Reliable information helps us make better decisions. From food labels that warn us about allergens to weather forecasts that influence our plans, we depend on information to understand risks and act accordingly. Financial markets are no different. But what happens when the information we need is about an uncertain future? Accounting information quietly underpins many of the decisions that shape our economy. Investors use it to decide where to put their money. Companies rely on it when making investment and financing decisions. Regulators use it to monitor risks to the financial system. For this information to be useful, it needs to be reliable and understandable. But achieving this is not always straightforward, particularly when it comes to financial instruments. Financial instruments, such as loans, bonds and derivatives, are contracts whose value can depend on a complex combination of future events. Estimating that value often requires assumptions about interest rates, economic conditions and the likelihood that borrowers will repay their debts. In other words, accounting sometimes requires organisations to put numbers on things that have not yet happened. Our research, funded by a Leverhulme project grant, examines how financial reporting standards can help make this information more useful and transparent and ultimately contribute to better-functioning financial markets. LOOKING INTO THE FUTURE The global financial crisis of 2008 demonstrated the importance of understanding financial risk before it is too late. One important response was a major change to international financial reporting standards (IFRS). In 2018, a new accounting standard, IFRS 9, changed how companies account for financial instruments. Among its most significant changes was a move towards recognising “expected credit losses”. Previously, banks generally recognised credit losses after evidence emerged that a borrower was unlikely to repay. The new approach asks them to look forward and consider what losses might reasonably be expected in the future? At first glance, this seems like an obvious improvement. If risks can be identified earlier, investors and regulators should have a clearer picture of a bank’s financial health. But there is a complication. The future is uncertain. Two banks looking at similar portfolios of loans may make different assumptions about future economic growth, unemployment, interest rates, or the probability of borrowers defaulting. As a result, a system designed to provide more timely information may also introduce greater managerial judgement into financial reporting. Our work examined whether these changes improved the comparability of accounting information across banks internationally. The answer was nuanced. Some elements of IFRS 9 appear to have improved comparability. However, the move towards estimating expected future credit losses reduced it. This highlights an important tension in financial reporting: looking further into the future may reveal risks earlier, but it can also make financial information more dependent on assumption. MORE IS NOT ALWAYS BETTER If accounting estimates involve uncertainty, one possible solution is to provide investors with more explanation. But this raises another question: does more disclosure in financial statements automatically mean better information? 12 |
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