Further supplementary memorandum by Mr
Timothy Bush (ADT 17)
FURTHER REMARKS ON THE SESSION DATED 25 JANUARY
2011, AS REQUESTED BY LORD MCGREGOR, Q540-547
Dear Lord McGregor
I am pleased to be asked to give my remarks.
I have watched, or read the transcripts of, every session including
this session with Mr Davey, Mr Carter and Mr Hoban.
I am happy to stand behind all of my evidence
to date. I treat the Committee as I would a Court, the whole truth,
not selective bits or half truths. I took all of my evidence from
prime information and the primacy of law rather than hearsay.
In this submission I have included prime law in appendices.
I noted with great interest that Mr Hoban did
say that regulation should start from the accounting numbers Q531.
He is correct, and that is precisely what happened. The FSA regulated
from IFRS numbers.
The FSA took (imprudent and unreliable) IFRS
statutory accounting numbers from banks and made regulatory adjustments
(Basle) to that. The problem was that those adjustments were also
imprudent and therefore did not negate the impact of IFRS where
the banks were in difficulty (running faulty/risky business models).
I believe that these adjustments in some cases merely amplified
The French banks did not use IFRS, they used
already prudent French GAAP, and then the regulator made regulatory
adjustments (Basle) to it. However, those adjustments were only
imprudent to the extent there was already a problem in those banks,
but there was no problem to amplify.
The difference between French GAAP+Basle and
IFRS+Basle is that the poor regulation in itself does not necessarily
mess up the running of the business. The regulator may regulate
less efficiently, whatever that means, but the business itself
is running on the correct ratios/KPIs if it is using prudent GAAP
in first instance. Basically the directors, managers and shareholders
can see what is properly going on in terms of proper business
economics, even if the regulator then puts himself in the dark
a bit. However, if you use IFRS numbers to run the business you
may well get lost, and then run the wrong model, but appear profitable,
with all the wrong ratios and KPIs.
In maths, as an analogy, the regulation and
the accounting are not commutative, like division and subtraction
you get a different answer depending on the order of things. If
an IFRS using business has a "softness factor" in it
due to imprudent accounting, regulation cannot re-harden it.
Those banks that failed due to bad debts (rather
than the investment banking/Lehman crisis) tended to be former
Buildings Societies (B&B, NR, HBOS and divisions of it such
as Birmingham Midshires). I presume, and I did observe this from
some analyst meetings, they seemed to be too dependent on IFRS,
ie they were only running one set of books. Those lending banks
that survived, HSBC-UK, Barclays-UK, NatWest and Lloyds-TSB, the
former clearers, seem to have used a form of UK GAAP before applying
IFRS (ie two sets of books, with the right ratios/KPIs). So did
Abbey/Santander which essentially ignored IFRS. It is fairly easy
to see why there was a systemic problem.
31 January, 2011
Neither the BIS nor the Treasury minister addressed
in Q540-547 (or elsewhere) that the law requires statutory accounts
for the purpose of conducting the business of the AGM properly.
That is a prudential purpose, a discipline, so that shareholders
and directors know where their business is truthfully at. For
banks at risk the audited IFRS numbers were unreliable for that
purpose; profits were exaggerated and dividends and bonuses were
paid out of unreal or reversible soft profits, for the banks to
then collapse shortly afterwards, depleted of capital.
Mr Carter hits the nail on the head without
perhaps realising it (Q547), "the losses were immensely
greater than all the bonuses and dividends that the banks had
paid", this is precisely due to the gearing of a bank.
False profits may be paid out or retained. Any false retained
profit is false capital, and that multiplied >20 timesin
gearing upgives (false) over-lending capacity. Over-lending
will be to more marginal borrowers. Eventual losses will be large,
more than merely the already false capital will emerge as losses.
Legally safe dividends are a function of safe reserves left behind
I dispute that there is no evidence on IFRS
versus UK GAAP and banking problems (Mr Davey Q546). Lord Turner
highlighted IFRS as a problem (a whole speech to ICAEW in February
2010 about "illusory profits"). There is also counterfactual
evidence. No French bank came anywhere near collapsing, they kept
prudent French GAAP for the accounts of banking companies, meaning
normal financial governance (self-control) operated properly in
first instance alongside prudential regulation (state intervention).
The problem is not merely regulators getting it wrong after the
fact, they do not run the business. The problem is a business
doing the wrong thing but thinking it is on the right track. Banks
are run on key ratios from the accounts.
