Further supplementary memorandum by Professor
Stella Fearnley, Bournemouth University (ADT 2)
HOW INTERNATIONAL FINANCIAL REPORTING STANDARDS
(IFRS) CHANGED ACCOUNTING FOR MARK TO MARKET AND LOAN LOSS PROVISIONS
IN UK AND IRISH BANKS
Before December 2005 all UK domestic company
accounts were prepared under UK Generally Accepted Accounting
Principles (UK GAAP). These standards are grounded by UK Company
Law. The more recent standards issued under UK GAAP are called
Financial Reporting Standards (FRSs), earlier ones are called
Statements of Standard Accounting Practice (SSAPs).
UK Company Law requires accounts to:
Be appropriately prudent.
Justify asset values on the basis of
the business being a demonstrable going concern.
Observe substance over form.
Prudence is in the law to protect creditors
and shareholders from abuse by directors by ensuring the maintenance
of capital particularly in relation to paying out dividends (S
837 CA 1986). Under UK law, all companies, including subsidiaries
of groups, must prepare and file their accounts on public record.
Subsidiaries can have their own creditors and some have external
shareholders. The holding company may also have its own creditors
and the holding company's individual balance sheet is included
in the group accounts as well as the consolidated balance sheet.
The underlying principle of prudence is that
losses should be booked at the earliest opportunity and profits
should not be recognised until earned, thus protecting capital
for the common benefit of directors, shareholders and creditors.
This is articulated twice in the law, in the accounting preparation
rules (input rules), and then separately in the capital maintenance
clauses, which instruct companies how to use the audited statutory
accounts to pay dividends lawfully. In a group, dividends are
paid up from subsidiary companies to the holding company, which
then pays out to shareholders. Some other EU states also have
capital maintenance regimes that are disconnected from audited
published accounts (eg Germany).
Because of the increasingly specialist nature
of banking business, a Statement of Recommended Practice (SORP)
was issued by the British and Irish Bankers Association in the
decade prior to 2005 and the introduction of IFRS. The SORP set
out detailed accounting methods for banks which all banks were
expected to follow. The SORP was entirely consistent with Company
Law and set out how to account for mark to market and loan loss
provisioning as follows:
Dealing securities could be marked to
market provided they were dealing positions of normal liquidity
(ie near cash).
Loan losses should be assessed so as
to carry loans at no more than their ultimate realisable value,
ie making provisions where defaults already existed and in addition
where there was recognised credit risk, but no evidence of default,
on all loan portfolios and especially higher risk loan portfolios.
Contingent liabilities had to be disclosed,
and this process required the bank to assess the likelihood of
a contingency materialising into true liability. This would cover
such things as margin calls, which are cash outflows sensitive
to asset prices going down.
OF IFRS IN
IFRS was brought into the EU by a 2002 EU Regulation
with mandatory application to the group accounts of EU listed
companies from and including December 2005 year ends. This Regulation
in some aspects overrides UK Company Law, for example, the general
presumption of prudence and substance over form. Accounts were
deemed to be true and fair if they complied with IFRS. In English
Common Law true and fair view is an objective which may change
over time and is not capped at compliance. There has since been
a change to reporting of true and fair but is too early to evaluate
whether it has made any difference.
Just after the regulation was issued in 2002,
the Enron scandal broke and the US standard setter, the Financial
Accounting Standards Board (FASB) was heavily criticised. A member
of the IASB was then appointed as chair of FASB. IASB then announced
later in 2002, without public consultation, that it was going
to converge its own standards with those of the US FASB. The IASB
already had accounting standards in issue which had been inherited
from its predecessor body. The IASB then had three years to prepare
a suite of standards for Europe, and the IFRS standards were therefore
open to the influence of US GAAP both by the convergence objective
and the short time frame. US GAAP serves a different legal regime
than the UK, for example: there is no federal company law and
it varies from state to state; in some states auditors report
to directors; it is much more difficult for shareholders to remove
directors from office; and the litigation regime makes much easier
for third parties to sue directors and auditors. US GAAP has become
increasingly focussed on valuing companies at a moment in time,
is getting increasingly less prudent and does not necessarily
protect creditors or maintain capital. The litigation regime to
an extent compensates for weaknesses in corporation law by making
it easier for shareholders and creditors to recover their losses
The EU Regulation left it to member states to
decide whether to require other companies, including subsidiary
accounts of listed groups, to apply IFRS. The UK government did
not mandate IFRS for the accounts of any non-listed companies.
