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

CHAPTER 5: The Impact of International Financial Reporting Standards (IFRS)


111.  Accounting standards were not at first within our intended scope for this inquiry. But we included them after witnesses made trenchant criticisms of the effects on audit of the International Financial Reporting Standards (IFRS) adopted in recent years in the EU and the UK.

112.  The previous British accounting standard was United Kingdom Generally Accepted Accounting Practices (UK GAAP). Audited financial statements were drawn up in accordance with it. Use of IFRS instead became mandatory for group accounts of EU listed companies from 2005. It has been the basis of large-company financial statements audited in the UK since then. The aim of IFRS is to achieve common reporting standards across the world with the aim of improving efficiency and liquidity in global financial markets and lowering the cost of capital. Although IFRS represent a convergence of standards with those of the US Financial Accounting Standards Board, which reflect a much more litigious culture, the US has still to decide if it will adopt IFRS.

113.  Some witnesses argued forcefully that adoption of IFRS in the UK had led to lower standards of audit. The central criticism is that, because IFRS is more rule-based than UK GAAP, it leads auditors to place conformity with IFRS rules before traditional, sceptical reliance on "the true and fair view, the prudence principle and the principle of substance over form".[144] In short, a box-ticking approach is replacing the exercise of professional judgment which allowed the auditor's view of what was true and fair to override form. In the words of Mr Iain Richards, Head of Governance at Aviva Investors: "The audit has become commoditised."[145] As Professor Stella Fearnley of the University of Bournemouth put it "the way you keep out of trouble is to comply with the rules".[146] Mr Stephen Kingsley, Senior Managing Director at FTI Consulting agreed: "'Do these accounts make sense?' That seems to have gone out of the window and been replaced by … 'these accounts comply with accounting standards'".[147]

IFRS and banks

114.  Critics suggested that under IFRS bank financial statements in the UK and Ireland (a common accounting standards area) were prepared and audited according to laxer standards than before, especially as regards valuation of assets by mark to market, and made provision only for incurred and not expected losses, so that profits were overstated, leading to excessive distributions and in particular bonuses which would not have occurred under UK GAAP. Mr Timothy Bush, Investment Management Association nominated representative on the Urgent Issues Task Force of the Accounting Standards Board, argued that the relevant IFR standard, IAS39, is in conflict with clause 19 of UK accounting rules under the Companies Act 2006 which requires accounts to be prepared prudently, and without crediting any unrealised profits, while recognising any contingent liabilities[148]. Professor Fearnley saw IAS 39 as far less prudent than its equivalent under UK GAAP because it substituted neutrality for prudence[149].

115.  Mr Richards suggested that IFRS contributed to pro-cyclicality in banks since mark to market tended to lead to greater volatility in reported results[150]. In his view, IFRS were partly responsible for bank losses in the financial crisis: "In terms of the standards themselves, they obfuscate the separation of realised items from unrealised ones. There also appears to be some confusion, in practice at least, with other Companies Act provisions, such as in relation to distributable reserves and dividends. It would certainly be possible to characterise a significant proportion of bank capital raising and tax-payer funds as having been necessary to redress precisely the results of the problem created by both bonuses paid on unrealised profits (that disappeared) and imprudent dividend distributions. In terms of prudence the point should be obvious."[151]

116.  Mr Bush went so far as to describe the bank crash in the UK and Ireland as "a crisis largely caused by accounting"[152] and supplied a chart to illustrate his point.[153] Mr Kingsley, though also a critic of IFRS, did not agree. While acknowledging that auditors might have done more, he saw banks' managements as mainly responsible: "For some of our banking institutions, the size and complexity got away from the capability of the management process and systems to cope."[154] It is notable that the final report of the US National Commission on the Causes of the Financial and Economic Crisis in the US, Public Affairs (2011) says little about the role of auditors, although a minority dissenting report criticised the omission.[155]

117.  It seems clear that there were distortions in bank financial statements under previous accounting regimes before IFRS was mandatory. As Mr Martin Taylor last year told the Future of Banking Commission, in his time as CEO of Barclays [pre-1998], "the accounting standards require you to recognise [losses] only when they occur, and that means that banks have overstated profitability in the up phase of the cycle, and understated profitability in the down phase of the cycle."[156]

