Banking StandardsWritten evidence from Timothy Bush

Introduction

1. I gave oral and written evidence to the House of Lords Economic Affairs Committee (EAC) for its inquiry of 2010–11 into “Auditors Market Concentration and their role” and felt that the conclusions and the analysis of the final report gave appropriate weight to that evidence. The EAC report conclusions expressed considerable concern about accounting standards in banks (IFRS) and that was carried forwards in Grand Committee. Unfortunately nothing much seems to have progressed despite that pressure from the EAC. That is odd, as both Houses of Parliament have been consistently astute when looking into this area (paras 44, 55, 56 and 57).

2. Rather than repeating my evidence to the EAC, which set out fundamental defects in International Accounting Standards (“IFRS”) and UK GAAP copies of IFRS as applied in the accounts of UK banks, I elaborate more on the conflicts of interest that gave rise to faulty accounting standards in the first place. I also cover the root causes of a lack of proper analysis and action to resolve the ongoing problem due to further conflicts, several years now after the events that first caused banks to collapse in 2007/8 (para 18). The standards required to be set under the law are in fact contrary to UK and EU law (paras 47 and 63).

3. The Walker Review (2009) in particular concluded—wrongly—that the banking crisis was essentially a liquidity crisis. It was not, it was a capital crisis. A lack of liquidity is just the symptom. The Bank of England now accepts that, though it too had given evidence to the Treasury Select Committee (TSC), regarding Northern Rock, that problems were liquidity rather than capital (latent losses).1 The distinction is critical both reputationally, and financially for particular parties, especially the auditors, and their regulator (para 10).

4. The consistent feature of capital crises that firstly manifest as liquidity problems (eg City of Glasgow Bank 1878, Johnson Matthey Bank 1984) is banks’ accounts overstating asset values above their recoverable amount, thus masking that they are profoundly insolvent, incapable of being going concerns, and without the prospect of normal additional shareholder funding from rights issues (shareholders would just be throwing good money after bad). Credit markets then correctly surmise the real condition and withdraw funding.

5. Accounting standards systemically overstated capital, and still do (para 23 and 24), and the Basle regime did not and does not adjust for it correctly (para 36). As of August 2012, particular banks (especially RBS) are trading at such a large discount to net asset value (shareholders’ funds per the accounts) that the only logical conclusion is that they are overstating their assets and the market knows this.

6. The fact that banks’ accounts are still following faulty accounting standards in my view makes any normal market capital raising (via a public prospectus) very difficult to envisage (para 27). It has been somewhat overlooked that as well as being an ineffective prudential regulator, the FSA was also the listing authority (handling prospectuses for new capital) at the time that banks raised new capital only to fail shortly afterwards (para 29). Both the prudential regime and the prospectus regime depended on reliable accounting numbers. As does governance. There are significant issues regarding pay—indeed tenure of executives and business models too—wherever there are any false profits.

7. The Financial Reporting Council (FRC) has made errors contrary to the structure of the law (para 47). The FRC has been overly reliant on people with a vested interest in not promoting the scope of the law (the solvency aspect of the true and fair view requirement) for auditor-defensive reasons (paras 8 & 49)). The FRC then had an ineffective policing model, itself defensive, rather than seeking the outcome required by the law (creditor and shareholder protection).

The Accounting Profession and Litigation Risk

8. The crux of the matter is that IFRS masks insolvency, and corporate insolvency is an auditor liability issue. The accounting profession (and their lead regulator, the FRC) has a particular problem in admitting faults with accounts of banks due to the application of defective IFRS.

9. Firstly, elements of the profession created IFRS in the first place, and the FRC depended on these elements for advice in assessing whether the recondite standards were fit for purpose.

10. Secondly, capital shortfalls masked by the accounts can be matters for litigation against auditors, as in the case of Johnson Matthey Bank. In that case the Bank of England was then plaintiff against the auditors having extended lender of last resort funding to that bank.

