The bad debt myth

Posted by Christie Malry on April 9, 2013 at 8:57 am

Worstall has a pretty good piece about HBOS here. You should go read it. He's right when he says that banks could only provision for actual losses, not potential ones. But this wasn't a Brown invention. It was always this way under UK GAAP. It's a common theme among the lazy and badly informed that UK GAAP would have prevented the banking crisis, by forcing banks to provide for the losses earlier. This is a myth. UK GAAP always required actual provisioning; expected provisioning was forbidden. What's the distinction? Forget debts, for a moment. Imagine a farmer with a warehouse full of crates of apples. Some of those apples will go bad before he can get them to market. A specific provision is a provision against a particular crate. The farmer knows that specific crate is bad, so he's written it off. A general provision is different. The farmer, based on his experience knows that by this time of year, in the current weather conditions, with his knowledge of insect levels, etc, a certain number of crates will already have gone bad. He just doesn't know which ones, because he hasn't inspected each one. But he knows that if he did inspect them, a certain proportion would already have gone off. An expected provision is also based on his experience. He knows that, between now and market time, a certain proportion will go bad, including some that are still fine now. So he provides for the lot now. The expected loss approach breaks with accounting tradition by allowing preparers to mark down assets now for events that haven't yet happened. And , inevitably, this will make it easier to manage earnings, both up and down. It might have been possible, in the slack days of the 80s, to make a big general provision and for few people to care. But now we do care, and we wouldn't permit expected losses under UK GAAP, no matter what the accounting polemicists would have you believe.

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