Were accountants to blame for the financial crisis?

Hannah Langworth asks if global financial reporting standards are dangerously flawed

International Financial Reporting Standards (IFRS) have come under scrutiny in recent weeks at a national and EU level. IFRS are a set of guidelines often used by auditors to prepare companies' accounts. They're designed to provide a global common framework for financial records and are in the process of being adopted as a national standard by many countries across the world. The EU has required all European public companies, including UK-listed ones, to use IFRS since 2005. Private companies in the UK can choose between IFRS and UK GAAP (UK Generally Accepted Accounting Practice).

However, the shift towards IFRS has proved controversial. At the end of last year, a group of ten institutional investors, including Threadneedle Investments and the London Pension Fund Authority, sent a letter to EU commissioner for internal market and services Michel Barnier expressing a number of concerns about the use of IFRS in the UK. As a result, the EU has agreed to review the use of IFRS in Europe this year.

Highs and lows

One of the investors' main concerns was the extent to which using IFRS can give the impression that a company's profits are higher and its losses lower than they are in reality. Under IFRS, some unrealised profits can be recorded as already made, yet companies do not have to make allowances for some potential future losses.

These features are problematic, argued the ten signatories to the letter, because investors need to be able to rely on a company's accounts as a prudent assessment of its financial status in order to make effective investment decisions which in turn, they argued, fosters macroeconomic stability. It can be argued that the potential problematic consequences of this method of accounting were demonstrated by the financial crisis of 2008/9. A collective failure to spot serious instabilities in banks' financial records had dramatic consequences for those institutions and, subsequently, the markets and the wider economy.

Problems with IFRS and their role in the financial crisis have also been highlighted recently in Westminster. In late January, former chancellor Lord Lawson quizzed the Big Four professional services firms about IFRS when representatives appeared before the Commission on Banking Standards, of which Lawson is a member. Lawson has subsequently suggested that, because of their complexity as businesses and their structural significance to the UK economy, banks should be subject to requirements additional to those currently imposed under IFRS.

The American way

The creation of IFRS and the EU's drive for them to be adopted have arguably been prompted by a desire to bring European accounting standards closer to US ones, which IFRS resemble, for business convenience. While the overriding principle of European accounting has traditionally been "prudence", US accounting is based around "neutrality". In simple terms, that means that while American accounts are designed to be as accurate about a company's current financial situation as possible, European ones have historically incorporated provision for future worst case scenarios.

However, in a recent letter to the Financial Times, two institutional investors pointed out that the origins and uses of corporate accounts in Europe and the US differ, making the shift in the EU to IFRS, and its American emphasis on neutrality rather than prudence, not necessarily a good idea for EU accounting. In the US, accounts evolved for the use of those considering investing in companies through the stock markets, making an emphasis on accurate current valuation key. In Europe however, they argued, accounts have traditionally been primarily constructed to enable a company's managers to protect and enhance a company's value, making prudence a more sensible guiding principle for them.

The Commission on Banking Standards will continue its investigation into the impact accounting rules had on the financial crisis in the coming weeks as the EU review process begins. And looking further forward, despite the current controversy over IFRS, many UK businesses will be aiming to convert to reporting in accordance with them rather than UK GAAP in the future. Helping them do so is and, unless IFRS are further discredited, will continue to be an important business area for professional services firms.

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