11. Thirdly, the regulator (the FRC’s Financial Reporting Review Panel—“FRRP”) appears not to have paid much attention to the accounts of banks despite the radical changeover to IFRS in 2005, whose implementation cost >£200 million for some banks. A large part of the cost of IFRS implementation arose because the banks had to appoint accountants (auditors, other than their own auditors) for implementation advice.

12. Further to bank collapses the FSA then commissioned accounting firms to look at the collapses of HBOS and RBS. That approach was almost bound to come up with insipid analysis and toothless outcomes if the core problem was systemically related to the accounts (or the internal books) of banks and could thus rebound on them as auditors in other banks. For breach of fiduciary duties (insolvency) auditors and directors have joint and several liability.

13. It is interesting that the FSA seems to have made no attempt to pursue directors of failed banks for breach of fiduciary duties. Indeed the FSA’s entire regulatory approach seems to have been designed to deal with matters de-linked entirely from fiduciary duties, which is broadly the maintenance of capital for the benefit of creditors and the shareholders as suppliers of capital. That is because the FSA’s entire regulatory approach was unfortunately based on another “risk” model instead, and that model also came from elements of the US accounting profession (para 41).

14. Proper accounts are fundamental to so many things that can be usually taken for granted, that a failure at accounting standard setting level, can create system-wide failure, and thence embarrassment (and litigation risk) for other parties. Proper accounts are essential for normal corporate governance and market conduct, including:-

Companies disclosing capital and reserves properly, crucial to being a going concern. Essentially, unsecured creditors need comfort that it is true share capital and reserves that is funding the company in addition to them.

Companies not making unlawful dividends, ie the accounts disclose that profits are realised or not and that reserves are distributable or undistributable.

Prospectuses, for raising new capital in the event that a reported loss requires more capital.

Making an acquisition of another company, without the acquiree pulling the acquiror down due to faulty accounts hiding losses, as Atlantic Computers did to Ferranti plc (1993), and HBOS did to Lloyds TSB (2008/9).

15. Particular banks’ accounts; HBOS, RBS, Alliance & Leicester, Northern Rock and Bradford & Bingley fail those objectives, as did Cattles plc, a non-bank doorstep lender since 1927. What is remarkable about the losses that were in the portfolios of these companies is that these levels of losses arose despite the emergency dropping of interest rates to 0.5%. On the basis of pre-2008 interest rates the inherent losses would have been even larger.

16. As Lord Forsyth identified at the EAC,2 there are significant vested interests in playing down the role of systemically faulty accounting standards in banking collapses. This table shows some of the issues.

Party

Issues arising with an insolvency rather than liquidity problem in a bank

Auditors

1. Accounts masking insolvency create auditor litigation risk.

2. Auditors promoted one model of IFRS globally.

3. Some firms were particularly keen on the IASB model, and led endorsement in the UK and EU.

The Bank

Is not permitted to lend as lender of last resort to an insolvent bank. If it does and it is left bearing losses then it may need to sue the auditors (Johnson Matthey).

The FRRP (FRC)

Reviews accounts for compliance with the law. It did not look at banks from 2005–2007 (the genesis of the crisis).

FSA—as prudential regulator

Uses audited accounts for the Basle Regime.

The FSA decided to let IFRS “bed in for 2 years” before reviewing the full consequences of the switchover in 2005.

FSA—as the listing authority

Accounts are central to prospectuses.

The FSA is also the owner of the listing regime, which also failed for bank capital raisings.

EU Commission

Common accounting standards were a central plank of “The Single Market” project. The EU Commission adopted standards contrary to the true and fair view of EU (and UK law).

BIS/FRC

BIS officials supported IFRS on the advice of the FRC for use in the EU.

Delays in Fixing IFRS (a Concern of the EAC) That is now a Matter of Urgency

17. IFRS has been described as “pro-cyclical”. In my view that is an inaccurate and dangerous euphemism. IFRS masks the destruction of capital and in banks this makes its replenishment, other than by taxpayer funding, impossible. Capital destruction is not cyclical, because without the regeneration of capital (in the form of true profits) the cycle never gets back to where it started. The private sector (losses in banks, or the perception of them) harms the public sector directly (support for banks). Distorted capital ratios also results in banks not lending according to a normal profit/growth model for a share capital funded company. Again, RBS demonstrates this dysfunction (see also para 70).

