The Times has reported this morning (paywall) that:
The legal cornerstone underpinning the entire edifice of bank accounting is defective, according to a QC's opinion that questions the approach by accountants at the top of the profession and criticises their regulator, the Financial Reporting Council.
The potentially explosive legal opinion, seen by The Times, makes plain that the billions of pounds of profits reported each year by UK banks cannot be relied upon to give a “true and fair” picture of the financial position of Britain's biggest financial institutions.
George Bompas, QC, accuses the FRC and the Institute for Chartered Accountants in England & Wales of defective logic in supporting the present accounting standards.
I have also seen the opinion in question, which was prepared for the Local Authority Pension Fund Forum, who I advise on tax matters. The chair of that Forum has said in response to the ruling:
The issues are far from trivial, as exemplified by the banks getting the standards wrong, meaning that the accounts in some cases were catastrophically wrong. The accounting profession has effectively become a ‘state within a state', interpreting the law incorrectly to suit its own interests and in LAPFF's opinion against the public interest.
I agree, and think that, if anything, the issue is more significant than the one on which the opinion focusses.
That focus is on whether or not International Financial Reporting Standard properly identify the split in the profits of a company between those that are realised and those that are not. The point is vital: dividends can only be paid out of realised profits (those likely to have resulted in real cash earned) to make sure that a company will remain solvent despite paying a reward to its members. Unrealised profits are not available for the payment of dividends as if used for that purpose they threaten solvency and so the ability of the company to pay its creditors. This is pretty fundamental stuff.
And George Bompas QC is quite clear: because accounts prepared under IFRS do not require that this split be shown, and because the law requires that they do in his opinion, and because there is no other place where the data could be obtained from, meaning that the omission is in effect a breach of the law since those needing the data to check that it is reasonable to trade with the company cannot secure it, then UK accounts prepared on this basis are defective.
I would go a little further than that: since auditors are meant to check this data to ensure dividends are legal not disclosing how they have done so makes their work deficient and their opinion that accounts are true and fair potentially invalid.
The Financial Reporting Council and Institute of Chartered Accountants in England and Wales supposedly addressed this issue last year: George Bompas is quite clear that they have not.
My concern is that the issue has not been taken far enough. This issue of the realised / unrealised profit split is key in another area, which is tax. In broad terms only realised profits are taxed, and for good reason, which is that realised profits alone create the capacity to pay tax. But, if the split is not clear it is not possible to understand how and why tax is due by a company, or for the user of those accounts, including a tax authority, to understand them. I am well aware that the International Financial Reporting Standard Foundation say that this is not their concern and that tax authorities should sort this out for themselves, but I do not agree. When we have outsourced accounting standard creation to an industry controlled body those standards should still be set in the public interest, and it is clear that they are not. The answer is that, very obviously, accounting standard setting, including those for tax, should now come back under parliamentary control. To comply with EU law IFRS can stay in place, but additional disclosure is now vital and needed. And that must be decided upon by the government and politicians and not by firms more concerned with setting up exclusive members only clubs or winning consultancy work instead of promoting audit quality.
I argued against the idea of the state taking control of democracy yesterday, and rightly so. But accountancy is different: this has to be subject to democratic, and so state, control. The time for radical reform in the face of accounting, audit and market failure amongst the firms that dominate the profession has arrived.
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Speaking as a capitalist, I have strong opinions on the matter of a true and fair opinion.
The question “What’s it worth?” is fundamental to capitalism and the auditors *owe* me an answer.
It’s great that you highlight how this affects both dividends and tax. However, I’m unsure how this feeds through into practise since the ‘incentives’ of what is clearly an opaque system seem to balance each other to some degree. Higher profits should lead to greater tax and vice-versa.
Are there ways in which both sides of this equation can be simultaneously ‘gamed’ by a bank/business? Or is the risk to the system only realised in aggregate when multiple businesses individually decide to reduce tax or boost dividends inappropriately?
Either way, I guess greater clarity will help!
I think all opacity aids gaming
I agree with the thrust of the post – realised/unrealised is an important data point and should be published.
This is a minor point, but non-disclosure doesn’t necessarily mean that the calculations haven’t been done. It’s perfectly possible (and I suggest likely) for the auditors to have ensured compliance with the dividend rules as part of their workings before signing off on their “true & fair” opinion.
As you say, this has the potential to undermine their opinion if they haven’t checked compliance, but I instinctively feel it will be more of a case of “show your workings”.
You miss the point: to say the accounts are true and fair it has to be seen that they are
On such a key point – with a critical legal responsibility hanging on it – to not disclose means the accounts fail that basic test
Banks trading all those neoliberal derivative products will have unrealised gains and losses on their trading books. Like interest rate swaps which amount to multiple trillions of dollars of gross notional outstanding. Knowing how much is unrealised is key to assessing their exposure.
Any views on this – making US tax avoidance less profitable (could apply to UK):
“I’ve noticed that companies with large cash-stashes and complex international tax strategies tend to issue bonds, usually token amounts, in various markets around the globe to determine market rates of interest. Then I assume that they loan money from their subsidiaries back to the parent using those rates as guidelines to justify the rates they charge the related company.
