IAS 39 problems flare up again

THE DEBATE over accounting standards flared up again in May when investor lobbyists Pirc called on shareholders to vote against the re-appointment of PwC as auditors of Barclays.

But why does Pirc continue to flag up an issue that is being rectified, albeit slowly?

Here’s the background: Pirc is advising its clients to vote against Barclays’ annual report, auditors PwC and non-executive/audit committee chair Sir Mike Rake because the organisation believes that flaws in the International Financial Reporting Standards (IFRS) accounting allow the bank to overstate its profits.

It is not only Barclays and PwC that have drawn Pirc’s ire. It will also tell clients to vote against Deloitte and KPMG, the auditors of RBS and HSBC, respectively.

Even more provocative is Pirc’s claim that “auditors are forcing boards to comply with IFRS, rather than the full scope of the law”. In other words, Pirc believes that IFRS fails to give the true and fair view of business’ financial position for which the Companies Act calls because IAS 39 is backward-looking.

Pirc has calculated that the IFRS methodology allows Barclays to overstate its net assets and profits by £6.7bn, HSBC by $16bn (£10bn) and RBS by £16.8bn.

The gripe is not a new one. Pirc has argued for some time that a fundamental problem in IFRS allows banks to pay out on unrealised profits because it does not force them to make adequate provision for loans that could go bad.

The issue centres on use of the IAS 39 incurred loss model, which requires evidence of a loss before the loans can be written down.

The flaw in the system was exposed during the financial crisis of 2007 when insolvent banks carrying overvalued assets were made to appear healthy. The losses in the cases or RBS and HBOS amounted to £30bn and resulted in one bank being bailed out by taxpayers while the other was snapped up by a rival.

The International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB), the UK and US accounting standards setters, have accepted that the IAS 39 financial instruments model simply shuts the gate after the horse has bolted, and they are still working towards replacing the incurred loss model with a more forward-looking expected loss or fair value model.

With the problem exposed and standard setters working to rectify it, auditors may wonder why it is such a bugbear for Pirc.

Real wrangling

It is here that the real wrangling begins. Changes to IAS 39 are not expected to come in to play until 2015 or later, and critics of IFRS argue that auditors should adhere to legislation over standards until that happens.

Critics contend that the Companies Act should carry more weight than IFRS as it currently stands. In its proposal to Barclays’ shareholders, Pirc states that “section 393 Companies Act 2006 requires that accounts give a true and fair view”.

“There is a general misunderstanding that a true and fair view means following accounting standards. That is not the case, and most certainly not when accounting standards produce an outcome that is defective against the true and fair view principle of the law,” the document said.

However, it has been suggested to our sister publication Accountancy Age that auditors would have to be “barking mad” to ignore the standard as it currently stands.

“Given that IAS 39 is endorsed by the EU, it would be a brave auditor to go from the standard,” said a senior audit professional, adding that the Financial Reporting Review Panel(FRRP) would come down on such an auditor like a “ton of bricks”.

The retort levelled by critics is that this argument carries no weight. Back in 2002, the FRRP supported the use of a “true and fair override”, which was adopted by Liberty International in relation to its acquisition in November 2000 of the minority interest of shares subsidiary Capital Shopping Centres.

That argument is supported by the Financial Reporting Council’s (FRC) July 2011 paper on true and fair accounting.

The FRC stated: “Where a company departs from a standard in order to give a true and fair view and a proper explanation is given of the reason for the departure and its effects, the Financial Reporting Review Panel will be reluctant to substitute its own judgement for that of the company’s board unless it is not satisfied that the board has acted reasonably.”

However, as PwC points out, auditors are simply preparing accounts under IFRS as endorsed by the European Commission.

“In some circumstances, where fair values are permitted or required, this involves the inclusion of profits that are not realised in cash terms in the income statement. This is done in order to give a true and fair view of the company’s performance in the year,” explained a PwC spokesman.

Until the IASB and FASB enact a conclusive change to IAS 39, prepare yourselves for another three years of this argument rumbling on.