18. As the EAC rightly concluded, there are problems in getting the problems with IFRS fixed.3 Almost two years after the EAC enquiry started, IFRS has not been fixed.

19. Poor accounting is like any addiction, it is easier to fall into than it is to get out if it. The core faults in assessing IFRS for adoption for banks lies with a tight circle of interconnected people in the International Accounting Standards Board (“IASB”), the FRC, the FSA and EU Commission, many of whom are still in place. The IASB is not fit for purpose. The US standard setter FASB and the IASB have now failed to come up with a joint standard on provisioning three years after being tasked by the G20 to do so. The US standard setter had in fact proposed a return to prudent general provisions (full expected loss). The IASB rejected that, and the FASB has, logically, pulled out of the IASB model which is merely a complicated extension of its existing flawed (incurred loss) model.

20. The UK is especially vulnerable due to its allowing IFRS for companies’ own accounts (as opposed to group accounts). With the majority of IASB members being from non-IFRS using countries (a “West Lothian problem”), and the majority of the EU having not opted for IFRS for companies own accounts, the UK has opted into something with competitive disadvantage with little ability to affect the outcome. France has outlawed IFRS for companies’ accounts, so has less difficulty.

The UK adoption route (IFRS in banking companies) causes the statutory capital maintenance regime to break down—it overstates assets and leaves out losses

21. The IFRS model of the IASB causes the Companies Act capital maintenance disclosure regime to fail in companies. It was Bank of Scotland as a company—with its faulty accounts—that caused HBOS Group to fail, Bank of Scotland was not a going concern.

22. That regime requires audited accounts to support demonstrating solvency (or the prima facie insolvency) of limited liability companies and for the audited accounts to support the lawful distribution of profits (realised profits, and including unrealised prospective losses). Both of these things require a “true and fair view” which in law means accounts prepared using prudence (including no unrealised profits) and accruals (matching costs to revenues irrespective of the timing of payment or settlement).

23. As the EAC inquiry correctly identified. IFRS frustrates both of these objectives because IFRS:

books unrealised gains (mark-up-to-an-up-market), and even unrealisable gains (mark-to-up-a-model based on something else going up); and

leaves out “losses no matter how likely” from bad debt provisions. It can therefore state loans above the ultimate recoverable amount, with no assurance on what the right amount is. That constitutes a material uncertainty. It is worse the higher risk the lending.

24. Both the EAC and the TSC identified that auditors had signed off banks as being going concerns, when in they were in fact about to fall over. IFRS masks material uncertainty. However it has also emerged that IFRS:-

leaves out bonuses from the accounts if the cash payment is deferred for 18 months. This is especially material with investment banks. Remarkably, the amount is not even charged a year later when the payment is then only 6 months away. The amount remains uncharged until paid. That contravenes the most basic principle of accruals (matching costs irrespective of timing of settlement). It is another manifestation of a backward looking approach adopted by the IASB; and

leaves out costs of de-risking and de-gearing in connection with open financial positions, however likely the loss. Again IFRS does not book likely losses connected with risk. It books the cost once there is contractual close out. That is not only opaque, it creates an incentive not to close out loss making positions.4

25. Since the EAC’s final report, the Sharman Report5 has been produced on the subject of going concern and banks. The subtext of the final report is that IFRS has a faulty definition of going concern, and IFRS accounts cannot be used by directors to assess whether a company is a going concern as it is imprudent. Given that means that directors cannot use IFRS to understand their own companies’ true financial position, it is hardly surprising that creditors and shareholders cannot either.

26. As the Sharman Review was led by the FRC, it may have been difficult to overtly challenge the misguided strategy of the FRC to have committed unreservedly to IFRS without any “Plan B”. My own experiences within the FRC is one of inconsistent public and private views on the subject of IFRS.

