EU negligence on accounting standards allowed Irish banks to conceal losses
The EU has not yet admitted a flaw that allows financial bodies to hide losses
Evidence emerged last week that suggested European Union negligence allowed Irish banks to conceal losses from regulators and shareholders in the run-up to the banking crisis. It gives Irish politicians more ammunition with which to negotiate a reduction in the promissory notes and other legacy debt the EU inflicted on Irish taxpayers.
Led by former British chancellor of the exchequer Nigel Lawson, a House of Lords inquiry that opened last week is examining why annual reports produced by Irish and UK banks were misleading. Between 2005 and 2010 insolvent and bankrupt banks said they were healthy and profitable.
Last Wednesday Hans Hoogervorst, head of the International Accounting Standards Board (IASB), architects of the EU accounting rules, said his rules were confusing and allowed bankers delay recognising losses. He said the IASB dropped prudence – the company law requirement that forces banks to instantly reveal losses on troubled loans – despite having a legal opinion from Martin Moore QC that said only accounts prepared on a prudent basis complied with company law. The IASB said banks that follow their rules can ignore this part of Moore’s opinion because the UK’s Financial Reporting Council (FRC) said they could. The FRC decides how the IASB rules apply in Ireland and Britain.
This raises worrying questions. Can the FRC override company law in this way? Both the Irish Institute of Chartered Accountants and the FRC claim Moore’s opinion endorses their claim that the IASB rules meet Irish company law requirements, despite the problem with “hidden losses”.
There is another issue. Gerald Flynn of Dublin’s Institute of Technology has just published research examining bank regulation. He says: “An important contributor to the financial crisis is not so much that the accounting profession abandoned prudence, it is that they abandoned prudence and also concealed from shareholders and regulators what they had done.”
Flynn says Irish banks first dropped prudence when the IASB rules were rolled out in 2005. His view is backed up by Central Bank governor Patrick Honohan and confirmed by Bank of Ireland.
However, between 2005 and 2010 a document called the IASB Framework reassured investors all entities must apply prudence. This document clashed with the accounting standard IAS 39, another IASB publication. It tells auditors in very opaque language that banks can ignore prudence and override its reference in the framework.
Prof Stella Fearnley, a witness at the Lords inquiry, told Lawson last week the accounting profession was privately able to ignore prudence but publically reassured investors and regulators via the framework that they applied prudence. Few outside banking knew of the loophole. Moore relied on the framework document for his 2008 opinion.
That year, Brian Lenihan commissioned auditors to estimate losses Irish banks had built up. Their report used IASB rules to calculate the losses and was therefore potentially misleading.
Tim Bush, head of governance and financial analysis at independent consultancy PIRC, said the IASB is confusing everyone.
“From 2005 the IASB standards had dropped prudence surreptitiously,” he said.
A 1983 legal opinion from Mary Arden QC concluded accounts must “meet the reasonable expectations of users”. It is illegal to tell investors you are applying prudence if you are doing something different.
A few months ago Hoogvorst continued to reassure shareholders: “It is not surprising that the British government recently stated that it ‘does not accept that IFRS has led to a loss of prudence’”, he said.
His predecessor, David Tweedie, said in 2008: “No entity is ever allowed to disclose assets valued at more than their recoverable amount in its financial statements.”
In other words, banks must follow prudence and recognise losses immediately.
Prudence ‘dropped on 2010’
Hoogvorst told Lawson last week the IASB “first dropped prudence in 2010” and not 2005, contrary to what Honohan and Bank of Ireland have said. The IASB issued a statement last Wednesday that made clear there were worries, internally at least.
“Mr Moore’s opinion was made before changes were made to the IASB’s conceptual framework in 2010 in which the qualitative characteristic of prudence was replaced by neutrality. Some take the view that this had rendered Mr Moore’s opinion out of date. However, we note that the importance of true and fair was reaffirmed by the FRC in a follow-up paper in 2011,” it said.
In 2005 the EU gave Ireland and other European countries an assurance it would never endorse an accounting standard that allowed any entity to conceal losses or overvalue assets. To date it has not yet admitted the flaw.
Cormac Butler was a contributor to Lessons for the Irish Government on Basel II and Accounting Failures, Vol 6, 11-14, Journal of Risk Management in Financial Institutions, Henry Stewart Publications.