Standards tug of war risks more Lehmans-style accounting

Proposed accounting rules could open the door to Lehmans-style off balance sheet trickery, investors and standard setters have warned.

The International Accounting Standards Board (IASB) is debating new rules on derecognition, which dictate when companies remove items from their balance sheets.

Derecognition often plays a central role in large scale frauds and scandals. Those that are too prescriptive often allow companies to remove items from their balance sheets, and distort their true risk exposure.

But rules that are too loose may result in over-recognition, with too many items on balance sheets, which, in the event of a bankruptcy, can’t be easily realised.

Investor groups fear the IASB is heading down a path which could result in accounting rules that are too narrow and increase the potential for fraud.

Current methods in use include a “risk and rewards” model, which allows companies to remove items from the balance sheet only if the corresponding risks are removed. The rival model, known as “control”, allows companies to remove items if they can prove they have lost control of the asset.

Proponents of the control model say it is applied more consistently and is closely aligned with the risks and rewards model in key areas. Critics point out that a similar model enabled Lehman Brothers to conceal $50bn (£34bn) from its balance sheet, by classifying repurchase or repo transactions as sales, according to the Valukas report, released in March.

The IASB proposal includes an exemption for repo transactions to avoid this issue, but it hasn’t stopped investors from raising fears the rules would encourage “financial engineering” opportunities.

“We see the risks and rewards model as a safeguard against restructuring opportunities so that assets are not consolidated or prematurely derecognised,” said Liz Murrall, from the Investment Management Association.

Michael McKersie, assistant director of capital markets at the Association of British Insurers, said the risks and rewards model “chimes better” with investors in the UK.

“It is somewhat perverse to say the impact of liabilities should not be reflected because there is a lack of control,” he said.

Asked if he had concerns the control approach would encourage Lehman-style off balance sheet behaviour, McKersie said: “There is a concern it may make it easier.”

In the last week the UK Accounting Standards Board also wrote to the IASB warning the proposed rules would increase “structuring possibilities”.

“In particular, we are concerned that the IASB’s model, by following the legal form so closely, is likely to lead to derecognition of more financial assets than is currently permitted,” he said.

The IASB is debating the rules at present and expect to release a final standard in early 2011.

Further reading:

Audit in turmoil over 'derecognition' standard