS
• What accounts can tell us, and what they cant
• Accounting for long-term assets
• Banking, accounting and society

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Compare

• Two financial firms taking exposure to leveraged
  loans
• Firm 1 gives loans at tight spreads, with weak
  covenants, and payment-in-kind features
• Firm 2 takes exposure synthetically through
  LCDS, takes care to avoid poorly-underwritten
  loans
• Which firm survives the credit crisis? Why?

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Compare

• Two firms with different capital structures
• Firm 1 industrial firm, 50 of its assets are
  financed with debt, all of which matures in one
  month
• Firm 2 bank, its entire loan book is financed
  by deposits
• Which firm gets an unqualified audit? Why?

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Consider

• Financial institution
• Has a portfolio of corporate bonds
• Hedges each bond in portfolio with a credit
  default swap
• It is fully hedged from an economic viewpoint.
• But how is its performance reported?

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Proponents of IFRS Approach

• Mark-to-market is the only measure thats
  meaningful
• Accrual accounting is Alice in Wonderland
  accounting
• Those who complain are shooting the messenger
• General provisions are a device for earnings
  management
• Off-balance sheet treatment of conduits and SIVs
  caused the credit crisis

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Opponents of IFRS Approach

• Why mark to a price in a market into which you
  have no intention of selling?
• The only sales occurring are distressed whose
  prices fail to reflect true economic value
• Pro-cyclicality write-downs force asset sales
  which drive prices down forcing further
  write-downs and further deleveraging ?
• General provisions recognise losses which will
  materialise over time
• Marking liabilities to market - the logical
  extension of the approach - serves only to
  highlight its illogicality

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Traditional Banking Model

• Traditional bank lending model
• Lend for five years at Libor150bp and fund at
  3-month Libor30bp
• 20bp of expected loss
• 20 times levered
• ROE 20
• If bank reports on an accruals basis, looks
  strong!
• If bank reports on a mark-to-market basis and new
  loans are at 270bp, bank is de-capitalised!

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Traditional Banking Model contd.

• Accrue income
• Make specific loss provisions when evidence of
  impairment emerges
• Make general provisions for losses which have yet
  to emerge
• Draw on provisions when heavy losses emerge
• Absorb losses over time

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Consider

• On mark-to-market basis, the worlds banking
  system is bankrupt!
• Whether we think a bank is sound or bankrupt,
  were right!
• Self-fulfilling prophesy

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Consequences of IFRS

• Banks which will always meet minimum capital
  ratios on MTM basis will need far more capital
  than any bank currently has
• A bank which had such a capital ratio would not
  have survived the ten years prior to 2007
• Conclusions
• Much more capital required in banking system
• Cost of borrowing from banks will rise
  significantly

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Consider

• Most financial institution fail before any loss
  is incurred
• AIG, Structured Credit Holdings
• Institutions fail because they are played out of
  the game
• Ratings triggers
• Cash calls
• Run

