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Howard Flight: Fixing the Accounting botch

Flight_howard_2 Howard Flight was MP for Arundel and South Downs between 1997 and 2005, is a former Shadow Chief Secretary to the Treasury and Deputy Chairman of the Conservative Party, and is now chairman of Flight & Partners Recovery Fund.

When the UK Government committed to International Financial Reporting Standards (IFRS) in 2002, I disagreed, in principle, with a number of the proposals and, in particular, charging the notional cost of options to the profit and loss account, rather than requiring a full analysis of the resulting equity dilution impact as it served to distort reported profits’ figures in relation to actual trading, and did not make clear to shareholders the real cost of option issues in terms of their potential equity dilution. 

Also IFRS 17 was a major contributor to the demise of Defined Benefit Pension Schemes, and in turn the decline in pension saving:  By requiring pension liabilities to be discounted to present value, at prevailing prime Bond yields – rather than at the higher, blended, expected portfolio rate of return including higher returns from the equity element; this exaggerated pension Fund liabilities, in turn damaging the contingent balance sheet strength of company sponsors of Final Salary Schemes.  Not surprisingly, the result was that companies have closed their Defined Benefit Schemes as fast as possible.

As IFRS was implemented from 2005, it also led to unnecessary and unhelpful detail in the notes to accounts; new “jargon” terms were coined which meant little or nothing to investors.  Company accounts became opaque and indigestible (HSBC’s accounts run to 500 pages) and have become difficult to understand, even by professional Fund Managers, let alone “Joe Public”.  The overall impression given has been that adding masses of indigestible detail has served to protect the accountancy profession against being sued!  The Accounting Standards Board was charged with overseeing all of this, with the Financial Reporting Council set up, in turn to oversee appointments to the UK Accounting Standards Board!

It now emerges that in addition, the UK, Ireland (and the US) implemented IFRS differently to the rest of the EU.  The EU only applied IFRS to listed Groups and not to their subsidiaries.  In the UK the Accounting Standards Board (ASB) forced “incurred loss” provisioning rules on to banking subsidiary companies.  IFRS, at banking company level, positively incentivised mis-pricing risk as it omits the cost of credit default.  The practical result of this was than bank profits were overstated in good times and losses accelerated and exaggerated in bad times – “mark to market”.  This was a major contributor to the banking crisis and the required tax payer funded recapitalisation of banks in the UK, Ireland and the USA.

IFRS was introduced into the UK in 2002 via the IAS EU Directive in 2002.  This removed the long established principles of UK law, decided by Parliament, requiring auditors to take “a true and fair view”; that profits could only be taken on the selling of assets and not on the appreciation in their value while they were still held; that losses on one asset could not be offset against the profits on another and that credit risk should be measured before the event and properly audited.  The first two, in particular, covered up the developing Subprime credit problems and for domestic banking loans, disconnected risk from profits, thus exaggerating disclosed profits by omitting prudent loan provisioning.  Auditors were required to audit banks with a flawed accounting model, which overstated profits, understated risk and obscured gearing and capital destructive business models in good times and then exaggerated losses in bad times.  When the banking crisis broke I remember asking at a seminar, “Where were the accountants”? 

“True and fair view” has since been restored under UK company law.  Changes to the Companies’ Act could also be introduced to require a more sensible and prudent interpretation of IFRS, applying it only to listed groups and not their subsidiaries, as in the rest of the EU.  An answer to a Parliamentary question in 2006 from Justine Greening MP confirmed that International Accounting Standards had not changed the primacy of the legislative purpose, including banking solvency.  Over-riding the Accounting Standards Board’s mistaken implementation of IFRS (at a banking subsidiary company level and thus effecting loan loss deferral in several guises) would correct the clash with the over-riding, statutory, company insolvency, capital maintenance and creditor protection provisions of Company Law.  As in the rest of the EU, if IFRS were applied to Group accounts and not underlying banking companies, the major bank accounting mistakes in the UK, could be alleviated.  It should also correct the undesirable practice of banks now having to maintain 2 sets of books.

In my view, however, it would be desirable for IFRS to be got rid of at a Pan-EU level.  The French and Germans are both hostile to IFRS, regarding it as bad practice emanating from the USA, which spawned and exported two major financial crises in the space of 8 years.  I am concerned at the impending application of IFRS to the insurance and leasing industries and, more particularly, the public sector.  In my judgement the rest of the EU would welcome a lead here from the UK.

But domestically, the problem parts of the Standards applied by the Accounting Standards Board (ASB) need to be revoked ASAP: given that the ASB is well represented by members who are the auditors of the very banks which were so damaged by the ASB Directives, I suggest legislation via amendment to the Companies’ Act here would address this more speedily!

I have written on this somewhat obscure and difficult territory as it is crucially important to the financial and commercial health of the UK.  When I raised my initial concerns about IFRS back in 2002, as part of the Conservative Shadow Treasury team, the view was taken that it was not for politicians and Parliament to interfere in Professionals’ territory.  What emerges, however, is that both to correct the ASB’s mistaken interpretation of IFRS in the UK, and to initiate possible Pan-EU measures to get rid of, or reform, IFRS, are both political matters.  The accounting profession has, in effect given itself the wrong ground rules, which now need correcting by “legislation”.


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