From: Macve,R
Sent: 23 May 2000 13:34
To: 'rule-comments@sec.gov'
Cc: Horton,J
Subject: File No. S7-04-00 : IASC standards

TO Secretary Jonathan G. Katz, SEC

Thank you for the opportunity to comment on this Concept Release which clearly has implications way beyond the US and SEC registrants. In our view, based in particular on work currently being developed internationally on standards for financial instruments and insurance, superior standards will result when issued by the IASC to the equivalent standards that would be issued by the FASB alone. Within the IASC's due process, the FASB's own approach can be at least influenced by exposure to arguments, experience and academic literature from outside the US. For example, the present the FASB approach of seeking to define 'fair value' for financial instruments as 'exit price', and all changes in fair value as 'income', does not adequately reflect the internationally well-understood arguments as to when the relevant 'value to the business' should be 'entry' or 'exit' value, and what each of those values should be in varying depths of markets. Nor does it deal adequately with the alternative approaches to reporting financial performance that are needed in different market circumstances. We would hope that when the FASB receives international comment on its Preliminary Views: Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value (December 14th 1999) it will revise its approach in order to provide a much more rigorous conceptual basis for the development of practicable International Standards on financial instruments and insurance that will achieve the overriding aims of seeking to deliver 'transparent, consistent, comparable, relevant and reliable financial information', and that reflect the considerable experience already gained in other countries, such as the UK, in reporting current values.

While the FASB's current approach to 'fair value' does appear to have had an undue influence to date on the IASC's own approach, the IASC forum at least allows the opportunity for this to change and for improvement to be made. We would therefore encourage the SEC to support the potential use of IASC standards for all cross-border listings, and to look to the FASB to bring its own standards into line with the best standards availailable internationally. In particular we would commend the IASC's approach of adopting 'benchmark' treatments but allowing alternative treatments in individual circumstances where appropriate, provided there is adequate disclosure to investors and other users of financial statements. This approach combines the necessary discipline of 'policing' financial reporting while maintaining the necessary flexibility for accounting treatments to properly reflect individual circumstances: in other words it assists achievement of the objective of representational faithfulness, i.e. that like things should be treated alike, and different things differently, so that investors and others can benefit from the highest level of genuine comparability (not arbitrary uniformity) that is possible between different enterprises, both US and foreign.

This argument was developed more fully in

Arnold, J., D. Egginton, L. Kirkham, R. Macve, and K. Peasnell (1992) Goodwill and Other Intangibles (London: Research Board ICAEW).

Horton, J. and Macve, R. (1997), UK Life Insurance: Accounting for Business Performance (London: FT Finance)

Our own recent critique of the FASB's current approach to accounting for financial instruments is set out more fully in:

Macve, R.H. , 'One Step Forward, Two Steps Back: IAS39', Accountancy, May, 1999, p.89 (of which we attach a draft version)

and in a forthcoming paper:

Horton, J. and Macve, R. (2000), ' "Fair value" for financial instruments: how erasing theory is leading to unworkable global accounting standards for performance reporting', forthcoming in The Australian Accounting Review (July).

We will be happy to provide any further information or explication of these views that would be helpful to you.

Yours sincerely

Richard Macve

Professor R.H. Macve, FCA
Professor of Accounting and Departmental Tutor
Department of Accounting and Finance (Y211)
London School of Economics
Houghton Street
London WC2A 2AE UK
Telephone: (020) 7955 6138 (from abroad: +44 20 7955 6138)
Fax: (020) 7955 7420 (from abroad: +44 20 7955 7420)
personal homepage: http://accfin.lse.ac.uk/staff/macve/

lt/rmvpaps/accy99/ias39sht 19.4.99

IAS 39: one step forward and two steps back in accounting for financial instruments

Richard Macve

IAS39 Financial Instruments: Recognition and Measurement completes the major projects in IASC's programme of `core' standards agreed with IOSCO. But ASB will not be implementing it here as financial instruments remain one of the most controversial accounting issues. IAS39 is only an `interim' standard-a stop-gap until proper agreement is reached. A Joint Working Group (`JWG') of standard setters (which includes the IASC's `inner circle', the `G4+1' group) is pressing on with a more fundamental approach. But in my view both IAS 39 and the JWG's current thinking are misdirected and unlikely to lead to significant progress in resolving the basic issues.

`Never mind the quality, feel the width'.

IAS 39 is recognisably derived from the US standards FAS115: Accounting for Certain Investments in Debt and Equity Securities (1993) and FAS133: Accounting for Derivative Instruments and Hedging Activities (1998). But there is enough variation to make the Americans uneasy about its acceptability in lieu of their own standards. Others fear that it represents a surreptitious introduction of an essentially US standard into the core of IASC's programme just when the battle-lines between IASC and FASB over becoming the `World Accounting Standards Board' are being drawn.