I can understand why BIS is defensive (and I
can see this whenever "prudence" or "law"
is raised). BIS legislated to allow the use of IFRS for banking
companies. This was in part because the FSA, which had used UK
GAAP for prudential banking regulation, signed off on IFRS for
use for prudential banking regulation, whilst appearing to miss
some of the major changes with IFRS, most notably:
the impact of the IFRS mark-up-to-market
or model without the BBA SORP moderating it (Mr Carter does seem
to acknowledge/allude to this omission in Q544 where he says "with
the benefit of hindsight" when referring to the loss
of the BBA SORP),
the impact of IFRS on bank profit and
loss accounts. The FSA only adjusted the balance sheet for its
identified IFRS impact, not profits, but IFRS has a disproportionate
effect on profits due to gearing, this can easily increase "profits"
by >20%, even more where there is increased risk, and
the impact of the IFRS bad debt provisioning
model on balance sheets, particularly where there was very high
risk lending (eg HBOS, Northern Rock, Bradford & Bingley).
The FSA reversed out the deficient IFRS defined "incurred
provision" to substitute it with a one-yearexpected
loss in the balance sheet. But, one-year-expected loss itself
was also deficient, as shareholders in any limited liability company
may walk away when total foreseeable losses exceed capital. One
year expected loss was not much better than "incurred loss".
It too rode with the boom, as it was also evidence based, rather
than commonsense economics.
In short, the FSA missed that prudential banking
regulation did not work with IFRS. The FRC (under BIS) seems to
have missed the dysfunctional impact on governance, pay and profits,
of IFRS. The Treasury allowed IFRS for Building Societies. The
Big-4 sought a global model (Mr Halliday-E&Y said so).
Q540-547To give some structure to my
remarks, as it all interlinks, I have ordered this under four
subjects that were covered in Q540-547. The subjects are:
GAAP" versus IFRS;
law/legality of IFRS as a preparation
method (which the IASB/EU decided);
audit purpose and the output standard
(which Parliament decides); and
going concern/expectation gap/"snap
shot" balance sheets.
All of the subjects interlink with going concern.
Going concern requires reliable accounts, and vice versa. The
law is structured so that AGM's can function (essentially on the
nod) with a one year ahead view based on a truthful and reliable
audited account of true condition, statutory accounts.
1. Prudence and IFRS and UK GAAP (Mr Carter,
Mr Davey and Mr Hoban's answers Q540)
I see a good deal of implying equivalence of
IFRS and pre-2005 UK GAAP. However, I have attached the Accounting
Rules ("the Rules") from the Companies Act statutory
instrument ("UK GAAP") as Appendix A for the benefit
of the Committee. The Rules give prudence a statutory bearing.
The law requiring prudence, Rule 19, is unequivocal,
it is a must. I agree that one might not agree on the precise
amount of it, calculating most things is subjective. But prudence
is directionally clear.
Mr Carter's evidence, Q544 states correctly
that prudence was not defined in statute. However, the required
accounting outcome from applying prudence is set out in objective
form in statute as Section 830-837 of the Companies Act which
links the audited accounts to the distributability of reserves.
As assets back all reserves, including those left behind ex-div,
I think it self-evident that asset values should be prudent and
reliable rather than soft or speculative. Rule 32 (1) specifically
requires bank loans to be carried at net realisable value where
lower than cost. In other words its recoverable amount. Rule 19
sits over Rule 32, ie UK GAAP in law is a prudent estimate of
net realisable value.
Also, Rule 19 (b) requires negative post balance
sheet changes to be adjusted. Mr Hoban's evidence though stated
that balance sheets are a "snap shot". Rules 19, and
32 are forward looking beyond being a snap shot, they adjust things
by requiring judgments. The same goes for inventory provisions.
By definition any inventory left at the balance sheet date is
goods not sold, inventory provisions are for goods not likely
to be sold. That is a judgment.
IFRS is more "snap shot" and evidential,
and not the same as UK GAAP. I therefore wholly disagree with
Mr Davey's comments and Mr Carter's then agreement with his minister
(Q540). The FRC paper on auditor "scepticism" is in
my opinion its way of resolving the prudence/IFRS problem without
overtly admitting it. It is worthy of note that that BIS (nor
the FRC) does not refer to scepticism in the context of the FRC's
(excellent) auditing standard on going concern (see later).
