Reducing Complexity

The IASB has made its discussion paper Reducing Complexity in Reporting Financial Instruments publicly available now. As complexity is a charge often raised against current accountancy trends by people who are either not aware of or uncomfortable with the more conceptual approach towards accounting used by the IASB, it would be interesting to observe the conclusions drawn in that paper. To make a long story short, I am quite happy with the outcome, namely that the DP accepts that fair value "seems" to be the only measure that is appropriate for all types of financial instruments, then going on to list no less than 24 different measurement methods for financial instruments (table 1). Some random thoughts in that context.

Complexity is bad. That seems to be the tenet of the proponents of reducing it. I tend to disagree, however. In line with Einstein's razor, there is a place for complexity in financial reporting where it faithfully represents economic reality. Complex economic reality necessitates an adequate level of complexity in its description, lest it over-simplifies. Where, however, complexity is merely a consequence of accounting artefacts, it may safely be dispensed with.

Fair value vilified. It is interesting to observe how some people try to make a case against fair value from the current financial market crisis, even though it is quite obvious that this is a clear case of trying to kill the messenger. This position is particularly difficult to understand coming from people with a background in engineering or science. There, it's evident that two variables can only be combined if they have the same unit of measurement: you cannot add metres and kilograms. In accounting, though, that seems to work just fine - it's currency units, after all. Or is it? Notionally, it certainly is, but I'd challenge anyone out there that a $'s worth of an asset measured at cost is very different from the same $ measured at, say, fair value. In short, the unity of measurement is an illusion under the mixed attribute model.

Multilocal pensions?

While not at all intended for that particular function, the McKinsey Quarterly Managing Cross-border Functions is a useful stimulus to consider the different organisational options in setting up a pan-European pensions operation. Clearly, the regulatory context may play a more prominent role than in many other industries, but this is not a qualitative differentiator.

Counterparty risk in credit markets

As pension funds increasingly seek to efficiently manage their balance sheets, they invariably come to rely on OTC derivatives, by way of which they become exposed to counterparty risk. On 20 February, thus shortly before 16 March which saw the US Fed-assisted emergency neutralisation of Bear Stearns counterparty risk, Barclays Capital issued a research note that assessed the transmission vectors and systemic fallout of a major counterparty's default. The knock-on effects due to immediate re-pricing of credit risk would amount to an estimated USD 36 - 47 bio for an imputed outstanding notional of USD 2'000 bio. Bear Stearns' notional was well over six times that number.

The (Mis)Behaviour of Markets

Benoit Mandelbrot's The (Mis)behavior of Markets: A Fractal View of Risk, Ruin and Reward (2004) is quite an intriguing read during these days of murderous market volatility. The list of his Ten Heresies in Finance goes a long way in giving a hint of his thinking, which is centred around his claim that the use of normal distributions in financial market modelling is a capital mistake:

Markets are turbulent.

Markets are very, very risky - more risky than standard theories imagine.

Market timing matters greatly - big gains and losses concentrate into small packages of time.

Prices often leap, not glide. That adds to the risk.

In markets, time is flexible.

Markets in all places and ages work alike.

Markets are inherently uncertain, and bubbles are inevitable.

Markets are deceptive.

Forecasting prices may be perilous, but you can estimate the odds of future volatility.

In financial markets, the idea of Value has limited value.

Don't miss!

On Thursday, 27 March the IASB is going to release its long expected discussion paper on post employment benefits. Don't miss IASB member Steven Cooper's live web presentation introducing the discussion paper from 1200h to 1230h (UTC). You can register for the event here.

It may be interesting to compare the IASB's position to the previously released paper of the UK ASB on the same topic. My guess is that the ASB's position will prove to be more aggressive, especially with regards to the highly controversial use of risk free interest rates to discount pension plan liabilities.