This includes subsidiaries of listed companies reporting their
group accounts under IFRS. France and Germany do not permit IFRS
to be used by individual companies.
Many UK listed companies chose to retain UK
GAAP in their subsidiary and holding company accounts and make
the adjustments to IFRS at group consolidation level in preference
to changing accounting systems throughout the group. This was
considered to be simpler and also provided more certainty for
continuing tax compliance and for paying dividends up to the holding
IFRS AND UK BANKS
The IFRS standard (IAS 39) which mandates the
accounting for securities dealing, accounting for financial instruments
and loan loss provisioning is far less prudent than the banking
SORP because IFRS did away with the principle of prudence, substituting
neutrality, thus allowing upward valuations. IAS 39 differs from
UK GAAP and the banking SORP as follows:
It changed fair value accounting which had been
restricted to market valuation of liquid dealing positions, thus
allowing marking to market of not only large and illiquid positions,
but allowing modelling of positions not traded at all;
It allowed profit taking on holding such
assets that were going up in a rising market, which UK GAAP did
not permit except for the most liquid positions traded at the
It had an less prudent loan loss model
"incurred loss", which did not allow for risk sensitive
loan provisioning where there was as yet no evidence of default,
thus not taking account of inherent risk in a loan portfolio.
This made subprime lending appear very profitable in the short
run, given that a profit may be booked on charging the risk premium,
but the cost of that risk was not booked.
In relation to the adoption of IAS 39 in UK
banking sector, the UK Accounting Standards Board (ASB) substantially
replicated this standard into UK GAAP as FRS 26. This change was
motivated by the difficulties that banks would have experienced
in trying to make all the IFRS changes needed at consolidation
level because of the complexity of their accounting systems. Thus
the banks in the UK and Ireland, whilst continuing to report under
UK/Irish GAAP in their subsidiaries, were applying some of the
requirements of the IAS 39 imprudent mark to market and loan loss
In order to accommodate this change, company
law was changed to relax the accounting for certain types of financial
transaction as, because it falls under UK GAAP, FRS 26 had to
comply with company law. The changes allowed "fair value"
(marking assets up) but still, supposedly, under the aegis of
The effect of this change for the accounting
in the subsidiary companies of UK and Irish banks was that it
allowed previously unrealised profits on more types of transaction
(marking to market/model) to be booked. For example Collateralised
Debt Obligations (CDOs), might contain good loans, as well as
bad loans already decaying, but the whole package was "insured",
so as to give a traded "value" that might be in excess
of cost. Marking to market/model allowed profit taking whilst
not booking losses. Company Law accounting rules do not allow
the netting of assets/liabilities, and premature profit taking,
and do not recognise insurance as an asset. Some CDO's under pre-2005
UK GAAP would have shown losses and no profits at all. The CDO
industry proliferated after 2005. Alongside banks that were using
the imprudent provisioning model, CDO's became depositories for
increasingly riskier and potentially mispriced loans.
FRS 26 also changed the loan loss provisioning
model removing the need for banks to provide prudently for expected
future loan losses, only requiring provisions where there was
already evidence of default as under IAS 39.
