Arguments over accounting’s role in the 2008 financial crisis persist. Few would go so far as to pin responsibility entirely on the permissive IAS 39 loss-recognition rules, but even their staunchest defender would concede that their labyrinthine intricacy rendered their meaning impenetrable. Many readers will recall Sir David Tweedie’s quip in 2005, when he chaired the IASB: “Anyone who claims to understand IAS 39 hasn’t read it properly.”

Yet the IASB has persistently refused to acknowledge that the IFRS framework, relied upon by banks both before and after the crash,lent legitimacy to the overstatement of profits by marking securities to a bubble market, while under-providing for real losses.

Under its “incurred loss” model, banks recognised loan losses only when management decided that a loan, having already been brought back from the dead through “restructuring”, “rescheduling” and “refinancing”, was finally as dead as John Cleese’s parrot. Under the guise of accounting rectitude the IAS 39 loss-recognition rules provided many banks with

a one-way ticket to financial annihilation.

a one-way ticket to financial annihilationThe ensuing bailouts compelled central banks to dissemble the precariousness of their own solvency by resorting to the device of buying freshly minted treasury bonds conjured out of thin air. The purchasing power generated was unsupported by production of any description, legitimised by President Nixon’s final abandonment of the gold standard in 1971.

Blameworthy accounting

These utterly misguided accounting rules were not the immediate cause of the banking fiasco, but they carry a fair measure of blame. Had the framework, for example, upheld prudence as a fundamental accounting principle it would have highlighted the lethal consequences of paying dividends and bonuses out of unrealised book profits.

Unsurprisingly, IAS 39 was unceremoniously ditched and replaced by IFRS 9, which (i) reinstates prudence; and (ii) replaces lethal “incurred” loss methodology with an “expected” loss model. Even this, however, is under attack since it does not prescribe full lifetime provisioning at a loan’s outset.

According to the Chairman of IASB, Hans Hoogervorst, recognition of expected lifetime losses on day one is “difficult” and “does not reflect the economics”. Actually, it’s not difficult and it reflects the economics perfectly: while a bank does not expect a loan to go bad at the outset, the very determination of an appropriate rate of interest reflects the risk of borrower default at some point.

Expressing this as loss provision is exactly what is needed.

Expressing this as loss provision is exactly what is needed. Instead IFRS 9 prescribes the creation of an arbitrary provisioning trigger point based on projections of a loan’s worsening outlook, the required provision being the amount by which any already impaired loan is expected to go bad over the ensuing 12-months.

As an exercise in guesstimation it is a back-door route to the very subjectivity that comprehensively discredited “incurred” loss provisioning under IAS 39.

Petitioning Brussels

The Local Authority Pension Fund Forum (LAPFF), the umbrella body for 65 public sector pension funds with close to £200 billion in assets, has clearly had enough of all this. It has now obtained a legal Opinion from leading silk George Bompas QC, who has concluded that IAS1 and the IFRS Framework are defective in replacing the overarching obligation for accounts to give a true and fair view with a mysterious concept called “usefulness”.

Bompas also demonstrates, by painstaking reference to the statutes, that accounts which mingle realised and unrealised profits self-evidently fail to differentiate between amounts available for distribution and those that are not, and therefore cannot claim to be true and fair.

The LAPFF has written to the Chairman of the accounting standards working group in Brussels stating that the European Parliament should reject IFRS 9. The vague obligation for information in the accounts to be “useful” does not meet EU law’s requirement of a true and fair view of profits and net assets, by reference to which alone lawful distributions may be made.

Those able to read the unvarnished symptoms – a steep rise in cheap mortgages fuelled by rates that leave savers unrewarded – see it all happening again.

Maybe next time the accounting will get it right.