One of the most debated issues since the beginning of the financial crisis is the extent to which fair value accounting contributed to the stress faced by financial institutions. Contrary to what many observers believe, the recent accounting debate has focused less on the choice of measurement criteria - amortised cost or fair value - than on how changes in value should be reported in the income statements.
According to International Financial Reporting Standards (IFRS), a firm's total income (or, more precisely, total comprehensive income) has two components: 'profit and loss' (P&L) and 'other comprehensive income' (OCI). What goes into each component of the income account is relevant since, under commercial law or, at least, established practice, only amounts under profit and loss are considered to be eligible for distribution to shareholders as dividends.
Classifying assets
The terms of this discussion became clear in the autumn of 2008 when the International Accounting Standards Board (IASB) bowed to severe pressure and allowed assets to be reclassified between cost and fair-value categories. The main objective was to protect financial institutions' P&L accounts from assets whose fair value had suffered significant losses following the subprime crisis.
Indeed, a study we conducted at the Committee of the European Securities Regulators revealed, as expected, that the majority of the reclassifications made in 2008 were tailored to skip losses arising from fair value reductions that would have been reported in the P&L account, by shifting assets from the fair value categories to the amortisation cost categories. However, we also discovered that more than 20% of companies reclassified assets from fair value with changes in P&L to fair value with changes in OCI. Those companies' primary goal was not, therefore, to evade fair value accounting; instead, they were seeking to make profits less dependent on fair value changes in the turbulent market conditions at the time.
Therefore, the real pressure faced by accounting standard setters from relevant authorities is mainly related to the criteria used to determine distributable income. The fact that the accounting debate has focused more on income recognition than on pure measurement has helped accounting standard setters to achieve pragmatic compromises between the need to ensure accurate measurement and the desire of stakeholders to reduce volatility in reported profits. The preferred approach for that purpose -used by both the US standard setter and the IASB - is to use the OCI account for income which relevant stakeholders do not want to be recognised as distributable, ie, profits. However, it is unclear whether this provides a sound and stable solution.
Establishing distributable income
It is by no means obvious what type of accounting criteria are used by accounting standard setters to determine how income is to be split between P&L and OCI. Accounting theory gives a good indication of how income should be determined. However, it does not help to determine what type of income should be distributed and what should not. Despite its relevance for deciding on dividend payments, the split of total comprehensive income between P&L and OCI is largely arbitrary, in the sense that is not covered by any coherent and conceptually sound accounting framework.
Interestingly, the task of deciding what part of income can be distributed or should remain within the firm as reserves, seems conceptually closer to the remit of other parties, such as commercial legislators and prudential regulators. Nonetheless, in most jurisdictions neither commercial nor prudential regulators provide sufficiently explicit and detailed rules for the distribution of a firm's income.
This means that the responsibility to determine not only income but also the split between distributable and non-distributable income in practice lies largely with accounting standard setters. A logical consequence is that, from time to time, there is enormous pressure from regulators to change the standards for determining P&L in order to accommodate specific considerations which have little to do with the objectives of accounting. This is an inefficient allocation of responsibilities and also a structural source of risks for standard setters' independence and due process.
An idea that should be explored is to gradually move in the direction of eliminating the current sharp dichotomy within total comprehensive income between P&L and OCI. Instead, the standards should establish a complete breakdown of income sources, including realised and unrealised capital gains on different types of financial and non-financial assets, rather than grouping them into two arbitrary categories as occurs at present.
This approach would make it clearer that the decision regarding income distribution should be under the remit of other regulators. Naturally, financial statements can report measures of distributable income and regulatory reserves as decided by the regulators. That strategy would permit accounting standard setters to concentrate on what they are supposed to do well: establish sound measurement and recognition criteria for assets and liabilities and determine the sources of companies' total income.
We should all be aware that the more focused the job of accounting standard setters becomes, the easier it will be to protect their independence and due process.
Fernando Restoy is vice-chairman of Spain's securities regulator and chairman of the Corporate Reporting Standing Committee of the Committee of the European Securities Regulators
