Banking StandardsWritten evidence from the Financial Reporting Council

The Chairman of the Financial Reporting Council (FRC), Baroness Hogg, gave evidence to the Commission on 8 November 2012. Subsequently the Commission1 has requested that FRC responds to the additional specific questions dealt with below.

The Commission has also now established a sub-committee to address accounting, audit and taxation. We have been told by Commission staff that we should expect further calls for evidence on these areas, and expect to submit further written and oral evidence to that sub-committee, which is likely to expand and amplify the points made below.

While financial reporting should be useful to a range of stakeholders, its core purpose is to communicate with investors on the stewardship and prospects of the company. We are concerned that insufficient attention is currently focussed on the needs of investors as the primary users of financial statements, and therefore on their readiness to provide risk capital. In addressing the financial reporting and audit frameworks for banks, we suggest, the sub-committee has a particular opportunity to contribute to re-establishing the investibility of banks.

Financial statements presented by systemically important listed banks are based on International Financial Reporting Standards (IFRS) which are issued by the International Accounting Standards board (IASB), and endorsed for use in the European Union by the EU Accounting Regulatory Committee. The main role the FRC plays in this area is to seek to influence the IASB throughout the standard-setting process, and to influence European authorities when the IASB’s standards come forward for endorsement.

We are stressing to the IASB the need to make timely improvements, and to ensure that it re-assesses those decisions, taken in pursuit of US convergence, which in our view do not support a culture of long-term investment. And where the IASB has agreed improvements to accounting standards that we consider important, we have been seeking to secure timely adoption by the European Union.

Meanwhile, the FRC can mandate changes or issue persuasive guidance in a number of areas of interest to the Parliamentary Commission. These include: enhancing the narrative reporting and disclosure provided by companies; enhancing and changing the governance requirements applicable to listed companies (including banks); making changes to guidance on directors’ responsibilities; and enhancing audit requirements. We can also seek to drive improvements in these areas through our conduct-related activities: specifically, by our reviews of corporate reporting and audit quality, or by taking disciplinary action with respect to the audit firms or professions within our remit.

We have already taken a number of important steps (detailed below) designed to enhance disclosure. It is not, however, the case that more is always better; we are concerned to avoid reporting overload at the behest of competing regulators. Our actions have been driven by the principles of accountability to investors. Although there is likely to be significant overlap between the investors’ needs and those of financial regulators, they do not always coincide. But since financial regulators can and do make extensive use of rights to ask for additional information, which can be reported privately or publically outside of the financial statements, we believe that further disclosure requirements should be added to banks’ accounts only if and where they demonstrably meet the needs of investors.

We are happy to enlarge on the answers given below to the Commission’s questions, should the sub-committee (or of course the Commission) require further detail.

Q—What are the problems with IFRS? What is being done to solve them?

The background to IFRS

Globally recognised accounting standards help investors to compare companies in different countries. A common reporting language is therefore seen as conducive to global economic growth and financial stability. Hence the call from the G20, amongst others, for both further development of IFRS and their more widespread adoption. The IFRS Foundation recently published a review of the arrangements and evidence as to their effect, most importantly perhaps on the cost of capital.2

The EU has mandated the use of IFRS for listed groups as the only practical way of achieving reporting comparability across Europe. In 2002 a regulation was passed requiring EU listed groups to prepare their financial statements following IFRS, as “adopted” in the EU, from 2005. The regulation requires the European Commission to endorse each IFRS for application; no additions or amendments can be made to the IFRS, but deletions, or “carve-outs”, are permitted. The adoption process has not proved easy and recent changes made by the IASB in response to the financial crisis remain to be adopted in part because the European Commission is waiting for all changes to be completed. We and others are pressing the European Commission to reconsider this policy, and move ahead faster.

The IASB has struggled to meet three sometimes conflicting aspirations: for standards that are timely, high-quality, and of the widest possible geographical application. These requirements have not always proved compatible. The aspiration for global reach drove the IASB to seek “convergence” between IFRS and US Generally Accepted Accounting Practices (US GAAP)—the standards used in the largest capital market in the world. As the Financial Stability Board (FSB) noted in its report to the G20 Finance ministers at the end of October 2012,3 considerable progress towards convergence has been made.

However, the pursuit of convergence has, in some instances, conflicted with the other objectives of timeliness and quality. Timeliness is inevitably affected by a wider search for compromise; quality may be differently perceived in the US, with its different corporate and legal history. (At the FRC, we would define quality standards as those which are principles-based, evidence-based and pragmatic.) We and many others have therefore for some time been pressing the IASB to emphasise quality over convergence. We are therefore glad to note that the IASB has said that—once the current convergence projects with FASB are concluded—convergence will no longer be a short-term priority.

