Dienstag, April 22, 2008

IFRS, Fair Value Stupidity...and How The Banks Lost $255 Billion

Robert Owen said this: All the world is queer save thee and me, and even thou art a little queer...

The topic today is how well-intentioned changes in accounting practices have created a monster that could devour us all: it's a monster with positive feedback loops, making any crisis much worse than it need be, and perversely also setting the ground for the development of massive bubbles that will implode with severity equal to none.

What is this monster?

IFRS. The International Financial Reporting Standards, the rules for international bookkeeping.

What is the problem?

This (from Wikipedia):

Receivables (debtors) and payables (creditors)

Receivables and payables are recorded initially at fair value (IAS39.43). Subsequent measurement is stated at amortised cost (IAS39.46 and 47). In most cases, trade receivables and trade payables can be stated at the amount expected to be received or paid; however, it is necessary to discount a receivable or payable with a substantial credit period (see for example IAS18.11 for accounting for revenue).

If a receivable has been impaired its carrying amount is written down its recoverable amount (the higher of value in use and its fair value less costs to sell). Value in use is the present value of cash flows expected to be derived from the receivable (IAS36.9 and 59). ...

and what is Fair Value?

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction (IFRS1 App A).....

Now, this all sounds reasonable, but is it?


The key is that receivables and payables, initially valued at what you actually paid for them, are then significantly and constantly revalued.

Not what the company expects to receive for them, as laid out in the contractual agreements signed, but what the company could get for such receivables if they were sold on the market as OTC or exchange instruments.

Most importantly, this effects the valuation of assets, defined as resources controlled by the company and with which the company makes money (in the form of future cash flows).

Now, why is this a problem, and more importantly, how does this form a positive feedback loop that causes any sort of modulation to start excessive swings?

Receivables must always be assessed for the purposes of bookkeeping at their fair market value. No particular need to do this every day or month, but it must be done once a year, at the very least, to determine equity of the company.

What happens when the market for <whatever the asset is> is down sharply? That means that the assets that the company holds must also be revised downward sharply, resulting in a reduction in equity. Given that net profits is equity of the previous year minus equity of today, this means that the usage of fair value leads to a reduction in equity, which must then be written off.

Given the large amount of financial paper held out there, this means that because of IFRS and fair value, and here I am quoting today's Handeslblatt on page 23, banks world-wide have written off no less than 255 billion dollars on value adjustment. The professional organization CFA even says that 55% of responding bankers see the IFRS rules as being responsible for the magnitude of the current problem.

Of course, the IFRS insists that these rules are right and proper, and reflect "reality" better than the old rules, where assets were simply depreciated over time and future receivables discounted to net present value.

The IFRS is wrong, wrong, wrong and did I mention that they are wrong?

If a concern were to be liquidated, then the IFRS interpretation would be correct: however, the IFRS itself says that the fundamental assumption is that when we look at a company, it is always the company as a going concern.

The IFRS interpretation would imply that an investor should "know" the "real" state of the company's finances before making any sort of investment decision, or that the company itself should "know" the "real" state of its receivables, both by acting as if the receivables were to be sold off to realize their current cash value.

That way lies madness.

I cannot underscore this more.

The problem isn't just the current downswing: the real problem will be the next dynamic upswing.


Because then the companies will revalue their receivables as markets recover and pick up: all of a sudden, companies will report massive increases in profits, vastly improving their equity position, and resulting in a major, major increase in their ... creditworthiness.

Hence companies will be able to increase their borrowings with significantly lower risk premiums.

Which means that the banks will increase their downside risks dramatically when the business cycle turns downward again, forcing them, per IFRS rules, to revalue their assets downwards significantly as the relative risk of the business partner worsens dramatically.

What the IFRS rules really do, in their absurd search for some resemblance of reality, is make it even more difficult for banks and lenders to determine "true" risk: bookkeeping, due to the highly volatile nature of fair value asset revaluation, will make it harder to see the true financial state of the company, as the swings due to asset valuations will overweight these significantly.

This means it will be harder for those who are not financial wizards to actually read a balance statement without being severely misled as to the true profitability of the company.

Now, that is stupidity.

It is what happens when you let the inmates run the asylum: this is the result of not an attempt to make finances more transparent, but rather to satisfy the desires of accountants to give themselves a "better" idea of how the company is doing, and shows how terrible things can happen.

When they don't ask economists how reality actually works. The stupidity of the IFRS and the very, very real damage being done to the economy comes from a fundamental ignorance of how destructive positive feedback loops really are.

If the IFRS simply allowed a secondary valuation of assets, but left straight-line depreciation alone for the purpose of determining profitability, then you'd have at least $255 billion less having been written off. What started out as a sensible internal measure - companies should know if they are facing significant price deterioration for key assets - has become a monster that has the potential for massive destruction.

All in the name of greater transparency. This isn't transparency, it's folly.

But they're accountants. One nasty joke is that economists are only glorified accountants, and I'd even accept that largely, with one caveat: economists are accountants who can actually think.

Sheer and total stupidity, and the destruction of $255 billion.

Even for the US government, that's real money.

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