1.1 Architecture of IFRS standards and the force
of law (Mr Carter and Mr Davey's answers on IFRS and prudence,
The answers here were incomplete or muddled.
Each EU-IAS (EU endorsed IFRS) Standard is an EU legal instrument,
ie the law. IAS 1 is the general "mother" standard of
IFRS. However, its principles/rules, are excluded for areas where
the subject matter is covered in another standard. For bank loans
IAS 39 is sovereign.
Furthermore, IAS 1 does not contain the word
prudence at all, nor a synonym. What Mr Carter describes in his
evidence as prudence in the "the Framework" (Q544) is
not only irrelevant as IAS 39 is sovereign, but "the Framework"
is not endorsed by the EU. The EU has quite remarkably incorporated
something into law that is definitively cross referencing to something
that is outside of the law. (Further, the IASB is currently changing
its "Framework" to exclude mention of prudence from
even "the Framework", ie neutrality instead).
But more simply than all of that, IAS 39 has
to exclude prudence. It is impossible to have mark-up-to-marketas
in IAS 39with prudence operative in IAS 39 itself, or from
anywhere else in IFRS, whether IAS 1 or "the Framework",
as prudence would counteract it.
IAS 39 (para 59) states "losses expected
as a result of future events, no matter how likely are not recognised".
It then goes on to give in AG 90, as an example in practice, that
even substantial credit risk from the death of borrowers, who
have not died before the balance sheet date does not require provisioning.
That exclusion of inevitable loss cannot possibly encompass the
"net realisable value" test of Rule 32 in the Companies
Act Accounting Rules (UK GAAP).
Further, IAS 39, para 59, has the rather weasel
words, "observable data that comes to the attention of
the holder of the asset". "Coming to the attention
of" is a qualifying term, a safe harbour sanctioning accounting
that is missing things, but it is also a perverse incentive not
to even look. The wording "holder of the asset" also
seems to exclude things coming to the attention of the auditors.
That to me is a limitation of scope, "I see no ships".
Company Law is worded to avoid any definitive frame of reference.
Truth is truth. The auditing issue should be digging sufficiently
to get at it.
1.2 Mark to market (again on UK GAAP and IFRS
having been similar Q544)
The Company Law Accounting Rules, Para 32, is
drafted such that "net realisable value" might be the
lower of cost or market value, where there is a market.
But the term "realisable value" is
not defined restrictively to be a market value (as with IAS 39).
UK GAAP is able to deal with the paradox of "price"
and "value" and take a recoverable amount rather than
a distressed price. IFRS was not able to, IFRS required "market"
or a model of a market when markets were distressed. The EU then
had to suspend part of EU-IAS 39 in Q4 2008. That is not an equality
with UK GAAP in my view. Different rules, different authority/sovereignty.
1.3 "UK GAAP was an incurred loss model"
Several bits of evidence have claimed an equality
of IFRS and UK GAAP for bank bad debts, due to UK GAAP also being
"an incurred loss model". I think that this is a well
rehearsed wordplay on the indefinite article "an". The
Companies Act Accounting Rules are not incurred loss, it is prudent
net realisable value.
The BBA SORP, is not saying what IAS 39 does,
nor is it is a legal instrument able to override the Companies
Act Rules. My understanding is that the BBA SORP was worded to
exclude recessionary forecast in provisioning, such as Spanish
economic cycle provisioning, the ultimate end of the spectrum
of "expected" loss. The BBA SORP was not excluding such
losses as might be expected by making 120% mortgage loans to people
of poor credit standing. If there is a spectrum from incurred
loss to expected loss, IFRS is at one extreme, Spanish economic
cycle provisioning at the other, and "UK GAAP" (Companies
Act Rules, including the SORP) was somewhere between.
Indeed, Old Mutual plc, which has banking business
(audited by KPMG), stated in its IFRS conversion statement that
it used UK GAAP's expected loss model.
Additionally, under IFRS, the Group has moved
to an "incurred loss" provisioning model within its
banking segment. Under UK GAAP, the Group utilised an "expected
loss" provisioning model.
Another example of the clear difference on transition
to IFRS, the Nationwide Building Society, Annual Report and Accounts,
"52j The net impact of more stringent
evidence testing required by IFRS has resulted in a decrease in
the carrying value of loan provisions of £86.0 million."
