Auditors: Market concentration and their role - Economic Affairs Committee Contents


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 THE CHANGE TO IFRS

  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.

THE INTRODUCTION OF IFRS IN THE EU

  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 through litigation.

  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 company.

IFRS AND UK BANKS SUBSIDIARIES

  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 margin.

    — 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 provisioning model.

  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 prudence.

  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.

THE IMPACT OF THESE ACCOUNTING CHANGES FOR AUDITORS

  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 firm.

  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.

THE PROMOTION OF IFRS IN THE UK

  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



 
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