The IASB has said that it recognises the need to make timely improvements in the case of financial instrument accounting in particular, and exposure drafts on key aspects are expected shortly (see more detail below for standard-specific problems). The IASB and the US Financial Accounting Standards Board (FASB) have agreed to continue to liaise, but to reach their own independent decisions.

The conceptual framework

Some of the criticisms that are made of the reporting by banks pertain to the principles set out in the IASB’s conceptual framework for its own work in standard-setting, of which initial—and, on some issues, controversial—revised chapters were published in 2010. We are concerned that, even though the IASB is now working without the constraint of seeking agreement with the FASB, it does not wish to re-open these issues. Areas of particular concern to us are:

(a)The lack of emphasis on prudence and reliability in standard-setting principles. Instead, the IASB has emphasised the need for “faithful representation”. The IASB Chairman recently defended the omission of prudence from the principles in the framework, preferring the concept of neutrality and citing the need to converge with US GAAP. He did, however, qualify this by arguing that “prudence” remains intact and visible throughout basic elements of IFRS. While we accept many such elements remain (and we are also alive to the risk that results may be distorted by excessive caution) we would urge the need for some re-emphasis of prudence and less emphasis on neutrality.

(b)The lack of a primary principle articulating the importance of stewardship, or accountability, which we believe would help focus standard-setting on the needs of investors. Stewardship is accorded only a subsidiary role in the initial chapters. There should be a clearly stated objective for financial reporting to provide investors with information on how the board of the group has exercised its stewardship of the business.

The IASB expects to issue the remaining chapters of its conceptual framework for discussion in June 2013. We will be encouraging the IASB to set principles to ensure sufficient weight is given to the need to give a clear view of the performance of the business over the year rather than focussing on the end-year position. At the same time we think the IASB should develop principles designed to ensure that any narrative disclosures required are useful to the investor and do not overload the report.

Standard-specific problems

IFRS are not industry-specific, but are frequently instrument or transaction-specific. Standards for financial instruments are clearly of great significance in banks’ accounts and have long caused controversy. Indeed, some of the features of IFRS that have attracted much concern since the financial crisis were only introduced in response to concerns that arose with the Enron scandal. These changes included the extension of “fair value” accounting, together with restrictions on off-balance sheet accounting and general provisioning. While it would not be sensible simply to reverse these changes, there are valid criticisms to be made of current standards for financial instruments.

The role of fair value in accounting

An important criticism levelled against “fair value” accounting (required for certain financial instruments under IFRS) is that it generates unrealised profits, which are relied on to support borrowing and/or justify dividends and bonuses. When markets fall, such actions may be revealed to be unsupportable or unsustainable.

“Fair value” is not a new concept. It has been permitted in the UK since the Companies Act 1948, when it was introduced to assist companies to fund post-war reconstruction by borrowing against re-valued property assets.4

In some instances it clearly remains the most appropriate basis for valuation. For example, the historic cost of a derivative, often zero, is completely irrelevant to its current value. Equally, in other instances historic cost is more appropriate, for example where the asset is held to maturity. In some instances fair value is positively unhelpful, for example in the case of own debt.

The post-Enron financial instrument standard did not give sufficient clarity as to which measurement basis should be used in which circumstances. The IASB is working to ensure that there are clearer principles as to when fair value is appropriate for accounting and when other bases should apply.

Moreover, even when fair value may be the most appropriate basis of accounting, we believe more should be done to ensure financial reporting makes clear that reported performance is measured using values which fluctuate with market movements.

Within the scope of IFRS 9, the IASB is seeking further to amend and simplify the classification and measurement of financial instruments held at fair value, as well as addressing hedge accounting requirements. Exposure drafts of the IASB’s proposals are due out early in 2013. However (as noted above) unless the EU accelerates its endorsement process, it could be a number of years before adoption.

The “incurred loss” impairment model

We share the view that the current impairment model, whereby losses may only be accounted for once they have occurred, does not properly allow for economic risk and led to provisions being made unsatisfactorily late. We would not favour a return to general provisioning, which is highly open to the manipulation of results, but have urged the IASB to move ahead rapidly towards the development of “expected loss” standards. While this would oblige companies to take a more forward-looking approach, of greater relevance to their investors, it must of course be noted that the results of such an approach can only be as good as the foresight of those making the “expected loss” judgements.

The use of fair value gains to support dividends

Some have raised concerns that fair value accounting led to dividends being paid out of “paper profits” which vanished with falls in the market. However, the Companies Act 2006 (s830), which imposes its own tests, allows such distributions to be made from realised profits only. The real issue of concern here is that this test does permit dividends to be paid out of profits that have subsequently been invested in illiquid assets. The FRC has long been pressing for a fundamental review of the capital maintenance regime (which is determined at the EU level). A solvency-based test for distributions would, we have argued, provide a better form of risk management.