The FSA, IFRS and the Failure of the Prospectus Regime

27. A very serious conflict of interest that has not received the attention it deserves, is the difficulty that was posed by the FSA as prudential regulator also being the listing authority. The FSA took the UKLA from the demutualised London Stock Exchange and was hence responsible too for prospectuses for capital raising.

28. There has therefore been a direct conflict between the FSA wanting a bank to raise capital and the Listing Authority requiring high standards to protect subscribers in a capital raising.

29. I note that the FSA reports into RBS and HBOS (commissioned from accounting firms that had also audited failed banks) fail to refer to the fact that “clean” 31 December 2007 accounts were also used for clean prospectuses in 2008. Bradford & Bingley was nationalised within six weeks of raising new capital (underwritten by institutional investors). HBOS and RBS were not much better. Both companies had produced accounts that declared dividends on a going concern basis. That condition, absent unforeseen circumstances, should have been robust for 1 year from when the accounts were signed (the UK auditing standard).

30. HBOS cancelled its dividend before the 2008 AGM. That was a red-flag that there was a latent foreseeable problem within its books. Accounts in law are for tabling at the AGM, a governance function, but HBOS loan losses have now been more than twice what it appeared to have had as shareholder’s funds in its 2007 audited accounts. Such losses are unprecedented in modern times. The losses have been disastrous for shareholders of HBOS and Lloyds-TSB.

31. Despite the move of prudential regulation to the Bank, the recent appointment of the former Chairman of KPMG (the firm which audited HBOS and Bradford & Bingley) to the Financial Conduct Authority, which will contain the UKLA, may create challenges for a full review of the abject failure of the FSA prospectus regime. Accountants can carry liability exposure for some years after retirement as partners.

IFRS and the Basle Regime

32. The Basle Regime (capital adequacy) was conceptually predicated on the accounts of a bank representing the going concern position of a bank properly. Basle then requires additional non-shareholder capital and subordinated debt to absorb losses in the event the bank is a “gone concern”. A bank is a “gone concern” when share capital and reserves are wiped out by falls in asset values (the recoverable amount of loans).

33. The Basle Regime is a product of the Bank of International Settlements, “the banks’ bank”. It is essentially a system to secure the interbank market on a going concern basis, and failing that on a gone concern basis. The objective is to help ensure “risk free” interbank lending.

34. Given that the policy objective that Basle is aiming for is risk free interbank lending, it is particularly ironic that from 2007 to late 2008, increased LIBOR spreads (a classic symptom of doubts about capital adequacy) were read as a liquidity problem rather than a symptom of the failure of the statutory capital maintenance regime of company law systems that the Basle Regime depended on.

35. The attached paper from PWC in 2004, “Joining the Dots”,6 sets out how the IASB in 20034 had, somewhat surreptitiously, moved from an expected loss model to a new model that could result in a bank having losses that are neither covered by provisions for bad debts or capital. In other words, the standards could mask insolvency. The paper did not point out that the true and fair view standard of the law was required for accounts to give a clear picture of company solvency (paras 49,52, 56).

36. The PWC paper is correct that IFRS can make an insolvent bank appear solvent. The rest of the paper is fatally incorrect in stating that the Basle regime had been adjusted to fix it. The adjustments made to correct for IFRS firstly were only partly (50%) against shareholder funds. The other part of the adjustment (50%), was to “Tier 2 capital”, an illogicality as that type of “capital” is only invoked once a bank has already collapsed. To correct any imprudence in an accounting standard 100% of any deduction should be against shareholders’ funds, as it is that which determines whether a bank is capable of being a going concern. The FSA team responsible for Basle policy was also responsible for IFRS.

37. More seriously than that, instead of taking all inherent loan losses into account, the Basle II adjustment PWC refers to only looked for losses on existing loans arising within one year, the same model that the IASB is still proposing for its proposed standard for bad debt provisioning. A rational shareholder (and unsecured creditor) would consider all losses relevant irrespective of timing.

