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September 30, 2014

Clash between IFRS and company law disregarded amid criticism of investors

An alliance of long-term investors, which recently called on the UK Financial Reporting Council (FRC) to reconsider its review of the true and fair requirement for accounts, finds disappointing that the UK regulator will not take further action on this issue.

In August a group of investors, with assets under management of about £372.3bn ($605bn), released a position paper where they argued the latest FRC’s review of the true and fair requirement falls short and leaves questions unanswered.

According to UK and EU company law, the director of a company has to apply the concept of prudence and cannot approve accounts unless they give a true and fair view of the business.

IFRS on the other hand focus on the usefulness of the financial statement through the application of the concept of neutrality.

These differences could impact the way a company balance its books and could lead to having two different sets of accounts: one under IFRS and another under company law, the group of investors has argued.

"This subject has been raised many times," a spokesperson for the FRC told The Accountant, "we have nothing to add to our earlier statements reporting on our and the Government’s thorough review of these issues."

However, Sarasin & Partners head of ESG Natasha Landell-Mills, member of this investors group, says that over the past two years they have been raising some "legitimate concerns" about financial reporting.

In particular, whether the accounting framework is consistent with the true and fair view requirement stipulated by company law.

Asked if she sees a conflict of laws between IFRS and company law and if this could be a compliance issue for company directors, Landell-Mills says that, while this legal question is important, the most important one is what kind of accounts should shareholders receive.

"Accounts need to provide us with the prudent and reliable view of capital and performance. IFRS doesn’t necessarily provide that, and we point to company law because requires that accounts to provide a clear view of distributable reserves," Landell-Mills says.

She explains that IFRS is a system of accounts that rises above national legal systems to provide comparability at international level. Therefore IFRS were never intended to fulfil any company law requirements. As result, she says, as soon as the statutory framework is disregarded then there is a risk of disconnect.

"In our opinion, that’s exactly what has happened here. Our ultimate goal is to ensure that we have an accounting framework in the UK, the EU and further afield that provides long-term investors with the information they need to fulfil their stewardship obligations.

Capital maintenance has a heavy emphasis in that regard, but it’s been lost," Landell-Mills says.

Lessons from the financial crisisIFRS have been criticised for their potential role in exacerbating the financial crisis. For this group of investors, the international standards allowed banks to recognise gains before being realised, contributing to over-state profits and failing to provide for foreseeable losses in their loan books.

"The banking sector is an extreme case where IFRS has failed us. I think it’s just an untruth to suggest that it played no role in that. IFRS delivered numbers based on which executives and boards made decisions, and moreover bonuses were paid," Landell-Mills says.

Landell-Mills continues: "When you have a situation where you realise the profits on loans but you are not matching the cost of producing those loans, you are necessarily overstating profitability. And that fits into equity, which generates more lending, so you can see how the numbers drove behaviour and fuelled excessive risk built up in the banking sector."

But the harm isn’t limited to that sector. Royal London Asset Management chief investment officer Robert Talbut (see Q&A), who is among the signatories of the position paper, says this is not just a 2008 issue which affects the banking industry.

He offers the recent example of Betfair, a bookmaker listed in the London Stock Exchange, which in August admitted it unlawfully distributed £80m in dividends and share repurchases during the previous three years.

Landell-Mills concurs with Talbut: "Clearly in any sector, if shareholders don’t have a clear view of distributable reserves there is a problem. Betfair is an example, it distributed out capital and nobody was aware of that because the numbers didn’t tell you."

Bompas opinionLandell-Mills finds "perplexing" that the FRC didn’t mention the opinion of barrister George Bompas QC in its June review. The UK regulator’s reviews are based on two opinions of barrister Martin Moore QC from 2008 and 2013.

Asked whether there is a need for a third legal opinion she explains: "There is a need for the FRC to fairly reflect the disagreement of two eminent QCs. Moore had a clear opinion. Bompas disagreed. Going back to Moore, the FRC was likely to get the same opinion, which he presumably needed to defend. I don’t believe Moore would be that independent third party. It wasn’t a fair process."

With regard to the legal opinions, Landell-Mills maintains that both barristers agreed on the fact that accounts showing distributable reserves need to be visible to directors. They disagreed, she says, about whether this needs to be disclosed to shareholders, which the group of investors supports.

The FRC stated in its June review that the true and fair requirement is not "a separate add-on" to accounting standards but rather their "whole essence". The regulator wrote that accounting standards passed extensive consultation and due process, with further reviews performed to ensure that IFRS meet the criteria for endorsement by the European Commission to ensure they would give a true and fair view of accounts.

The FRC’s review continued: "The statement in IAS 1 that departures from the standards should only be necessary in ‘extremely rare circumstances’ […] does not release directors from their legal obligation to only approve particular accounts if they are satisfied that they give a true and fair view."

It also stated that if following a particular accounting policy directors and auditors don’t believe it will give a true and fair view, they are legally required to adopt a more appropriate policy, even if it requires a departure from a particular standard (i.e. the true and fair override).

Landell-Mills notes, however, that the route to overriding the standards has to be consistent with the IFRS conceptual framework, which is not in line with company law.

"If they say you can override standards to achieve the requirements of company law, that would be different, but they don’t. In fact, that’s exactly what Bompas QC pointed out: there is no mechanism for doing that, it’s an override against the wrong set of goals established in the IFRS conceptual framework."

The FRC referred to this issue in its June review and wrote: "These concerns arose, in part, because the IFRS Conceptual Framework states that the objective of financial statements is that they should be useful and does not refer to the legal requirement that accounts present a true and fair view."

The FRC continued: "However such concerns are misplaced because the concepts of usefulness and true and fair are, in the context of financial statements, inseparable -for financial statements to be useful they must present a true and fair view."

Long-termismAsked whether the investor community would find the information they are looking for in financial statements produced using IFRS, Landell-Mills says that depends on the type of investor.

Ultimately, she adds, it’s a political decision to determine what accounting framework is most consistent with the public interest and what the most socially desirable set of accounts are.

"From our perspective as long-term investors, we want to know what the distributable reserves are; we want to be able to distinguish between realised and unrealised profits. Prudent accounts which comply with company law and give you a non-exaggerated view of capital would deliver that."


Signatory funds AUM (372.3£bn)Threadneedle Investments: 92.8Royal London Asset Management: 75USS Investment Management: 40RPMI Railpen: 20Sarasin & Partners: 14London Pensions Fund Authority: 5GO Investment Partners: 0.5Other signatories Local Authority Pension Fund Forum: 125UK Shareholders Association: n/aNotes: The LAPFF brings together 60 UK local authority pension funds with combined assets of over £125bn; LPFA is part of the LAPFF


Related stories

Directors are governed by company law, not by accounting standards: Robert Talbut

IFRS versus company law: long-term investors concerned over regulator’s passivity

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