The FT has two articles this morning highlighting the failure of accounting rules to handle the impact of the coronavirus crisis, most especially in banking.
The problem that is being faced has persisted since 2005 when International Financial Reporting Standards were introduced as the de facto accounting standard system for the UK, the EU and over 100 other countries.
This is not the moment to critique the multitudinous failings of IFRS accounting, although they exist. It is instead the moment to note that they are the very opposite of the reasonably objective standards for reporting that any user of accounts might require, most especially at times like this.
The current problem relates to loss reporting. As Jonathan Ford notes in the FT, when IFRS reporting was introduced the rules on loss reporting were absurdly relaxed:
You may remember the issue that emerged in 2008. Banks hung back from revealing their losses on loans because they claimed the standards then in force required them only to provide for losses when a loan was actually at, or on the threshold of, default.
That's why, say, Bank of Ireland was able to publish a clean set of accounts in the summer of 2008, just months before heeling over and having to request a €5bn bailout.
The result was bank accounting that helped deliver the 2008 crash because insufficient accounting warnings were given. That is a big charge to lay. It is wholly justified.
Reform has happened. This is in what is called IFRS9. The trouble is the reform is also deeply flawed, largely by being too formulaic, and by (as is normal in IFRS accounting) ignoring the time dimension as to what is happening and instead accounting for all the consequences as if they happen in the present, when that is not the case. Jonathan Ford describes this, and I will not reiterate it.
Suffice to say IFRS9 is also considered to be failing. That's partly because it is resulting in the reporting of a great many losses and that means banks could fail the supposed stress tests that central bankers so recently said they passed. Of course, these losses may be real. Who knows? The accounting system will not let us know. And that is because, as the FT also reports, the Bank of England and its agencies are encouraging a lax approach to the accounting.
None of this is remotely acceptable, of course. It's bad enough having bad rules. It's worse when bad rules are known to exist and so encouragement is provided to apply them badly.
So what do we need? The answer seems very clear. Historical cost accounting has a simple heuristic test for addressing this issue, which along with much else in that approach to accounting (which was abandoned in favour of IFRS) worked. The rule was that all assets should be valued at the lower of cost or net realisable value.
The cost of a loan was the sum advanced.
The net realisable value was the net sum now likely to be recovered from the advance, ignoring interest to be earned that should be allocated to future accounting periods.
And, if there was doubt prudence required that a provision be made. Reinstatement thereafter was not permitted. That stopped game playing.
This rule would work now.
It is the rule we need now.
We need prudence back now.
We need to scrap IFRS for many reasons, but this is an excellent example. Accounting is about the application of clear logic to uncertain situations where clear guidance as to the required decision criteria (I.e. prudence in this scenario) can be given so that the likelihood of the opinion formed being capable of replication is high. That is as close to objective reporting as accounting can get.
IFRS accounting is far removed from that. That is why it has to go. Dithering on this issue is no longer needed. We know how to account properly. Historical cost accounting worked well for everyone barring management in pursuit of the overstatement of profits for their own ends.
Let's now scrap this neoliberal form of accounting that is intended to misinform and go back to accounting that does not in that case. We might then get some reasonably objective data on which to base decisions during this crisis. That is the last thing we are going to get right now.
Thanks for reading this post.
You can share this post on social media of your choice by clicking these icons:
You can subscribe to this blog's daily email here.
And if you would like to support this blog you can, here:
“Historical cost accounting has a simple heuristic test for addressing this issue, which along with much else in that approach to accounting (which was abandoned in favour of IFRS) worked. The rule was that all assets should be valued at the lower of cost or net realisable value.”
May I suggest that it was more than a heuristic test, but a test which had the authority of a basic principle of reporting, since Adam was a boy? Or am I wrong? The question that now interests me is fairly basic; what was the justification for abandoning this robust and reliable principle for IFRS? Somehow, I have that sinking feeling it was inflation accounting……..
No: HCA embraced inflation accounting in SSAP 16
It was the desire to inflate profits which IFRS permitted, by the bucketload
Well, inflation of a kind!
Agreed in full.
I don’t think inflation was a driver for IFRS at all. It was the regional demand for a standard set of rules across capital markets jurisdictions – as companies became more global in operations and fund raising, there was at least a perceived need for standardised accounting.
The problem with IFRS is that is developed its own complex bureaucratic system and bears too much input from academics rather than users of accounts. This resulted in a drive to formulate ×´pure” accounting concepts which were theoretically defendable and correct. This replaced having accounting concepts that were of value to users of accounts i.e. useful! Hence most listed financial statements are extremely hard to understand even for those with accountancy qualifications so what chance does the ordinary shareholder have? (Some of the blame lies with the users who did not stand up for their own interests – but it is much harder for disparate users to organise themselves than it is for bureaucratic regulators).
We now have the absurd situation where the Bank of England is sailing very close to asking banks not to comply with IFRS 9 and yet the banks are obliged to do so by the FRC who mandates use of IFRS. This is not a healthy regulatory system.
On a wider perspective of IFRS, there is a fundamental problem with the entire focus being on asset and liability values and no emphasis on matching income and costs – which is the underlying rationale for accruals accounting. Matching is fundamental as it seeks to overcome the impact of an arbitrary cut off date at which a balance sheet is drawn up. Until IFRS accepts that matching is fundamental, it will continue to be a theoretically correct accounting system that is of very limited practical usefulness.
