The Technical Director
Accounting Standards Board
28 June 2001
Dear Sir,
RE: JWG PROPOSALS FOR ACCOUNTING FOR FINANCIAL INSTRUMENTS
Thank you for giving us the opportunity to comment on your consultation paper. We have canvassed opinion amongst our members who have expressed a number of concerns on the effectiveness and usefulness of fair value accounting, particularly in its application to a class as wide-ranging as financial instruments. Our comments relate to the application of fair value accounting to corporates, not financial services organisations.
Our main points can be summarised as follows:
The volatility in the figures reported on the face of the profit and loss account as a result of using fair values will, we believe, encourage companies to take avoiding action by changing their risk management policies.
The essential requirement of accounting for financial instruments is to allow readers of accounts to distinguish between instruments that reduce risk and those that increase it i.e. what is hedging and what is speculation. The proposals as currently structured do not achieve this and in some cases are positively misleading in this respect.
Fair value accounting will not achieve clarity for the readers of accounts and will lead to the misinterpretation of risks and risk management activity which is invariably focused on managing cashflows not fair value. We support the JWG’s intention that companies should disclose their risk management objectives and policies, their financial risk positions and their financial performance. However we do not think it useful for the exposition of the effectiveness of the company’s policies to be based (as would be necessary) on information that is fundamentally different from what appears on the face of the accounts.
We believe that the way forward is for some fair value information to be disclosed by larger companies in notes to the accounts, for the benefit of sophisticated users. However, to require corporates to provide extensive fair value information on the face of their accounts is an inappropriate response. We believe that the issue of the cost relative to the benefit is crucial to assessing the merits of any move towards fair value accounting.
It is essential that there should be a cost benefit exercise similar to that conducted by the FSA before there is any firm commitment to a fair value based approach.
We have organised our comments by reference to the major uses of accounting information for our members: corporate governance, explaining company performance, the measurement of shareholder value and the impact on financial covenants in loan and bond documentation. We also make more detailed comments on the cost benefit trade-off of providing fair value information.
The Association has been at the forefront of calls for greater disclosure to enable investors to assess the risks that a company is facing and how well it manages those risks. We are concerned that the JWG proposals will give rise to figures that will be misleading to anyone attempting to evaluate the success of risk management activity by the company. We stress again that we are concerned with corporates, not financial services organisations.
The financial risks managed by treasurers are cash flow risks not fair value risks. Although the JWG mentions more than once that "many" enterprises manage their risks on a fair value basis, we are not aware of any company outside financial services and the property sector that does so across the board. Since the fair value model reflects the results of taking fair value risk, it will not (except coincidentally) give information that will enable readers of accounts to evaluate the success or otherwise of a company’s cash flow risk management.
Interest rate risk is a case in point. Many companies select fixed rate debt because they perceive it be a low risk strategy. There is a large body of literature that supports this view, based upon the fact that the fixed rate borrower has reduced the risk of financial distress or bankruptcy by eliminating the risk of an increase in variable interest rates increasing its debt servicing costs. This may, for example, occur to enable the company to comply with financial covenants. Or, the company may have incoming cashflows that are not correlated with the interest rate cycle and its objective is to reduce the volatility of its post-interest cash flows.
In neither of these cases is the change in the fair value of the debt of any significance. The JWG accepts (paragraphs 1.22 to 1.26) that if a company borrowed on a fixed rate basis this would increase the volatility in its accounts, and that this would make the company look as if it is adopting a higher risk strategy. Some companies may be tempted to change their policies to avoid such volatility from increasing in their accounts and examples of this are mentioned below. This would result in readers assuming that less volatility on a fair value basis equals lower risk generally, whereas in fact the opposite would be the case.
The JWG suggests that a disclosure in the notes to the accounts, providing an alternative view to the fair value one reflected on the face of the accounts, is an adequate means of dealing with such issues. We strongly disagree. We feel that it is absolutely essential to the reporting of risk management that the face of the accounts should provide information that is not directly misleading as to the cash flow position of the company. We would also like to point out that the negative implications of reporting fixed rate debt under the JWG proposals are likely to impact particularly on smaller and/or more highly geared companies. These are often companies who can least afford the risk of variable rate debt, and many do not have the choice from their lenders but to borrow fixed rate. They will be the same companies that lack the resources and expertise to use derivatives to manage the risk.
We note (from paragraphs 156 to 163) and support the JWG’s intention that companies should disclose their risk management objectives and policies, their financial risk positions and their financial performance in this regard. JWG accepts that this would require companies to provide additional information to that in the accounts. We do not think it useful for the exposition of the effectiveness of the company’s policies to be based (as would be necessary) on information that is fundamentally different from what appears on the face of the accounts.
