Banking Crisis - Treasury Contents



Memorandum by Professors Vivien Beattie, Professor Stella Fearnley and Mr Tony Hines (Vivien Beattie: (Professor of Accounting, University of Glasgow) Stella Fearnley: (Professor in Accounting, University of Bournemouth) Tony Hines: (Principal Lecturer, University of Portsmouth))

  The views expressed in this memorandum are those of the researchers and not of their organisations.

EVIDENCE SESSION—ACCOUNTANCY IN THE CONTEXT OF THE CURRENT BANKING CRISIS

Summary of recommendations

    —  We are concerned that the growing complexity of financial reporting as defined by IFRS standards is confusing users. A distinction needs to be made between data and information. What is useful and what is not?

    —  We suggest that impact of the practice of stock lending on the stewardship and accountability of directors should be investigated.

    —  We believe a radical review of the fair value accounting model is needed and an investigation should take place as to whether accounting standards allowed the construction of off-balance sheet vehicles or inadequate disclosure of the true position.

    —  We do not believe that convergence with US GAAP is necessarily the right way forward to achieve high quality accounting standards. Monopoly inhibits progress. A full consultation on convergence with US GAAP should be carried out. There should also be a rethink from first principles of the accountability of the IASB.

    —  We suggest there should be no such person as a full-time career standard setter. Regular change is essential for standard setters to keep pace with business and market developments. Standard setting boards should have a majority of part-time members.

    —  We believe that all funding for IASB activities should be channelled through governments or regulators. IASB's influence is too powerful for it to be mainly financially dependent on voluntary contributions and from those with vested interests in promoting global standards. This would give governments more authority and provide the added advantage of encouraging more participation in the consultation process from parties who find themselves paying the true price for the use of IASB standards.

    —  We suggest that radical change is needed to the consultation process. A self-selecting respondent model favours those with the most resources and the greatest vested interests. Independent units should conduct pro-active consultation into a wide range of stakeholder views on Discussion Papers and Exposure Drafts, putting forward balanced views from all stakeholders groups. IASB should be required to take notice of these results and explain publicly if they choose to reject them. As with IASB itself, the units should be provided with adequate funding provided by the users of standards and channelled through government agencies or regulators, in order to do their job properly.

    —  Although established with the best of intentions we do not believe the current model for IASB activity is sustainable.

EVIDENCE SESSION—ACCOUNTANCY IN THE CONTEXT OF THE CURRENT BANKING CRISIS: DETAILED COMMENTS

1.   The purpose and intended audience of financial statements

  1.1  In the UK context, historically the primary purpose under company law of financial statements is for the directors (ie the managers) of a company to give an account of their stewardship of the business to their shareholders (ie the owners). These financial statements are primarily based on a historical cost model. The shareholders can then question the directors at an annual meeting and choose to re-appoint them, or if the company is listed, dispose of or retain the shares they hold. There are many other stakeholders, (creditors, employees, tax authorities etc) in company financial statements who may be described as free riders.

  1.2  A view has been promulgated by standard setters over time that the primary purpose of financial statements is decision usefulness rather than accountability or stewardship. This brings a more forward looking context to financial statements and focuses on the balance sheet as a representation of future cash flows with the profit for the year effectively being the difference between two balance sheets. To some extent this emanates from the US regime where removal of directors from office is not a simple matter (Bush, 2005).

  1.3  This debate is still not resolved as the International Accounting Standards Board's (IASB's) conceptual framework favours decision usefulness and general purpose financial statements, not financial statements primarily intended for the use of the shareholders.

  1.4  However in the current environment both models are flawed. The growth of stock lending (ie sale and buy back arrangements) by large investors had led to situations where directors of companies may not know who their shareholders are and hedge funds and others are "borrowing" for short periods and may in effect be acting against the interests of the majority of shareholders and the company eg by short selling. Thus accountability becomes compromised. In a market such as UK where a high proportion of shares are held by institutions the small shareholder has little influence. (This problem has become particularly apparent in the lack of attention to the interests of small shareholders in the banks during the present crisis.) There are also concerns about the growing complexity of the financial statements under the present regime.

  1.5  Similarly decision usefulness based on future cash flows leads to a balance sheet which may be awash with estimates, particularly when fair value is applied.

  1.6  It is widely recognised that the publication of financial statements itself does not move markets, as preliminary announcements of results have already been made and other information such as profit warnings is disseminated to markets as events take place. If the final financial statements results were different from the preliminary announcement the company would have a lot of explaining to do.

  1.7  There is, however, a concern that the growing complexity of financial reporting as defined by IFRS standards is confusing users. A distinction needs to be made between data and information. What is useful and what is not?

  1.8  We also suggest that impact of the practice of stock lending on the stewardship and accountability of directors should be investigated.