118.  The Bank of England and FSA are concerned that under current accounting standards some bank assets, including complex financial instruments, are not valued in consistent and comparable manner. Especially important evidence was given to us by Mr Andrew Bailey, Chief Cashier at the Bank of England, about the Bank/FSA Working Group, which is to report by the end of June, and is "to consider enhanced disclosure requirements around the valuation of banks' less liquid assets to enable users to compare financial instrument valuations between institutions … Current financial statement disclosures around asset valuations, despite being compliant with accounting standards, are often not sufficiently granular or transparent in respect of the critical valuation assumptions, and sensitivities of those assumptions, to support users' understanding and meaningful comparisons. It is arguable that this lack of transparency and comparability undermines the operation of market discipline and hinders the promotion of financial stability".[157]

119.  Practitioners consider that differences between IFRS and UK GAAP are not significant. In the view of Ernst & Young and KPMG, the relevant standards, guidance and accounting by banks for loan loss provisions and fair value provisions were not significantly different under UK GAAP and IFRS. Both were based on the 'incurred loss model' (or 'loan loss impairment' model) which means that provisions for impairment were based on the prevailing conditions at a given time (the balance sheet date).[158]

120.  The Financial Reporting Council (FRC) denied that IFRS was inconsistent with the Companies Acts. "The FRC shares BIS' view that … changes are not required to either IFRS or to the Companies Act 2006 in order to reduce any possibility of illegality … directors make … decisions [on distributions, etc] in the light of the company's 'realised profits' as defined by section 853(4), Companies Act 2006. The method of calculating profits regarded as realised 'in accordance with principles generally accepted at the time when the accounts are prepared' is set out in 'Guidance on the Determination of Realised Profits and Losses in the context of Distributions under the Companies Act 2010.'"[159]

121.  Mr Steve Cooper of the International Accounting Standards Board (IASB), which sets IFRS standards, argued that IFRS gave due, though less, weight to prudence, to reach a more realistic view of profits: "Prudence does permeate accounting standards, revenue recognition, and all sorts of areas. We are careful to make sure that profits are only recognised when they really are profits. However, prudence acts two ways: if you understate things now, it gives an opportunity for companies to report a profit later; and at the very times that things are getting worse, if you are living off past fat and past unrealised profits, you can conceal the bad things that are coming later. So we do not want to create a bias within financial reporting that has that counterintuitive effect later on. We want things to be realistic, neutral, to faithfully reflect the economics of transactions."[160]

122.  Mr Cooper also argued that auditors could still adopt a true and fair override: "There is a perception that ... IFRS do not have a true and fair basis, which ... is completely untrue ... the true and fair override is in IFRS ... in IAS 1 ... Paragraph 19 says that, in certain circumstances, it may be appropriate to depart from a specific set of rules if you need to do so in order to fairly present the information, fairly present the underlying economics of the business and the transactions entered into. So I do not believe there is any significant difference between the wording in international standards and what we have in UK accounting and UK legislation." Mr Roger Marshall of the Accounting Standards Board (ASB) agreed: ASB had counsel's opinion that "the requirement in IFRS to present fairly is not a different requirement to that of showing a true and fair view, but is a different articulation of the same concept."[161]

123.  Other witnesses disagreed. In Mr Richards's view: "IFRS has muddied the waters both as a result of how it has been implemented and its effects on accounts. Let me start with the observation that in practice critical concepts like prudence and accounting conservatism have been superseded in IFRS by process and compliance to standards. Aspects of the model seem more targeted at short-term trading (decision usefulness) rather than stewardship accountability. As a result concepts like the 'true and fair view' have been diluted and subordinated to that dynamic and other Companies Act accounting requirements have been obfuscated. Increasingly the True & Fair View has been characterised as being evidenced by compliance to the standards, particularly by standard setters."[162]

124.  Mr Peter Wyman, formerly of PwC, recently said: "The rules allowed banks to pay dividends and bonuses out of unrealised profits—from profits that were anything but certain. The system is still in place now—we can't tell if similar problems are building up because there is no requirement to separate realised from unrealised profits." He added: "Significant further work is necessary before IFRS can be said to be totally fit for purpose."[163] Mr Cooper acknowledged that IFRS did not allow provision for expected losses: "It is very true that if you expect loans to go bad three years from now, the customer is currently paying and there is no indication that they are going to stop paying, but you just think that some … will go bad in three years … it wouldn't be possible to provide now." The IASB was developing a revised Standard (IFRS 9) intended to address concerns about expected but not incurred losses.[164] It was not clear, however, when the new standards might be adopted.