I broadly agree with your first para But think the motive was to change reporting for the benefit of management first of all
The EU fell for the label
The rest I do agree with
For the avoidance of doubt, I was not really proposing inflation as a serious “driver” of IFRS; I did not know, hoped that was apparent in the tenor of my remarks but merely mentioned it, slightly whimsically, and ‘tongue in cheek’. I was not in the least surprised to be corrected by Richard, but I am slightly alarmed at the prospect of having inadvertently set an erroneous hare running!
How careful we have to be in what we write; sadly, especially when attempting wit in the pursuit of light relief. Okay, maybe the ‘wit’ was a little clunky, but the price has been instantly sobering! I much prefer words to express myself than ‘smileys’, but I suppose I could have avoided this unexpected backdraft had I just used a closing smiley …….
It was useful, not clunky
Sound thinking out loud is to be encouraged
It’s only the cynicism of trolls that is
Im not an accountant, but I class it as dark art.
This is always a problem, I have absolutely no doubt at all that private banks are insolvent most of the time,it just depends on which method you want to use this week to keep them solvent.
As to the new rules,the FT says they mean a 40 % increase in capital!!!
I ‘m all for it,but even the FT admits that might not be enough, In fact why don’t we just go the whole hog and make it a 100 %, then all the accountants can stop worrying about it : )
It is arguably the case that ALL banking innovation/activity since deregulation in the 80s has been about taking more risk using less capital. Regulators have always been “behind the curve” but Basel Capital requirements I, II and III (and liquidity rules) have been attempts to curtail/control this… but the industry has been ever more ingenious trying to arbitrage the rules. Once that is exhausted they try blackmail – “unless you relax the rules we won’t lend and everyone suffers”.
So, whilst I don’t oppose your suggestions I am not sure that they will fundamentally change the game.
Also, there are some technical issues. I don’t know how you would account for a government bond trading book or interest rate swap trading book? If long positions were marked at the lower or market price or par (and short at higher of market price and par) it would completely destroy liquidity in these important markets. I presume “mark to market” would be OK for you here in these very liquid markets?
But then the next question is “what about the corporate bond book?”… “the loan book” etc.. Yes, I know there are some rules about trading book assets and banking book assets but it becomes murky. Can your approach handle these issues?
Finally, even in an area where your treatment suits most obviously (a loan book to small companies where there are no market prices), how do you value diversification? A prudent banker might during coronavirus mark each individual loan at 25% of face value – but is reasonable from a portfolio perspective? Marking the whole portfolio at 25% would have serious ramifications for Capital levels and might be overly pessemistic. Surely there must be some recognition of the value of diversity?
So, I am in complete agreement that we need a return to more prudent accounting….. but I think it is tricky.
Trading books are easy
Cost or NRV
We know NRV. It’s current price
And we gave prudence
So you can’t mark up
You can mark down
Not quite clear to me what you mean.
If you are suggesting that trading books mark positions at market price (and “lower of cost/market price” applies to the banking books only) then I am fine with that…. except that it is often difficult to distinguish between trading and banking books. As you have correctly observed, banks do not have large portfolios of loans to small local business, it is more likely a large portfolio of loans, bonds, derivatives linked to large borrowers that are all highly correlated to each other, one often acting as a hedge for another. Is it a banking book or a trading book? It is often unclear and banks are good at arbitraging different regulatory/accounting regimes for their own benefit.
I guess that I am saying that there is a lot of detail to be worked out to ensure the accounting changes actually have the desired impact. Banking regulators have been trying for years to achieve this with mixed success.
If, on the other hand, you think “lower of cost and market” should apply to trading books as well then I have to disagree. Trading books will have long and short positions in different securities and the risk/value of the book MUST be assessed on a portfolio basis. If not, government bond markets would seize up completely as the cost of being a risk taker/liquidity provider would dwarf the profitability of any trading activity. Indeed, it might have the perverse result of increasing risk at banks as hedging activity becomes too expensive.
If you accept this (and I hope you do) then you are back with my first paragraph – the problems related to differential treatment based on (possibly) arbitrary decisions.
Finally, the other solution is to step back 50 years to a simpler banking/securities world. Frankly, I find this the most appealing solution but I have no idea how we get there.
I’d have to go back to check how this was done under HCA
I admit I have not audited a bank for a long time….let alone under HCA
I think Clive is saying, before there was “fair value” under IFRS, there was “mark to market” under UK GAAP. But that does depend on their being a liquid market into which you can make a sale at will.
And that was a very peculiar situation – and actually I think does not negate the point at all – a liquid market did provide an NRV test
Well, you are the accountant, but I was under the impression that the concept of “prudence” had already been expressly brought back into the 2018 IFRS Conceptual Framework (“the exercise of caution when making judgements under conditions of uncertainty”).
You seem to be arguing for a conservative (small C) approach to accounting. Does that not run the risk of understating assets or overstating liabilities, and perhaps deferring recognition of income or gains?
The concept of “objective accounting” is an interesting one. If accountants exercise judgement – as they must if they are not tied up by prescriptive rules (that can be abused) – then there must be the possibility that different accountants will make different decisions.
Rather like stewardship, it makes fleeting appearance
But nothing has fundamentally changed on this issue and prudence is not the dominant theme it was in HCA
Of course judgement is part of accounting: but a direction of travel is always required and prudence provides it