Panel on Tax, Audit and Accounting

2. After leaving the IASC, I have provided IFRS consultancy and training services to companies, audit firms, professional bodies and government agencies. I have carried out surveys of the IFRS accounting policies of EU listed companies and interviewed approximately 20 UK listed companies on their experiences of making the transition from UK GAAP to IFRS. I have served on the IASB’s advisory group for SMEs, the UK’s Financial Reporting Review Panel and the Financial Services and Other Specialised Industries committee of the UK’s Accounting Council. I assisted the Institute of Chartered Accountants of Scotland on its "principles versus rules" project. I have held academic appointments at the London School of Economics and Political Science and the University of Edinburgh Business School, taught at other universities and participated in many academic conferences.

3. My evidence focuses on questions 10 to 14 of panel’s call for evidence. I have prefaced that evidence with my views on two related issues:

· the role of the IASB (and national standard setters) with respect to the possible effects of accounting standards; and

· the similarities and differences between IFRS and UK GAAP on the impairment of financial assets accounted for under the cost model.

The role of the IASB and other standard setting bodies

4. The role of the IASB is to develop, in the public interest, a single set of high quality, understandable, enforceable and globally accepted financial reporting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help investors, other participants in the various capital markets of the world and other users of financial information make economic decisions [4] . Put another way, IFRS financial statements should present fairly (or show a true and fair view of) the reporting entity’s financial position at the reporting date and its performance and cash flows for the period ending on that date. The IFRS financial statements of different entities should present like transactions and other events in a like way.

5. IFRS financial statements are a comparable and reliable reference point or milestone that seek to meet the common needs of users who wish to make decisions about the entity. Those decisions include, for example [5] :

· deciding whether to buy, hold or sell an equity investment in that entity;

· assessing the stewardship or accountability of management and, as result, deciding whether to retain and how to remunerate that management;

· assessing the ability of the entity to pay employee benefits;

· assessing the security for amounts lent to the entity;

· measuring how much taxation the entity should pay;

· measuring the distributable profits of the entity and determining its distributions to shareholders; and

· regulating the activities of the entity.

6. The IFRS financial statements are not the only information that users use to make such decisions. Furthermore, users often adjust the amounts reported in the IFRS financial statements to meet their specific needs. For example, investors adjust IFRS profits for use in the models they use to estimate the value of the reporting entity. Tax authorities (such as the UK HMRC) require adjustments to IFRS profits so as to exclude non-taxable income and non-tax deductible expenditure. Banking and insurance regulators adjust IFRS amounts in order to decide whether a bank or insurance entity has sufficient capital. The reporting entity itself may have to adjust IFRS profits in order to calculate its distributable profits in accordance with company law. These adjustments are not included in the IFRS financial statements because the adjusted measures are designed to meet the specific needs rather than the common needs of users. IFRS financial statements could, and sometimes do, disclose these adjusted measures, for example IAS 1 Presentation of Financial Statements requires disclosures about whether a reporting entity has complied with externally imposed capital requirements.

7. Some of the adjustments are the result of political decisions to favour or protect particular entities or other interested parties, for example some tax deductions are intended to encourage entities to incur capital expenditure and some regulatory capital requirements are intended to protect depositors and, hence, the stability of financial markets. Decisions about such matters are the province of democratically elected governments and agencies appointed by such governments. They are not the province of the IASB or many national standard setting bodies. The IASB should not, and should not be allowed to, write accounting standards which favour or protect particular entities or other interested parties. For example, the IASB should not be allowed to write accounting standards which seek to protect banks or the banking system, protect the interests of beneficiaries of pension plans, protect the leasing industry or achieve of particular levels of tax revenues for governments. [6] The same constraint should also apply to the UK’s Financial Reporting Council (FRC).