38. A loan is merely a term contract. A bank is a collection of contracts receivable and contracts payable. All future losses are relevant in coming up with a number to reflect what an asset will recover. A loan contract that will fail in year 12 of a 25 year, is like any other loss on that a contract, but with IFRS and Basle such losses are not taken account of. The loss profile of RBS loans as shown in the accounts of the Asset Protection Scheme indicates that losses on RBS’s bad lending are material for at least years 0 to year 5 of loan life.

(*Note: Given that the IASB had an expected loss model in 2003, it is somewhat odd that it has not been able to reconstitute it, 3 years after being asked to by the G20).

Solvency II for insurance companies—”enterprise risk management”—a faulty going concern model similar to IFRS

39. The faulty going concern description within IFRS is about management’s internal perception of the risk of it not being able to raise new capital. The Sharman Review wisely recommends changing it. The IFRS model of going concern is different to the Company Law concept of going concern, which is about telling the facts to the members prudently so that markets know that a company is a solvent going concern and are thus likely to support it or not if it needs help. The first test of going concern is the generation of true profits.

40. Worryingly, the same flawed going concern definition also appears in Solvency II (the pending EU-Commission led regime for insurance companies). The same flaw arises in elements of the Basle regime, in Basle II’s “internal ratings approach” too. The reason for the same flaw cropping up is not a random coincidence.

41. IFRS, Basle and Solvency II draw on the “Enterprise Risk Management” approach of the “COSO” (Committee of the Sponsoring Organisations of the Treadway Commission) model from the USA. It is sponsored by the US accounting profession. It is conceptually flawed.

42. Rather than starting with the fact that limited liability status of any company is a risk to the creditors and an opportunity for the shareholders to leave losses with creditors, the COSO approach itself is a risk to shareholders and creditors. COSO has the company itself trying to second guess the market, in the absence of it giving the actual market reliable audited numbers. From that model also flowed the “mark to model” approach in IFRS itself. The now discredited Value at Risk approach, also flows from such a model. COSO essentially accommodates risk models that management like to use, rather than a critical shareholder capital model that they ought to have. COSO is the antithesis of what is needed for a free and transparent capital market. The COSO model downplays “accounts” and “books”, things that are in law auditor matters, and instead creates woolly abstractions, such as “internal control” and “financial reporting” instead.

43. A speech of Callum McCarthy, then FSA Chairman, of 13 February 2006,7 reveals that exactly the same risk model was used by the FSA to manage itself. Rather than addressing risk, the COSO model is more like a vehicle for consultancy. It is analogous to students setting, and then marking their own exam papers.

The regime for setting accounting standards broke down, contrary to law

44. Particularly noteworthy for a Parliamentary Commission is to consider how the consistently wise counsel of the Treasury Select Committee (2001–2010)—which had looked at accounting standards post-Enron and also on the matter of Equitable Life—was positively ignored by the accounting standard setters. In particular the TSC (and evidence from the Bank of England) saw the centrality of the “true and fair view” objective as the safeguard in case of faulty accounting standards (as had occurred in the case of Enron). The ICAEW also warned against mark to model in its evidence to the TSC.8

45. However, the EU Commission then endorsed IFRS that failed to give a true and fair view and the Accounting Standards Board copied the errors (FRS 26). But, the EU Commission’s locus—like the ASB’s—was to adopt accounting standards under the law.9 That law is the true and fair view. Parliament created it in 1947, and the EU reinforced it in 1978 and 1983 as the EU wide model (the 4th and 7th Accounting Directives). As with Greek entry into the euro-zone, expediency tended to trump what was correct.

46. Post crisis, the FRC is prone to citing legal opinion (Martin Moore QC,10 citing earlier Hoffman/Arden advice) that following accounting standards will normally ensure that accounts give a true and fair view. However, the FRC is reciting only part of the story. The QC opinion is, naturally, presumptive that the accounting standard setters are correctly setting standards under the law.11

47. The FRC seems to have wrongly assumed that the QC opinion is saying that true and fair view is the result of following anything that is in accounting standards irrespective of what the standard setters chose to put in, ie sanctioning “garbage in garbage out”. It is in fact the other way round, the QC opinion is in fact setting out how standards should be set to be consistent with the true and fair view requirement of the law which is the primary requirement of the EU Accounting Directives and UK Company Law.

