Mark to market accounting is commonplace in the US of course and has since 2005 been used throughout the EU as well because it is at the core of the International Accounting Standards Board’s International Financial Reporting Standards which were adopted Europe wide in that year.
Despite this no-one has solved the problem mark to market accounting creates when it comes to recognizing bad debts in banks. As a result the difference between the Basel Committee and accounting standard’s setters is no minor spat: the whole basis of bank accounting is opened up by this apparently simple quest for an acceptable standard on debt provisions.
This needs explanation. What must be understood is that the mark to market model is the absolute reverse of what accounting used to be when it came to bad debts. Accountants always used to anticipate losses on debts and make provision for them as soon as they thought there was any risk they might not pay. This was considered prudent, and in those days accountants liked to be prudent.
But the combination of mark to market rules and securitized loans created an entirely different scenario, particularly post 2005 when mark to market rules became commonplace in all major banks. Under International Financial Reporting Standards so long as there was a market for a securitized debt no provision for loss was allowed even if the underlying assets were obviously not performing: the market determined the value of the loan and prudence could not overrule it. So there was no provisioning. Imprudence ruled. Losses could only be recognized when they had occurred with regard to the vast majority of bank debt.
As a result IFRS compliant accounts allowed bank profits to sky rocket as loss provisions fell. This was a trend exacerbated by the fact that whilst loss provisioning was not allowed mark to market accounting did allow the recognition of unrealized profits – a practice previously considered imprudent. As such mark to market was doubly imprudent.
The result was, perhaps, inevitable: the financial world fell apart because bankers had believed they could lend and never make provision for a loss. Creation of that culture is the responsibility of the International Accounting Standards Board. No wonder Basel disagrees with them.
As a consequence Basel has to win this dispute and all accountants should support that Committee against the IASB and its US allies in the Federal Accounting Standards Board: prudence may be boring but it is also what good accountancy is about.
So too should it be what good auditing is about. But in this regard the big banks auditor’s – almost without exception from the Big 4 firms of auditors – were also at fault. With the introduction of International Financial Reporting Standards the Big 4 firms of auditors ensured that the rules of auditing were changed so they no longer had to enforce prudence.
This was because they ensured they no longer had to say accounts were true and fair – they just had to say they were true and fair in that they complied with IFRS. This meant that even if IFRS produced nonsense, auditors had no duty to require use of what was once called the ‘true and fair over-ride’ so that numbers were restated on a reasonable basis because that option no longer existed.
For that you can blame the IASB and the seemingly independent IAASB – the International Auditing and Assurance Standards Board. And let’s never forget that both the IASB and IAASB are dominated and even significantly financed by the Big 4 firms of accountants and auditors – PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young.
According to popular myth these firms have had a ‘good recession’ – little blame attaching to them for what has happened. But that’s just a myth, because the truth is they carry a great deal of responsibility for what has gone wrong – and should bear the consequences.
Richard Murphy FCA FRSA is a U.K. chartered accountant, former serial entrepreneur and is currently director of Tax Research U.K. He has been a visiting fellow at several U.K. universities and now works mainly on tax and economic policy issues for a wide range of organizations including the U.K. Trade Union Congress and the Tax Justice Network. He blogs at www.taxresearch.org.uk/blog