The impairment of financial assets under the cost model under IFRS and UK GAAP

8. Some have asserted that IFRS requirements for the impairment of financial assets accounted for under the cost model differ from the equivalent UK GAAP requirements. They have also asserted that UK banks reported lower amounts of loans losses following the transition from UK GAAP to IFRS. There is no evidence to support these assertions. The evidence available by comparing the requirements of IFRS and UK GAAP [7] shows that:

· both IFRS and UK GAAP require the use of an incurred loss model;

· both IFRS and UK GAAP require the use of forward-looking measures to assess the impairment of financial assets accounted for under the cost model, that is they both require the reporting entity to estimate the expected future cash flows from those assets;

· IFRS requires, but UK GAAP does not require, the reporting entity to discount those expected future cash flows to their present values at the balance sheet date;

· both IFRS and UK GAAP require the identification of losses that can be specifically identified at the reporting date and those which exist at the reporting date but which cannot be specifically identified; and

· both IFRS and UK GAAP require the estimate of future cash flows to be based on the facts and circumstances at the balance sheet date, including those facts and circumstances which are specific to the borrower (for example default or potential bankruptcy) and those which reflect national and local economic conditions.

9. Mann and Michael acknowledge that "in practice, some [UK] banks have established provisioning policies with forward-looking elements that attempt to cover some expected losses over the life of a loan" but suggest that this represents "only a relatively small part of total provisions" (partly for tax and Basel reasons). Hitchins, Hogg and Mallet report that the Bank of England raised the issue of accounting for expected losses in the mid-1990s but support was limited as it raised conceptual and legal difficulties (including conflicts with UK GAAP and the Companies Act 1985). Until recently, the IASB and its predecessor body had, not considered the use of an expected loss model but both bodies issued, or have been associated with, discussion papers [8] which proposed that loans and advances should be measured at fair value which would have meant that, among other things, some expected losses would have been recognised. In practice, therefore, neither UK GAAP nor IFRS currently require an expected loss model.

10. Until 1969, UK clearing banks used secret or hidden reserves to smooth their financial results. They were able to do this because the Companies Acts 1948 and 1967 exempted them from publishing "true and fair" financial statements. With effect from 1970, the UK clearing banks voluntarily ceased this practice and started publishing "true and fair" financial statements. The UK persuaded the EU to limit the use of hidden reserves in the EU Bank Accounts Directive. In the 1970s and 1980s, the UK accountancy profession and the Bank of England played a major part in persuading the IASB’s predecessor body to prohibit the use of hidden reserves in the financial statements of banks. In practice, therefore, neither UK GAAP nor IFRS have, over the last 30 years, permitted the use of secret or hidden reserves.

11. The evidence provided by the disclosures made by UK banks on their transition from UK GAAP to IFRS [9] also supports the view that UK GAAP and IFRS have very similar requirements for the measurement of the impairment of financial assets accounted for under the cost model differ. Most UK banks made only small adjustments to their provisions for loan losses; some banks increased, rather than decreased, their provisions. Some UK banks increased their loan loss provisions because IFRS require that losses are measured by reference to the present value of expected future cash flows whereas UK GAAP allow them to be measured by reference to the undiscounted amounts of expected future cash flows. In this respect, IFRS are therefore more prudent than UK GAAP. Furthermore, under IFRS, some UK banks had to adopt more a prudent approach to the recognition of income on loans and advances.

12. The evidence that IFRS and UK GAAP are similar could indicate that UK banks applied IFRS wrongly but there is no published evidence to support such a conclusion. Of course, the evidence also does not show whether IFRS and UK GAAP requirements are "correct" but it does suggest that any accounting failures before and after the financial crisis would have occurred had UK banks continued to report under UK GAAP. It is time, therefore, to move on from the "IFRS blame game" and to focus on supporting the IASB and the FRC in their search for the "correct" answers to important accounting questions.

Responses to specific questions in panel’s call for written evidence

Q10. What was the role of accounting standards and reliance on fair value principles in the
banking crisis? What does a ‘true and fair view’ really represent to the market?

The role of accounting standards and reliance on fair value principles in the banking crisis

13. Some have asserted that accounting standards, in particular the use of fair value measurement, caused or played a major part in the financial crisis. There is little evidence to support these assertions. Regulatory and academic evidence shows that the assertions are unfounded [10] . The evidence also suggests that the major accounting issue arising from the financial crisis was the impairment of financial assets accounted for using the cost model rather than the losses arising from the use of fair value measurement.

What does a true and fair view really represent to the markets?