2.   The role that fair value has played in the banking crisis

  2.1  We do not intend to offer a detailed technical explanation of the role of accounting in the present crisis. Many concerns have been expressed about fair value by academics eg Ball (2006). However the fact that the Treasury Committee is holding this evidence session indicates the degree of concern about the impact accounting may have had on the current crisis. If all was well the Treasury Committee would not need to get involved.

  2.2  Our primary concern is that fair value allows both unrealised losses and unrealised gains to be booked to the income statement (profit and loss account). There have been no complaints from banks about the booking of unrealised gains. However, this is a concern as bonuses and dividends have been paid from unrealised gains, thus depriving the institution of working capital and creating negative cash flow. None of this cash outflow will return to the banks.

  2.3  Fair value assumes that markets behave rationally. Sadly they do not, and in a bubble, mark to market will inflate the bubble by picking up inflated prices and feeding them back to the market (Fearnley and Sunder, 2007). Had accounting been more conservative the sub-prime bubble would have been exposed earlier. It is also not clear whether any of the toxic financial instruments were constructed with the aim of keeping them off the balance sheet or avoiding disclosure.

  2.4  The present situation is such that it is impossible to attach a value to an asset, which may have long term value, when there is no market for it. This may cause greater losses to be booked than are justifiable.

  2.5  We believe a radical review of the fair value accounting model is needed and an investigation should take place as to whether accounting standards allowed the construction of off balance sheet vehicles or inadequate disclosure of the true position.

3.   The role and accountability of the International Accounting Standards Board and the process of amending accounting standards

  3.1  The IASB (International Accounting Standards Board) is an independent standard-setting board, appointed and overseen by a geographically and professionally diverse group of Trustees of the IASC Foundation who are accountable to the public interest. (www.iasb.org). Thus IASB is overseen by a body which is accountable to an abstract, undefinable concept, understanding of which may vary from one jurisdiction to another. IASB is therefore effectively beyond democratic controls although its power and influence over global financial reporting is of great significance. By way of contrast, national standard setters are ultimately accountable to their national government, which can step in if there is concern about any of their activities. The UK's Accounting Standards Board can now only try to influence IASB along with other bodies. Thus the influence of the UK government over accounting for listed companies is much diminished. The IASB model has been widely criticised (for example by EU Internal Market Commissioner Charlie McCreevy (Accountancy Age, 9 October 2008) and ECOFIN (European Report, 9 July 2008).

  3.2  A recent consultation by IASC Trustees (www.IASB.org) has suggested the creation of a monitoring group linked to major official institutions to oversee the Trustees who in turn oversee the IASB. This appears convoluted with too many layers. A more radical accountability model is needed to challenge decision making as well as process.

  3.3  The shortcomings with the present accountability arrangements can best be illustrated by the process of convergence of accounting standards with the US Financial Accounting Standards Board (FASB). The process openly began with the Norwalk Agreement (FASB & IASB, 2002). It committed the two standard setters to make their existing financial reporting standards fully compatible as soon as is practicable and to co-ordinate future work programs to ensure that once achieved, compatibility is maintained. This arrangement was made shortly after the Enron crisis when US accounting was in disrepute, and was certain to have a major impact on the development of IFRS. Any future proposal would have to be tested against what would be acceptable to the litigious US environment. Although the IASB model requires public consultation for accounting standards, there was no constitutional requirement for public consultation on this fundamental convergence decision. Furthermore, there are indications that that more concessions have been made on the IASB side than the US side. FASB Chair Bob Herz has suggested "the IASB has amended many of its standards, and, to a lesser extent, we in FASB have modified some of our own" (Herz, 2005). The IASB may to an extent be insulated from political influence at individual state and EU level. The US FASB is overseen by the US Securities and Exchange Commission which is itself subject to US political influence. The convergence project undermines IASB's claim to be a truly independent standard-setter and could easily lead to global accounting standards effectively becoming US GAAP under the oversight of the SEC and subject to the US political system. Given that the two most recent accounting problems (Enron and sub-prime) have emanated from US practices, this background is not an incentive to converge accounting practices. Furthermore, global monopoly is not desirable as it stifles new ideas and hinders progress. There should be room for more than one set of standards in the world.

  3.4  We do not believe that convergence with US GAAP is necessarily the right way forward to achieve high quality accounting standards. Monopoly inhibits progress. A full consultation on convergence with US GAAP should be carried out. There should also be a rethink from first principles of the accountability of the IASB.

  3.5  According to the IASC Foundation Constitution, IASB members must: "comprise a group of people representing, within that group, the best available combination of technical skills and background experience of relevant international business and market conditions in order to contribute to the development of high quality, global accounting standards" (www.iasb.org). IASB allows 14 members (currently 13) two of whom are part-time (seen as a key component in preserving independence) but this composition may not reflect recent experience in international business and market conditions. A number have been standard setters for a substantial period of time. For example, the current Chairman, Sir David Tweedie has been a full-time standard setter since 1990 having previously chaired the UK ASB. Some other members have similar experience. James Leisenring, has been a standard setter since 1987 having previously served on FASB. Warren McGregor served as Chief Executive Officer of the Australian Accounting Research Foundation (the body responsible for supplying technical support in the development of Australian accounting standards) for 10 years prior to his appointment to the IASB in 2001.

