Accounting and Finance 52 (2012) 920

Special Issue Article

doi: 10.1111/j.1467-629X.2011.00417.x

Financial reporting: Hearing the GFC message?

What message?
Kevin M. Stevenson
Chairman and CEO, Australian Accounting Standards Board

1. Introduction
In some circles, it has either been argued or implied that the use of fair values in
measuring nancial instruments for nancial reporting purposes has been a contributing cause of the global nancial crisis (GFC). The uses of those values has
been said to be procyclical, feeding unrealistic over-pricing in boom times and
then exacerbating downward pressures when prices decline in illiquid markets.1
Financial reporting requirements for the impairment of nancial assets carried
at historical cost have, on the other hand, been seen to delay the recognition of
losses because of insistence in existing reporting requirements that losses be
incurred before recognition.
Yet other criticisms have focussed on the possibility that requirements have
allowed the derecognition, or non-recognition, of nancial assets despite the
retention or existence of exposures to risks that eventually have proved to be
catastrophic.
Questions have also been raised around the adequacy of consolidation requirements despite the lessons of the Enron era. This has been said to both facilitate
o-balance sheet nancing, especially in the area of securitised mortgage obligations and deepen concerns about the inadequate recognition of assets and liabilities arising from leasing transactions under the nance/operating lease model.
In response to these various criticisms of nancial reporting, a considerable
number of signicant reform initiatives are underway that will directly impact
Australian nancial reporting. This paper reviews these criticisms and the steps
being taken to respond to them.
1

The Report of the Financial Crisis Advisory Group (FCAG), 28 July 2009, to the Members of the International Accounting Standards Board and the US Financial Accounting
Standards Board (http://iasb.org.uk) brings together the criticisms cited in this introduction.

Received 24 October 2009; accepted 23 February 2011 by David Allen (Guest Editor) &
Robert Fa (Editor).
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The paper does not support the view that nancial reporting was a cause of
the GFC or that it exacerbated it. However, it does acknowledge that the GFC
has been a wake-up call for standard setters and their constituents who may,
with the benet of hindsight, have been somewhat preoccupied with the complex
structural challenge of establishing global standards and less focussed on some
of the known weaknesses and gaps in those standards.
The GFC generated calls for answers to problems that may have otherwise
been queued for attention some time in the future. Answers suddenly became
more critical than rening process. Real standard setting was needed, quickly.
But much of the criticism seems to have been well and truly born outside of
the GFC especially in the travail of introducing IFRS in Europe. Some may
also have been whipped up by those under pressure from the GFC and feeling
the need to divert blame. And some may well have come from confused expectations of the role of nancial reporting.
2. Pre-GFC debates
In reviewing the criticisms of accounting during the GFC, it is worth placing
them in the context of pre-existing debates. The IASB came into operational
existence in 2001 after considerable controversy over whether it should be
formed as an independent expert group (preferred by the SEC and others) or a
model more akin to a bi-cameral parliament in which the sponsors occupied the
upper house and the standards-making body the lower house (a model preferred
by key European interests). The former view provided, whilst those in the latter
camp then sought to ensure that the EU could retain some control over the
IASBs decision-making and output through the endorsement processes to be
applied in the EU to IASB standards.
The tensions between the two camps were very high, and it was not long
before those in the EU wanting a greater say became quite unaccepting of some
of the key reforms that IFRS could bring especially in relation to fair valuing
derivatives and other nancial instruments. This was despite the fact that the
nancial instruments standards2 had been in existence since 1995 and 1999 and
that the IASB had decided not to try to reform them before 2005. In other
words, the decision by the EU to adopt IFRS was based on the raft of standards
that included those on nancial instruments. The subsequent decision to endorse
the latter with carve outs came much later in 2004.
More broadly, it was perceived that the new IASB was pro fair value and, in
some European eyes, too inclined to accept US GAAP (which was what many in
Europe hoped to avoid when opting for international standards).

2
IAS 32 Financial Instruments: Disclosure and Presentation 1995 and IAS 39 Financial
Instruments: Recognition and Measurement 1999. International Accounting Standards
Committee.

