Tax Research UK

I’m told one member of the audience at yesterday’s meeting where Adair Turner spoke about the need to transform the accounting of banks asked:

whether a failed standard setter should be able to fail, given free market principles..?

A panellist from the right wing American Enterprise Institute said "good question" and:

it hasn’t failed financially but it has failed intellectually, so it should be allowed to fail.

and added:

It shows the problem of one uniform model when it is the wrong one

which rather reminds me of Voltaire who said:

It is dangerous to be right in matters where established men are wrong.

Not spoken in jest, I suspect.

Richard Murphy Accounting, IASB

Earlier this week I had an article on Forbes about the absurdity of bad debt less provisioning for banks under the rules of International Financial Reporting Standards established by the International Accounting Standards  Board. I summarised all the arguments there: I won’t repeat them.

Yesterday Adair Tuner – Lord Turner, chair of the Financial services Authority – joined in the attack in a speech at the Institute of Chartered Accountants in England and Wales. The speech is here. It is, I admit, pretty technical. It’s also (rather refreshingly) highly competent. he asked the question:

So are banks different in ways relevant to accounting standards? In what ways, and what should we do about it?

His answer was they are, of course. As he noted:

Two aspects of bank accounting in particular could be relevant to the macro-prudential and macroeconomic concerns which make banks different.

• First, the treatment of loan losses within the banking book, the way in which we capture, or fail to capture, present or future potential loan losses arising from credit default.
• Second, the valuation approach in the trading book (and other items which are marked to market), the recognition of unrealised gains or losses in general, but in particular in more illiquid securities.

In both these areas, there is a strong case that the present accounting treatment contributes to the problem of procyclicality.

To out it another way, mark to market accounting rules when used by banks helped create the current crisis for the reasons I noted in Forbes. Or as he puts it:

On the banking book side, the current IASB accounting treatment requires banks to recognise the implications for potential loan losses of events which have already occurred, such as failures to make interest or principal payments; but also requires them only to recognise such known events, not to anticipate possible or probable future events. This necessarily implies that loan loss provisions will vary dramatically through the economic cycle, and means that in good years income will be declared which does not reflect the average future loan losses likely to arise from loans being put on the books.

As a result, this accounting treatment can contribute to a cycle of self-reinforcing responses which tends to exacerbate the volatility of credit extension and of the economic cycle, both on the way up and the way down.

At long last! Someone has said it. Actually, he said more than that. As he pointed out:

For the fundamental problem we face is that there are no definitive ‘facts’ about value – but that value in financial markets is contingent on specific circumstances and on the action of all other participants. For an individual bank selling slices of its individual portfolio in conditions where the actions of other banks can be considered as independent, mark-to-market accounting provides meaningful facts and a useful management discipline. But if all banks simultaneously try to sell all or a significant proportion of their assets, the facts become quite different.

Or to put it another way – those who built accounting rules on the basis of the efficient market hypothesis get those rules very, very wrong.

So he argues for a new form of accounting for bank losses:

Faced with that trade off between divergent aims, the FSA’s ideal preference would be to provide not one but two separate lines of account information on loan loss provisions.

• The existing line, based as now, on the facts of already incurred credit impairment events.
• And a separate line, based either on a formula, as in Spain, or on the judgements of management, challenged by regulators, and with the details, basis and rationale for that judgement extensively disclosed.

Which is am pretty damning indictment of what has gone before.

It’s also a damning indictment of the International Accounting Standards Board’s claim that the only people with interest in accounts are providers of capital. he is saying there is reason to provide data for many more reasons than that, and if that is all that is done disaster can follow – as it has.

Not a good day for the  IASB. Or banks

But a good day for accountancy, maybe.

Richard Murphy Accounting, Banking, IASB

My latest Forbes column is out. Entitled ‘Precious Little Prudence’ it asks ‘When is a debt a bad thing–do accountants really even know?’

As I conclude:

[L]et’s never forget that both the IASB and IAASB are dominated and even significantly financed by the Big 4 firms of accountants and auditors - PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young.