  3.6  The IASB board structure is based on the FASB structure (Sawers, 2008), not on the UK model of primarily non-executive standard setting boards with recent and relevant experience from varied backgrounds and a with only a full-time chair or director, but supported by a competent staff. A primarily full-time board risks becoming remote from current business practices and the experience of applying accounting standards in a variety of practical settings. These problems are exacerbated if the standard setters have had little direct practical engagement of working with the standards in a business context for a number of years.

  3.7  In July 2008 the IASC Foundation constitutional review suggests the minor change of increasing the number of board members by two. It also suggests change to the Standards Advisory Council, a stakeholder body which normally meets three times a year.

  3.8  We suggest there should be no such person as a full time career standard setter. Regular experience in applying standards should be a requirement for standard setters to keep pace with business and market developments.

  3.9  Sources of IASC Foundation funding are published but not widely publicised. Out of total funding of £11.3 million for 2007 almost 30% came from international accountancy firms (IASC Foundation Annual Report, 2007) and a high proportion of the rest from multinational enterprises. Thus a significant proportion of those funding IASC foundation and IASB's global ambitions have a vested interest in achieving global accounting standards.

  3.10  We believe that all funding for IASB activities should be channelled through governments or regulators. IASB's influence is too powerful for it to be mainly financially dependent on voluntary contributions and from those with vested interests in promoting global standards. This would give governments more authority and provide the added advantage of encouraging more participation in the consultation process from parties who find themselves paying the true price for the use of IASB standards.

4.   The process of amending accounting standards

  4.1  According to the IASB, International Financial Reporting Standards are developed through an international consultation process which involves individuals and organisations from around the world. The due process invites comments at two stages. The first stage invites comments on a discussion paper (an early exploration of the issues and how they might be dealt with in a standard). The second stage invites comments on an exposure draft (a draft standard) which the IASB consider to be the main vehicle for consulting stakeholders. Although the IASB says that it considers the comments received and may revise its proposals as a consequence of them, it is not clear how and to what extent the comments received feed in to the standard setting process and what role the Standards Advisory Council plays. Are supportive comments given more weight than critical ones? Are comments from particular organisations taken more seriously? The IASB appears to have complete discretion over its response to the stakeholder consultation. In theory standards should not require amendment once they have been issued if there is an effective consultation process which identifies the issues and the unintended consequences are thought through properly. Furthermore there is no independent mechanism for making change such as the UK Urgent Issues Task Force.

  4.2  A further issue is that the consultation process is self selecting, not pro-active. Only larger organisations have the resources available to respond to invitations to comment in a full and timely fashion. Only those with the greatest vested interest will be motivated to engage in the process. For example, the IASB published a discussion paper "Amendments to IAS 19 Employee Benefits" in March 2008 requesting comments to be received by 28 September 2008. A total of 149 comment letters were received. Fewer than 60 of these were from individuals or companies (and these were dominated by large multinational enterprises). The majority of responses are from other standard setters, governmental organisations, trade associations and professional accountancy bodies. It is not clear to what extent these various bodies have consulted their own members. Thus the responses received are unlikely to be fully representative of the whole user group.

  4.3  We suggest that radical change is needed to the consultation process. A self-selecting respondent model favours those with the most resources and the greatest vested interests. Independent units should conduct pro-active consultation into a wide range of stakeholder views on Discussion Papers and Exposure Drafts, putting forward balanced views from all stakeholders groups. IASB should be required to take notice of these results and explain publicly if they choose to reject them. As with IASB itself, the units should be provided with adequate funding provided by the users of standards and channelled through government agencies or regulators, in order to do their job properly.

  Although established with the best of intentions we do not believe the current model for IASB activity is sustainable.

REFERENCES

Accountancy Age (2008), McCreevy calls for urgency on fair value suspension. Accountancy Age, 9 October.

Ball, R. (2006). International Financial Reporting Standards (IFRS): pros and cons for investors, Accounting and Business Research—International Accounting Policy Forum, pp 5-27.

Bush, T. (2005). Divided by a Common Language: Where Economics Meets the Law: US versus UK Financial Reporting Models. London: ICAEW.

ECOFIN (2008) European Report, 9 July.

Financial Accounting Standards Board & International Accounting Standards Board (2002), Memorandum of Understanding: "The Norwalk Agreement". Norwalk, Connecticut: FASB & IASB.

Fearnley, S and Sunder, S. Pursuit of Convergence is coming at too high a cost (2007). Financial Times Accountancy Column. 23 August.

Herz, R H. (2005). In search of a new financial order. One global standard for financial reporting makes sense. Chief Executive, May.

Sawers, A. (2008), Profile Sir David Tweedie, setting the standards. Accountancy Age, 17 April.

3 November 2008





 
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