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Modern Accountancy!
The adage that a bird in the hand is worth two in
the bush is now old hat. A conservative
accountant counts the bags at the end of the
shoot and a less conservative one registers the
number of birds as they fall from the sky. But
the modern accountant not only eats what he kills
but also takes credit for the expected cull as
soon as the hunters guns are primed. John Kay,
Financial Times, 14-Oct-08
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2008 IFRS The Road Ahead
IFRS The Road Ahead
Practitioners of Modern Accountancy!
Mark-to-market accounting is criticised today for
forcing banks to recognise that unsalable assets
have little value. Companies resent the
obligation to use mark-to-market accounting when
the market is down. But the public should be more
concerned for the implications of mark-to-market
accounting when the market is up. ? Enrons Jeff
Skilling, in a fit of uncharacteristic
generosity, once ordered champagne for all his
colleagues. The toast was in appreciation of a
letter from the Securities and Exchange
Commission agreeing that Enron could make wide
use of mark-to-market accounting. John Kay,
Financial Times, 14-Oct-08
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2008 IFRS The Road Ahead
IFRS The Road Ahead
Innocent Fraud
Revenue recognition and mark-to-market accounting
? are the means by which successive generations
of financial hotshots perpetrate what John
Kenneth Galbraith described as innocent fraud.
This is the process that systematically benefits
one group at the expense of another but generally
falls short of outright criminality. John Kay,
Financial Times, 14-Oct-08
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2008 IFRS The Road Ahead
IFRS The Road Ahead
David Tweedies View
Fair value accounting has been accused by some of
exacerbating the present financial crisis.
Perhaps we should get a few points clear. The
crisis has been caused by bad lending which has
then been scattered around the world by bankings
originate loans and then distribute them
policies. These loans have been sliced and diced
in many ways and wrapped up in complex financial
instruments that probably stretched the ratings
agencies to their limits and probably gave some
investors who didnt do enough due diligence more
assurance than they should have, and because the
banks had distributed the loans these loans
probably moved outside the banks risk assessment
practices.
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2008 IFRS The Road Ahead
IFRS The Road Ahead
Misguided Accuracy
That pensions pose a volatility risk to balance
sheets is not in doubt. Recent market gyrations
are a case in point. According to Watson Wyatt,
the actuarial consultants, the combined schemes
of FTSE 100 companies had a deficit of 12bn
(15bn, 21bn) at the end of August, but by the
middle of last month, that had swung to a 7bn
surplus. The reason was a surge in corporate bond
yields which links directly to the ASBs latest
proposals. The future liabilities of a scheme are
currently discounted to their present value using
a blend of AA-corporate bond yields, which are
designed to reflect the returns expected on fund
assets. Jennifer Hughes, Financial Times,
5-Oct-08
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2008 IFRS The Road Ahead
IFRS The Road Ahead
Misguided Accuracy
However, in the current crisis corporate
borrowing costs have spiked sharply higher as
investors have demanded higher returns for the
greater risk they perceive. In spite of that
rising risk, the bigger number has served to
reduce scheme deficits, meaning it has worked in
the opposite way to that intended, since expected
fund returns have not changed and if anything
given the current market, are under some
threat. Jennifer Hughes, Financial Times,
5-Oct-08 An expert is a person who avoids small
error as he sweeps on to the grand
fallacy. Benjamin Stolberg
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2008 IFRS The Road Ahead
IFRS The Road Ahead
The Pressure is On!

• IASB say there will be no let up in use of fair
  value, even in illiquid markets (16/9/08)
• The key point is that ? you cannot default to
  some fundamental value. You are required to
  find some estimate of the current price. The
  price might be thought to be irrational,
  exuberant or completely depressed but this makes
  it clear that is what you must see.
• Anthony Clifford, Ernst Young

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2008 IFRS The Road Ahead
IFRS The Road Ahead
But the Jury is Out!

• IASB, under pressure from EU, make it easier for
  banks to account for assets at cost, not market
  value (13/10/08)
• FASB reconsiders fair value rules in inactive
  markets (10/10/08)
• Financial Services Roundtable asks SEC to exclude
  mortgage assets from fair value (21/9/08)
• British Bankers Association asks not to apply
  fair value to assets held for the long term
  (20/9/08)

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Banking Banana Skins 2008 (2006 rankings in
brackets)

• Liquidity (-)
• Credit risk (2)
• Credit spreads (-)
• Derivatives (3)
• Macro-economic trends (14)
• Risk management techniques (10)
• Equities (12)
• Too much regulation (1)

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Conundrum

• If your business depends on borrowed funds, you
  must hope each day that your lenders still like
  you
• Warren Buffett

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Philosophical Questions

• Business model of lending long-term funded by
  short-dated liabilities has been cruelly exposed
• Do banks provide an essential public service?
• Is Government the only entity capable of running
  this maturity mis-match?
• Is the mark-to-market accounting paradigm
  anathema to long-term investing?

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2008 IFRS The Road Ahead
IFRS The Road Ahead
More Philosophical Questions

• To what extent can accounts measure whats
  important?
• Employee engagement?
• Integrity?
• Have we unrealistic expectations of what accounts
  can tell us?
• How robust is the business model?
• Is it durable by design?

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2008 IFRS The Road Ahead
IFRS The Road Ahead
Conclusion

• Accounting answers particular questions in a
  prescribed way
• Accounting cannot answer the most important
  questions
• Need to ensure the business model is not
  undermined by accounting reporting
• An idea is not responsible for those who believe
  in it