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From 2001 until the GFC, we saw much wrangling between the IASB and
Europe over the formers attempts to improve and extend IFRS, with Europe
increasingly of the view that it was the IASBs major customer and its views
should be better heard. One of the outows of this was a good deal of pressure
on the due processes of the IASB, its governance model and its membership.
Partly this was to try to ensure Europes views could not be dismissed and partly
it was to slow down the standard-setting process.
When the GFC burst upon the world economy, the IASB had been trying to
placate Europe whilst seeing its main focus as being convergence of IFRS and
US GAAP. Much had been achieved in terms of acceptance of IFRS in other
countries (with over 100 coming within the fold), the spread of US GAAP
had been stopped and talks were well under way about a transition date for
the US.3
The European involvements repeatedly reminded the IASB that political interference was something to be managed, and they dispelled early optimism that an
independent standard setter could easily make progress on long-standing issues
such as revenue, leases and insurance. Further, the success achieved in extending
the reach of IFRS brought with it the realisation that managing change on a
worldwide basis required much more than achieving change in domestic standard setting (albeit that the latter was always considered very dicult too).
As the GFC opened up, both the IASB and FASB found themselves under
pressure to react quickly. At rst, the responses were reactive and sometimes ad
hoc and diered between the two boards despite their attempts to work closely
with one another.
However, it did not take long for the pressures that had built up with Europe,
and now signicantly exacerbated by the GFC, to lead to the recognition by the
Boards that major reforms were needed.
The curious thing about the reforms, overall, is that they have reected builtup pressures as much as any of the lessons, set out below, that are specic to
GFC problems. Indeed, as will be commented upon later in this paper, one
might argue that the real culprit in the GFC the overstated receivable recorded
at amortised cost has yet to be bought to justice.
In the early days of the GFC, the SEC published its ndings4 after reviewing
the failures to that time in US banks. Those ndings demonstrated that there was
very little use of fair value in those banks and that the failures were the result of
3

These talks have since been resumed, and in February 2010, the SEC conrmed that it
supported having the US adopt IFRS around 2015 or 2016 depending on the outcome of
a 2011 review. Securities and Exchange Commission Release Nos. 33-9109; 34-61578,
Commission Statement in Support of Convergence and Global Accounting. February
2010. This release contains a history of the SECs consideration of IFRS.

Securities Exchange Report to Congress: Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market
Accounting, 30 Dec 2008.
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K. Stevenson/Accounting and Finance 52 (2012) 920

credit risks undertaken before various critical markets collapsed. The SECs ndings were helpful to the IASBs position but were not going to deter those wishing
to blame IFRS or the IASB for the shortcomings of the nance industry.
3. Key observations arising from GFC
Despite all of the above, some matters seem to have been generally accepted
by standard setters as a result of the GFC criticisms of nancial reporting and
accounting standards. As this paper will illustrate, that acceptance, to the extent
it relates to matters within the brief of standard setters, is now evidenced by steps
taken or being taken.
The matters on which consensus seems to have emerged, or become selfevident, include:
1 the conceptual underpinnings for fair value, and the extensiveness or otherwise of its use, have not been well understood or accepted;
2 the guidance for how to determine fair value was found to be wanting when
markets became either less active or inactive;
3 the signicance and measurement of credit risk had not been suciently
understood and explored in relation to nancial assets generally, and derivatives specically;
4 the need for the independence of standard setting was not valued enough to
stop political opportunism, either by actual politicians or by those in Europe
bearing scars from lost technical debates (e.g. over fair value);
5 there was actually a limit to the tolerance for complexity in nancial engineering and, as a consequence, in nancial reporting requirements that tried to
deal with that complexity;
6 there was an acceptance that a large and growing body of nancial reporting
requirements, focussed on capital markets, was getting beyond the capabilities
of smaller entities and arguably beyond the needs of the users of their nancial statements;
7 required nancial reporting disclosures had accumulated to the point where
they needed to be culled and then made more coherent and purposeful; and
8 any remaining doubts about standards needing to be principle based were dispelled by the observable fact that detailed rules and a climate of nancial engineering seemed to go hand-in-hand. Professional judgement, exercised within
clearly stated principles, has been accepted, albeit with some trepidation, as
the way forward.
On a more prosaic level, standard setters have come to realise that rules,
exceptions to rules and anti-abuse-driven requirements are the stu of complexity. They also have begun to limit their preparedness to provide detailed
interpretation or guidance, as this is not consistent with fostering professional
judgement.
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One of the unrecognised achievements of the globalisation of accounting standards has been that practice has responded to the challenge of working out how
to apply the principles in international standards. The GFC has accentuated the
need for this and nancial reporting benetted from the process being well
under way. This at least has at least obviated the need for extended debate and
soul searching. Rather, it has provided reason to hasten the process.
A notable area in which lessons seem not to have been learned is that, if nancial reporting is to serve the public interest, it cannot be private sector, for-prot
oriented. The GFC has seen large nancial institutions become controlled by the
public sector. We have seen the public sector comment to stimulus packages of
an incomprehensible size, and we have seen Governments become heavily
exposed to derivatives (guarantees), they have written.
Unfortunately, the focus on reforming IFRS and US GAAP completely ignores
this public sector reporting. The latter falls to the International Public Sector
Accounting Standards Board and a handful of progressive domestic standard setters, all operating on a much lower scale than the FASB and IASB. Despite this,
the Trustees of the IASB have recently again rejected the notion that the IASB
focus should extend beyond certain capital markets. The real threat of impending
sovereign failure seems to be needed before reforms will be seen as needed.
4. Financial Crisis Advisory Group
Although private sector standard setters were coming to the above realisations,
it is instructive to look also at the ndings of the FCAG.5 This group was independent and comprised people with substantial experience in the nance industry
or in nancial regulation. They were not a recycled group of accountants or standard setters. Their role was to advise both the IASB and FASB about the implications of the GFC and to identify areas for potential changes.
The group came to the following general propositions that conditioned their
more specic recommendations:
1
2
3
4