According to popular myth these firms have had a ‘good recession’ – little blame attaching to them for what has happened. But that’s just a myth, because the truth is they carry a great deal of responsibility for what has gone wrong – and should bear the consequences.

Which is something I firmly believe.

Richard Murphy Accounting, Auditing, Big 4

FT.com / Companies / Banks - Central bankers demand new rules.

The FT notes:

Top central bankers and regulators underlined their differences with accounting rule-makers on Monday over the way banks account for bad loans, highlighting the politicisation of the standard-setting process.

The central bank governors and heads of supervision of the world’s largest economies, who oversee the Basel Committee on Banking Supervision, said it was “essential” that accounting rule-makers and their supervisors develop a “truly robust” approach on banks’ provision for bad loans.

This was becasue:

The oversight body’s proposals would, crucially, lead to more smoothing-out of bank profits through the financial cycle than the IASB proposals would allow.

This, I stress is not a minor difference. This is the two bodies being fundamentally at odds with each other and with the IASB being absolutely in the wrong.

The IASB promotes the mark to market model. This is the absolute reverse of what accounting used to be when it came to bad debts. Accountants always used to anticipate losses on debts and make provision for them. This was prudent.

But come mark to market and securitised loans so long as there was a market for the security no provision for loss was allowed EVEN IF the underlying assets were obviously not performing: the market ruled value and prudence could not overtake. So there was no provisioning. Imprudence ruled. Losses could only be recognised when they had occurred with regard to the vast majority of bank debt.

So, of course, IFRS accounts allowed bank profit to sky rocket as loss provisions fell.

And then the world fell apart because bankers believed they could lend and never make a loss.

That is completely and utterly the fault of the International Accounting Standards Board.

No wonder Basel disagrees with them.

And Basel has to win this one. And all accountants should support Basel because prudent may be boring but it’s what good accountancy is about.

PS And you can’t blame the auditors - the Big 4 ensured the rules of auditing were changed so they no longer had to be prudent either - because they no longer had to say accounts were true and fair - they just had to say they were true and fair within IFRS - which meant that even if IFRS were nonsense they had no duty to apply what used to be called the ‘true and fair over-ride’ because that no longer existed.

Blame the IASB by all means. But let’s never forget that the IASB is the mere agent of PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young. And they are really to blame.

Richard Murphy Accountancy, Accounting, Auditing, Banking

FT.com / Companies / Financial Services - UK fraud losses rise to a high of £2.1bn.

BDO have monitored recorded fraud loss since 2003. It’s reached a new high, according to them, of £2.1bn.

As they say:

The statistics significantly under-report actual losses to fraud because they include only those cases publicly reported to authorities. More than 90 per cent of the losses investigated by BDO and other forensic accounting firms are never prosecuted. Many companies prefer to handle problems such as employee theft, accounting misdeeds and kickback payments privately or via civil litigation.

Management fraud, in which senior executives issue misleading financial statements, was the single largest category of fraud, accounting for 24 per cent of total losses.

As some of us have said, chaps don’t like prosecuting chaps for msi-stating accounts. That’s just not what you do.

But the chaps at BDO are also guilty of turning a blind eye to fraud. Tax evasion is fraud. My current estimate of annual tax evasion in the UK is £70 billion per annum.

I can’t help but ask why BDO appear to ignore every single penny of it when calculating their fraud stats? Is de-frauding the state somehow acceptable and not worthy of the name but defrauding business is serious?

I’d like to know their reasoning.

Richard Murphy Accounting, Corruption

IFRS 8, ‘Operating Segments’ has been applied to some 2008 financial statements of quoted companies and to all their 2009 interim statements.

The standard has been controversial since its adoption was proposed. This is not, unlike other International Financial Reporting Standards a truly European standard. IFRS 8 was lifted straight from US GAAP as a political gesture to the US Federal Accounting Standards Board to show the process of alignment of standards would not mean US GHAAP would be completely subsumed by the IFRS.

The difficulty was that academic research had already shown that the US equivalent of IFRS 8 (called SFAS 131) had been bad news for shareholders. 

