Accounting Complexity and Implications

Abstract

Accounting standards and in particular their contribution to the financial crisis have been intensely debated for quite some time. A central aspect of accounting relates to the valuation of financial instruments. International financial reporting standards (IFRS) dictate that financial instruments are either carried at amortized costs or have to be valued mark-to-market (fair value). Both approaches have their merits and their drawbacks. Fair value enhances transparency on the worthiness of assets but has also been blamed for having intensified the downward spiral when the crisis broke. Significantly depreciating the value of assets led to banks experiencing capital shortage. Banks then sold assets to ensure that their capital position met the minimum regulatory requirements. Forced selling put additional pressure on market prices. As a result, asset valuations had to be reduced again, with pronounced detrimental effects on capital. These events led in October 2009 to an amendment to IAS 39 and IFRS 7 which did permit the reclassification of some assets out of the fair value through the profit and loss category to new cost or amortized cost. The pro-cyclicality of fair value was a major concern of politicians, who requested changes to the accounting rules. Under IAS 39, which deals with the recognition and measurement of financial instruments, financial assets are classified into four categories: Held for Trading, measured at fair value through profit and loss; Loans and Receivables, measured at amortized costs through profit and loss; Held to Maturity, measured at amortized costs through profit and loss; and Available for Sale, measured at fair value through equity.