Fair Value Accounting and Capital Maintenance: Let Companies Learn from the Banks
In countries where annual statements also perform an "organizational" function, the introduction of IAS/IFRS also affects company law rules. In Europe, according to the second council directive 77/91/EEC, the company financial statement is the instrument used to determine the profits that can be distributed among the shareholders and any reductions in legal capital due to losses. But the recent financial crisis has made it even clearer that a financial statement drawn up according to IAS/IFRS is not suitable for carrying out these functions. Fair value accounting can limit the effectiveness of capital maintenance rules and can cause them to be applied in a distorted way.
Giovanni Strampelli (Department of Law) in The IAS/IFRS after the Crisis: Limiting the Impact of Fair Value Accounting on Companies' Capital (European Company and Financial Law Review, Volume 8, Issue 1, 1–29, doi: 10.1515/ECFR.2011.1) shows how to limit the distorted effects arising from the interaction between fair value accounting and the capital maintenance rules, without compromising the relevance of the accounting information and the comparability of financial statements within the European Union.
To limit the effects of fair value accounting on the capital maintenance rules, two different strategies may be considered: modifying the accounting principles restricting the scope of application of fair value or facilitating the non application of mark-to-market; leaving accounting principles unaltered but modifying the capital maintenance rules, and, to that end, providing for the "neutralization" of revenue components that correspond to fair value fluctuations.
The provision of full authority for non-application of mark-to-market could have the undesirable effect of reducing the transparency and relevance of accounting information, and not even the abandonment of fair value and a return to the traditional accounting system based on the use of prudential valuation criteria seem to constitute an appropriate solution.
Firstly, such a "counter-revolution" in accounting (although advanced as a hypothesis by some) is not on the agenda and, on the contrary, recent tendencies seem to be heading in a clearly different direction. Besides, a return to historical cost would reduce the relevance of information of annual accounts. Historical cost turns out to be less "relevant" than fair value in that it does not make it possible to adjust book value to (higher) current value and deprives the financial statement users of every indication as to actual asset value.
To limit the negative effects of fair value on the capital maintenance system, it is preferable to modify the provisions of company or bankruptcy law which make reference to accounting numbers in order to render them "insensitive" to the recording of unrealized profits and losses resulting from IAS/IFRS financial statements. The fair value would thus have an effect only on the information level. The financial statement users would be offered more significant information on the value of company assets and on the performance of the period, without, however, any distribution of unrealized profits being allowed, or without compromising the correct workings of the discipline of the reduction of capital through losses.
To that end, it is first necessary to neutralize (through their deduction from the net results) the positive and negative variations of fair value as recorded in the income statement. This would make it possible to adopt as a parameter for measuring distributable profits or capital losses only the actual realized share of the net results.
The solution proposed is conceptually analogous to that employed in the banking sector where, following the adoption of the IAS/IFRS, appropriate provisions (i.e. prudential filters) have been introduced in order to limit the impact of positive and negative variations of fair value on regulatory capital. The prudential filters exclude from the calculation of capital ratios set out by the Basel capital accord those unrealized fair value gains estimated with a large degree of subjectivity and which are not meant to be realized in the short term.
The implementation of the solution outlined in the previous section does not necessarily call for any intervention from the EU legislator. Rules meant to neutralize the effect of fair value on the legal capital system can be introduced autonomously by national legislators, even in the absence of harmonized regulation.