Thus for UK/Irish domiciled banking companies,
profits, assets and capital, were inflated by:
the mark to market/model regime to the
extent it was less prudent than the BBA SORP;
covering up realised losses within CDOs
etc by mark to market/model gains; and
reducing loan loss provisions under the
incurred loss provisioning regime and, by increasing profits,
increasing capital and therefore lending capacity.
It can be observed that the UK and Ireland,
with the most comprehensive introduction of IFRS and IFRS style
accounting in banking companies, have had the most non-investment
bank collapses in the EU. There are now some concerns that FRS
26 does not match up with the UK capital maintenance rules and
the requirement for prudence, which still applies under UK GAAP.
As referred to in the submission to the Committee
from Beattie, Fearnley and Hines, the UK now has a very strong
enforcement regime both for identifying non-compliance in financial
reporting and auditing for listed and public interest companies.
The Financial Reporting Review Panel (FRRP) reviews company accounts
and raises queries with directors of companies about accounts
where there may be non-compliance. In the case of the FRRP, research
has shown that an FRRP adverse finding can rebound on an auditor
who has signed off the accounts as being in order and damage a
client relationship. It is not a career enhancing event for the
audit partners involved and can also bring bad publicity for the
The Audit Inspection Unit (AIU) inspects the
audits of listed companies to ensure that the auditors are carrying
out their work in accordance with Auditing and Ethical Standards
are making sound judgments. As with the FRRP a poor inspection
report for an audit partner is career damaging and brings public
criticism for the firm.
In the UK now, the risk for an auditor of being
caught out not complying with the accounting or auditing rules
is high, and therefore there is a strong incentive to comply with
the rules regardless of whether compliance produces optimal outcomes
for shareholders and other users of accounts. The quality of the
standards themselves becomes paramount. There is now considerable
disquiet with the outcomes of the IFRS accounting model in the
banking sector, where profits were inflated in the asset bubble
because off the mark to market regime as described above, including
the change to the loan loss provisions, which took no account
of credit risk.
If an audit firms ensures that all their clients'
audited accounts comply with the accounting and auditing rules,
they avoid costly encounters with regulators, which they cannot
recover from clients and both reputation and litigation risk.
The individual partner also avoids damaging his career and all
parties avoid litigation.
The incentives for compliance are therefore
very strong and there was little incentive in the system itself
for auditors to do more than ensure compliance.
OF IFRS IN
Whilst other European countries such as France
and Germany have been cautious in extending the application of
IFRS beyond what was been mandated by the EU Regulation for 2005.
The UK Accounting Standards Board has since 2004 been promoting
IFRS adoption beyond what was mandated.
IFRS has been introduced into the AIM market
and the UK Accounting Standards Board (ASB) has been steadily
changing UK GAAP standards to make them compatible with the IFRS
model. The is now consulting again on trying to get agreement
to introduce a reduced form of IFRS for non-listed companies other
than those defined by EU as small. Also a form of IFRS was introduced
into central government accounting and NHS accounting for March
2010 year ends, at considerable cost in consultant fees, and will
be introduced into local government and some other public bodies
in 2011 again at considerable cost, and at a time when resources
are under great pressure. It is not entirely clear whether the
benefits to the public interest of these initiatives outweigh
the cost, particularly given the continuing major concerns about
IFRS's underlying principles and the complexity of the outputs.
The UK Accounting Standards Board seems to have
been more determined and more willing than other European countries
to give up control of its own accounting standards entirely to
a body over which it has little, if any control, and whose outputs
remain of questionable quality.
A further issue is that HMRC has mandated that
for March 2011, all UK companies should file accounts required
for taxation purposes using single software package called XBRL,
which has been developed in the US and requires specific accounting
formats or taxonomies. XBRL has attributes of monopoly. XBRL is
being promoted around the world as a mechanism for lodging accounts
with securities regulators. The UK via HMRS is again in the forefront
of adoption outside the US. This will add further cost to the
UK corporate sector and more fees to consultants, again at a time
where growth rather than unnecessary expense is needed.
2 November 2010