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Wednesday, 15 July 2009

Fair enough?

The International Accounting Standards Board has proposed a radical shake-up of how banks and insurers report the value of financial instruments. Banks don’t like to report excessively volatile assets and liabilities, particularly when the values don’t move in their favour, so the IASB says that if a bank’s investment produces predictable cash flow, it can be valued in accounts using an accounting treatment that smooths out the blips.

On the other hand, if the asset’s cash flow is unpredictable, like some blow-up-in-your-face derivatives, it should be valued at current fair market values.

But note that the ability to report the asset at “amortised cost” is at the option of the holder and appears to be on an asset-by-asset basis. SO a bank that holds a portfolio of bonds could decide that certain bonds that are trading above their purchase price could be held at fair market value, whereas bonds trading at a discount could be held as long term investments because their fair value is lower than the amortised cost.

The Exposure Draft does not permit reclassification of individual assets, but this is easily circumvented by the following. All assets and liabilities acquired at near par values are initially reported on an amortised cost basis, but when assets trade at a premium over book value they are sold and possibly replaced by similar securities trading at a premium which are held on a mark-to-market basis. All the god news gets booked early while the bad news is deferred.

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