So it looks like it is also proving to be now the standard has been put into use in Europe. In its pronouncement of 2010 the Financial Reporting Review Panel of the Financial Reporting Council has said it is concerned about how companies are reporting the performance of key parts of their business in the light of the introduction of IFRS 8. It requires some understanding of IFRS 8 and its predecessor, International Accounting Standard 14, to see why.

IFRS 8 requires companies to provide an analysis of profit, assets and liabilities so that investors can see the performance of the principal operations or "segments" of the reporting entity. The new standard requires management to define the company’s operating segments in accordance with how its operations are managed in practice. In this way the IASB sought to respond to criticisms of IAS 14 (the previous standard), to reduce the ability of management to disguise poor performance of a part of the business, and to enable investors to review a company’s operations from the same perspective as management. IAS 14 supposedly did this by focussing primarily on the disclosure of segment data by geographic location (usually by continent) with business focussed data being treated as secondary.

However, in doing so IAS 14 had some considerable advantages over IFRS 8:

· All trade had to be allocated to a segment so that segment reports had to reconcile to the full financial statements. This is not required under IFRS 8 where only 75% of trading need be segment reported;

· The same accounting standards had to be used for IAS 14 segment reports as for the main financial statements. This would seem logical. It is not a requirement of IFRS 8 – so its segment data can offer a completely different view from the rest of the audited financial statements.

· ISA 14 segments were to an extent mandatory assisting comparison between entities and over time. IFRS 8 segments are created by the company at will. There is no reason why they need ever be consistent.

The resulting problems are already coming to light. The FRRP has apparently reviewed a sample of 2009 interim accounts and 2008 annual accounts (when they had early applied the standard) and has asked a number of questions about the implementation of IFRS 8. In particular they have asked a number of companies to provide additional explanations where:

• only one operating segment is reported, but the group appears to be diverse with different businesses or with significant operations in different countries;
• the operating analysis set out in the narrative report differs from the operating segments in the financial statements;
• the titles and responsibilities of the directors or executive management team imply an organisational structure which is not reflected in the operating segments; or
• the commentary in the narrative report focuses on non-IFRS measures whereas the segmental disclosures are based on IFRS amounts.

The FRRP has encouraged Boards of Directors to test their initial conclusions about their segmental reporting by considering the following questions:

1. What are the key operating decisions made in running the business?
2. Who makes these key operating decisions?
3. Who are the segment managers (as defined in the standard) and who do they report to?
4. How are the group’s activities reported in the information used by management to review performance and make resource allocation decisions between segments?
5. Is any proposed aggregation of operating segments into one reportable segment supported by the aggregation criteria in the standard, including consistency with the core principle?
6. Is the information about reportable segments based on IFRS measures or on an alternative basis?
7. Have the reported segment amounts been reconciled to the IFRS aggregate amounts?
8. Do the accounts describe the factors used to identify the reportable segments including the basis on which the company is organised?

As a final question, the FRRP has reminded management to ask themselves whether the reported segments appear consistent with their internal reporting and, if not, why not.

The nature of these questions is pretty damning. It suggests that at least in some cases the FRRP believes management is misleading shareholders.

Those, like me, who criticised the adoption of IFRS 8 from the outset predicted this would happen: the US research, which I have summarised  here showed that managers, when not monitored by shareholders, will make self-maximizing decisions which may not be in the best interest of those shareholders. These decisions include aggressively growing the firm, which reduces profitability and destroys firm value. They used geographic earnings disclosures to examine this issue. Statement of Financial Accounting Standards No. 131 (SFAS 131), which is almost identical to the controversial new IASB standard IFRS 8 let them do so. Under its provisions US companies could abandon geographic disclosure of earnings and other key data. They expected that such non-disclosure potentially reduced the ability of shareholders to monitor managers’ decisions related to foreign operations.

Using a sample of U.S. multinationals with substantial foreign operations, they found that geographic non-disclosing firms experienced greater expansion of foreign sales, produced lower foreign profit margins and had lower firm value in the post-SFAS 131 period when compared to companies that continued to disclose geographic earnings. These differences did not exist in the pre-SFAS 131 period and did not relate to domestic operations. Compellingly, the only variable they could find that explained this was disclosure of geographic data.