Criticisms have also been made of the link between volatile unrealised profits and bonuses. While the setting of bonus targets is a matter for directors, an approach to reporting that highlighted the unrealised element of profits might also act as a check on bonus distributions, and we are working with the Bank of England to pursue this approach.

Q—Stephen Haddrill recently questioned (in his speech to the E&Y conference on 5 November) whether banks should have separate accounting standards. What are your views on this proposal and what areas should any change in accounting standards focus on? In seeking to change accounting standards for banks, what is the desired outcome? Is it possible to achieve this more simply?

Stephen Haddrill was raising an open question—“Are banks different?”—rather than announcing a concluded view. The FRC has facilitated discussion on this question, and its implications for a number of issues ranging from accounting standards to reporting requirements and governance.

In principle, we do not favour separate accounting standards for banks. It is difficult to ring fence the banking sector. Conducting banking activities is not the sole preserve of traditional banks; others involved include the shadow banking sector, insurance companies (and companies whose primary business is in an entirely different sector). Moreover many companies use financial instruments which are identical to those used by banks, so that attempt could lead to different accounting for similar financial instruments. A better solution is to improve accounting standards for these instruments wherever they are being used.

However, where banks may be different is in the need to improve the flow of relevant information to their investors, thus enhancing their understanding of banks’ performance and hence willingness to invest. This can, of course, be achieved through mechanisms other than accounting standards.

A key area of concern has been the “going concern” process. The FRC asked Lord Sharman to review the guidance to directors on going concern, liquidity and solvency. Certain of his recommendations, on which we will shortly consult, are specifically relevant to banks. The extra disclosures he proposes are narrative in form, and require greater analysis of risks to going concern over a longer period than required by accounting standards. We believe this should encourage a longer-term focus on solvency and liquidity.

We also gave evidence to the Financial Stability Board’s Enhanced Disclosure Taskforce (which included 10 investor groups) as to improvements that could be made in the context of a disclosure framework that provides better and more relevant information for banks’ investors.

Q—What does a “true and fair view” really represent to the market? Is it delivering what it is meant to? How far do you think the FRC’s proposals on disclosure go in terms of bridging the information gap between a bank and its stakeholders, and to what extent will this help present a “true and fair view”?

As we sought to clarify in the FRC’s July 2011 paper, “True and Fair”,5 this concept is not something that should be seen as a separate add-on to accounting standards but as their essence. So, in the vast majority of cases, compliance with accounting standards should result in a true and fair view. Disagreement with a particular standard does not, on its own, provide grounds for departing from it. And, in the past, under UK GAAP, almost all true and fair overrides were of law rather than of a standard.

There are instances, as discussed above, where accounting standards clearly address an issue, but the answer does not seem to accord with common sense. Fuller disclosure can be used to address exceptional examples of this, and indeed has been used to deal with more general issues that arise with standards. For example, many companies have added information on—for example—the effect of stripping out fair value movements on their own debt, an IFRS issue referred to above.

However, it remains the case, clearly stated under IFRS (under IAS 1) that where directors and auditors do not believe that following a particular accounting policy will give a true and fair view they are legally required to adopt a more appropriate policy, even if this requires a departure from the standard. These circumstances are more likely to arise where the precise circumstances are not covered by a relevant standard.

Q—The Sharman Report suggested (paragraph 209) that there might be a need for a more prudent approach to the assessment of asset values in banks. Do you consider there is a need for this and if so, what are your views on how this “more prudent approach” should work?

The FRC will consult shortly on the Sharman recommendations, including:

(a)a focus on both solvency and liquidity risks to going concern;

(b)“the need for a more prudent approach to the assessment of asset values than the normal accounting basis in assessing solvency risks” (and a particularly prudent approach to the assessment of bank solvency); and

(c)the introduction of stress tests in relation to both solvency and liquidity risks, undertaken with an appropriate degree of prudence.

The Panel’s recommendation is very different from simply changing the accounting standards to reintroduce greater prudence in the measurement and recognition of assets and liabilities. However (as noted above) we do believe there should be a greater emphasis on prudence in the IASB’s conceptual framework.

Q—Should the audit framework be enhanced so that auditors can better express views on governance and banking standards? If so, what changes are required?

Since the financial crisis, the FRC has taken several steps to improve the audit framework, and audit reporting.

The initiatives that have been, or that will shortly have been, implemented that are most pertinent to this question include:

The extension of the scope of FRC’s audit quality work to cover all bank and building society audits, and the inclusion of an overview of the findings from inspections of bank audits in the FRC’s annual report;

Changes in connection with the Sharman Review recommendations;

Changes in the Corporate Governance Code, issued at the end of September; and

Regular meetings with the FSA to share information on audit quality.