125.  Practitioners denied that IFRS had contributed to the banking crisis. Ernst & Young noted: ''Some countries which do not use IFRS have experienced difficulties in their banking sector (e.g. USA). Equally other countries which use IFRS have not experienced difficulties in their banking sector (e.g. Australia). This provides additional support for the view that there is no causal link between adoption of IFRS and problems in the banking sector."[165]

126.  Nevertheless, during the boom some banks clearly saw IFRS as inflating profits. Mr Adam Applegarth, then CEO of Northern Rock, told the Daily Telegraph in 2005 that moving to IFRS had introduced more volatility and led to "faintly insane" profits growth.[166] Some regulators took precautions in spite of the EU requirement to move to IFRS. Lord Turner of Ecchinswell, Chairman of the Financial Services Authority, has drawn attention to the practice in Spain of "dynamic provisioning" or putting aside funds in good times to meet needs in bad[167], not provided for by IFRS.

127.  Professor Fearnley criticised IFRS standard setters as "dangling regulators" without clear lines of accountability.[168]  Mr Cooper defended the status of the IASB: "We are not tied to anyone. We are not representing anybody. We are not tied to any interested party. The whole idea is that we are appointed from a diverse range of geographical and business backgrounds, we are independent and take decisions in an independent transparent manner with appropriate, very public, due process." [169]

128.  The Financial Secretary to the Treasury, Mr Mark Hoban MP, defended IFRS, provided that standards in its admittedly more prescriptive approach were steadily updated: "There was a shift between UK GAAP and IFRS, a move to a much more rules-based approach to accounting standards ... it is important those standards remain up-to-date and reflect current practice in capital markets, rather than what may have been the case in the past."[170]

129.  Obvious benefits should flow from global adoption of common accounting standards for a global economy. But there is a corresponding risk that the lowest common denominator will prevail. So all concerned need to insist on the highest possible standards of rigour, clarity and quality of accounting and audit.

130.  We accept that standards for use in many countries need clear rules which all can apply. It follows that IFRS is more rules-based than UK GAAP. But we are concerned by evidence that, by limiting auditors' scope to exercise prudent judgment, IFRS is an inferior system which offers less assurance. IFRS also has specific defects, such as its inability to account for expected losses. The weaknesses of IFRS are especially serious in relation to bank audits.

131.  We recommend that the profession, regulators and the Government should all seek ways to defend and promote the exercise of auditors' traditional, prudent scepticism. The Government should reassert the vital role of prudence in audit in the UK, whatever the accounting standard, and emphasise the importance of the going concern statement.

132.  Achieving general agreement on IFRS could be a long and uncertain process. In the meantime, we recommend that the Government and regulators should not extend application of IFRS beyond the larger, listed companies where it is already mandatory. Continued use of UK GAAP should be permitted elsewhere, so that the basis of a functioning, alternative system remains in place in case IFRS do not meet their aims.

133.  As it revises banking regulation, we recommend that the Government should have the importance of accounting standards at the forefront of its mind. It should promote a prudent interpretation of IFRS as applied to banks. This would include sober valuation of complex financial instruments. At present IFRS permits recognition only of incurred losses, not expected losses. So it is essential that banks put aside reserves in good times to provide against downturns. This would have the incidental advantage of reducing the scope for banks to pay bonuses on the basis of profits struck without taking account of possible losses. We recognise that a fully satisfactory outcome depends on international negotiation and believe that the Government should give a lead.

144   Q 1(Professor Beattie). Back

145   Q 411. Back

146   Q 30. Back

147   Q 87. Back

148   ADT 10. Back

149   ADT 2. Back

150   ADT 44. Back

151   ADT 44. Back

152   Q 87. Back

153   ADT 16. Back

154   Q 88. Back

155   "The Commission majority did not discuss the significance of mark-to-market accounting in its report. This was a serious lapse, given the views of many that accounting policies played an important role in the financial crisis." From dissenting report by Peter J Wallison.  Back

156   The Future of Banking Commission report (2010), page 70. Back

157   ADT 75. Back

158   ADT 35 (KPMG), ADT 34 (Ernst & Young). Back

159   ADT 27; ICAEW Technical Release-Tech 02/10: 'Guidance on the determination of realised profits and losses in the context of distribution under the Companies Act 2006'. Available at: This guidance is issued following public exposure and independent legal review. Back

160   Q 452. Back

161   Q 450. Back

162   ADT 44. Back

163   The Sunday Telegraph, 'Bank balance sheets 'flawed'' by Louise Armitstead, 13 March 2011. Back

164   QQ 452-454. Back

165   ADT 34. Back

166   The Daily Telegraph, 'Northern Rock boosts loan book' by Stephen Seawright, 29 July 2005. Back

167   Speech by Lord Turner at ICAEW, Banks are different: should accounting reflect that fact?, 21 January 2010. Back

168   Q 41. Back

169   Q 462. Back

170   Q 540. Back

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