48. The requirement for accounting standard setters to comply with the law is also contained in

the Foreword to ASB Accounting Standards. The ASB must set standards consistent with UK law, and the EU Directives, which includes the true and fair view principle of the Accounting Directives; and

the IAS Regulation 2002 of the EU Parliament and Council. The Regulation states that the Commission can only endorse IFRS that are not contrary to the true and fair view principle of the Accounting Directives.

49. True and fair view is correctly (consistent with UK law) interpreted in two European Court Justice case as:

the functional standard required of accounts to disclose proper profit to then deliver lawful dividends;12 and

the requisite accounting requirement not to overstate net assets (shareholder capital and distributable and non-distributable reserves).13

50. The FRC made the same error in 20045 (that true and fair view is only the product of following accounting standards) when adopting IFRS by statutory instrument, and Alun Michael MP as Minister intervened to put in what is now section 393 of the Companies Act. Section 393 specifies the overall true and fair view requirement, notwithstanding the use of IFRS. The Minister saw through the FRC’s then position on the basis of alternative legal advice.

Statements made by the former IASB Chairman (Sir David Tweedie) following press articles

51. Following various letters and articles in the Financial Times, including an article by Lord Lawson, Sir David Tweedie, chairman of the International Accounting Standards Board 2001–2011 (and the UK standard setter prior to that) wrote a letter to the Financial Times.14 In that letter he states that the distributablity of profits was not a matter for accounting standard setters to be concerned with. When one looks at the law (whether UK or EU case law, ICAEW legal advice (para 52) or merely the statute itself). That letter requires as good deal of explaining.

52. Attached is the ICAEW (Institute of Chartered Accountants in England and Wales) technical advice on the 1985 Companies Act under Counsel Opinion15 for the period Sir David was setting firstly UK and then International Standards. it is clear from that advice that:

Accounting standard setters should be concerned with distributable profits (para 1 of the appendix).

Demonstrating whether profits are distributable requires the fundamental concepts of prudence and accruals (para 4–7).

Distributable profits are needed for accounts to give a true and fair view (para 15).

53. The ICAEW has been unable to come up with equivalent advice on IFRS under the 2006 Companies Act. My supposition is that Counsel will not sign off on a revision to the above 1985 Act advice, because IFRS positively conflicts with the capital maintenance provisions of the Companies Act. That is because IFRS have been adopted that are contrary to the true and fair view principle of the law needed for the Companies Act to function.

54. I note that Sir David Tweedie did not give evidence to the EAC in 2010.

The 1947 Companies Act—the function of a balance sheet and the true and fair view

55. To complete this evidence, I enclose extracts from the 1945 Cohen Report16 (Lord Cohen) to The Secretary of State (Hugh Dalton MP) on Company Law Reform which states the function of a balance sheet, and recommends true and fair view as the legal standard for company accounts. That then became the 1947 Companies (Amendment) Act.

“Function of balance sheet.—As stated in the evidence of the Institute of Chartered Accountants, ‘the function of a balance sheet may be stated briefly to be an endeavour to show the share capital, reserves (distinguishing those which are available for distribution as dividends from those not regarded as so available) and liabilities of a company at the date as at which it is prepared, and the manner in which the total moneys representing them are distributed over the several types of assets.”

56. Para 105 then recommends true and fair view as the standard that then went into the 1947 Act.

“Section I24(i) [Companies Act 1929] be amended so as to provide that the balance sheet shall give a true and fair view of the state of affairs of the company; that for this purpose it shall classify under headings appropriate to the business of the company the share capital, reserves, provisions, liabilities and asset of the company, shall distinguish between the amounts respectively of the fixed and of the current assets and shall state how the amounts at which the fixed assets are stated have been arrived at.”

