IFRS: you can say no

by admin on May 21, 2009

in Tax and Ethics

Richard Murphy uses a Daily Telegraph report as the basis for suggesting that IASB has effectively thrown the principle of prudence out the window. I was surprised when I read the DT piece which asserts:

Some believe the IFRS regime was the crucial factor that allowed banks to get out of control, overstating their profits, making heavy use of off balance sheet vehicles and not taking provisions for likely bad debts until loans had actually soured.

The most ardent critics of IFRS have written a document, now circulating in the City among major investors, that lays out a detailed analysis of the shortcomings of the system in relation to banks. The group believes the IFRS approach allowed certain banks such as HBOS, Bradford & Bingley and Northern Rock to trade while they were insolvent last year…

…One of the biggest criticism the way banks provision for losses under IFRS. The old system allowed lenders to smooth their results from one year to the next by guessing at bad debts to come and using forward provisioning, IFRS prevents banks from making a provision unless a loan has actually gone bad. Critics believe the change fundamentally weakened banks.

I’ve not seen this report and would welcome sight of the technical arguments it is making. I have however looked up my old nemesis IAS39 (or IR39 when I was diving into it.) OK – so we’re back in derivative hell. For some of the latest thinking, you need to see this press notice from the Financial Reporting Council which inter alia states:

Accounting currently looks at the relationship between the borrower and the lender at the transaction level. Provisioning or reserving that takes the economic cycle into account operates at a much higher level and is likely to change accounting as it currently stands.

IASB, FRC and no doubt PCAOB and FASB will toss this ball around for a while but all the intellectual posturing fails to recognize several important points:

  • Attempting to scientifically provision is always going to end up with the need for judgment based on facts that go way beyond the transaction itself. Narrowing down the criteria to let companies off the hook because it is too hard is not a valid reason for failing to provision.
  • I don’t believe on my re-reading of IAS39 and understanding of mark-to-market that the provisioning rules have been substantially undermined. Even if they have been, I cannot believe that internal risk management systems would not at least flag up potential provisioning recommendations.
  • While most observers acknowledge that internal risk management has been flawed in part due to lack of visibility between front and back office systems, the thought that fund managers can blame shift in this way is untenable unless they believe they were misled. Management could for instance have agreed with auditors that whatever the rules may say, if their systems are suggesting otherwise then an addendum schedule and note in the chairperson’s report would at least highlight the issue. The argument this might create uncertainty equally doesn’t hold water because as we now know, the results were flawed anyway, based on the suggested implications of expected loss reporting.
  • I cannot believe that in their economic models, fund managers will not have taken a historical view of risk and, where there was doubt in comparison to to market data, considered the likely impact going forward. That makes their assertions doubly untenable.
  • Auditors who have doubts arising out of the imposed methodology and the apparent conflict that must exist with risk management could work with clients to find ways of expressing an opinion AND support management in their more prudent assumptions. Contrary to what I have been hearing lately about the ability to advise on this topic, that would be a positive and helpful way to bring the debate about asset valuation back to the regulating bodies. It already happens in other places where for example companies report against IFRS but also show constant currency results as a way of explaining what’s really going on in trading volumes. Investors have no difficulty understanding this so why should provisioning be any different?

The DT piece talks about grumblings that Sir David Tweedie’s IASB  is too slow. I have some sympathy with this view. When IR39 as it was first surfaced, technology companies had no idea that it might bring important changes. In fact it wasn’t until after the formal introduction of IFRS that tech companies had much of an idea what was going on. Tweedie never thought to talk to the industry until change was well under way.

At the time I came flat out and said that as formulated, IR39 was almost impossible of representation in software because of the need to understand counter party risk. I also said that I had serious doubts whether as then formulated, IR39 was capable of rational interpretation. At that time, there was no real way to peer through to assess the counter party component parts. I’m not sure the position has changed that much in the last few intervening years as evidenced by the collapse in the brokerage market and general fallout from Lehmans, Bear Stearns, B&B, Northern Rock etc.

As we are starting to realize, not all regulation is good regulation. People who look more deeply into these things must know the problems they are encountering and I don’t believe for one minute that someone, somewhere hasn’t blinked and gone ‘duh?’

Practical solutions to these issues are not going to be easy, especially given the way in which they have become mired in cross institution blame. That’s no excuse for auditors to at least raise their hands and point up what must be obvious problems. In doing so, they would be offering stakeholders an opportunity to assess the contribution they make to the debate. Silence is not the answer, especially in a blame environment.

Of course I could be entirely wrong and being too generous to the risk managers. The Washington Post for instance reports that Q’s contributed significantly to many banks being able to stretch liquidity rules. Where is the audit responsibility there?

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Tagged as: Bear Stearns, David Tweedie, FASB, FRC, IASB, Northern Rock, PCAOB

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