Feature
The changes to accounting standards are not the solution to the crisis

In the context of the measures being taken to put an end to the current financial crisis, the extent to which fair value accounting can be blamed—or whether it can be blamed at all—for the intensification of the slump has been widely debated.

This position paper shows that this debate, which ignores the real issues, has led to accounting changes that are at odds with their objectives. We examine the relevance of the accusations levelled at fair value and of the responses proposed in an attempt to improve the use of fair value accounting and make it more relevant to the economic realities faced by banks as well as by companies in general.

The critics of fair value accounting have failed to consider the problem upstream; that is, they do not first examine the role of accounting. As it happens, the objective of accounting is to provide as reliable a description as possible of the net assets of a company at a given time, in the environment prevailing at the moment of the statement of the accounts. The role of financial reporting is to act as a source of information; it does not have a prudential role. Although accounting doctrine has taken a more financial approach in recent years, accounting cannot replace financial and prudential analysis.

In an attempt to reduce the pro-cyclicality of accounting, some have advocated suspending fair value accounting or even doing away with it altogether. The October 2008 amendments to IFRS 7 and IAS 39 go in this direction, as they now make it possible, on certain conditions, to report at historical cost transactions that had previously been reported at fair value.
In our view, this change is likely to hide the real risks to which companies are exposed and to increase the mistrust of the financial community, which will continue seeking information in fair value terms, as it did during the previous financial crisis early in the current millennium.

In 2002, as it happens, when accounting was done at historical cost in most European countries, the pro-cyclical nature of accounting rules had already been made clear: at the time, insurers had reported massive provisions for durable depreciation, forcing them to cede a great portion of their stock portfolios and to raise capital to maintain their solvency margins.

As early as 2006 our research showed the limits and the impact of certain accounting treatments adopted by the IASB. All the same, the accusations currently being levelled at fair value seem altogether distorted to us and as such cannot serve as a foundation for reflection on ways of resolving the crisis. That the measure of fair value and the accounting treatments adopted by the IASB are highly debatable doesn’t necessarily mean that fair value accounting itself must be rejected. In our view, a return to accounting at historical cost would be mistaken; it would only prolong the crisis, much as it prolonged the Japanese banking and financial crisis.

Even though fair value accounting reveals a weakening of bank balance sheets, it is not the domain of accounting to estimate the need for additional capital and/or for a necessary curtailing of business. That is the role of the regulator. Accounting is but one of the available media, and the judgment of the regulators should also be founded on the ability of financial institutions to recover in the near future, on their real susceptibility to the crisis, and, more broadly, on their ability to manage the situation and turn it around. This prospective dimension is not the province of accounting.

[More : The Fair Value Controversy: Ignoring the Real Issue]

Focus :
EDHEC Financial Analysis and Accounting Research Centre

Research is a strategic investment for EDHEC, not just to maintain its academic reputation but also, and above all, because it is at the heart of the growth in the offerings of the school. What makes its strategy of European excellence unique is that it strives to put its research at the service of business. These efforts may seem banal, but they are in fact a break from the purely academic vision of research (in which competition for top spots in the rankings often determines publication strategies and research subjects); the aim is to favour the creation of a dynamic in which business and society are at the heart of research. This innovative approach to research, which aims to make it useful to business, makes it unique and is the reason for its success.

The Financial Analysis and Accounting Research Centre was created in 2006 around the theme of company valuation. Cultural and technological changes now make it possible to use multiple dynamic analyses, the cornerstone of which is the discount rate. There is an abundance of academic research into the determination of the discount rate, but the gap between academe and business seems to be growing wider by the day. In practice, those who do the valuations often oversimplify, invalidating their reasoning; they may even ignore theory and transform the discount rate into a black box to hide the absence of objective and academic foundations in the determination of the risk premium and of beta.

The objective of the EDHEC Financial Analysis and Accounting Research Centre is to call into question certain financial paradigms, in particular that which consists of separating idiosyncratic risk because it is diversifiable from the risk premium and to provide the financial markets (financial analysts, investors, companies, rating agencies, auditors) with new light on the discount rate and to recommend new ways to determine it.

The great diversity of backgrounds is one of the advantages of the research centre (specialists in financial analysis, in accounting, in law, researchers from academe and from business), and it allows the centre to take a multi-disciplinary approach to financial analysis: company valuation, impact of IFRS and Solvency II on insurance companies, the impact of IFRS on the valuation and pricing of risk, growing use of fairness opinions, the status of the outside expert, and the measurement of intangible assets.