57. The Cohen Report in defining the function of accounts for which the true and fair view standard is for, explicitly rejected the model that the IASB has in fact followed (valuing, and especially overvaluing things). What the Cohen report described as unwise is precisely what can cause a bank that overvaluing its assets to collapse, due to it not being a going concern.

“Moreover, if a balance sheet were to attempt to show the net worth of the undertaking, the fixed assets would require to be re-valued at frequent intervals and the information thus given would be deceptive since the value of such assets while the company is a going concern will in most cases have no relation to their value if the undertaking falls”.

The governance of the FRC from 2002 ceased to involve the Bank of England

58. It is interesting to note that when the FRC was established in the early 1990s the Chairman was a joint appointment of the Governor of the Bank of England and the Secretary of State for Trade and Industry (responsible for Company Law and thus all company accounts including banking companies). Rather than merely being a “great and good” figurehead for the organisation the appointment was someone who was also accomplished in the subject matter. The first Chairman was Sir Ron Dearing, the second Sir Sydney Lipworth.

59. In 2002 that arrangement was changed. Since 2002 the Bank of England ceased to appoint the Chair of the Financial Reporting Council. On the retirement of Sir Sydney Lipworth in 2002, the FRC has had DTI (now BIS) appointed Chairs with less obvious expertise in banking or accountancy. Given the intense vested interests at play, that was not wise in my view. The Bank as well as being a contingent creditor of banks also had the sharp eye of a potential plaintiff.

60. The problem of the FRC setting and approving faulty accounting standards was then compounded by the FRC ceasing to appoint QC’s as chairs of the Financial Reporting Review Panel, which has a statutory role in assessing accounts for compliance with the law. The FRRP Chairman had been Sir Richard Sykes QC (Erskine Chambers, the leading Chambers in true and fair view and capital maintenance, the same chambers as Martin Moore QC).

61. Following the retirement of Sir Richard Sykes QC as FRRP chairman, the FRRP was no longer chaired by a QC with expertise in accountancy law. The FRRP is now set on a course of assessing accounts for compliance with standards. That was peculiar as Sir Richard Sykes’ tenure had found instances where compliance with ASB standards was the cause of the problem with the accounts (Liberty International plc). Essentially Sir Richard Sykes was not only finding faults with companies’ accounts, but also with the outputs of the ASB. The Liberty case involved FRS 10, an ASB copy of the then international standard.

62. Given that banks’ accounts, in following IFRS, may not give a true and fair view, such a compliance led approach has in my view been a strategic error by the FRC.

63. I attach to this evidence a letter from the Accounting Standards Board Chairman in 2005, which is unequivocal that IFRS does not match with company law (Appendix 3E, para 10 and 11). A later meeting in February confirms this (Appendix 3F, page 3). The accounting framework has diverged from the law. Unfortunately what the Chairman does not flag in either the meeting or the letter is that the matter is not trifling, the problem could mask the insolvency of a banking company.

64. Given that “following standards” (rather than delivering according to the spirit of the law) is an auditor defence. I can only conclude that whether by accident or design, that as soon as the Bank of England ceased having a role in FRC governance, the FRC then followed a compliance-with-standards model, that may have suited the defence model of particular accounting firms. That model proves fatal if, as has occurred, the standards themselves become faulty. That is a recipe for a “garbage in garbage out” model of reporting and auditing that upsets normal governance, oversight and investment processes.

Conclusions

65. My ultimate conclusion is that banks will not be stabilised until IFRS fully complies with the existing law which was eminently sensible and had worked. It had in fact been a global standard, other than in the USA, prior to the introduction of IFRS in 2005. The true and fair view model not only applied in the EU, but numerous current and former UK territories.

66. In the meantime section 395(1)(b) Companies Act 2006, which gives the option to use IFRS for companies, including for banking companies, should be repealed. A Bill enabling this (the Bill of Steve Baker MP17) was tabled in the 201011 session.