Treasurers frequently need to explain to outside parties the performance of the company, usually with the aim of convincing them of its ability to service its debt going forward. The fair value method looks at a company on a break-up rather than going concern basis. This is completely contrary to the forward-looking perspective of the treasurer and his lenders who focus on the company’s capacity to generate cash to service its debt.
In Basis for Conclusions under "Relevance", paragraph 1.8 (d) states that "Fair value reflects the effects of management’s decisions to continue to hold assets or owe liabilities, as well as decisions to acquire or sell assets and to incur or settle liabilities."
Paragraph 1.10 goes on to say (in connection with risk management based on cashflows) "accounting for these financial assets and liabilities on a cost basis cannot provide as relevant a measure of their matched and mismatched cashflow positions as can fair value measurement."
When applied to companies which, like banks, trade their positions in financial derivatives (rather than holding them to maturity), we agree with these statements. However the percentage of corporates trading in this way, in the UK or anywhere else, is extremely small. For the vast majority of corporates their policy is to hold all financial instruments to maturity (or until an interest rest date on a floating rate loan, when they can repay at par). For many, the predominant financial instruments on their balance sheet are (apart from trade items) cash deposits on one side and bank loans on the other.
To say that fair value reflects management decisions in these cases does not accord with reality. Corporate entities do not operate like banks. They do not trade financial instruments, it is not their business to do so and in many cases they do not have the expertise to do so. They structure debt and cash to meet their needs for certainty in financing their business activities.
The fair value of a loan will in any case often bear little relation to the value realised if the loan is prepaid, usually the only option to holding it to maturity. For companies whose credit weakens during the life of the loan, the fair value of the loan will be less than historic value but the company is still obligated to repay the loan in full. Sophisticated companies may have access to the derivatives markets to realise fair value but rarely do so, as they invariably plan to hold financial instruments to maturity to achieve the certainty they require. Apart from the very few corporates that manage their risks on a fair value basis the statement made in paragraph 1.10 is simply not realistic. For the majority of corporates fair value information cannot be said to have much relevance to actual cashflow at all.
While the performance focus for both management and investors must be on cashflow and its volatility, it is inevitable that fair value information given in the accounting figures will be accorded significance. Analysts are used to reading balance sheet figures with a pinch of salt, due to the snapshot nature of the figures, but they depend heavily on the profit and loss statement. We are concerned that the increased volatility in this statement will be difficult to explain and poorly understood.
We do not believe that most lenders and investors will be able to provide the time and expertise to cut through the complexity implied by the JWG proposals and the result could be greater avoidance of risk and a resulting increase in costs for companies. In addition, if the performance statement becomes more difficult to understand because of the provision of large amounts of additional data which do not appear to be demanded by users, this will undermine the credibility of the accounts. Already we have the example of the goodwill standard where corporates prepare their accounts in accordance with the standard but then quote their numbers before the goodwill write-off. We can envisage a situation in which companies explain the volatility in their earnings in their "statutory" accounts, by producing an alternative set of accounts for public consumption ignoring those standards that don’t suit them. This would be a resounding indictment of the accounting standard setters’ ability to get the cost-benefit trade off equation right in this case and would counteract the excellent work done over recent years in eliminating accounting abuses.
Clearly, listed companies pay a great deal of attention to shareholder value and we understand that the JWG proposals are an attempt to bring the accounting figures a little closer to the "real" value of the company at any particular time. Accounting figures will never encompass the entire value of a company (since they exclude e.g. staff, knowledge, competitive advantage). In our view, the proposals imply a break-up valuation rather than one based on the concept of going concern.
We believe that the volatility that would result from adopting fair value accounting treatment would tend to drive down value and by corollary increase the cost of funds. We have heard fund managers say that companies should not be too concerned about volatility as investors will ignore the fair value information and concentrate on cashflow. We believe this is the wrong principle to adopt. The intention of the JWG in insisting on putting such information on the face of the accounts rather than in footnotes must be that the volatility is reflected in investors’ evaluation of the risk inherent in investing a particular company. Corporates attempting to reduce their cost of capital will have to consider the accounting implications of their risk management policies and may well amend them accordingly. The accounting tail will be wagging the risk management dog.
An area where this could be most damaging is the hedging of future cash flows. If a corporate is hedging currency exposures a year or two out, the mark-to-market value of these hedges could be quite material and therefore any movements could result in significant volatility (= high risk) in a situation where the economic effect is a reduction of risk. The effect of not hedging such exposures could be to transform the profit margins on part of its business from a predictable to an unpredictable basis, a higher risk strategy.
