Marco teórico

The qualitative research approach adopted in this paper necessitates only a brief theoretical section as an over-emphasis on theory could restrict insights and create bias.

4.1 Fair Value Accounting

In the recent past, most financial reporting was based on historical cost. Assets or liabilities (but for brevity, only assets are discussed in this paragraph) were shown on the balance sheet of companies at the original price paid for the asset or at the original price paid for the asset amortised over time. Under mark-to-market accounting, an asset is carried on the balance sheet at the price the asset could fetch in the current market. Changes in mark-to-market value, in other words unrealised holding gains or losses, are recognised in current earnings. In contrast, under historical cost accounting, changes in value are usually only recognised when realised.4

FVA is more complex than mark-to-market accounting. Fair value is the exchange value in an idealised market and can be determined in three ways, in order of preference:5

• Mark-to-market accounting (level 1): the significant inputs are quoted prices on an idealised market for similar instruments.

• Mix of mark-to-market accounting and modelling (level 2): the significant inputs are directly observable market inputs other than Level 1 inputs; for example, adjusted market values etc.

• Mark-to-model (level 3): significant inputs are not based on observable market data; instead, an estimate is made of what the value of the instrument would be if it were to be traded.

The adoption of FVA for financial instruments was the culmination of the introduction of fair value into accounting (Magnan, 2009:192). IAS 39 Financial Instruments: Recognition and Measurement came into effect from 1 January 2001 and is the accounting standard on

4

Historical cost accounting recognised declines in the market value of assets if that decline indicated impairment.

5

A formal order of preference only entered accounting standards under the IASB in October 2008 with an amendment to IAS 39 which adopted the American tiered system of fair value determination.

70

financial instruments under which the banks in the study reported. IAS 39 is summarised in the following table.

Classification of financial instruments

Treatment Reclassification allowed? ASSETS

1.1 Held for trading financial instruments*

Financial instrument valued at fair value and value change taken to profit and loss and thus ordinary capital

1.1 Can be reclassified out of this category if non- derivative, change of intention and “rare circumstances” or meets definition of loans and receivables

1.2 Financial instruments designated as at fair value through profit or loss

1.2 No reclassification allowed in or out

2. Held-to-maturity financial instruments

Financial instrument valued at amortised cost

Reclassification possible subject to “tainting” rule 3. Loans and receivables Financial instrument valued at

amortised cost

Reclassification possible 4. Available-for-sale financial

instruments

Financial instrument valued at fair value and value change taken directly to capital

Can be reclassified to 3. if change of intention and meets definition of loans and receivables

Can be reclassified to 2 & 3 if change of intention and “rare circumstances” LIABILITIES

1.1 Held for trading financial instruments*

Financial instrument valued at fair value and value change taken to profit and loss and thus ordinary capital

1.1 Can be reclassified out of this category if non- derivative, change of intention and “rare circumstances” or meets definition of loans and receivables

1.2 Financial instruments designated as at fair value through profit or loss

1.2 No reclassification allowed in or out

2. Other financial liabilities Financial instrument valued at amortised cost

Reclassification possible Table 4.1 Disclosure categories for financial instruments according to IAS 39.

* - Includes all derivatives.

Two matters in Table 4.1 warrant further explanation as they become relevant in the rest of the study:

1) Financial instruments designated at fair value through profit and loss: IAS 39 permits the designation of any financial asset or financial liability to be measured at fair value even if the item would ordinarily, by its nature, be measured at amortised cost. In 2005 the IASB issued an amendment to IAS 39 that restricted the use of the fair value option. The revision limited the use of the fair value option to the elimination or reduction of an

71

accounting mismatch (so called macro hedging/ portfolio hedging) or to where a group of financial assets, financial liabilities or both are managed on a fair value basis. The basis for conclusions that accompanied the amendment explained that some constituents, including prudential supervisors of banks, securities companies and insurers, were concerned that the fair value option might be used inappropriately and that the use of the option might increase profit and loss volatility. In other words there were worries that bankers might finesse the option in an unacceptable way.

2) Reclassification changes in the midst of the global financial crisis: on 13 October 2008, and in response to the global financial crisis, the IASB issued amendments to IAS 39 and the International Financial Reporting Standard (IFRS) 7 Financial Instruments: Disclosure. These amendments created the space for banks to reclassify non-derivative financial instruments from the held-for-trading category in “rare circumstances” or if those instruments met the definition of loans and receivables. Similar reclassifications from the Available-for-sale category were made possible if the item met the definition of loans and receivables. The amendment reiterated that no reclassification out of the designated at fair value category is allowed.

IFRS 9 Financial Instruments, is expected to become effective from 1 January 2015 but with early adoption allowed. This will replace the classification and measurement provisions of IAS 39. The four categories of IAS 39 will be reduced to two categories; one measured at amortised cost and the other at fair value. Financial instruments with basic loan features, managed on a contractual yield basis and not classified as at fair value at initial recognition, will be carried at amortised cost. Other financial instruments will be at fair value. The fair value option under IAS 39 will be retained.

Reclassifications and movements between the levels of fair value measurement are the official IAS 39 channels of accounting choice. How do bank managers make use of this flexibility?

4.2 The use of accounting numbers in bank capital

According to Berger, Herring and Szego (1995) banks differ from other firms in two important respects that affect their capital structure: the first difference is the existence of a

72

regulatory safety net that protects the soundness of the sector and the second is the imposition of minimum required capital levels.

The combination of a regulatory safety net that encourages “risk shifting” behaviour where banks take more risk than normal (Merton, 1977) and a declining return on assets (ROA) due to competition from other firms, incentivises bank managers to increase leverage. One way in which bank managers can maintain or achieve the expected return on equity (ROE), even when ROA is decreasing, is to increase leverage.

Banks are thus highly leveraged institutions and the primary protection offered to depositors against bank failure is a prescribed minimum level of capital. The Basel Accord provides a standardised framework for measuring capital adequacy and it imposes minimum required capital reserves. These are expressed in the following formula (highly simplified):

Accounting capital

> required % Risk weighted assets

This combination of a regulatory safety net and a minimum capital level can be used to explain an asymmetry in the acceptance by bank managers of FVA profits and losses.

During the business cycle upswing, profits are likely to be generated by FVA as asset values are increasing. More profits provide flexibility, making it possible for the bank to take on more debt to increase gearing and maximise future profits and remuneration, or pay out increased levels of remuneration or dividends.

During crisis periods, banks would be incentivised to carry higher levels of capital. This is not only because banks want to signal health to potential depositors but also because they are often directly required by bank supervisors to carry those higher levels of capital. However, capital is expensive or unavailable during crisis periods and thus retained earnings are the usual source of capital during crisis periods, putting pressure on accounting and FVA results for positive results. This is especially true if there are reversals of previously increased asset values or if there are assets that are held to maturity but should be written down.

73