Have financial reporting standards gone off the rails?

The credibility of future financial statements will be greatly undermined unless significant changes to certain accounting standards are considered, according to A. Rashad Abdel-khalik, a professor in the Department of Accountancy at Gies College of Business. His paper, “The FASB and IASB Achilles Heel: Un-Faithful Representations of Financial Instruments,” delves into the reporting of hedging, which are tactics businesses or firms use to protect themselves against risk. Specifically when it comes to the volatility of fair values and future cash flow, he argues certain accounting treatments of derivatives and hedging violate the critical principle of “faithful representation.”

Under the Hypothetical Derivatives Method, when using a forecasted transaction whose fair value is not measurable, accounting standards allow for inventing a fake derivative to hold the place of a hedged item. Under this method, fair values of the actual derivative would not be recorded in the income statement, which Abdel-khalik says would cause the statement to greatly deviate from reality. Different firms could report the same forecasted transaction in very different ways, just by choosing – or not choosing – to employ the Hypothetical Derivatives Method.

Abdel-khalik, the V.K. Zimmerman Professor of International Accounting, also takes issue with the way accounting standards require “metaphysical separation of embedded derivatives that have risk and value generators different from the host contract.” Under this requirement, if one contract possesses multiple embedded derivatives, they must be valued together as one. This requirement incentivizes businesses to embed multiple derivatives because management can simply guess their overall estimated fair value. As Abdel-khalik argues, “the treatment of embedded derivatives provides management with an additional accounting approach to manufacture gains and losses at will.”

Finally Abdel-Khalik laments the lack of guidance for setting up discretionary valuation adjustments CVA and DVA. The credit valuation adjustment (CVA) prices credit risk for what others may not pay the reporting entity, and the debt valuation adjustment (DVA) prices the reporting entity’s credit risk (what the reporting entity may not pay others). Abdel-khalik argues that all approaches to this are homemade and not universally verifiable. Again, the unknowns and possibilities of manipulation cause the reported earnings and valuation numbers to deviate from reality.

“In my opinion, accounting standards have abandoned the concept of ‘realization,’” said Abdel-khalik. “Instead they have accepted the recognition of holding gains and losses in the income statement and balance sheet.”

“In today’s environment, there has been a significant dilution of the hardness of accounting numbers,” he continued. “Reporting entities are given a multitude of tools they can use in manipulating and smoothing reported income. We need to restore the concept of realization in financial reporting, even if doing so results in reporting a separate set of financial statements.”

Professor Abdel-khalik’s paper has been accepted for publication in the journal Abacus.