14. UK company law requires that the financial statements show a "a true and fair view of the state of affairs as at the end of the financial year and the profit or loss for the financial year" [11] . The law does not define a "true and fair view". Neither the FRC nor any its constituent bodies have defined a "true and fair view" but the FRC has obtained counsel’s opinions on both the relationship between the "true and fair view" and accounting standards and on the status of the "true and fair view" following the adoption of IFRS by some UK companies.

15. The professional accountancy bodies in the UK have not issues any recent pronouncement on the meaning of "a true and fair view". The Institute of Chartered accountants of Scotland did publish in 1982 a monograph A True and Fair View in Company Accounts by Professor David Flint which is often quoted as an authoritative source and which concludes:

"... accounts which are required to give a true and fair view should comply with specific statutory requirements of disclosure and presentation, and disclose the accounting policies and bases which have been adopted; they should ordinarily be prepared in accordance with normal accounting practice and in compliance with Statements of Standard Accounting Practice, recognising, however, that these are a means to an end and not the end itself. They should be prepared to satisfy the professional technical information requirements of what is necessary as a basis of opinion and decision on the part of those who may legitimately expect their needs to be met. They should meet both the general legal requirement for the protection of shareholders of full and frank disclosure of information on matters on which they ought to be informed in relation to the company’s affairs, and the social expectation of what is necessary, judged against the ethical standards of society in communication with shareholders and other relevant groups."

While Professor Flint’s terminology is somewhat dated and the nature and status of accounting standards has changed in the UK since 1982, his definition conveys much of what is still understood today by "a true and fair view".

16. The IASB uses the term "fair presentation" which IAS 1 Presentation of Financial Statements defines as [12] :

"... faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework. "

IAS 1 goes on to assert [13] :

"The application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation."

17. IFRS treat "fair presentation" as an overriding principle in the same way that the UK company law treats "a true and fair view" as an overriding principle. Both IAS 1 and UK company law require an entity to depart from a specific requirement when compliance with that requirement would not result in a "fair presentation" or "a true and fair view". IAS 1 states [14] :

"In the extremely rare circumstances in which management concludes that compliance with a requirement in an IFRS would be so misleading that it would conflict with the objective of financial statements set out in the Framework, the entity shall depart from that requirement ..."

18. While IFRS use "fair presentation" and UK company law uses "a true and fair view", the FRC has received a legal opinion that states that fair presentation in IAS 1 "is not a different requirement to that of showing a true and fair view but is a different articulation of the same concept" [15] . This opinion is consistent with the thinking of the IASB’s predecessor body when it referred to "fair presentation" and "a true and fair view" in its Framework for the Preparation and Presentation of Financial Statements and when it issued IAS 1 in 1997.

19. While the use of the shorthand "a true and fair view" is common and understandable, it is important to acknowledge that UK company law requires financial statements to show a true and fair view at the balance sheet date and in the period up to and including that date (IFRS imply the same restriction to fair presentation). Therefore "true and fair" financial statements must reflect the transaction and other events that occur up to and including the balance sheet date. The financial statements must not reflect transactions and other events occurring after the balance sheet date that do not provide evidence about conditions at the balance sheet date [16] . Therefore, UK banks were correct in reporting the effects of the financial crisis that started in 2008 in their 2008 financial statements (they would also have been correct to do so had the financial crisis started early in 2008, that it before the banks issued their 2007 financial statements).

20. It is also important to acknowledge that it is generally accepted in the UK that the use of secret or hidden reserves to smooth profits does not result in a true and fair view. While UK clearing banks used secret or hidden reserves to smooth their profits until the late 1960s, they could do so only because the Companies Act 1948 exempted them (and some insurance and shipping entities) from the requirement to publish "true and fair" financial statements. While the meaning of "a true and fair view" has undoubtedly evolved over the ensuing forty years, the meaning has not evolved to permit the use of secret or hidden reserves.

Q11. What are your views on the current incurred-loss impairment model and its role in the banking crisis? Do you consider that proposals to move to an expected-loss model will address criticisms of the current accounting rules?