eective nancial reporting is critical to the credibility of capital markets;

high-quality, global accounting standards are needed;
the limitations of nancial reporting need to be kept in mind; and
the independence of standard setters is vital, as is the need for them to be
accountable.
In terms of specic ndings, FCAG concluded that:

1 there were weaknesses in the guidance for determining fair value in illiquid
markets;

See Note 1.

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2 the use of the incurred loss model, in conjunction with historical cost accounting for nancial receivables, had led to delayed recognition of losses;
3 the lessons of Enron on o-balance sheet nancing had still not been fully
learned;
4 there was undue complexity in accounting standard for nancial instruments;
and
5 the existence of multiple impairment models needed urgent review.
In relation to the criticisms that the use of fair values had been procyclical,
FCAG stated:
Whatever the nal outcome of the debate over fair value accounting, it is unlikely that,
on balance, accounting standards led to an understatement of the value of nancial
assets. While the crisis may have led to some understatement of the value of mark-tomarket assets, it is important to recognize that, in most countries, a majority of bank
assets are still valued at historic cost using the amortized cost basis.5 Those assets are
not marked to market and are not adjusted for market liquidity. By now it seems clear
that the overall value of these assets has not been understated but overstated. The
incurred loss model for loan loss provisioning and diculties in applying the model
in particular, identifying appropriate trigger points for loss recognition in many
instances has delayed the recognition of losses on loan portfolios. (The results of the
US stress tests seem to bear this out.)6

Expressed dierently, and something we have always known, historical cost

accounting is inadequate when prices change signicantly. Absent transactions
in the receivables, it does not set out to measure those price changes and measures impairments only when they are known to have happened (i.e., have been
incurred).7
To rectify the problems, FCAG recommended that the Boards should:

simplify and improve standards, especially on nancial instruments;

converge US GAAP and IFRS;
extend IFRS to other countries;
explore adoption of the expected loss model;
be wary of earnings management if impairment models are to be changed;
reconsider when fair valuing an entitys own debt allowance for changes in
the entitys own creditworthiness;
consult with prudential regulators on consolidation, derecognition and risk
disclosure;

See Note 1.

FCAG Report, page 4. See Note 1.

In contrast, fair value takes into account all available information and anticipates the
future. It considers what a receivable could be sold for in an orderly and knowledgeable
market.

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maintain the integrity of due process; and

document the limitations of nancial reports in the conceptual framework.

Of these recommendations, the only matters not in keeping with the accepted
or developing wisdoms noted earlier in this paper were those dealing with exploring the expected loss models and reconsideration of the inclusion of own credit
risk when valuing liabilities. As will be discussed later in the paper, the standard
setters have since responded on all of the FCAG issues, albeit still without clear
answers on some matters.
The FCAG also argued for:

tighter control of OTC markets for derivatives and structured products;

improved valuation and verication processes in companies;
ensuring that the interpretation of standards during any enforcement not be
allowed to cause divergence;
policy-makers to refrain from trying to inuence specic standards;
the independence of the IASB to be strengthened; and
regulators from more countries to be included on the IASB Monitoring
Board.

