The consistently good Adam Smith Institute has published a report that points the finger at IFRS for making the financial crisis worse. It says that IFRS allowed banks to overstate their profits and draw big bonuses based on these illusory gains.

I'm by no means a banking expert, but I am deeply suspicious of the notion that accounting standards caused the crisis. It sounds to me like a thesis designed solely to let regulators, governments and investors off the hook for their own bad choices while unfairly overemphasising the role of financial reporting in the crisis.

The report identifies six main areas that it blames for allowing bankers to overstate their profits. The six areas, together with some initial reflections on them, are as follows:

• Uncertain future cashflows can be recognised as certain by purchasing a credit default swap (CDS) or similar “protection”, even though the supplier of the protection is likely to default if the insured event occurs;

I'm fairly sure that counterparty risk has always been a consideration of any sort of hedging or netting accounting treatment. Certainly if the supplier of the protection is "likely" to default, the hedging treatment would not be permitted. So, the big question must be "likely" in whose opinion? 

• Profits can be recognised from the increased value of assets, or decreased value of liabilities, on the basis of a market price, even though the totality of revalued assets or liabilities could not be sold at that price;

This sounds damning. But I think it's merely observing that if the entire stock of financial assets were sold all at the same time then there would be financial meltdown. Of course. For every seller there has to be a buyer. But there simply aren't enough buyers to pick up all the financial assets if they were to be sold at once.

But I think it's unrealistic to expect preparers to undertake the sophisticated calculus required to determine what would be the market price if they did try to sell all at the same time. Because they're not actually trying to do this, it's a slightly arbitrary exercise. Accounting aims to represent the world as best it can, but it's not trying to produce a perfect economic representation of the company at a point in time. Its preferred approach in this area is to pretend that you could make a marginal sale of these assets at their market price. That's all.

• Profits can be recognised from the increased value of assets, or decreased value of liabilities, even when the revaluation of assets is estimated, not by market prices, but by a model built by bank employees. This is the so-called mark-to-model approach to valuation;

This has long been a problem. Banks create bespoke products for which there really is no market. So, while the accounting treatment for most financial products requires that you look to the market price, in respect of non-market products you must look to the internal model instead. It's less than ideal, but what would you actually do instead?

• The net present value of uncertain future cashflows can be recognised as profits even when they are estimated using implausibly optimistic forecasts. (This is a variation of the mark-to-model problem listed above);

Again with the pejorative language. In whose opinion are they "implausibly optimistic"? Certainly, if the bank's auditors thought they were implausibly optimistic, they would have qualified the accounts. Is this the voice of reason talking or is it the report's author making substantial use of hindsight?

• The EU’s IFRS accounting system, voluntarily adopted by UK and Irish banks at the banking company level, is inconsistent with UK law

Ah yes, I've seen this argument before. And, indeedy, Tim Bush is one of the report's references. I don't really know enough about the law behind it to be able to respond to Bush's argument. But I know it's not universally held by all experts, including those at BIS and the FRC.

• Banks need not make provision for expected losses when calculating their profit.

Well, no. IFRS doesn't let them. But a project to implement some sort of expected loss provisioning is underway at the IASB. The main reason for forbidding expected loss provisioning was that, in the bad old days, banks were using it to smooth income by establishing large general provisions. So the accounting standard setters prohibited any form of forward provisioning. Now that general provisions are felt to be useful, they're being reintroduced. But they were absent by design, not by accident.

I'm left distinctly underwhelmed by the ASI report. It doesn't really reveal anything new. Indeed, all six points would have been known by analysts pre-crash and should have been known by regulators too (if they weren't then the FSA really does need to do some serious soul-searching). While the report does refer to a set of normative proposals to fix the identified problems, it's not clear that they really would work in the way intended. Financial instrument accounting is complex, so a set of solutions that might have helped somewhat in respect of a past crisis may prove insufficient in the face of an unspecified future crisis. 

 

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Filed under: Accounting, Regulation with tags adam smith institute, credit default swaps, financial instruments, fsa, mark to market, tim bush