In other words, IFRS 8 and its US equivalent are bad for shareholders because directors wilfully mislead them whilst pursuing their own aggressive agendas in vain pursuit of self –glorification.

There is an alternative: for some years I have been promoting the idea of country-by-country reporting. This version of segment reporting would require disclosure of the following information by each Multinational Corporation (MNC) in its annual financial statements:

1. The name of each country in which it operates;

2. The names of all its companies trading in each country in which it operates;

3. What its financial performance is in every country in which it operates, without exception, including:

· It sales, both third party and with other group companies;

· Purchases, split between third parties and intra-group transactions;

· Labour costs and employee numbers;

· Financing costs split between those paid to third parties and to other group members;

· Its pre-tax profit;

4. The tax charge included in its accounts for the country in question split as noted in more detail below;

5. Details of the cost and net book value of its physical fixed assets located in each country;

6. Details of its gross and net assets in total for each country in which operates.

Tax information would need to be analysed by country in more depth requiring disclosure of the following for each country in which the corporation operates:

1. The tax charge for the year split between current and deferred tax;

2. The actual tax payments made to the government of the country in the period;

3. The liabilities (and assets, if relevant) owing for tax and equivalent charges at the beginning and end of each accounting period;

4. Deferred taxation liabilities for the country at the start and close of each accounting period.

This is real segment reporting, disclosing who does what, where and with what attached risk. The added value is enormous and for the first time people would be able to meaningfully assess the risk they engage in when trading with a multinational corporation. In addition, the whole issue relating to transfer pricing abuse would be exposed.

It’s for the last reason that many of the world’s most significant development charities support country-by-country reporting and the OECD is now looking at the issue, which already has the support of the EU Parliament.

As IFRS 8 fails to deliver the demand for country-by-country reporting can only grow.

Richard Murphy Accounting, Country-by-country, IASB

Quotes of the year must have some essential qualities. They must be routed in reality. They must encapsulate a moment. They must have inherent in tem a demand for action. Hopefully they’re elegant, pithy, pertinent and prescient all at the same time.

The following from Steve Hadrill, new head of the UK’s Financial reporting Council responsible for regulating auditors fails on elegance. It also needs contextual setting so it is not pithy. But it’s good on the other two. In December 2009 he said, when speaking about whether a fifth large firm of auditors was needed:

[T]he priority for us has to be that we are prepared for the worst and that is where I will put my focus

Blow creating a fifth firm in other words, making sure we keep four is going to be tough enough in his view, and mine.

The prescience? Threefold, I suggest: first, failure of one of the Big 4 is inevitable; second, he has no idea what will happen if they do and third we’re setting ourselves up for another ‘too big to fail’ scenario. As the pillars of our current version of capitalism collapse all around us all we seem able to do is prop them up until like dominoes they’ll fall again.

It’s not encouraging. And it shows, time and again, that the wrong people are in  the regulatory jobs.

Richard Murphy Accounting, Big 4

re: The Auditors » Blog Archive » EY Settles SEC Charges Re: Bally’s Fraud-Lives To Audit Another Day .

Ernst & Young picks up yet more penalties and Francine McKenna asks an apposite question: how many strikes does a firm get before it’s out?

Quite a lot, she suggests, if you’re on the regulatory body.

Richard Murphy Accounting, Auditing, Ernst & Young, Ethics

ICAS executive director of technical policy, David Wood has added his voice to the campaign by Christian Aid against tax avoidance by companies working in the developing world.

View the video here.

It’s good to see a spokesperson for a professional institute standing up and being counted in this way.

I look forward to more joining him.

Richard Murphy Accounting, Development, Ethics, Tax avoidance

FT Alphaville » Basel blows out DTAs.

The Basel committee on banking supervision has ruled deferred tax assets are not part of a bank’s tier one capital that underpins their solvency.

That’s eminently sensible.

What is mad is that they ever were.

Richard Murphy Accounting, Banking