The EDHEC Financial Analysis and Accounting Research Centre is working on five research programmes:
- Determination of the cost of capital
- Impact of IFRS on company valuation
- Corporate governance, valuation, and cost of capital
- Impact of regulations for outside appraisals on company valuation
- Impact of non-financial information on company valuation

[More : EDHEC Financial Analysis and Accounting Research Centre]

Interview :

Philippe Foulquier, Director of the EDHEC Financial Analysis and Accounting Research Centre

You have just published a position paper on the debate around fair value and the changes to IAS 39. Could you tell us a bit about the context?
With the elaboration of measures to respond to the current financial crisis, the extent to which fair value accounting can be blamed for the intensification of the slump has been widely debated. As the crisis worsened over the summer of 2008, there were more and more government interventions and the ranks of the critics of fair value grew apace. The critics focus on its pro-cyclical nature and the insufficient information provided by the standard-setting bodies on the means of valuing financial instruments in inactive markets. On 30 September 2008, the SEC and the FASB issued additional guidelines for valuing assets in inactive markets. On 3 October, under pressure from the European Commission, which was threatening another carve out, the IASB prepared amendments to IAS 39 and IFRS 7, the intention of these amendments being to reduce divergences between US GAAP and IFRS when it comes to reclassifying assets. So as not to hold up the adoption of these amendments by the European Community, the trustees of the IASC Foundation went so far as to announce, on 9 October, that they would agree to suspend the usual due process (a first!). This permitted publication of the amendments by the IASB on 13 October, their approval the following day by the EFRAG (European Financial Reporting Advisory Group), and their adoption by the European Commission on 16 October.

Have these amendments met their ultimate objective, which is to restore investor confidence? Are they likely to reduce pro-cyclicality?
The pro-cyclical nature of accounting had already been denounced in the 2000-2003 financial crisis, as it had forced insurers to sell a part of their stock portfolios to comply with solvency requirements. At the time, in most European countries, the accounts were prepared at historical cost.

Besides, going back to historical cost, as is now possible on certain conditions, detracts from the role of accounting as a source of information. These amendments increase smoothing possibilities as well as the possibilities for discretionary management of the accounts. This is likely to hide companies’ real risk exposures and lead to mistrust in the financial community. As it happens, one wonders about the quality of the information that will be supplied by 2008 financial statements when they show in the balance sheets an amount for debt securities that is the same as it was in July 2008. We have shown in our position paper that a debate that ignores the real issues has led to counterproductive amendments to IAS 39.

In what way does the debate on the relevance of fair value ignore the real issues?
Just as IFRS is becoming the global benchmark for accounting systems, the current crisis is serving as a testing grounds for the suitability of both the IASB’s conceptual framework and the choices made in terms of accounting treatments. The debate ignores the real issues because it fails to make allowances for the role of accounting: the informative role of accounting should not be confused with the prudential role of Basel rules for capital. The role of accounting is to provide as reliable description as possible of the net assets of a company, in the environment prevailing at the moment of the statement of the accounts. It cannot replace financial and prudential analysis. Accounting is but one of the means of studying the solvency of a financial institution. It’s not the job of accounting to decide if the weakening of balance sheets should lead to a call for additional capital or a curtailment of business. That is the role of the regulator.

Some debt securities have been created to meet the demands of particular investors, and by design there is no secondary market for them. In the absence of active markets, it is worth asking the following question: how is it possible that putting these products in the trading book is allowed (by accounting standards and most of all by regulators)? Banks were given an incentive to make this choice by capital requirements that are lower in this category than they are in the banking book. The calling into question of fair value is thus altogether out of place: the problems caused by the opportunistic gaming of prudential rules and the relevance of fair value accounting are confused. The opportunistic gaming of prudential regulations with respect to the classification of some bank portfolios is no justification for calling into question fair value accounting.

Finally, that the measure of fair value and the choice of accounting treatments adopted by the IASB are highly debatable and need to undergo great reform, as EDHEC has been showing since 2006, doesn’t necessarily mean that fair value accounting must be rejected. It is our belief fair value plays a role as a source of information better than any other system would and that it has permitted a swifter gauging of the depth of the crisis.

Philippe Foulquier, Director of the EDHEC Financial Analysis and Accounting Research Centre.

PUBLICATIONS

• EDHEC Publications
• Academic Publications

EDHEC PUBLICATIONS

Additional examination shows that, in the current environment, sovereign wealth funds and governments are the possible buyers of theseassets. As public intervention entails  moral hazard, it follows that for the stability of the financial system throughout the business cycle regulations must be improved. Our proposal is to include buffers, by which we mean an amount of regulatory capital that will vary over the business cycle and could eventually disappear provided it is recovered over the medium term above minimum capital requirements in the prudential regulations.

Samuel Sender (November 2008) "Banking: Why Does Regulation Alone Not Suffice? Why Must Governments Intervene?", EDHEC Risk Asset Management Research Centre, EDHEC Position Paper.
[More]

Reactions to an EDHEC Study on Asset-Liability Management Decisions in Private Wealth Management

The objective of the current paper which was produced with the support of ORTEC Finance, is to compare the conclusions drawn by the Asset-Liability Management Decisions in Private Banking study with current industry perceptions. That paper discussed the sources of addedvalue in private wealth management, and argued through a series of illustrations that asset-liability management is the natural approach for the design of truly client-driven services in private banking. The basic question we are asking is: what do practitioners think about using asset-liability management in private wealth management?

