Auditors: Market concentration and their role - Economic Affairs Committee Contents

Supplementary letter from Mr Timothy Bush (ADT 11)

  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:

    (1) & (2)

    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 bank—its prime risk in fact).


  1.  IFRS is imprudent (not allowing loan risk sensitive bad debt provisions—IAS 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 accounts).

  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 group numbers).

  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


Company law individual accounts and IAS (IFRS) individual accounts

  1.1  ICAEW/ICAS guidance on the law, under counsel opinion,[20] states that prudence applies as a fundamental valuation objective[21] 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 Act.

  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.[22] 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 26/IAS 39.

Capital, and profits, the problem when IFRS is used in companies especially banks

Basic position (compliance with the accounting rules of Company Law—IVth 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:

    N + t = C + D + t

  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 all—don'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 risk.

20   ICAEW/ICAS TECH 07/03 and TECH 02/07 (the final form of TECH 21/05) Back

21   TECH 07/03 para 6, 7 & 39, TECH 09 para 4.18 Back

22   A1.25. Back

previous page contents next page

© Parliamentary copyright 2011