Supplementary memorandum by Professor
Stella Fearnley, Professor Vivien Beattie and Tony Hines (ADT
RE: EVIDENCE GIVEN AT THE HEARING ON 25.01.2011
At the committee's request we have reviewed
the evidence relating to questions 540-547 given by Mark Hoban
MP (MH), Ed Davey MP (ED) and Richard Carter (RC). The following
issues were referred, to and we comment on each in turn based
on our own research and also on publicly available sources.
1. Whether, since the introduction of IFRS in
the UK for 2005 year ends, accounting and auditing has become
more rules based than principles based;
2. Accounting measures economic value much more
than historical cost;
3. IAS 39 the financial instruments standard
is under revision;
4. The only IFRS standard which is significantly
different from UK GAAP is IAS 39;
5. Accounts are not a substitute for prudential
6. Asking auditors to change their traditional
binary approach (to reporting) would create a lot of difficulties;
7. The losses sustained by the banks were greater
than the bonuses and dividends paid out;
8. The position of the principle of prudence
1. WHETHER, SINCE
OF IFRS IN
THE UK FOR
2005 YEAR ENDS,
There is a difference of opinion between MH
and ED on this matter. Our research with finance directors, audit
committee chairs and audit partners of UK listed companies finds
that these three preparer groups believe that accounting has become
more rules based and auditing is more process driven then under
UK GAAP and UK auditing standards. We attach chapter 14 of our
forthcoming book which the Committee may find helpful.
This statement by MH does not reflect what IAS
39 actually delivered in the crisis, as the economic value of
the loans and financial instruments was grossly overstated. Therefore
the accounting model, as applied in the crisis, could not be relied
on to deliver economic value as it did not distinguish in all
cases between price and value. It failed.
3. IAS 39 THE
This revision was referred to by all three witnesses.
However we have two major concerns about the need for revision.
First, the IASB has set itself up as a body fit to set accounting
standards for the whole world and yet, within two years of its
standards being adopted in the UK and the rest of the EU, the
banking sector, which is at the heart of a capitalist society,
was reporting grossly inflated profits in compliance with this
new regime. Second, because of the convoluted process of agreeing
change, which is inevitable with a body which purports to serve
the world, it will be some years before IAS 39 is changed and
adopted by the financial sector. This time delay was referred
to by Steve Cooper, an IASB board member, in his evidence to the
Committee on 18 January 2011. Some minor changes have already
been made to IAS 39 but profits could continue to be misrepresented
until all the changes are agreed and introduced.
Our view is that the IASB cannot be trusted
to deliver high quality standards.
4. THE ONLY
IFRS STANDARD WHICH
UK GAAP IS IAS 39
Our research indicates that IFRS differed from
UK GAAP much more widely in 2007-8 that ED suggests eg accounting
for: intangible assets and goodwill; employee benefits; share
based payments; deferred tax and segmental reporting. All of these
topics were the subject of criticism from preparers. Also there
was wide criticism of the complexity of the standards and length
of disclosures required. Concerns were expressed that non-accountant
board members had difficulty understanding their company's accounts
after the change to IFRS. The UK Accounting Standards Board has
been changing UK GAAP to IFRS but originally major differences
existed between the two.
5. ACCOUNTS ARE
We find this comment by MH disturbing. This
is a view included in the IASB's latest conceptual framework for
the preparation of financial statements (IASB, 2010). This framework
now claims that:
"the objectives of general purpose financial
reporting and the objectives of financial regulation may not be
consistent, hence regulators are not considered a primary user
and general purpose financial reports are not directed to regulators
and other parties. " [F OB10 and F BC.1.20-BC 1.23].
We are concerned that this statement implies
that accounting information as mandated by the IASB is not for
regulators. If accounts are claimed to be general purpose this
makes no sense as the objectives of other users may also differ.
We do not understand where regulators get their information from
if it is not based on the audited accounts. Protection of capital
is a primary issue for shareholders, regulators and other users
Our view is that it is an attempt by the standard
setters to deny their responsibility to regulators and to make
their framework fit with what they are currently doing and wish
to do going forward.
6. ASKING AUDITORS
We do not support this comment by ED. He does
not explain what sort for difficulties would be encountered and
it would be helpful to know. We can see no reason why the auditors
should not provide more information about the quality of earnings.
The more responsibility is passed on to the audit committee, the
less valuable audit becomes. It should be borne in mind that although
audit committees are usually composed of independent directors,
they are still directors of a company under the UK unitary board
model, thus they are not independent to the same extent as auditors
are required to be.
Our view is that auditors do not wish to change
their audit report and prefer further responsibility to be passed
on to the audit committee, probably because of liability concerns.
The audit committee, although making a valuable contribution to
the integrity of financial reporting is not a substitute for the
auditor. Auditing requirements are not subject to an EU regulation
and could change under UK law and regulation.
7. THE LOSSES
RC made this point. Our view is that it would
have been even more disturbing if the banks had paid out all their
false profits in bonuses and dividends and added nothing to reserves.
This comment does nothing to mitigate the effect of imprudent
8. THE POSITION
There is some confusion about this issue. RC
and ED refer to prudence. RD refers to the IFRS standards and
ED refers to the IFRS Framework. These are different documents.
The IAS Framework (for the preparation and presentation of financial
statements (2001) which is currently applicable is subordinate
to the standards themselves. Para 3 states that if there is a
conflict between a standard and the Framework, the requirements
of the standard prevail. The 2001 Framework sets out primary qualitative
characteristics of financial statements and includes prudence
as part of the qualitative characteristic of reliability. Other
principal characteristics are: understandability; relevance; and
Prudence is defined as:
Assets or income are not overstated and liabilities
or expenses are not understated.
A caveat continues:
"The exercise of prudence does not allow,
for example, the creation of hidden reserves or excessive provisions,
the deliberate understatement of assets or income or the deliberate
overstatement of liabilities or expenses, and therefore, the financial
statements would not be neutral and therefore not have the quality
of reliability. " (para 37)
The other characteristics of reliability in
the 2001 Framework are: faithful representation; substance over
form; neutrality and completeness. IAS 39 as a standard would
override prudence. Our view is that the prevention of hidden reserves
or excessive provisions and the overstatement of liabilities or
expenses is a matter for auditors not standard setters. Even if
there was what is often referred to as "earnings management"
in the banks, this would be preferable to the imprudent outcome
of IAS 39.
The Committee may also wish to note that the
IASB Framework has recently been revised (IASB, 2010) and both
prudence and reliability are no longer in the Framework. The current
primary characteristics are: relevance; faithful representation
(with a subordinate quality of neutrality); comparability; verifiability;
timeliness; and understandability.
Our view is that leaving prudence and reliability
completely out of the current Framework takes away some the judgements
that auditors may face and denies the principle of substance over
form for shareholders and regulators. Faithful representation
and verifiability are much easier to check. The new IASB framework
is now the same as the US Framework and therefore is subject to
greater influence relating to litigation defence. This again undermines
the value of audit.
We hope these comments are helpful for the Committee.
3 February 2011