Here we come to the underlying issue of principle: FAS115 is one of the many `low quality' US standards which have often resulted from the messy compromises necessary to satisfy FASB's various domestic constituencies. What is wrong with it, and therefore with IAS 39?

In respect of listed portfolio investments, IAS 39, like FAS115, distinguishes three major categories:

(1) `Hold-to-maturity' debt securities-which are reported at amortized cost.

(2) 'Trading' securities-including derivative positions-which are reported at fair value, with the changes in value reported in P&L. As under FAS133, where derivatives are `hedges' of items which are not themselves marked to market (such as anticipated sales in a foreign currency), any gain or loss on revaluation to fair value is taken direct to equity and profit recognition is deferred until the matching transaction is also accounted for.

(3) 'Available-for-sale' securities-which are reported at fair value. Under FAS115 changes in their value are taken direct to owners' equity and not reported in earnings until the securities are sold. Under IAS 39, companies have a `one-time' enterprise-wide option either to adopt this approach, or to include changes in their value in P&L as for trading securities.

With regard to non-derivative liabilities, the most controversial item has been companies' own long-term fixed-interest borrowings (e.g. debentures), where IAS 39 keeps the `effective interest' method (required by both FRS4 and FAS4) which is the mirror image of the `amortized cost' basis for `hold-to-maturity' investments.

A curate's egg

IAS 39's major strength lies in accepting the need for `hedge accounting', without which it is impossible in the current accounting model (which does not reflect the impact of transactions and events on all future cash flows)¹ to present an undistorted measure of performance. Its major conceptual weaknesses are:

• Holdings of the same securities (e.g. investments in a FTSE100 company's debentures) could be accounted for in three different ways according to the `management's intention' for each holding.

• If revaluations of `available for sale' securities are accounted for `American-style', earnings can be manipulated by choosing which securities to sell. Similar effects can be obtained by choosing when to buy in fixed interest loans (which is also a current weakness of FRS4). The two dissenting Board members to FAS115 stated: `An impressive amount of empirical evidence indicates that many financial institutions have engaged in that behaviour'.

• The issue of whether and when `hedge deferral' should be allowed remains controversial and goes beyond gains and losses just on derivatives. Financial institutions such as banks and insurance companies hold investments and mortgages matching their deposit and policy liabilities.²

Following the Pied Piper

The JWG is working on the approach of comprehensive fair valuation (including long-term fixed-interest liabilities) originally put forward in IASC's March 1997 Discussion Paper, with the changes in fair value being reported as.........? And here lies the real difficulty. The JWG has not listened to the important conceptual arguments that, while incorporating as many fair value measurements as are feasible would be good for balance sheets, it does not follow that all changes in value are the same. Some changes, such as those resulting from inflation, from changes in interest rates, and from the effects of market assessments of changes in an entity's own credit risk, may even not be regarded as financial performance at all. Moreover the G4+1 group is enthusiastic about having only one performance statement (like our present P&L account) which would report all gains and losses, so that there would be no longer be any other statement (such as the present STRGL) in which these `dubious' value changes could be parked.

What is needed to make progress?

The crucial issue is not `fair values' but performance measurement.<sup>3</sup> This is where the discussion on financial instruments, including the hedging issues, needs to be focused-which makes it all the more surprising that ASB's revised ED of its Statement of Principles for Financial Reporting (March 1999) considers that `no significant financial reporting principle is involved' in deciding how many performance statements should be presented or what are the components of financial performance and their characteristics. Did the ASB miss the furious controversy in the US surrounding the exposure draft that preceded the issue of SFAS130: Reporting Comprehensive Income in 1998? Just maybe, if the standard setters could sort out some principles for measuring and reporting financial performance, then there might be some sensible progress on resolving the issues around financial instruments. Otherwise we shall all end up adopting the FASB standards-including their `low quality' standards-just because they are there, and, as with IAS 39, take several steps backwards from the goal of designing standards that combine the rules necessary for objectivity with the flexibility needed to enable businesses to report their performance against appropriate benchmarks and without which businesses will also be handicapped in managing that performance successfully.

Richard Macve, a former member of Council, is Professor of Accounting at the London School of Economics and Academic Advisor to the Institute's Centre for Business Performance.

1 see ICAEW discussion paper, Financial Performance: Alternative views of the bottom line, January 1999, prepared by the Financial Reporting Committee.

2 for further discussion based on research sponsored by ICAEW's Research Board see e.g. Horton, J.G. and Macve, R.H., UK Life Insurance: Accounting for Business Performance (London: FT Finance, 1997).

3 As the ICAEW's Financial Reporting Committee has rightly argued, in the recent discussion paper referred to above