It is hard to argue with any of these recommendations, but most of the

reforms recommended have yet to happen.
5. The responses so far
The IASB has been most active in acting upon its own views about the GFC
lessons and in responding to FCAG recommendations. The most signicant
move has been to decide to completely replace IAS 39 on nancial instruments.
Troubled from the beginning of its operations about this inherited standard, the
IASB nally decided that incremental changes were not enough. Rather, the
IASB set out in 2009 to overhaul IAS 39 in three phases as shown in Figure 1.8
The rst phase aimed immediately to go to issues of complexity, when to
employ fair value and the vexed question of own credit risk. The existing standard had too many classes of nancial instruments each with their own requirements, too many anti-abuse clauses and too many exceptions to principles. It has
been dicult to both understand and apply. The second phase would deal with
the core issue of the GFC when and how to write down uncollectible receivables. The third phase, hedging, has not been an area of much debate during the
GFC but has undoubtedly been both an area of considerable complexity and
one also concerned with fair value.

The FASB similarly concluded that they needed to revise US GAAP but have opted for
an overall approach in a single exposure draft to be issued in 2010.

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Financial instruments:
IAS 39 replacement
project

Phase 1: Classification
and Measurement

Phase 2: Impairment of
Financial Assets
Phase 3: Hedge
Accounting
Figure 1 Overview replacement of IAS 39.

Managed on a contractual yield

basis
Basic loan features
No tainting and no need to
consider
intention

Fair value

Amortised
cost

All other instruments

Irrevocable option to present
changes in fair value in OCI for
equity investments not held for
trading
Fair value option for

Figure 2 Classication and measurement of nancial assets.

Although the reform of IAS 39 began only in the rst half of 2009, the classication and measurement reformed requirements were issued by the International
Accounting Standards Board in November 2009 as IFRS 9 Financial Instruments
(and in December 2009, by the Australian Accounting Standards Board, as
AASB 9). That standard applies only to nancial assets. The existing requirements of IAS 39 will continue to apply to nancial liabilities for the time being.
The latter means that the own credit risk issue identied by FCAG has, at the
time of writing, yet to be dealt with.
However, as Figure 2 shows, the new model for classication and measurement is quite simplied in its application to nancial assets. They are to be classied as nancial assets carried at either historical cost or fair value. If nancial

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assets are managed on a contractual basis and have basic loan features, they will
be carried at historical cost. Otherwise, they will be carried at fair value.
The standard eliminates the bifurcation rules for derivatives embedded
within nancial assets and instead requires assessment of the classication and
measurement of the hybrid contract in its entirety in accordance with the classication criteria. It also eliminates the (anti-abuse) tainting rules that applied to
held to maturity nancial assets.
The proposals retain a fair value option at inception, when its application
eliminates, or signicantly would reduce, an accounting mismatch.
Thus, the new requirements are simpler, do not have an anti-abuse orientation
and adopt what is argued by some to be a more practical approach to embedded
derivatives.
At the time of writing, IFRS 9 seems to have been accepted in practice
although there are concerns as to how well the approach will stand up when the
later phases of replacing IAS 39 are nalised. There is also a signicant concern
that the FASB, which intends to issue a holistic exposure draft later in 2010, will
come to dierent answers. The most contentious issue in the FASBs deliberations will be whether to retain amortised cost for receivables.
6. Impairment of nancial assets
The second phase of the reform of IAS 39 is to review the impairment of nancial assets.
On 5 November 2009, the IASB released an exposure draft,9 which seeks to
reduce to one the number of impairment models and to change from an incurred
loss model to an expected loss model. It thus addresses the recommendation of
FCAG aimed at overcoming the perceived lateness of loss recognition in existing accounting using the incurred loss model (Figure 3).
The expected loss model would bring a greater alignment between accounting
for, and pricing of, nancial receivables. Interest income would reconcile the cash
outows and estimated cash inows, rather than the contractual amounts. The
curious eect of this model is that if impairments are priced accurately at the
inception of the loan and no unexpected impairment occurs, there will be no bad
debt expense just a dierent interest income over the life of the receivable when
compared with now. However, if circumstances change, the anticipated eects of
that change will all be drawn forward into the period of reassessment. Although
the expected loss model does not yield fair values, it will tend to recognise losses
in a similar way and amount. Some may prefer the expected loss model as a
means of reducing volatility in reported earnings, but it is clear that this will only
occur for expected losses at inception of a loan. When markets shift signicantly,

Financial Instruments: Amortised Cost and Impairment. The ED is open for comment
until 30 June 2010.
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3. Impairment framework
Impairment models

Amortised
cost

Available
for sale

n
Cu rr e

Incurred
loss model

Pro p o


At cost

s ed

Expected
loss model

Figure 3 Reform of the impairment framework.