Amenc N., F. Goltz, D. Schröder (October 2008) "Reactions to an EDHEC Study on Asset-Liability Management Decisions in Private Wealth Management", EDHEC Risk Asset Management Research Centre, EDHEC Publication.
[More]

ACADEMIC PUBLICATIONS

The Journal of Portfolio Management

Martellini, L. : "Toward the Design of Better Equity Benchmarks: Rehabilitating the Tangency Portfolio from Modern Portfolio Theory", The Journal of Portfolio Management, August 2008 - Volume 34, Issue 4.
[More]

European Journal of Economics, Finance and Administrative Sciences

Arouri, M., F. Jawadi, D. Nguyen : "International Stock Return Linkages: Evidence from Latin American Markets", European Journal of Economics, Finance and Administrative Sciences, September 2008 - N° 11, p57-65.
[More]

Economie et Statistiques

Chéron A., Q. Ding : "L'incidence du salaire perçu sur la fréquence d'une mobilité professionnelle en France : une remise en cause du modèle de recherche d'emploi ?", Economie et Statistiques, October 2008 - N° 412.
[More]

Journal of Multinational Financial Management

Caicedo-Llano, J., T. Dionysopoulos : "Market integration: A risk-budgeting guide for pure alpha investors.", Journal of Multinational Financial Management, October 2008, Volume 18, Issue 4.
[More]

Journal of Alternative Investments

Amenc, N., W. Géhin, L. Martellini, J-C Meyfredi : "Passive Hedge Fund Replication: A Critical Assessment of Existing Techniques", Journal of Alternative Investments, Volume 11 Issue 2.
[More]

Concurrences

Collard C., A. Zardkoohi : "Rupture brutale d’une relation commerciale établie : Analyse statistique de la pratique judiciaire liée à la détermination du préavis", Concurrences, November 2008, N° 4.
[More]

Banques et Marchés

Martellini L., V. Le Sourd, V. Ziemann : "The benefits of hedge funds in asset liability management", Banques et Marchés, November 2008, N°97.
[More]

RESEARCH CENTRES

News

Presentation by Arnaud Chéron
Arnaud Chéron, associate research director in the EDHEC Accounting, Law and Finance department, presented at a macroeconomics seminar co-organised by the Ecole d’Economie de Paris, the CEPREMAP, and the Université de Paris I entitled “Turbulence, Training and Unemployment: Do We Need Higher Training Subsidies?” The co-author of his presentation was Pascal Belan.

Olivier Oger at the “Club de l’Economie”
Olivier Oger, dean of EDHEC, appeared on the television programme “Le Club de l’Economie”, hosted by Jean-Marc Sylvestre, head editor for LC1 and TF1. The subject was the impact of the financial crisis on the real economy and the responsibility borne by traders. Alongside him were three other well known figures: Patrick Kron, head of Alstom; Y. d Kerdrel, editorialist for Le Figaro; and Jean-Louis Levet, head of IRES.

Leadership and Corporate Governance Research Centre
Jean-Luc Arrègle, professor of strategy at EDHEC and academic director of the EDHEC Leadership and Corporate Governance Research Centre, has been named editor of the journal M@n@gement. Björn Fasterling, professor of law at EDHEC, joins the board of the European Business Ethics Network, an association whose goal is to promote ethics in business, and, in the broader sense, in society at large.

Creation of a new research chair
The EDHEC Risk and Asset Management Research Centre and UFG have announced the creation of a new research chair. The three-year project involves academic research into dynamic asset allocation models and into new forms of target funds.

EVENTS

In the Media ...

EDHEC is spotlighted several times in the Financial Times. There is an article by Lionel Martellini, professor of finance and academic director of the EDHEC Risk and Asset Management Research Centre, and there are several quotations of work done at EDHEC. There is also a mention of EDHEC in the Wall Street Journal.

In the French-language press, there is an interview of Noël Amenc, director of the EDHEC Risk and Asset Management Research Centre, in Les Echos, as well as an interview of Philippe Foulquier, director of the Financial Analysis and Accounting Research Centre, and Samuel Sender, applied research manager at the EDHEC Risk and Asset Management Research Centre, on the subject of fair value accounting. Also in Les Echos was an article by Valérie Petit, director of the EDHEC Leadership and Corporate Governance Research Centre.

The results for the EDHEC hedge fund indices were widely reproduced in the press—in particular in Le Monde Economie, Le Figaro, and Les Echos.

All EDHEC citations are available in the EDHEC Press Review.

Prizes, awards, and appointments...

Two new members join the International Advisory Board of the EDHEC Risk and Asset Management Research Centre
The EDHEC Risk and Asset Management Research Centre is pleased to announce the appointment of two new members to its International Advisory Board:

• Mr. Jaap Maassen, Member of the Executive Board and Chief Pension Officer, ABP Investments
• Mr. Ton van Welie, Chief Executive Officer, ORTEC Finance

The 35 members of the board, which brings together high-level representatives from regulatory bodies, leading pension funds, professional organisations and business partners, are responsible for validating the relevance and goals of the research programme proposals presented by the centre’s management and for evaluating research outcomes with respect to their potential impact on industry practices.

The board also advises on the objectives and contents of projects deriving from the expertise of the research centre thereby ensuring that graduate and executive programmes remain at the forefront of developments in the marketplace.