Supplementary letter from Mr Timothy Bush
I have pleasure in submitting written evidence
to the Committee supplementing that I submitted on 4 August 2010.
I was the chair of the Institute of Chartered
Accountants in England and Wales' (ICAEW) Competition and Choice
working group set up under the then Department of Trade and Industry,
which then evolved into the Financial Reporting Council's (FRC)
project on the same issue. I am a past member of the Governing
Council of the ICAEW and an investor, an FSA registered fund manager.
I am the Investment Management Association nominated representative
on the Urgent Issues Task Force of the Accounting Standards Board
(ASB). I have analysed banks in particular since 2006.
The supplementary evidence covers:
a memoranda relating to a standard setting committee
to be held on 29th September 2010.
(3) a maths based summary of what is not
audited with IFRS (for a bankits prime risk in fact).
1. IFRS is imprudent (not allowing
loan risk sensitive bad debt provisionsIAS 39).
2. The EU only required IFRS for the consolidated
accounts of listed groups. Most EU states did not use IFRS in
banking companies (ie banking companies used pre-IFRS prudent
3. Ireland and the UK (and Iceland, which
is an EU affiliated EEA state) allowed IFRS for use in banking
companies. This may result in significant problems in banking
companies, by affecting capital, profits and behaviour:
(i) understating risk by overstating loan values,
(ii) understating the cost of lending, leading
to risk mispricing and hidden capital destruction,
(iii) creating artificial (temporary) profits,
and pay and bonuses,
(iv) even deferring losses when they do arise
(by not classifying escalating payment rollovers as impaired debt),
(v) overstating capital at the same time as hiding
the ongoing destruction of it (frustrating whatever level of capital
Basle I and II sets).
(Applying IFRS at only group level, where banking
companies still produce proper prudent accounts, does not affect
banking company margins, behaviour or capital, it may have a relatively
minor impact on bonuses to the extent that these are based on
4. The most systemic (non-investment) banking
failures in the EU/EEA have been in the UK, Ireland and Iceland,
those states where IFRS was used as the accounting system for
banking companies. The USA used a similar model.
Northern Rock, HBOS, Bradford & Bingley,
London Scottish Bank, Cattles plc (a non-bank), Allied Irish,
Anglo Irish and Bank of Ireland, all collapsed, with similar symptoms,
lower provisioning levels with seemingly higher (temporary) profitability.
As did Landsbanki, Glitnir and Kaupthing.
5. IFRS were first used from 2005, from
which point there is a distinct increase in the inflation of house
prices in the UK and Ireland (source HM Land Registry UK, Ireland
Financial Times, September 2010). Seemingly profitable banks (due
to an accounting illusion) were attracting more and more credit
to lend, and appearing to generate capital, increasing the capacity
to lend, a Ponzi/pyramid effect.
6. However, the law in the UK and Ireland
goes further than IFRS requires. Company Law requires accounts
reliable for the purpose of creditor (and depositor protection).
Some banks appear to have applied the law fully rather than IFRS-only,
and not got into the same difficulty (or "fools paradise").
7. Northern Rock used IFRS from 2004 (a
year early, it failed approximately a year earlier than other
banks, suggesting an unchecked (IFRS driven) "burn"
time of 3 and a half to 3 and three quarter years).
8. There appears to have been inconsistent
application of the law within the UK (not Ireland where essentially
every bank failed). A mitigating factor in the UK may be the presence
of ICAEW (Institute of Chartered Accountants in England and Wales)
guidance on mitigating the effects of IFRS, published 2003).
9. This paper for the UITF, to minute, will
form a proposal be taken to the full Accounting Standards Board
for 12 October 2010.
28 September 2010
UITF (URGENT ISSUES
MINUTE, 29 SEPTEMBER
Company law individual accounts and IAS (IFRS)
1.1 ICAEW/ICAS guidance on the law, under
states that prudence applies as a fundamental valuation
for companies individual accounts, whether their accounts are
Companies Act accounts or IAS Accounts.
1.2 The law post-IFRS is intact in the statute
(and common law). The main relevant change to the Companies Act,
for IAS individual accounts, was to require that the use of IAS
accounts was stated in a note to the accounts. The preparation
rules ("form and content"for large and medium
sized companies including banking and insurance companies) remained
as Schedule IV to the Act. These rules include the fundamental
valuation principles from the 4th Directive which includes prudence
in valuing assets and liabilities.
1.3 The ICAEW guidance states that compliance
with the Companies Act for the purposes of section 837(2) (capital
maintenance and distributions) requires complying with the fundamental
principles, notwithstanding IFRS requiring otherwise. Prudence
may be overridden for accounts to give a true and fair view, but,
prudence is still a matter for compliance with the Act. Hence,
prudence must be applied in valuations and then the numerical
impact of dis-applying it disclosed in the accounts so that the
directors discharge their duties under Section 837(2) and prepare
accounts properly. The audit opinion post-IFRS remained "two
part", and required a true and fair view in accordance with
IAS (or Companies Act accounts) and compliance with the Companies
1.4 However, the Financial Services Authority
and Financial Reporting Council in a Discussion Paper (DP 10/3),
dated June 2010, in observing valuation practice in some banks'
accounts states that "UK GAAP" (ie Companies Act accounts
with FRS 26) does not require prudence.
That statement it incorrect if it relates to company individual
accounts. It does not accord with the ICAEW advice, indeed were
it correct the UK would be in breach of the 4th Directive. The
DP also states the same in the context of IAS accounts (using
IAS 39), if that is in the context of individual company accounts,
then again, that statement is inconsistent with company law.
1.5 There is a problem with FRS 26 which
needs to be corrected with guidance for IAS 39. It would appear
from the scale and frequency of bank failures in the UK and Ireland
that risk has gone unaddressed in banking companies using FRS
Capital, and profits, the problem when IFRS is
used in companies especially banks
Basic position (compliance with the accounting
rules of Company LawIVth Schedule)
If a company is Net Assets N, Capital, C,
and distributable profits D.
then, N = C + D, (ie the balance sheet).
if D is paid as a dividend, then the position
is (N - D) = C
Given that D is cash or borrowings, what remains
as capital (residual net assets less cash, or with more gearing),
must be sufficient for capital maintenance purposes (Section 830
to the Companies Act) to cover the capital. "N" is valued
with sufficient hardness for that proposition.
Section 837(2) and (5) sets audited accounts
quality to that numerical position + going concern. Profits
are the increase in the company's assets on that basis.
True and fair override ("prudence plus")
If the True and Fair override is used to inflate
the balance sheet by an amount "t".
t is an imprudent addition (unrealised profit/revaluation
reserve etc, or an omission of a loss).
Applying that to the above:
If D is paid as a dividend, then the position
is N - D + t = C + t
Capital is maintained. And capital ratios can
be calculated. "t" is not distributable in law and is
prevented from being distributed.
Pure form IFRS ("value is alldon't
worry about prudence")
If t is not disclosed then N + t = T
and T = C + "D" (where t is not
disclosed or audited)
t = the ability to over-lend (inflating capital),
to overstate profit (bonuses and tax), dividends (depleting capital)
and the ability to misprice credit and over-trade. A particular
problem in banks and in contracting companies (overvaluing assets).
t = "to know what the capital or distributable
reserves is a case of pin the tail on the donkey" = unaudited
20 ICAEW/ICAS TECH 07/03 and TECH 02/07 (the final
form of TECH 21/05) Back
TECH 07/03 para 6, 7 & 39, TECH 09 para 4.18 Back