Steve Baker MP: Accounting has never been so exciting!

By Steve Baker MP

There is a growing awareness that one of the main contributors – if not the main contributor – to the severity of the financial crisis was the system of accounting rules under which UK banks continue to operate. In particular, the culprit is the system of International Financial Reporting Standards (IFRS), an EU-sponsored regime which has applied to UK and Irish banks since 2005. It's something Howard Flight covered in Fixing the Accounting Botch here on ConHome and which I highlighted with a ten-minute rule bill, which appeared on the order paper for second reading on Friday.

The IFRS regime has required banks, amongst other things, to book unrealized gains (or losses) on certain items, leading to banks manufacturing fake profits based on dubious financial models and then paying bonuses and dividends out of those fake profits. Indeed, it may have led some banks to make distributions that were illegal through conflicting with existing UK companies law. It led to poor provisioning for expected losses; this allowed credit to be mispriced, with risky assets portrayed as safe until the crisis hit and the true risks (and losses) involved were revealed.

IFRS did away with prudence and reliability, so weakening the role of the audit function and undermining the accountability of both banks and their auditors. This led to sloppy auditing, gravely weakening auditors' traditional function of challenging the management.

The net result was that accounts compiled on this basis were deemed to be true and fair, precisely because they complied with these accounting standards, despite the fact that they were unreliable, imprudent and lacking economic substance. These rules created fake profits and fake capital, misleading stakeholders – shareholders, the Bank of England, the FSA and everyone else, even the banks themselves – about the banks’ true financial positions.

IFRS led banks to appear to be profitable and well capitalized, when in fact they were unprofitable and rapidly devouring their own capital. When the crisis hit, our hitherto apparently healthy banks were then revealed to be bust, and the taxpayer was dragooned in to prop them up.

It appears that the severity of the crisis was greater in Ireland and the UK because they had rolled out IFRS more fully than elsewhere in the EU: the footprint of IFRS and the footprint of the crisis were suspiciously similar. That suggests the former is a major contributor to the latter. Indeed, since Ireland follows UK accountancy rules, it also means that the UK implementation of IFRS will have been a major contributor to the severity of the crisis in Ireland.

Nor does it help that these rules are incomprehensible, even to experts. In fact, the Chairman of the IASB (the IFRS rule-setting authority) is on record as saying that if you think you understand IAS 39 - the relevant accounting standard - then you haven’t read it properly. Such an assessment of the IFRS rules by the person principally responsible for them makes any attempt at satire redundant.

Accounts derived on this basis provide a perfect smokescreen behind which bankers can plunder the banks, aided and abetted by the large accountancy firms, legitimised by flawed international rules and now at taxpayer expense.

Yet a market economy cannot function if banks’ and other firms' accounts give us no reliable indication of financial health.  We still have no idea how weak our banks really are: all we know for sure is that their accounts give an over-optimistic view of their finances. The slightest shock could bring the whole house of cards crashing down, again. 

So I was sorry that my Bill to introduce parallel prudent accounting in line with UK companies law could not have a hearing on Friday. As ever, there were more private member's bills than time allowed. Hopefully, the Government is paying close attention to this issue: the penalty for ignoring it could be catastrophe.

Accounting has never been so exciting.