The FRC is responsible for reviewing audits on a regular basis. The findings of our reviews indicate that improvements still need to be made to improve audit quality, but we hope that the steps we have taken will help to stimulate such improvements.

We are proposing further changes to the framework to implement Lord Sharman’s recommendations (discussed above), notably a requirement on auditors to report if the directors’ going concern assessment is inconsistent with the auditors’ knowledge of the business.

A number of initiatives (further described below) have been, or will shortly have been, implemented for companies that apply the UK Corporate Governance Code. These initiatives have been developed to enhance the auditor’s ability to express views about such matters to the Audit Committee and to ensure, if they believe it is appropriate, that those views are disclosed (either in the annual report or in their auditor’s report).

We believe these changes now need to be given time to take effect before we can assess their impact on the effect of the audit process.

It should however be noted that these initiatives apply to listed UK banks. It is for the FSA to determine whether and to what extent these requirements should be applied to other UK banks.

Moreover, these initiatives are based on the current scope of the audit, which is primarily directed towards obtaining assurance that the financial statements are free from material misstatements, whether due to fraud or error. So we will continue to analyse public policy concerns arising from the crisis, to assess whether any more fundamental changes are needed to align the auditor’s role with public expectations. In doing so, we will consider whether such changes should be implemented through auditing standards or would require regulatory or legislative changes.

The Corporate Governance Code

In the 2010 version of the UK Corporate Governance Code (the Code), we introduced the proposition that the company’s business model should be explained and that the company’s board should be responsible for determining the nature and extent of the significant risks it was willing to take.

In the 2012 version boards are requested to confirm that the annual report and accounts taken as a whole are fair, balanced and understandable. This version also calls on boards to include in the annual report a separate section describing the work of the audit committee, including a description of the significant issues the audit committee considered in relation to the financial statements, and how they were addressed. In developing these disclosures, the audit committee is expected to have regard to the matters communicated to it by the auditor.

Changes to the Auditing Standards support these changes to the Code, by expanding the nature and extent of the communications to be provided by auditors to Audit Committees. These changes are intended to refocus the auditor on providing the committee with the insights about the company arising from the audit.

The Auditing Standards have also been revised to require auditors to report if they believe that the board’s statement that the annual report is fair, balanced and understandable is inconsistent with the knowledge acquired by the auditor in the course of performing the audit, and to include any information communicated by the auditor to the audit committee, that has not been, but in the auditor’s judgement should have been, disclosed by the board in the annual report.

These are significant changes that the FRC hopes will stimulate better disclosures by companies (including banks) through the constructive tension that results from giving auditors the responsibility to report publicly if they are not satisfied that the directors have fully met their reporting responsibilities. An important feature of this approach is, in our view, that the directors’ primary responsibility for reporting is not undermined unless they do not fulfil their responsibilities. This also provides the auditor with a much more proportionate and credible sanction than the nuclear option of qualifying the audit report.

Q—What are your views on the current level of dialogue between bank auditors and supervisors on banking standards and organisational culture? Do you think there is a need for a “safe environment” in which auditors and regulatory authorities can share confidential information and concerns?

We believe that this question would be most appropriately directed towards the FSA since they have actual experience of the dialogue between bank auditors and supervisors. However, our impressions are that the levels of such dialogue have improved. We are not able to comment on the extent to which that dialogue addresses banking standards and organisational culture. However, we do consider that the Code of Practice for auditors and supervisors appropriately addresses the need for such dialogue.

This Code was developed in response to concerns expressed in the joint discussion paper that we issued in 2010 with the FSA to consult on the issues that we each observed from our work with auditors and to determine how to enhance the contribution of auditors to prudential regulation in the future. The Code of Practice was developed by the FSA with our input, alongside the Bank of England, to enhance dialogue between auditors and supervisors.

The Financial Services and Markets Bill already includes arrangements that should enable auditors to share confidential information and concerns with the supervisory authorities. Auditors of a UK bank will have both a right and a duty to disclose matters relevant to the functions of the FSA, and protection where they do so in good faith.

The FRC’s Audit Practice Note 19, which provides guidance to auditors on areas identified by the FSA where particularly close consideration should be given as to whether the duty to report arises.

29 November 2012

1 Through various emails from Commission staff


3 The full report can be obtained from the FSB website here

4 The UK is currently seeking to ensure that the ability to revalue is retained in the Accounts Directive governing UK GAAP. Businesses and banks have told us that it remains important to facilitate lending and support growth.

5 The FRC paper “True and Fair” can be obtained from the FRC’s website here

Prepared 19th June 2013