The Accounting Standards Debate: The Academics
5 May 2009 Tony Hines, Vivien Beattie and Stella Fearnley
The current economic crisis has exposed weaknesses arising from the IFRS fair value model and the dropping of the concept of prudence. Stella Fearnley and Vivien Beattie, professors at Glasgow and Bournemouth Universities and Tony Hines, principle lecturer at the University of Portsmouth, explore some of the perceived inconveniences of IFRS.
In January 2009, Lord Turner Chairman of the UK Financial Services Authority, criticised the ‘illusory profits’ delivered by IFRS in a rising market where holding gains on securities held for trading become profits available for dividends and bonuses.
There are other illusions. A debt downgrade marked to market reduces the liability, producing another illusory profit. Nevertheless IASB has robustly defended its model in the name of global consistency and US GAAP convergence and attacked non-conformity. In 2008 Société Générale and their auditors were pilloried by current and former IASB members in the International Herald Tribune for ‘creative’ accounting, because they prudently carried back the whole loss caused by their rogue trader to their December 2007 year end accounts. Doing away with prudence also changed bank bad debt provisioning to an incurred loss loss model, thus limiting provisions when debt portfolios were growing in riskiness.
Sir David Tweedie, the IASB chairman, has claimed that marking toxic derivatives to market exposed the banking crisis more quickly, but the historical cost approach of lower of cost or net realisable value and the application of prudence in what had become a market for lemons would have produced appropriately conservative results, rather than firesale prices. (Nobel Laureate Akerlof characterises a market for lemons as one where trust is lost and fear of buying a lemon means no-one buys anything, and the market collapses.)
Sir David has acknowledged that IAS 39, the derivatives standard, was inherited from the US and requires significant change. Nevetheless IAS 39 was pushed into the EU in 2005.
UK policy makers have supported IFRS and US GAAP convergence. But our research identifies significant concerns about IFRS among expert UK preparer groups before the current crisis.
In June 2007 we conducted a major survey of finance directors (FDs), audit committee chairs (ACCs) and audit partners (APs) of UK listed companies. We received 498 responses giving an overall response rate of 36% (149 FDs, 130 ACCs and 219 APs).
We sought views (using a scale of 1 to 7) whether recent and proposed changes to the UK regulatory framework for financial reporting, auditing and corporate governance enhanced or undermined UK financial reporting integrity. We identified (a) 14 recent (i.e. post Enron) and forthcoming changes and (b) 15 proposals/suggestions for change. Of the 14 factors in (a) only three were considered to undermine integrity. The two with the lowest ranking were both related to IFRS: impact of IFRS on the true and fair view (ranked 14) and other aspects of IFRS (ranked 13).
Of the 15 proposed factors in (b) two IFRS related issues received low rankings: further use of fair values as a basis for financial reporting (ranked 12); and new and revised IFRS to be adopted throughout the EU in 2009 (ranked 10).
177 respondents made 289 narrative comments about IFRS of which only 24 were favourable, referring mainly to the benefits of global common standards. The criticisms from FDs, ACCs and APs covered similar issues but with different emphases. All groups complained that IFRS was rules driven and too complex. They regretted the loss of prudence and wanted a return to principles based accounting and true and fair.
The ACCs overriding concern was the complexity and irrationality of IFRS accounts and the lack of understanding by investors and analysts:
"The adoption of endless time consuming paper generating details seems to conceal the simple facts of any company. All our IFRS reporting has served to directly reduce the level of knowledge by the average investor. The analyst does not use the information." (ACC).
"99% of shareholders do not understand them and do not bother to read them. Several accounting adjustments make little sense to almost everyone." (ACC).
The FDs expressed concerns about risks inherent in the accounting model, detachment from business activity, unreliability of fair value results and US GAAP convergence:
"Get rid of IFRS – accounts no longer make common sense and inherent dangers are in this." (FD).
"The balance sheet is now an utter mess. How shareholders can be expected to understand it when so many of the numbers are discounted, or never expected to crystallise is beyond me. If the target audience is shareholders, IFRS has missed the mark." (FD).
"The move away from principles based reporting to a more prescriptive regime under IFRS is a retrograde step, as is convergence of IFRS with US GAAP." (FD).
"Great concept, totally unworkable." (FD)
The audit partners complained about the counter-intuitive effects of fair value, the demotivating effect of working with IFRS, the complexity and US GAAP convergence:
"There is nothing less motivating than spending the bulk of one’s time ticking boxes and trying to justify to clients counter intuitive accounting principles enunciated by an overly theoretical standards board. This tension between fair value principles and historic cost/stewardship principles means financial statements are increasingly incomprehensible to boards of directors." (AP).
"IFRS is fundamentally flawed as it represents neither an accurate measurement of the stewardship of a company nor a measure of its worth." (AP).
"Boards don’t understand IFRS and as a result are becoming increasingly disengaged on financial reporting. That is a bad thing for our profession and the future quality of people it attracts. The relevance of the auditor in the boardroom is increasingly under threat." (AP).
These views of UK accounting experts, combined with the now recognised unfortunate contribution IFRS made to illusory banking profits before the credit crunch, indicate that a radical rethink of the whole global accounting game is needed.