Banks’ auditors have had to deal with the absurdity of accounts failing the ‘true & fair’ test for the very reason that they comply with a flawed standard. Auditors accused of rubber-stamping defective accounts of banks should now feel some relief.

The International Accounting Standards Board appears at last to acknowledge the folly of its stipulation in IAS39 that banks must account for losses on bad loans only after borrowers actually default, even when rudimentary enquiry would highlight virtually no chance of recovery.

This rule allows the timing of loss recognition to be “assessed” by management despite the temptation to “reschedule” repayments in a borrower’s favour rather than confront a prudent write-off. The level of profit overstatement attributable to the rules themselves can be gauged by the finding in a recent Deloitte study that this tentative return to accounting sanity will, on its own, cause banks to raise their loan loss provisioning by 50 per cent.

The antidote proved more lethal than the disease.

The preposterous “incurred loss” model originally entered the canon as an antidote to the contrary practice of “big bath” provisioning, whereby companies contrived reported results by clearing out all the skeletons in one period only to declare a miraculous jump in profits (and bonuses) the following year. The antidote proved more lethal than the disease. Predictable consequences include a parade of bankrupt banks, their IFRS-compliant balance sheets masking hopeless insolvency.

My own warnings in “Accountancy”, quoted in the Lords a year ago by Lord Lawson, appear to have been heeded – although hardly with alacrity. The rules prescribing the prevailing nonsense are scheduled for replacement by a new standard, IFRS 9, to be mandatory in 2018 –  10 years after the banking crisis they undoubtedly exacerbated.

‘Expected loss’ model of sorts

IFRS 9 will require banks to adopt IASB’s version of an “expected credit loss” model. With the hindsight of a snail IASB concedes that its previous insistence on the borrower’s default as a precondition of loss recognition “has been identified as a weakness”.

However, IASB fudges the issue by limiting the foresight test for “expected” losses to 12-months. Bearing in mind that RBS’s expected losses took six years to come through, this is some way short of a reform.

IFRS 9 will also remove the ultimate “fair value” absurdity whereby a fall in the market value of a bank’s own bonds must be chalked up as a gain in its revenue statement. Thus is a bank able to lift itself by its own bootstraps: every loss of its creditworthiness in the market must be registered in its accounts as a gain. Use it to pay a dividend? Why not? In this land of pure fantasy real losses remain unrecorded and illusory gains are treated as real. Until the money runs out.

Fair value folly

In the late 80s I sat on the Accounting Standards Committee as an observer on behalf of the Auditing Practices Committee when fair value accounting for current assets (expressed as “marking-to-market”) was postulated as the framework for the future. It seemed obvious to me that, under this framework, a rising derivates market would cause reported revenues to include unrealised gains. Clearly, the geniuses promoting this change hadn’t heard of the law of unintended consequences. Their framework has fallen victim to its own impeccable, but insane, logic.

The IASB has also launched IFRS 15 (“Revenue from contracts”). This provides yet another model for that old warhorse: revenue recognition. Although incomprehensible to mere mortals, experts have accompanied their own explanations with dire warnings: (1) its challenging and time-consuming implementation will demand a “change of mindset” in the way revenue is determined and reported; (2) it will substantially increase the volume of disclosures; (3) its full effect is unpredictable because of its complex 5-step process for determining how much, if any, revenue is to be recognised; (4) it will widen the divergence between reported revenue and cash flow; and (5) variable and subjective estimation will be widespread.

When we see this sort of stuff, we know we are heading, as the ancient Chinese curse puts it, for interesting times.