We would, of course, be extremely concerned if corporates did allow accounting to determine their hedging strategies. Sadly, this seems to be a likely outcome. PricewaterhouseCoopers has recently published a survey of major companies in the Nordic countries (Nordic Corporate Treasury Benchmarking Survey 2001). These countries are particularly interesting because of the high percentage of corporates, approximately two thirds of the sample, reporting under US GAAP or IAS, and therefore applying FAS 133 or IAS 39. The survey showed that 61% of respondents claimed that accounting had a significant impact on their treasury policies. The report remarks "The overall result is not surprising as many companies have implemented strategies to ensure minimum accounting volatility. From a group-wide risk management point of view, however, such strategies may increase risk." Quite so.
In today’s volatile financial markets, investors in bonds and loans are demanding stronger protection in documentation and are pushing for more extensive financial covenants. Of course, many long-term instruments currently outstanding already contain such covenants.
The philosophy underlying the negotiation of financial covenants is that performance is reflected in a predictable pattern in the accounting figures on which the covenants are based. Lenders expect borrowers to be able to manage their activities to keep within their covenants. A borrower's inability to do this normally indicates a situation in which the lender would want to foreclose or alter the terms of doing business. The value of using covenants demands a certain level of predictability and stability of relevant financial figures
The two most commonly used covenants are interest cover (earnings before interest and tax over interest cost) and gearing (debt/equity). Our concern about interest cover is that it will include fair value differences from one year to another and therefore be out of management’s control. This makes the use of interest cover based on the financial accounts quite unsuitable for covenant purposes.
[NB We have been unable to understand the JWG’s basis of measuring the period cost of finance and believe it to be far too theoretical. Collecting and reporting information on interest on this basis would be likely to require a significant investment in new accounting software for what appears to be a relatively small change in reported numbers, and therefore the best cost benefit outcome would be to continue with the existing historic cost method.]
Gearing ratios also present problems. Using fair value for a company’s debt in a deteriorating credit situation would result in the company’s gearing ratio improving owing to the reduction in book value of debt on the one hand and the consequent "profit" which would be reflected in shareholders’ funds on the other. Thus a gearing covenant would give no control at all. Not exactly what the lenders had in mind!
There may be alternative ways of documenting funding commitments entered into after such time as the JWG proposals came into effect. However their purpose is to enable lenders to monitor the ability of the borrower to service debt, and as such, must reflect cash flow reality, not performance adjusted by unrealised charges. The further that the accounting figures move from cashflow, the less useful they are for lenders.
We believe that it will be very difficult to devise workable financial covenants based on volatile fair value accounting figures. We suspect the result will be that lenders will require companies to produce figures based on historic cost for the purpose of monitoring compliance with financial covenants. This will increase the likelihood of companies producing two sets of accounts.
The position of borrowers with outstanding commitments should not be forgotten. If fair value accounting were to become accepted, the transition for these borrowers (and particularly for bond issuers who have no opportunity to re-negotiate) could be extremely painful. A very long lead time for any such change in accounting standard would be required to avoid disruption in the financial markets.
We are fully supportive of providing sufficient information for investors to evaluate the risks that a company faces, and its policies and effectiveness in managing them. However we believe that the JWG’s objectives can be met by providing the fair value information as a disclosure rather than on the face of the accounts. It is clear from paragraphs 1.12 and 1.13 that such pressure as exists from users of accounts for fair value information is for it to be provided through disclosures rather than on the face of the accounts.
Any further move towards fair value accounting should be accompanied by a cost benefit exercise similar to that conducted by the FSA on each of their regulatory proposals. We have concerns, especially for smaller corporates i.e. anything not in the top 250 listed companies in the UK, that the costs of implementing these proposals would be disproportionately high. Given the minimal benefit likely to be derived from thousands of smaller companies trying to "fair value" their bank loans, we question the wisdom of loading a further regulatory burden on this sector.
The issue of expertise is also relevant, being particularly hard to find in small companies and the audit firms that tend to service them. We note that the JWG is aware of the shortage of experienced staff in this area, even amongst larger companies and auditors. We suspect that the fact that some companies are failing to provide FRS 13 information is a testament to the lack of specialist knowledge in many companies. The training, systems and valuation services required to deliver the JWG’s proposals will be extensive and expensive.
To summarise, while we generally support the provision of fair value information to sophisticated users of accounts, the current proposals will, we believe, result in confusion for the users of accounts and unjustifiable costs for most corporates.
We hope that you find our comments of interest and we look forward to being involved in future discussions on this topic. Please contact our technical team at techncial@treasurers.co.uk or on 020 7213 0738.1
Yours sincerely
Judith Harris-Jones
Chairman, Technical Committee