Accounting Body Changes Rule to Close Structured-Product Reporting Anomaly

The International Accounting Standards Board is amending the treatment of so-called own credit risk on financial liabilities, closing a loophole that banks have used to show bigger profits on structured debt.

Under current rules, banks book a fair-value gain on securities including structured products even as credit spreads widen and the lender is perceived to be more risky.

The new ruling is designed to “address the counter- intuitive way a company in severe financial trouble can book a large profit based on its theoretical ability to buy back its own debt at a reduced cost,” David Tweedie, chairman of the IASB, said in a statement today.

Starting Jan. 1, 2013, banks will be required to report fair-value adjustments on their debt in the “other comprehensive income” section of income statements instead of within the profit and loss account, the IASB said.

The own credit accounting convention is used mainly on structured notes as an alternative to valuing the products’ debt and derivatives components separately. While fair value losses and gains are only realized if a bank buys back the debt, the reporting method causes earnings volatility, the IASB said.

UBS AG reported a 387 million-franc ($393 million) fair- value loss on financial liabilities, consisting mainly of “issued structured products,” the Zurich-based bank said in its third-quarter earnings statement on Oct. 26. UBS reported a fair-value gain of 595 million francs on similar liabilities in the second quarter.

Structured notes are securities created by banks, which package debt with derivatives to offer customized bets to investors while earning fees and raising money. Derivatives are contracts whose value is derived from stocks, bonds, currencies and commodities.

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