67. The UK has the highest % of assets to GDP faultily accounted for than any other nation (due to the size of the banking sector, and the total dependence on IFRS). The problem is too large for those parties that have made mistakes to own up to. Consideration should be given to a moratorium for liability for auditors of banks which used IFRS as the accounting framework. The complexity of negligence and potential negligence, of auditors and standard setters, does not create the right environment to move forwards.

68. Parliament should approach Martin Moore QC directly in order to talk through his opinion independently of any spin that the FRC (or BIS officials) might have chosen to put on it.

69. Standard setters and relevant regulators should be held to account. Clear breaches of law were knowingly made over an extended period of time, thence causing other parties (directors and auditors) to fail to discharge their statutory duties. There is no more fundamental a statutory duty than demonstrating solvency. The impact was not merely banks getting into difficulty (false accounting before the insolvency event) but the tax payer bailout funding not being value for money either (the problem with false accounting after the insolvency event).

70. There are significant problems in RBS and conflicts of interest that the accounting is inextricably linked with. The governments’ “B Shares” convert, wiping out the free float minority interest (shareholders other than the government), in the event that the Basle ratio falls below 5%. The Basle ratio is based on IFRS numbers.

71. Given that management have an interest in existing shares, and hence an interest in not being wiped out on conversion, there would appear to be a direct incentive to affect both the numerator and the denominator in the capital ratio. The capital ratio is:-

IFRS based capital/risk weighted assets = capital ratio

72. There are therefore two basic ways of boosting the capital ratio:-

to overstate capital (overstate assets and understate losses in the accounts); and

not extend lending, ie preserve the Basle ratio by not growing the asset base.

See also Appendix 2 for problems with RBS accounting per press articles.

73. The RBS IFRS accounting problems in particular seems to be prejudicial to the wider economy. There are structural reasons as to why Project Merlin is not working if there are accounting, and remuneration incentives not to lend.

74. IFRS is also incentivising RBS not to de-gear/close out existing risk positions where it knows it will make a loss on close-out (IFRS only requires booking that loss on actual close out, not on the expectation of a loss). The implications of that must be that the benefit to the capital ratio of de-risking (the reduction in the risk weighted assets, the denominator) would be more than offset by the losses that would be taken on closing out the risk positions (reducing the numerator).

75. A rational shareholder (as does UK GAAP) would recognise that there is an economic loss to the shareholders of RBS. The accounting is not booking losses, and hence the capital ratio is not reflecting them. In my opinion, the problems with RBS are deserving of special Parliamentary attention, over and above the conclusions I have given in para’s 65–69 above.

21 August 2012

1 Further details provided in Appendix 1 (not printed).

2 EAC “Auditors Market Concentration and their Role” Evidence session, Q87, 26 October 2010.

3 EAC, “Auditors Market Concentration and their Role” – Conclusions, para 132.

4 Comments by Stephen Hester in February 2012. See Appendix 2.

5 The Sharman Report – Going Concern. FRC – 2012.

6 Appendix 3A

7 Speech of FSA Chairman http://www.fsa.gov.uk/library/communication/speeches/2006/0213_cm.shtml

8 ICAEW Evidence to Treasury Select Committee, 10 April 2002. http://www.publications.parliament.uk/pa/cm200102/cmselect/cmtreasy/758/2041005.htm

9 See IAS Regulation 2002, setting out the true and fair view Principle, ICAEW TECH 1982.

10 Opinion on True and Fair View and the structure of the law, Martin Moore QC for the FRC 2008

11 Appendix 3D

12 ECJ Case C-234/94,1996 “Tomberger”.

13 ECJ case C-275-97, 1999, “DE + ES Bauunternehmung”.

14 Appendix 3B

15 Appendix 3C

16 See Cohen Report to the SoS 1945, then enacted as the 1947 Companies Act Sections 147-149.

17 Financial Service Regulation of Derivatives Bill http://services.parliament.uk/bills/2010-11/financialservicesregulationofderivatives.html

Prepared 19th June 2013