2. The legality/conformity of IFRS with the
purpose of accounts (Mr Davey' specific answer Q544)
Mr Davey, was asked specifically about my evidence.
But he seems to misunderstand the question around "conformity
of law". I was not saying IFRS is "illegal" which
is how Mr Davey has answered the question.
Law is law and IFRS is law. But one part of
law can clash with other law. Statute can clash with other statute
or common law. The issue is not IFRS being "illegal"
the issue is law not working. Tax law is notorious for inconsistency,
and hence creating overlap or loopholes.
The purpose of audited accounts set out in IFRS
and also the purpose against which the EU assesses an IFRS for
adoption does not accord with the purpose of accounts set out
in UK Company Law, which is corporate financial governance ("stewardship").
The purpose in English Law is set out in the Caparo case which
describes the statutory position (see Appendix 3):
(i) audited accounts protect the company (such
detecting frauds and not paying dividends out of capital, Companies
Act 2006 Section 830-837, which is a statutory articulation of
the common law), and
(ii) audited accounts inform the members at the
AGM for the AGM to properly hold the directors to account and
pay them properly for performance (even though this is retrospective,
it takes reliable profits (and ratios) to do it).
This law "concatenates-pyramids",
ie if a if company owned by another company pays a dividend, then
the above model applies. eg HBOS plc's board (as shareholder)
could rely on the audited accounts of Bank of Scotland when Bank
of Scotland declared its 2007 dividend, and paid it up to HBOS
plc in February 2008.
Bank of Scotland has now had had >£28
billion injected into it but the y/e 2007 accounts had justified
a final dividend of £1.2 billion off capital and reserves
of £18 billion. The accounts were not at all reliable for
the AGM (nor the acquisition by Lloyds), nor had they been for
expanding lending. Total losses since the 2007 Accounts were signed
off have been £30 billion.
IFRS has a very vague stated purpose (see Appendix
4). IFRS is concerned with ill-defined "users" for an
ill-defined purpose which is "to be useful for users".
It is an inconsequential definition. It came from the litigation
conscious USA. (See going concern later).
Usually if statute clashes with common law statute
wins, or if statute clashes with statute the latter statute wins
by the doctrine of constructive repeal. However, the purpose of
accounts in English law, is expressly not overriden by the EU
Regulation under Article 5. The EU and the Department of Business
confirmed this prior to the adoption of IFRS. However, IFRS in
practice frustrates delivery of Section 830-837. This is evidenced
clearly by the bad debt provisioning model not being prudent or
mark to market accounting not addressing net realisable amounts.
It is directionally wrong to be prudent.
In summary there was no functional mechanism
to deliver the law, as the law is at cross purposes. This incompatibility
can be seen in the ICAEW/ICAS legal advice on applying IFRS with
Company Law. From 1982 to 2005, the ICAEW guidance on distributable
reserves was three to four pages. Under IFRS it is >120 pages
and increasingly confused. It is clear from reading it, that one
leg of the law (Sections 830-837) requires prudence, whilst IAS
39 is imprudent. I question whether the BIS Minister was made
aware of that. I am happy to supply it to the Committee.
However, there is a legal problem with UK-Eire
FRS 26 as part of "UK GAAP" (ie not part of IFRS). ASB
standards are not law, and must conform with the law or state
their deviation from it so that the impact is shown nevertheless.
I cannot see how the paragraphs in FRS 26 which have been copied
straight from IAS 39 can possibly conform with the Companies Act
Accounting Rules. In that case, this is not a clash of law, the
inferior body (the Accounting Standards Board) is contravening
the law of Rules 19 and 32.
3. Going concern and "expectation gap"
Lord Hollick had asked about auditors needing
to be more sceptical on going concern (Q531) and Lord Forsyth
on the risk of carrying 40 times gearing (Q537).
I was perturbed by what Mr Davey said about
there being an inevitable "expectation gap" with auditors
when he was asked about going concern. I would also refer him
and the Committee to the Barings plc and Baring Futures Singapore
cases. They tend to betray any expectation gap (both were settled
under English Law). I do not know what "literature"
he refers to on "expectation gap" but if any of it is
from the USA, it may well not accord with English law. US auditors
contract essentially for reporting for the market, not for the
company. The "market" can be ambivalent on going concern.
