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".
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."
As Professor Stella Fearnley of the University of Bournemouth
put it "the way you keep out of trouble is to comply with
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gone out of the window and been replaced by
comply with accounting standards'".
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.
Professor Fearnley saw IAS 39 as far less prudent than its
equivalent under UK GAAP because it substituted neutrality for
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.
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."
116. Mr Bush went so far as to describe
the bank crash in the UK and Ireland as "a crisis largely
caused by accounting"
and supplied a chart to illustrate his point.
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."
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.
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."
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
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).
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
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.'"
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."
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."
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."
124. Mr Peter Wyman, formerly of PwC, recently
said: "The rules allowed banks to pay dividends and bonuses
out of unrealised profitsfrom profits that were anything
but certain. The system is still in place nowwe 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."
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
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.
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
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.
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,
not provided for by IFRS.
127. Professor Fearnley criticised IFRS
standard setters as "dangling regulators" without clear
lines of accountability. 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." 
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."
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
Q 411. Back
Q 30. Back
Q 87. Back
ADT 10. Back
ADT 2. Back
ADT 44. Back
ADT 44. Back
Q 87. Back
ADT 16. Back
Q 88. Back
"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
The Future of Banking Commission report (2010), page 70. Back
ADT 75. Back
ADT 35 (KPMG), ADT 34 (Ernst & Young). Back
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
Q 452. Back
Q 450. Back
ADT 44. Back
The Sunday Telegraph, 'Bank balance sheets 'flawed'' by
Louise Armitstead, 13 March 2011. Back
QQ 452-454. Back
ADT 34. Back
The Daily Telegraph, 'Northern
Rock boosts loan book' by Stephen Seawright, 29 July 2005. Back
Speech by Lord Turner at ICAEW, Banks are different: should accounting
reflect that fact?, 21 January 2010. Back
Q 41. Back
Q 462. Back
Q 540. Back