31 May 2012

Talking point: Can IFRS give a true and fair view of banks?

Two experts debate whether the real state of a bank's health can be captured IFRS. Tell us which side you agree with

No: Andy Haldane, executive director of financial stability at the Bank of England

Banks are different. Their flighty liabilities and uncertain assets make for a fragile mix. If nothing else, events of the past few years illustrate that. If they are to be useful to investors, banks’ financial statements need to capture those fragilities so that risk can be priced. This calls for accounting rules that properly recognise the special characteristics of banks’ assets and liabilities. IFRS requirements currently fall short of that objective.

One example would be accounting for unrealised gains on banks’ fair-valued assets. Taking these gains through to capital, and in some cases distributable profit, will flatter both during asset upswings and flatten both during downswings. This is a recipe for pro-cyclicality, adding fuel to boom and bust. It is also a recipe for imprudence – eating paper profits before they are earned. Prudence should be the bedrock of accounting standards.

A second example would be accounting for the uncertainty around bank assets. To provide point valuations of banks’ assets, as at present, is to ask auditors to pin the tail on a boisterous donkey. It risks giving a hit-and-miss evaluation of banks’ underlying solvency position. Accounting standards for banks could help investors to price risk by providing both prudent valuations and confidence limits around banks’ assets.

A third example would be the classification scheme for banks’ accounts. At present this takes a binary form – accounts are either qualified or not. A qualification of banks’ accounts risks sending a bank into bankruptcy. It places auditors in the role of judge, jury – and, if there is a qualification, executioner. A more graduated scheme would lessen this dilemma. It too would make for greater prudence on the part of auditors and better pricing on the part of investors.

Investors in banks are scarred by the financial crisis. It is in the interests of auditors, as much as banks, their investors and regulators, to right that wrong. Looking again at accounting rules for banks, through a prudential lens, is part of a lasting solution.


Yes: Kathryn Cearns, consultant accountant at Herbert Smith LLP and the chairman of the ICAEW Financial Reporting Committee

The assertion that IFRS caused the financial crisis needs to be examined dispassionately. Various academic studies have now explored whether accounting contributed substantially to the crisis. While commentators have made widely reported claims that accounting was to blame, as yet these claims have no established basis in fact.

Derivatives and instruments held for trading under a company’s business model should be measured at fair value as historical cost has proved deficient in providing investor information. It is hard to see why banks, with the same assets and liabilities as other firms, should account for them differently just because they have more of them.

Some argue that fair value profits on financial instruments are not "real". A financial instrument is made up of real contractual rights and obligations, and changes in its value reflect real economic phenomena. Without fair value, no derivative would appear in the accounts until it was realised. "Realised" seems to be used by some as a proxy for "permanent" in relation to profits. But if I invest £1 in a risky instrument, which rises in value to £1.50, and I then sell that asset for cash and reinvest the full proceeds in an equally risky instrument, then my "profit" of 50p is no more permanent than if I had taken a fair value uplift to £1.50 on the original instrument into my books; and both the realised and fair value profits can be wiped out by a subsequent loss without undermining the legality of a previous distribution.

Some kind of graded audit opinion has been proposed for banks. But the binary audit opinion has substantial signalling value; where a clean opinion is a possibility, being a little bit qualified will be like being a little bit pregnant.

What investors currently think about banks has nothing to do with the accounting or auditing rules per se and everything to do with an economic view of their prospects. Conflating transparent financial reporting for investors with prudential priorities will not change that view.


Views expressed are the writers' own