Pre-crash deficiencies in accounting standards delayed the discovery of hidden losses and new rules are needed but accountancy can’t stop imprudent lending

DEBATES ON technical matters such as accounting standards, auditing and company law can be, by their nature, complex. Sometimes there are no easy ways to explain issues that require the type of good understanding of accounting concepts that not everyone will have.

Using the demise of Irish stockbroker Bloxham as a starting point, a number of comment pieces have again raised wider issues about the apparent absence of specific inquiries into the role of auditors, the lack of accountability of auditors, and accusations that the accountancy profession is in some way guilty of setting dubious rules that involve a flagrant disregard for the requirements of company law.

It has even been suggested that the accounting profession is in no rush to change or even explain what is going on.

Society has a right to raise such questions. It also has a right to receive answers in a manner that facilitates a balanced and informed debate.

That is why it is important to address some inaccuracies that have appeared in the media on accounting, auditing and lack of action and progress in addressing many issues thrown up by the financial crisis.

At its simplest, accounting rules, such as the International Financial Reporting Standards (IFRS), are used by company directors in preparing financial statements that give a true and fair view of the financial position and performance of an entity.

External auditors, in turn, express their own opinion about whether those financial statements do, indeed, provide such a true and fair view. “True and fair” is one of those technical concepts referred to above. In essence it represents compliance with relevant accounting provisions of company law and applicable accounting standards such as IFRS. While it is possible to depart from the requirements of IFRS in certain circumstances, a legal opinion by Michael Moore QC concludes that the circumstances in which departure from a standard is appropriate are very limited.

Mr Moore’s opinion was not commissioned by the accountancy profession, but by the UK’s Financial Reporting Council (FRC), the independent Government-sponsored body responsible for promoting high quality governance and financial reporting and for regulating the accountancy and auditing professions.

IFRS standards are not set by the auditing profession but by the International Accounting Standards Board (IASB) whose members include securities regulators, analysts, academics, investors, and central bankers. It is chaired by a former finance minister from the Netherlands.

The IASB’s standard-setting activities are overseen and monitored by a complex governance mechanism that ensures standard-setting takes place in the public interest and that due process is observed.

Before application in the EU, IFRS are subject to a rigorous assessment by a number of expert committees that include representation from the ECB, banking supervisors, insurance supervisors and member states to ensure the standards meet the “true and fair” requirement of EU company law. Compliance with IFRS by listed companies, when preparing group accounts, is a requirement of both EU and Irish company law.

Financial-crisis commentators are right: there have been deficiencies concerning an accounting standard relating to loan-loss recognition – the so-called “incurred loss model” that prohibited earlier recognition of losses by financial, and other, institutions.

In 2009, the Financial Crisis Advisory Group of the IASB concluded that the incurred-loss model had delayed recognition of losses on loan portfolios, which led to the understating of losses embedded in the system. There is now widespread acceptance of this deficiency.

It is misleading to say that the IASB has not responded. Both it and its US counterpart have been working to revise the accounting rules on loss provisioning. The new standard is likely to allow for earlier recognition of losses (“expected loss”).

But the new rules will not necessarily prevent a repeat of events that precipitated the financial crisis. Risk is risk and imprudent lending is imprudent lending. Simply changing accounting rules will do little to prevent toxic loan damage. The chairman of the IASB recently cautioned banking regulators that “economic cyclicality can be too powerful to be dented significantly by . . . accounting”.

Accounting standards, he said, are not an instrument of economic policy; they merely serve to depict financial and economic reality as reliably as possible. The introduction of these changes has been frustratingly slow; the new requirements relating to impairments remain some time away. But an amended loan-loss provisioning model would probably have had little impact on the pursuing, by certain banks, of a business model that was largely dependent on continuing access to cheap credit being on-lent into an already over-heated property market.

No accounting model could have foreseen the extent of losses that would ultimately crystallise in the absence of objective indicators of impairment – and there were none.

There could not have been any sound basis for estimation of likely future losses. To suggest that any accounting model would have indicated future losses, at the same time that bankers, credit committees and boards were still actively lending into that same market, is to grossly misrepresent what any accounting standard is capable of achieving.

Ireland has had a number of inquiries which, among other things, have addressed accounting matters and the role of audit.

Central Bank governor Patrick Honohan’s report on the financial crisis and that of Regling and Watson both commented on the restrictions on provisioning imposed by extant accounting rules. In his report into the causes of the crisis, published in March 2011, Prof Peter Nyberg concluded that while the auditors of Irish banks fulfilled their statutory role, this role was now too narrow to meet the needs of society. He also said that the problem of clean audit opinions on financial institutions, followed soon afterwards by the threat of closure was not new, nor was it just an Irish phenomenon. Similar observations were made in the UK in a House of Commons Treasury Committee report.

Policy makers, regulators and the auditing profession have been responding to such challenges. In Europe, proposals aimed at reforming the role of auditors, and their supervision and regulation are well advanced.

How auditors are supervised and regulated will change once the European proposals are implemented.

The profession will no longer have any role in supervising auditors of public interest entities. Indeed, it may no longer have a role in regulating any statutory auditors.

It is inaccurate to suggest that the status quo will remain in financial reporting, the role of audit and the regulation of auditors.

We are about to see some of the most radical changes ever to be confronted by the accountancy profession. Chartered Accountants Ireland will continue to play an active and positive role in the debates to follow.

Aidan Lambe is director of technical policy at Chartered Accountants Ireland