Dark hole in accountancy rules still exists as prudence is clearly lacking in standards

To protect investors against fraud, particularly from bankrupt companies or Ponzi schemes, the Irish Stock Exchange has special Listing and Continuing Obligation rules (LCO) in place. The recent Anglo tapes have, nevertheless, revealed a potential breakdown.

A significant part of the problem is that changes in EU regulation have meant it is not too difficult for bankrupt companies to raise money by misleading investors – even though it remains illegal for them to knowingly do so.

In September 2008, at the time of the Anglo tapes, there was the danger that all the major banks in Ireland and the UK were insolvent yet no bank informed the stock market, or the regulator. In March 2009 a report for the UK government, the Turner Review, summarised the banking crisis as follows:

Autumn 2007-2008
Severe mark-to-market losses in trading books; collapse of commercial paper markets; funding strains in the secured financing markets and worries about liquidity of major institutions.

Summer 2008
Mark-to-market losses and liquidity strains continue to escalate. Housing market problems recognised as widespread in UK, US and other countries as house prices fall and supply of credit dries up. Funding problems in UK mortgage banks intensify.

September 2008
Bankruptcy of Lehmans breaks confidence that major institutions are too big to fail. Credit downgrade of AIG triggers rising collateral calls.

Clearly the extract recognised a liquidity and confidence crisis but failed to mention something even more damaging. Since 2005, unknown to regulators and shareholders, banks had changed how they recognised losses on troubled loans.

Before then, banks had been forced to reveal instantly losses from poor lending decisions. But, after 2005, banks were in a position where they could actually record accounting profits on reckless loans. So flawed were the rules that investors could not distinguish solvent from insolvent banks, contrary to stock exchange rules.

Unlike Ireland, British auditors knew what was happening in early 2008. Referring to the failed Royal Bank of Scotland, Deloitte said: "During the early months of 2008, we carried out our audits of the financial statements ... for the year ended 31 December 2007. At that time, audit teams on our banking clients considered going concern ... We concluded that, based on conditions in the market at that point, we did not have significant concerns...

"This assessment was reached after considering both the state of the banking market and the actions of the Treasury, the Bank of England, and others following the collapse of Northern Rock. "

Possibly in 2007, but certainly in 2008, Deloittes knew that RBS did not have access to sufficient cash but claimed that there was a good chance that the UK government would rescue them, hence there was no need to cause alarm by telling shareholders anything.

"I find this astonishing, absolutely astonishing" is how former chancellor Nigel Lawson responded.

KPMG, auditors to troubled bank HBOS, said: "'going concern' in a bank is inextricably linked with a question of confidence … when confidence is lost there is no longer a going concern."

KPMG claimed that HBOS was not a threat because a report from the Bank of England speculated that gross domestic product would grow in the next year.

KPMG also got assurances that the UK regulators, then called the FSA, had no immediate concerns.

PricewaterhouseCooopers, auditors to Northern Rock and Lloyds (both failed banks), say that the role of the auditor is to "conclude whether there is any material uncertainty that may cast significant doubt". PwC also said "in terms of capital requirements, the banks PwC audited were still profitable in early 2008 and had levels of capital well above regulatory minimum requirements".

Flawed rules
Unfortunately, those profits and levels of capital were calculated using flawed European accounting rules.

Corporate governance expert Tim Bush, giving evidence to a UK bank inquiry, said: "In early 2008, I produced a brief analysis of problems with banks and their accounts and, having sent that to HM Treasury, I was immediately asked to meet officials in July 2008, where I ran a model (similar to that the FSA now has) past members of the Financial Crisis Team.

“I gave them my view that I thought that accounting standards were not only covering up problems in banks but were causative of them.”

Bush, head of governance and financial analysis at independent consultancy PIRC, claimed that the ability of banks to record profits on reckless lending since 2005 has encouraged reckless lending.

The inquiry concluded: “The Government should reassert the vital role of prudence [the rule that makes sure losses are revealed] in audit in the UK, whatever the accounting standard.”

Until the British and Irish government do this, it is impossible to tell if banks are meeting the LCO requirements of the Irish Stock Exchange, which is a worry for shareholders.

In 2010, the architects behind the European Union accounting rules ignored the inquiry by removing prudence from the accounting framework. Even today, solvent banks can claim they are profitable. The Bank of England warns that banks are still not revealing losses.

Auditors are often afraid to say a bank is insolvent. Had auditors warned shareholders what was happening, they could have started a “run” on a particular financial institution, with panicked depositors withdrawing their money instantly. Some believe that it is better to wait until they have concrete evidence that the bank will fail. Many burnt shareholders disagree.

One leading Irish lawyer has advised that it is difficult for shareholders to take legal action against auditors who give false assurances that banks are meeting LCO requirements but referred to the recent Irish case KBC v BCM Hanby Wallace for some pointers on auditors' duty to shareholders.

Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options. cormacbutler.com