Given all that, much of the stashed cash, probably shows up as financial debt or money market debt that will simply be destroyed once the tax liability is extinguished. The entire tax strategy is based on the idea that the government will fold before they do. The best thing that the US Govt can do, is nothing or eliminate the tax loophole that allows laundering profits through subsidiaries that do nothing in the first place but have dubious sales to put technology assets, patents, and other things into their possession. So scrutinize the “hard to value” assets transferred from the parent to the subsidiary and scare up the hornets nest. Make the whole tax avoidance game less profitable by tangling companies in hard to win legal battles with endless numbers of attorneys and accountants. Lots of Good Middle Class jobs there.”
This is the focus of the OECD Base Erosion and Profits Shifting process
No time to write at length on that now
I have been involved in some ways in negotiating on this process
It would be of interest if you could come back to BEPS and the upcoming EU regulations allowing for the EC recognition of national derivatives exchanges – given that OTC trades (as opposed to exchange-traded) would appear to be surpassing the quadrillion+? dollars world-wide (notional value).
This comes back to the “true and fair” accuracy of banks’ accounts. I gather the hierarchy of most banks’ financial structures still includes a dense thicket of arm’s-length hedge funds, SIVs and the like, just as we had in 2007, with the consequences you certainly lived in depth. Leverage is not what it used to be in the (very) old days!!! (I have no professional or in-depth knowledge of the issues involved or key points.)
If time permits….
Do the terms ‘true’ followed by ‘fair’ actually work together to give us the clarity we really need? I doubt it. The first word seems based in facts; the latter may be just a matter of opinion (Jolyon would have a field day with this problem as I have just stated it). It’s a statement that contradicts itself.
A new definition is surely needed.
I think not
It has survived the test of time
You mention the Local Authority Pension Fund Forum. Does what you write about affect Local Authority Pension Funds and if so, how?
It does impact them
If the accounting is wrong so are pension investment allocations and so are future returns impacted
That is why I and they are concerned
A lot of things have stood the test of time Richard – and not all of them for the good of mankind – unfortunately!
“In broad terms only realised profits are taxed, and for good reason, which is that realised profits alone create the capacity to pay tax.”
In broad terms you’re wrong. The general rule these days is that profits are taxed as and when they are shown in the P&L account, whether they’re realised or not, unless there is a particular provision to say that they should not be – generally the rationale for such relieving provisions is that dry tax charges are a bad thing.
Capital gains are normally taxed only when realised, but not profits.
Oh come on Andrew
You know as well as I do there’s more than a P&L these days
Please do not be misleading
I think you’re the one being misleading, rather than me. Yes there is more than a P&L, but the P&L is the core of the tax computation which everything else hangs around and adjusts.
I’m not sure how much corporation tax work you’ve done recently, but there have been significant changes over the last 20 years which mean that we use the accounting profit as the starting point in a large number of areas where once you would start off from tax principles. Corporate debt, provisions, intangibles – most of the areas that once had a DI adjustment now start from the accounts position, and mean that adjustments are required far less commonly.
In some areas you will then have a look at whether profit is realised or not, but they are quite rare and have in fact been reduced – unrealised foreign exchange gains, for example, could once be deferred but are now taxed.
On the other hand I can think of a few common areas where *losses* are adjusted out until they’re realised, though – pension contributions, provisions, and so on.
In parliamentary terms you are dissembling Andrew
“Parliamentary terms”? I genuinely have no idea what you’re talking about – I thought this was about how IFRS and tax accounting intersect?
Your point seems to be that:
– UK tax principles only tax realised profits
– IFRS just shows “profits”, whether realised or unrealised
– This makes it impossible to reconcile tax to profit
My reply is that as the “realised/unrealised” distinction is pretty much irrelevant to UK tax, then whether IFRS makes such a distinction or not has no impact at all on one’s ability to judge whether the correct amount of tax has been charged.
Where does Parliament come in?
I’ve never had any problems preparing computations based on IFRS accounts – they require no particularly odd steps to be taken.
I really don’t know why I bother…..
Thank you for that extremely enlightening reply.
If something is apparently obvious to you, but not to me, why can you be bothered to make pointless comments but not bothered to explain it?
Because in your case it would make me your personal tutor
And that is not my job
i would think that lack of disclosure making the accounts invalid would be a problem. Surely part of the reason auditors give an opinion is that not all the information to make a determination are available to users of the accounts. There may well be good reasons for this such as commercial sensitivity, many companies are reluctant to split out Sales data by product/region beyond the required level; additionally as an accountant yourself in sure you are aware of many technical matters where full discussion in the accounts regarding treatment would add little other than serve to confuse non technical users.
Also while there is more than the p&l the tax definition of profit has always been the subject of the tax authority not the accounting bodies, otherwise we would not need tax specialists I guess
The issue in this case is that the law requires the dsiclosure
As George Bompas QC has made clear
Couple of points
IFRS does not prohibit additional disclosures, especially if it’s to comply with local law.
IFRS is a developing/evolving system, it is expected to change and incorporate changes in practices as they become required or withdrawn as they become obselete (you may recall that there was once even a UK standard on accounting in high inflation environments many years ago)
On that basis it is perhaps disingenuous to claim IFRS has failed or is broken over a disclosure requirement surely. If you were arguing IFRS should be amended so that the reporting basis was different that is another matter, though even there as a memeber of the accounting profession there are processes in place to allow you to attempt to have such a change implemented (and that ignores that such a ruling won’t be considered by the appropriate professional bodies anyway)
Sorry about lag in reply, not currently based in the UK, appreciate you may well have moved onto other postings/topics