Going concern is the economic phenomenon of
the company being able to stand on its own two feet, ie shareholders
are funding it, are standing behind it and will continue to do
so. Members have the prerogative to wind up a solvent company,
and administrators insolvent ones. New equity will only be forthcoming
when it is economically beneficial to put new money in. Shareholders
will not rationally do if their new subscription is firstly funding
IFRS leaves out losses and included unrealised
and unrealisable profits. (Q 546, Lord Lawson, hits the nail on
the head, so does Mr Carter, Q547). IFRS accounts in my opinion
can be unsuitable for assessing whether a company is a going concern
or for raising new capital.
Further I note that KPMG's evidence on going
concern was not consistent with the UK and Irish auditing standard
ISA 570 that it claimed to be quoting from. ISA 570 does not allow
a general presumption about the availability of capital whether
debt or equity regardless of source or circumstances (KPMG supplementary
evidence) when an auditor signs off the accounts. That would be
illogical given that the audited accounts are supposed to be reliable
enough for shareholders to take money out, as a final dividend.
Shareholders vote on final dividends, based on the audited accounts
Further, the KPMG statement "regardless
of source" is at odds with the pre-emption regime in this
country. Shareholders have first refusal, and to exercise that
right without being misled they require accounts that are true
and fair, ie they are not being kept in the dark about hidden
losses and/or loss making trends.
Requiring new capital to be injected is fair
to satisfy the going concern presumption if it is flagged to shareholdersthe
membersthat new capital is required, such as with a co-terminous
underwritten rights issue. In such a case the auditor opinion,
and also the prospectus, should still look at the sufficiency
of these additional capital resources at least a year ahead. (Or,
for a subsidiary that requires support, binding parent company
The FRC/APB auditing standard ISA 570 on going
concern is strong, and is aiming to correct IFRS. It sets out
quite clearly that [probable] future losses/asset write downs
are a going concern risk, they are a loss of capital. But, there
is no operative accounting standard with IFRS (or FRS 26) to pick
For a group holding company to be a going concern,
the subsidiaries need to be going concerns, but some subsidiaries
may rely on parent support. The only way to properly assess whether
a group holding company is a going concern (and not being stressed
by some subsidiaries) is if the group and the subsidiaries prepare
prudent accounts. IFRS has upset that model, even in respect of
the mandatory EU requirement for consolidated group accounts.
I also submit, as it has not come out in evidence,
that UK GAAP (the Accounting Standards Board element) was able
to react to new issues within weeks (following the Dearing Review
of 1988 any issue could be fast tracked). The IASB takes up to
three years even when there is a known problem eg incurred loss
and the EU can take two or more years on top of that after that.
In particular I note your question to Mr Davey
Q544 which referred to my evidence. I believe that the minister
took your question about "conformity with the law" to
mean "was IFRS illegal?"
However that matter is bad law/clash of laws.
IFRS as an EU legally sanctioned preparation
method (under the option to use imprudent IFRS), versus the capital
maintenance/solvency clauses of the Companies Act as an output
requirement dependent on prudence. A clash of law in itself is
not illegal, and that is how Mr Davey correctly responded. But
he did not address the conflict of laws.
Further, he did not answer your actual question
which was the conformity of accounts prepared under the "statutory
instrument", ie the detailed Accounting Rules for Companies
Act accounts "UK GAAP", with the capital maintenance/solvency
clauses of the Companies Act.
However, the specific problem with "UK
GAAP" in your question is that FRS 26 (the Accounting Standards
Board copy of IAS 39) does not accord with the Accounting Rules.
The ASB is supposed to set accounting standards in accordance
with the Companies Act in both senses, complying with the Accounting
Rules (input) and the capital maintenance/solvency clauses (output).
This is not a matter of UK law clashing with
EU law but is a matter of FRS 26 as a UK standard not conforming
with UK law; neither the Accounting Rules of UK GAAP nor the capital
maintenance/solvency clauses. The ASB thus unnecessarily copied
the EU/UK law mismatch to create a UK/UK mismatch (and Eire/Eire).
Bank directors applying IFRS (IFRS using companies)
or FRS 26 (non-IFRS using companies) may not comply with Sections
830-837, the capital maintenance/solvency requirements. If that
is so they will not have discharged their solvency obligations,
but they may very well think that they have, as may their auditors
and everyone else.
Rather than being a counter to IFRS, like French
GAAP was, FRS 26 made UK GAAP equally bad, Hobson's choice.