21. Both IFRS and UK currently require the incurred loss model for the measurement of the impairment of financial assets accounted for using the cost model (which includes the loans and advances of banks). The model is consistent with the requirement for financial statements to present fairly or show a true and fair view of the financial position at the balance sheet date and performance in the period up to and including that date. It is also consistent with the approach adopted for the measurement of the impairment of other assets (for example, goodwill, intangible assets, property, plant and equipment, inventories, pension assets, tax assets etc.). Academic research shows that these requirements lead to timely loss recognition.

22. Notwithstanding the benefits of the incurred loss model, it has been criticised for allowing banks to recognise loan losses later than some commentators want. It has also been criticised because it allows the income statement to benefit from the risk premium charged to borrowers before it suffers from the effects of the related loan losses. The challenge for standard setters and others has been to find an appropriate model (an "expected loss model") which recognises loan losses earlier than they are recognised under the "incurred loss model" but in a way that does not impair fair presentation or a true and fair view at the balance sheet date or for the period ending on that date [17] .

23. As explained in paragraph 8, the incurred loss model requires banks to estimate the present value of the expected future cash flows from the relevant financial assets. The estimates of expected future cash flows are based on the facts and circumstances at the balance sheet date, including both facts and circumstances that are specific to the borrower (for example default or potential bankruptcy) and national and local economic conditions that correlate with defaults. The model already requires a bank to recognise some losses which it expects to incur but which it has not yet identified.

24. For an expected loss model to be different from the incurred loss model it would, in practice, have to require a bank to either:

· use assumptions about future events when estimating expected future cash flows, for example future deteriorations in credit rating or a future worsening in economic circumstances; or

· recognise specified levels of loan losses for financial assets that share common characteristics, for example recognise x% loan losses for financial assets for which repayments are overdue by three months.

25. The IASB’s current draft proposals follow the first option, that is they change the assumptions used when a bank estimates expected future cash flows. Depending on the circumstances, the proposals require an estimate of loan losses either in the next year or over the life-time of the financial assets. The IASB has tentatively decided to restrict the events that require an estimate of life-time losses to those circumstances in which "there has been significant deterioration in credit quality since initial recognition" [18] .

26. Had the proposed model been applied by banks in 2007, I believe that it is unlikely that it would have shifted significant amount of losses from 2008 into 2007. Therefore, the IASB’s proposals may not meet the expectations of some critics of the incurred loss model. In particular, they may not meet the expectations of all those critics who have been calling for (a return of) prudence or want a return of smoothing through the use of secret or hidden reserves. However, these critics have been unclear on what they do want and how what they may want is consistent with requirements for transparent financial information and fair presentation or a true and fair view.

27. My personal preference is to retain the incurred loss model (although I could live with the IASB’s current draft proposals if they receive widespread support). In the case of banks (and some other financial institutions) I would require that the recognition in the financial statements of any additional amounts of provisions or reserves required by the banking regulator. These additional amounts should be presented prominently. They should also be presented separately from IFRS profit and IFRS assets, liabilities, income and expenses. For example, I prefer that the changes in these additional amounts are presented prominently as a deduction from, or addition to, the IFRS profit. They should not be treated as expenses or income that are included in the measurement of IFRS profit.

Q12. What is the best method of accounting for profits and losses in trading instruments? Are there any alternatives to mark-to-market or mark-to-model that might better represent a ‘true and fair view’?

28. The only appropriate method of accounting for trading instruments is the measurement of those instruments at a defined current value (fair value) and the inclusion of the resulting changes in those values in profit or loss. This method was used by banks and investment companies and similar entities under UK GAAP and is required under IFRS for all entities (in practice, it has relatively little effect on many entities other than financial institutions). No other method provides useful information to users of the financial statements. No other method provides information about management’s stewardship of the funds entrusted to it.

29. The use of the fair value model for trading instruments requires the use of valuation techniques (models) and inputs to those techniques. It is important to acknowledge that the use of valuation techniques or models is not unique to the accounting for trading instruments. The preparation of financial statements often requires the use of techniques and models, for example, models are used to estimate the depreciation, amortisation and impairment of non-current tangible and intangible assets. Models are used to measure the cost of inventories, to apply the effective interest rate method to financial assets and financial liabilities, and to measure pension liabilities. These models are a means to an end; they are not an end in themselves. IFRS 13 Fair Value Measurement now provides a robust basis for the selection and use of appropriate valuation techniques and the inputs to those techniques when measuring fair value.

