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The Bruce Column — IFRS and the House of Lords

08 Apr 2011

To say that their Lordships were out of their depth when it came to IFRS would be unfair.

There is probably a convention within the UK House of Lords that such a criticism would be deemed to be un-parliamentary language and so ruled out of order. On the other hand there are distinct signs within the Lords Select Committee on Economic Affairs final published report, 'Auditors: Market Concentration and Their Role', that when they turned their attentions to IFRS they were not entirely sure about how things worked. They should have no worries about this. They would be far from being the first to realise that IFRS were just too complex for a simple understanding.

And, in any case, it was not a subject they intended to cover in the first place. As their report says, 'accounting standards were not at first within our intended scope for this inquiry'. But at the first of their hearings they ran into Professor Stella Fearnley of Bournemouth University in full flow. Lord Lawson, onetime Chancellor of the Exchequer, was bowled over. 'I have considerable sympathy with your magnificent outburst', he exclaimed. 'Sorry, sir,' responded Fearnley, 'it was a rant'. It didn't really matter. The hare was up and running.

As a result of what the report describes as these 'trenchant criticisms' the inquiry was widened and across eight months and eleven sets of hearings IFRS kept popping up as a bit of a diversion from their Lordships main concerns with audit concentration, audit committees, bank auditors and the siren songs of such possible solutions as joint audits or mandatory audit rotation.

The critics' line was that IFRS had overthrown the principle of prudence, judgement, and the idea of substance over form. As a result auditors had given up thinking and, with an IFRS rulebook in one hand, were simply ticking checklists with the other. It fell to Steve Cooper, an IASB member, to clarify the issue towards the end of the hearings. 'Prudence does permeate accounting standards, revenue recognition, and all sorts of areas', he said. 'We are careful to make sure that profits are only recognised when they really are profits'. He then suggested that prudence was not necessarily the universal panacea which the critics had described. 'Prudence acts two ways', he suggested. 'If you understate things now, it gives an opportunity for companies to report a profit later; and at the very times that things are getting worse, if you are living off past fat and past unrealised profits, you can conceal the bad things that are coming later'. And then he came to the key point. 'We do not want to create a bias within financial reporting that has that counterintuitive effect later on. We want things to be realistic, neutral, to faithfully reflect the economics of transactions'.

He could have harked back to the great and punishingly lengthy Japanese banking crisis in the early 1990s which was exacerbated by exactly the excessive prudence which creates hidden reserves and enables a crisis to rumble on without anyone being able to work out the real depth of the disaster for years. And he could also have pointed out that the current IFRS regime, promoting realism and transparency, helped to bring the effects of the most recent financial crisis quickly out into the open, whether people liked it or not, and so it was able to be dealt with earlier than it might otherwise have been.

But their Lordships instead found that the conspiracy theories of the critics were far too enticing. To the critics the noble edifice of UK GAAP, flanked by the guardian angels of prudence, had been usurped by what Fearnley described as 'dangling regulators'. This was the IASB, 'who in fact are sitting in a hot air balloon just off the coast of the US'.

As a result the conclusions of the section of the report which deal with IFRS have a strange air to them. And one produces the bizarre conclusion that in the UK IFRS should not be extended 'beyond the larger listed companies where it is already mandatory'. This could perhaps result, for example, in UK companies which wish to use the IFRS for small and medium-sized companies, which has been lauded from Brazil to South Africa for its ability to attract inward investment to companies which hitherto had been totally ignored by the rest of the world, not being allowed to follow in their footsteps. It is, as all can see, an unintended consequence.

The House of Lords report comes up with many excellent proposals around its central remit. It is clearly thought through and precise in intention. But their Lordships should have looked with suspicion at the more outlandish ideas they were being offered on IFRS. And they should have turned down the flattering offer to grasp the wrong end of the stick.

Robert Bruce
April 2011

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