as in the GFC, the expected loss model could well amplify volatility when compared with the incurred loss model. Thus, whilst the expected loss model should
meet FCAGs objectives in terms of more timely recognition of losses, it will also
bring the concerns of those who already believe in the argument that fair value is
procyclical.
Although implementation of the incurred loss model by the banks upon the
adoption of IFRS was costly, the costs are likely to be quite daunting when it
comes to the expected loss model. This is because banks do not use expected values to survive at the present value of nancial receivables.
Rather, they apply factors to amortised contractual amounts to allow for the
probability of default and the exposure to loss upon default.
In essence, for large volume receivables, various overlays are used to arrive at
a composite rate to apply to the carrying amount of a class of receivables to create a provision for doubtful debts.
Banks also use roll-rate methods to estimate, based on past experience and
upon the existing ageing of overdue amounts, how much of the latter will prove
bad.
At the time of writing, banks are assessing the cost of moving to an expected
loss model and the meaningfulness of so doing. It is clear the costs will be very
high. However, it does seem that pricing models and the expected loss model
align, whereas the incurred loss model is seen as an accounting method only.
7. Hedging
At the time of writing, it is too early to see where the review of hedge accounting might lead. Some see hedge accounting as being reective of the inadequacy
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of historical cost accounting and/or the desire of accountants to defy the

accounting period concept by transferring the events of one period into another
so as to smooth the outcome. Others see hedge accounting as a necessary
exception to normal accounting to cope with its deciencies. If the latter view
prevails, as is most likely, the dilemma for the IASB is to nd guiding principles
for exceptional and elective accounting, without complexity and anti-abuse provisions. This is a daunting challenge for the IASB.
8. Reections on the outcomes
It is hard to disagree with the recommendations of the FCAG. They are balanced and mercifully free of the pre-GFC debates. FCAG did run risks in its
comments on the need to revisit the unused own credit risk and whether the
expected loss model has a role to play. It remains to be seen whether the time
spent on these issues will lead to worthwhile reform. However, the standard setters have moved to rationalise impairment testing by concentrating on one
model. That legacy is highly likely to endure. The author suspects that own
credit risk is not the problem some see, but rather a symptom of broader problems with the conceptual basis for fair value, or at least in eectively communicating that basis. If the revisiting of the issue leads to more fundamental
considerations of measurement, the FCAG will have contributed signicantly.
The moves to focus on reducing complexity and greater employment of principle
are strongly linked. The test will be whether, as the move to converge US GAAP
and IFRS regain strength, comprise is minimised by agreement on principle.
Very clearly, the pressures around the world to dierential reporting have
gathered momentum, and change is now upon us, even in Australia.10 Ironically,
these pressures were the result, in no small part, of the very complexity in IFRS
that is now being redressed. It remains to be seen whether users will be better
served by the simplied nancial statements of non-publicly accountable entities,
then they would have been by much improved and rationalised IFRS. One suspects that IFRS and IFRS for SMEs will have their own convergence problems
in the future.
Will the reductions in disclosures, oddly following a period of scandalous
crashes, survive if a more purposeful and economical disclosure regime is created
in IFRS? Will we be able to tolerate dierent recognition and measurement of
the same economic transactions and events simply because one group of entities
are listed or in a duciary role whilst another, possible more signicant in economic terms, is not? Or is there one set of economic phenomena that all entities
should be recognising and measuring in a comparable way? I suspect this question will continued to be obscured until general purpose nancial reports are

10

The Australian Accounting Standards Board released its exposure draft 192 on the
Revised Dierential Reporting Framework on 26 February 2010.
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required only for reporting entities and not just because of arbitrary legal classication.
9. Financial receivables
The most critical issue coming out of the GFC, from an accounting viewpoint,
is whether there should be continued acceptance of the amortised cost method
for accounting for nancial receivables. The FASB has highlighted this issue as
being common to the savings and loans scandal in the United States, the Japanese banking crisis and the GFC. They question whether the IASBs classication and measurement decisions (phase 1 of the IAS 39 replacement) go far
enough. At the time of writing, they favour a single measurement basis, fair
value, for most nancial instruments.
What should be remembered as this debate between fair value and amortised
cost is conducted during 2010 is that past history shows that failed attempts to
reform measurement, when the window is open, can be followed by long periods
in which that topic becomes quarantined.
If the expected loss model is employed, it will reduce some of the need to
reform the accounting for nancial receivables, but only because it would mitigate the risk of overstatement. But receivables need to be managed on an economic basis in both good and bad times. Amortised cost in good times means
very little. With the expected loss model, it will be dicult to explain, but numerically will be closer to a current value.
What this all suggests is that the GFC has created a useful opportunity for
reform, but the reforms need to be based on enduring principles and not on current circumstances. This will only be possible if standard setting can be allowed
to operate with independence.

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