30. Some advocate accounting for trading instruments using the cost model under which the instruments are measured at each balance sheet date at the lower of cost and market value. This method does not provide useful information about the entity’s financial position and performance. It does it not measure management’s stewardship of the funds entrusted to it. The method is also open to abuse because management can dispose of specific instruments and, therefore, selectively report profits (sometimes referred to as "gains-trading") or selectively control the amount of realised profits that are available for distribution or available for the payment of bonuses. The use of the cost model also tends to delay the recognition of losses because many of its advocates argue that "temporary" losses should not be recognised or that cost and market value should be compared at an aggregate, portfolio level rather than an individual investment level.

Q13. Did IFRS accounting standards contribute to a box-ticking culture to the exclusion of promoting transparency and a ‘true and fair view’ of the business?

31. Accountants use checklists in the same way that other professionals use checklists, that is as a starting point to remind them of any relevant requirements and the steps they must undertake to carry out a particular task. The proper use of IFRS accounting checklists does not replace the need for judgment in applying accounting standards, in fact checklists often highlight the areas in which judgement must be exercised. While several critics have suggested that IFRS have led to a box ticking culture, I am not aware of any evidence that the use of checklists has resulted in "wrong" accounting or the lack of appropriate judgements.

Q14. Do we need a special accounting regime for banks? If so, what should it look like?

32. No. The explosion of new financial instruments in the late 1980s led the IASB’s predecessor body to conclude that it should develop a single financial instrument standard that applied to all financial instruments whether they were held by banks or by other entities. This approach continues to be followed. The approach probably causes greater problems for non-banks than it does for banks. In general, accounting standard should be developed for transactions and other events. They should not be developed for industries or sectors.

9 January 2013

Appendix 1: Comparison of Loan Loss Provisions Reported by Major UK Banks on Transition From UK GAAP to IFRS

1. This appendix compares the loan loss provisions reported by six major UK banks, all of which published IFRS financial statements for the first time for the calendar year 2005. All six banks took advantage of transitional requirements which allowed them not to restate 2004 (or earlier periods) for the effects of IAS 39 Financial Instruments: Recognition and Measurement.

2. The six banks first reported provisions for loan losses in accordance with IAS 39 on restating their 31 December 2004 balance sheets from UK GAAP to IFRS (table 1). This is the only date at which comparisons can be made. There are no comparisons for the loan loss expenses included in the income statement.

Table 1: Loan loss provisions 31/12/2004

UK GAAP IFRS Change Change

%

Barclays £2,613m £2,637m +£24m +0.92

HSBC $12,680m $12,542m -$138m -1.09

HBOS £2,509m £2,494m -£15m -0.60

Lloyds TSB £1,663m £1,919m +£256m +15.39

Northern Rock £127m £124m -£3m -2.36

RBS £4,063m £4,145m +£82m +2.02

3. The large increase reported by LloydsTSB arose because IFRS requires, but UK GAAP does not require, the discount of the expected future cash flows to their present values at the balance sheet date. As LloydsTSB explained:

"Impairment principles under IFRS are similar to those followed by the group under UK GAAP, with the exception of the requirements to discount the expected future cash flows at the original effective interest rate when determining the provisioning requirement." [19]

The disclosure implies that LloydsTSB made the same estimate of expected future cash flows under both UK GAAP and IFRS.

4. The reduction in loan loss provisions at HSBC related primarily to its consumer finance business. Under UK GAAP loan losses in the consumer finance business were recognised "in accordance with a predetermined overdue status" [20] . The adoption of the IFRS incurred loss model for the consumer finance business resulted in the reinstatement of loans which had been written off under UK GAAP "but which, based on historical evidence, were recoverable" [21] .

5. The disclosures made by some banks imply that other adjustments were made to the way in which they applied the effective interest rate method and, hence, measured the loans before the recognition of loan losses. For example, Northern Rock explained that under UK GAAP it recognised some loan fees as revenue when the loan was made. Under IFRS, it spread these fees over the life of the loans [22] . This change increased the amortised cost carrying amounts of loans as at 31 December 2004 by £199m [23] .