IFRS – compounding the problem, and auditors are neglecting their duty to say so

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I wrote recently about how IFRS pension accounting would compound the current financial problems created by the irrational behaviour of the world's so called financial experts.

The FT has joined in the theme, publishing an article by Stella Fearnley and Shyam Sunder yesterday. Stella has been professor of accounting at Portsmouth where I was a visiting fellow for a period. They say:

There are a variety of problems behind the present market turmoil - chiefly reckless lending and inaccurate credit ratings of securitised debt. But one has so far had little attention - the role played by so-called "fair" value accounting.

Under IFRS financial instruments are stated on balance sheets at their "fair" values, which are taken from markets where possible, or for more complex securities are estimated from valuation models. But as they say:

The problem is that this assumes markets have good information from inputs such as financial reports and credit ratings. But there is a circularity built in: if credit raters and investors get their information from accounting numbers, which are themselves based on prices inflated by a market bubble, the accounting numbers support the bubble.

So instead of informing markets through prudent valuation and controlling management excess, "fair" values feed the prices back to the market. For example, a drop in the market value of the borrowings of a troubled company is reported as an increase in its income because the reduced liability flows through the income statement, thus obscuring the problem.

As they note, this gave rise to inflated earnings earlier this year. But, as they also note:

There were warnings. In 2006 the US Federal Reserve warned that fair value accounting could make an insolvent company look solvent. The UK's Financial Services Authority expressed concerns this year that fair value might not fully represent the economic reality of a business. Four months after some banks reported high first-quarter profits using fair value accounting, the Fed has cut interest rates to stabilise markets and keep some highly leveraged investment banks and hedge funds afloat.

As they say:

This is the second time in seven years that widespread problems have arisen in US accounting, securities' ratings and governance. Despite the onerous and costly requirements of Sarbanes-Oxley, and stringent audit controls, the system was unable to fix something as basic as the existence and collectibility of loans.

Meanwhile, US and international accounting standard setters are pressing ahead with a global framework which would embed this aggressive accounting. They seek one global system, however defective. They want verifiability, via a market price or a management estimate, rather than reliability of the underlying substance.

Auditors won't challenge this. That's because an audit is now defined as:

The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework.

Note that's got nothing to do with a true and fair view. Now that's interesting because this is in direct conflict with UK law (for example), which says (and I'm sorry to have to reproduce much of s495 Companies Act 2006 in full, but it's important):

(3) The report must state clearly whether, in the auditor's opinion, the annual
accounts-
(a) give a true and fair view-
i) in the case of an individual balance sheet, of the state of
affairs of the company as at the end of the financial year,
(ii) in the case of an individual profit and loss account, of
the profit or loss of the company for the financial year,
(iii) in the case of group accounts, of the state of affairs as at
the end of the financial year and of the profit or loss for the
financial year of the undertakings included in the consolidation
as a whole, so far as concerns members of the company;
(b) have been properly prepared in accordance with the relevant
financial reporting framework; and
(c) have been prepared in accordance with the requirements of this Act
(and, where applicable, Article 4 of the IAS Regulation).

Now note, section b (the secondary clause) refers to the financial reporting framework, but section (a) (the primary clause) requires a true and fair view. That is a deliberate oversight on the part of the International Auditing and Assurance Standards Board in my opinion. Opinion has gone out of the window. Box ticking to say that International Financial Reporting Standards have been followed is all that will be required by them. This contravenes UK law. But look at why. This is a body that is run by and for accountants. Box ticking has low risk. It also fuels markets when there's an upside, but compounds the problem on the downside. And auditors want to do nothing to stop this. Stella Fearnley explains why by comparing this approach with:

The gold standard in financial reporting has long been "lower of cost or market", meaning an asset is on the books at either its purchase cost or its current valuation - whichever was lower. This conservatism counterbalances the inherent tendency of managers to overstate performance by preventing them from reporting profits before cash is in hand.

This is right. But accountants and auditors have abandoned conservative counterbalancing for reckless endorsement. It gives complete lie to the claim that

The International Auditing and Assurance Standards Board (IAASB) serves the public interest by setting, independently and under its own authority, high quality standards dealing with auditing, review, other assurance, quality control and related services

Nothing could be further from the truth. The public are losing from their self interested recklessness.

When will we get our profession back from this madness?