If timing is all, the International Accounting Standards Board has got it made. With the world’s financial markets, regulators and governments pole-axed by the credit crunch, up pipes the IASB with the suggestion to reduce the complexity crippling those markets. It is a bit like asking a man who has just crawled out of the desert whether he fancies a sip of water.

In what must rank as one of the best understatements in the history of standard setting, the IASB admits that “the existing requirements for the reporting of financial instruments are widely regarded as difficult to understand, interpret and apply”.

Once and for all
So in a bid to reduce the complexity, the IASB has launched a discussion paper. In the spirit of its International Financial Reporting Standards’ raison d’être, the key argument in the paper examines a possible long-term approach that would use one measurement method for all types of financial instruments in the scope of a financial instruments standard.

“IAS 39, which the IASB inherited from its predecessor body, is far too complex,” IASB chairman Sir David Tweedie says. “We are determined to simplify and improve IAS 39 by creating a principles-based standard. Those who believe in reducing complexity in accounting standards have now the opportunity to shape the way ahead.”

The IASB is interested to hear from the market on possible alternative ways to develop new standards for principles-based reporting that could minimise the complexity inherent in financial instruments such as derivatives, and their application.

One of the main causes of the complexity of financial instruments is the number of ways to measure them and the rules associated with this. The US Securities and Exchange Commission’s project committee on improving financial reporting says this complexity impacts users, who fail to understand the economic substance of the transactions, and hence the overall financial position of the underlying company. It also says this affects finance directors and their colleagues, who struggle to ensure that generally accepted accounting principles are applied and others – notably regulators and auditors – who struggle to do their jobs.

Stating the obvious
Of course, one of the reasons why financial instruments are complex is because they are, er, complex. One amusing aftermath of the credit crunch has been the outpouring of honesty – the admission that few of us understand these instruments.

The term ‘financial instrument’ encompasses a variety of instruments, from the relatively straightforward to the obscure. In the light of current events, it is clear that credit risk may make even instruments with simple terms difficult to analyse.

Think you understand
Even if you think you understand a financial instrument, there is no guarantee you would understand the accounting treatment. The current accounting standards contain many alternatives or exceptions that often obscure the underlying principles.

These alternatives result in a host of accounting rules. One example is how financial instruments should be measured, and when and how financial assets measured using a cost-based method should be impaired. The IASB has named 17 ways in which financial instruments as assets can be measured, and says its list is not comprehensive.

Regulators across the globe have been saying that one of the lessons to be learned from the credit crunch is the need for transparency, governance and accountability. This links into the presentation and disclosure of financial instruments.

Disclosure is critical, says the IASB’s discussion paper, although the paper is not about presentation and disclosure. Why critical? Because no single number, regardless of the measurement attribute used, provides all the information users need to understand financial instruments – such as the purpose for which the company purchased the instrument. Clear presentation is also critical in helping understand the effects of changes in measurements.

Of most interest is how the IASB sees possible long-term solutions for reducing measurement-related complexity. Critics of fair value and of the IASB’s perceived love affair with fair value will note with concern that the discussion paper says fair value “seems to be the only measurement attribute that provides relevant information for all types of financial instruments”.

Fair value is an example of current value. The definition of fair value itself is crucial and the IASB has an ongoing project to establish general principles in determining fair value. The criticism of fair value measurement has been magnified by the market turmoil – volatility of earnings arising from changes in fair values and presentation of unrealised gains and losses in earnings.

But despite the drawback, it seems unimaginable that accounting for financial instruments won’t be under a fair value regime. Ultimately, the IASB sticks to its ideal of measuring in the same way all types of financial instruments within the scope of a standard for financial instruments.
A single measurement attribute for all types of financial instruments would facilitate comparisons between entities and between accounting periods for the same business. If that can be achieved, it would be welcomed by users, preparers and regulators. The credit crunch may have opened minds to the possibility of change, but it still won’t make coming up with an accounting standard for financial instruments that actually works well any less of a brain-ache.

The IASB invites comments on the discussion paper by 19 September 2008.