Accounting rules place box ticking above prudence

Syed Kamall
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AN INCREASINGLY acrimonious battle on accounting standards is playing out that few people can follow with ease. Accounting standards, as a consequence of their highly technical nature, are easy to put aside as only of interest to those who have spent decades deciphering company finances. However, accounts are fundamental to the functioning of the modern market economy. If the accounts are wrong, how can we know whether a company – especially a bank – is a going concern or not?

Unease centres on the blind faith that both the UK government and European regulators place in International Financial Reporting Standards (IFRS). Much ink has been spilt on the issue of IFRS allowing banks to inflate their balance sheets and profits. The standards may have exacerbated the boom before the banking collapse brought down the markets. Even today, we see huge bonuses being paid out on the basis of accounts that do not reflect reality, but are deemed acceptable because they conform to the standards. In February 2012, HSBC admitted that directors were paid £5.019m, rather than the £3.076m disclosed in the 2010 accounts which had been prepared under IFRS. In Ireland, a heated debate continues on why auditors signed off the accounts of banks such as AIB which then collapsed within a year. The auditors’ defence is that the accounts were signed off as “true and fair in accordance with IFRS”.

IFRS has encouraged a move away from the principle of prudence, whereby accounts must not overstate assets or understate liabilities. Profits should only be booked once they are realised, and sufficient funds are put aside to cover any potential losses. This has been replaced by an American-inspired principle of auditor neutrality, which means accounts are always deemed “true and fair” if they have ticked all the boxes required by IFRS. This encourages auditors to move away from exercising professional scepticism when assessing a company’s accounts to simply ticking boxes.

This box ticking failed to spot financial institutions recording expected income from complex financial instruments in advance. We all saw the result of that when financial institutions failed, or had to be bailed out, since they simply did not put aside enough funds to cover their exposure to credit default swaps and collateralised debt obligations. AIG Financial Products was able to build a portfolio of $2.7 trillion (£1.7 trillion) in derivatives, resulting in liabilities many times its capacity to pay out.

As we consider the ongoing negotiations on a new EU accounting directive, we should be looking for accountants and auditors to be guided above all by the principle of prudence. Without this, some financial institutions and corporates will be able to continue to hide behind the mask of international accounting standards and claim they are solvent when they may be anything but.

Syed Kamall is Conservative MEP for London and a member of the European Parliament’s Economic and Monetary Affairs Committee.