10 April 2013

IASB/Hoogervorst: Accounting and long term investment – 'Buy and hold' should not mean 'buy and hope'

Corporate governance and regulation have been struggling to keep up with the complexity of financial intermediation and its many temptations. Not many investors are capable of keeping a close eye on the managers they have entrusted their money to. In addition, conflicts of interest are rife. Investment companies, who should be holding their investee’s management to account, might also be interested in managing their pension fund.

What is the role of the IASB in promoting healthy, long-term investment? Financial reporting forces management to show how they have discharged their responsibilities to make efficient and effective use of the company’s resources. This is the principle of stewardship. In essence, it means accountability.

A couple of years ago, it was removed the term ‘Stewardship’ from the Conceptual Framework. Some critics regret this removal of the word stewardship. Some see it as an indication that the IASB would no longer attach sufficient importance to the interests of the long term-investor. To these critics, the IASB usually answers that the word Stewardship was only removed because it was so difficult to translate in other languages. The IASB also points out that the essence of the principle is still covered by the Conceptual Framework.

There should be no ambivalence about Stewardship being a central goal of financial reporting. Apart from IASB´s general principles, are there other ways in which IFRSs could affect long-term investors? It is often said that IFRSs discourage long-term investment by relying excessively on fair value or other forms of current measurement. Excessive use of fair value would, supposedly, encourage financial engineering and short-term profit taking.

So what are the facts? The truth is that, outside the financial industry, most companies have little to do with fair value accounting. The bulk of their assets and liabilities are measured on a cost basis. Those who follow our discussions on the Conceptual Framework know this is not likely to change. Even in the financial industry amortised cost is still an important measurement base. Most of a bank’s traditional assets, such as loans, are measured at amortised cost, now and in the future. It is no surprise, that most academic research shows that fair value accounting was not a major driver of volatility during the financial crisis.

Still, in the financial industry current measurement techniques play a bigger role than in other parts of the economy. As many financial instruments are traded around the clock in active markets, market value often gives the most relevant information. Where fair value was used during the crisis, it often gave much more timely information on the poisonous instruments that had been injected into the system. Preparers and investors who paid attention to fair value signals were often much better at limiting damage than those who chose to ignore them. The use of current measurement techniques in the financial industry will be substantially increased by IASB´s upcoming insurance standard. The IASB is close to finalising an ED on insurance contracts. The proposed standard will prescribe current measurement of the insurance liability, while many insurers currently still use historic cost. The public discussions on this standard provide a microcosm of the debate on long term investment versus short-termism.

Many in the insurance industry are concerned about what is coming. They criticise the new standards for creating too much volatility. They claim that this volatility will discourage them from making long-term investments and from providing products with guaranteed results. So what is fact and what is fiction? The insurance industry is a hugely important investor. In Europe alone, the insurance industry has a €5.4 trillion investment portfolio. Life insurance is a long-term liability business, so the industry potentially has an enormous appetite for solid long-term investments.

Unfortunately, current monetary policies make life very difficult for the insurance industry. EIOPA, the European Insurance regulator recently raised the alarm bell about the effects of persistent low interest rates on the industry. On the liability-side, low interest rates increase an insurer’s obligations in today’s terms, while the return on assets is depressed. Said differently, if low interest rates persist, insurers may find that their assets do not generate the cash flows needed to pay policyholders’ claims.

EIOPA is concerned that a considerable number of insurance companies will not be able to meet their capital requirements. EIOPA refers to Japan, where persistent low interest rates caused some insurers to fail, while others had to lower the returns they had promised to their customers. If the insurance industry is a victim of the crisis, it has been a rather silent victim thus far. Part of the reason why it has not made more headlines is that the problems cannot be seen for lack of a proper accounting standard.

In many jurisdictions, insurance companies measure their insurance liabilities at cost. They still show reasonable results, but these results might be based on completely outdated interest rates from, say, 10 years ago. EIOPA says about these firms: ‘the fact that the effects of low interest rates are slow to emerge in balance sheet terms does not mean the problem is not there and there is a real risk that firms could build up hidden problems.’

New IFRS will bring these problems to light because it requires measurement of the liability using current interest rates. This will allow investors to gain a much more reliable view on the true performance of the industry. Markets will gain much more insight into how effective insurers are in matching their liabilities with assets. Critics say that interest rates and other market fluctuations go all over the place and that our standard will lead to unnecessary short-term volatility.

The IASB has not turned a blind eye to these criticisms. Indeed, IASB´s ED will contain a host of proposals to reduce accounting volatility. But the IASB has rejected proposals that reduce volatility in an artificial way. Some insurers have brought forward proposals which are echoed in the report of the Group of Thirty which I mentioned earlier. One proposal is that the measurement of the insurance liability should be based on the expected return on the assets held by the insurer. While some in the insurance industry are enthusiastic about this idea, the IASB has its doubts. The IASB calls this “hope-and-wish”-accounting. The IASB does not think it is prudent to base the measurement of a liability on an uncertain yield of assets. ‘Buy-and-hold’ should not turn into ‘buy-and-hope’.

The appendix to the report of the Group of Thirty contains a yet more radical idea to eliminate short-term fluctuations, the so-called “target-date accounting approach”. In this approach, a diversified portfolio of equities would be put in a “target-date fund” with a binding commitment to hold them for a long horizon. The fund would then be valued at a time-weighted average of cost and market value with the objective of smoothing out short-term volatility.

This proposal is fraught with difficulties as well. If the books of a company were based on averages that are different from market values at the reporting date, trust in financial reporting might be seriously jeopardised. Market participants will react by simply converting the whole target-date fund back to market values. Mr Hoogervorst thinks “we should save them the trouble. We remain convinced that a model based on current measurement gives the best insight in the financial position of an insurance company.” New IFRS will be a huge improvement in that respect. Where it leads to more volatility, it is probably a reflection of real economic risks. Only adequate levels of capital can deal with this risk; accounting standards should not serve to cover it up.

Press release

Full speech

© IASB - International Accounting Standards Board