Can accounting standards save the G20?

Many regard April’s G20 meeting as the most important political gathering for
the world economy since the 1930s. Its primary aim is to create conditions for a
coordinated effort to rescue banking, restart growth and avoid recession
becoming depression.

The meeting could mark a watershed in the role of accounting in achieving
stability. Nothing reflects this better than whether banks can use so-called
‘dynamic provisioning’ to smooth reported results.

The Financial Services
Authority unveiled proposed regulatory changes for the banking sector in the
Turner Review last month. These are expected to form the thrust of the
government’s stance at the G20, which aims to improve the international
financial regulatory regime.

The report highlights how the extraordinary conditions created by the credit
crunch could lead to a change in the centuries-old practice of preparing audited
accounts purely for shareholders and force the profession to share standard
setting with other regulators.

Counter-cyclical

Turner’s report includes several recommendations to make financial
regulations more counter-cyclical, allowing banks to set aside amounts in the
economic cycle’s upswing to prepare for the downswing. It identifies dynamic
provisioning as a useful tool in meeting this objective.

The report highlights that Spanish banks and credit institutions have been
able to use dynamic provisioning since June 2000. The report states the Spanish
model ‘aims to ensure that the aggregate annual provisioning – including the
dynamic provision – equals the average annual net losses suffered by the banking
system over the last decade’.

John Hitchins, banking sector leader at
PwC, says there are two
types of dynamic provisioning. He says: ‘The first involves setting provisions
based on the expected loss of the portfolio as it is constituted at the balance
sheet date each year.

‘The other approach involves setting annual provisions evenly over the
economic cycle based on the characteristics of the portfolio which, to some
degree, will include provisions against loans not yet entered into at the
balance sheet date.

‘Only the second of these methods is counter-cyclical. Neither fits within
the current IFRS accounting framework although it would be possible to adjust
the framework to accommodate the first method.’ The second is wholly
incompatible with the IFRS framework and he would be opposed to any proposal to
base a provision charge in the profit and loss account on this method.

Colin Martin, head of FS technical advisory at
KPMG, thinks there are many
technical accounting issues that would need addressing by standard setters to
implement dynamic provisioning coherently.

He warns: ‘The thrust of the regulatory component of the G20 summit concerns
the banking sector and financial regulation. The
International Accounting
Standards Board has never written a standard for one industry before and a
standard directed at one corporate sector would be a significant divergence for
the standard setters. It is unclear how accounting rules on dynamic provisioning
would affect non-financial corporates.’

Indeed, he suggests accounting rules could be left alone if company law is
changed to allow dynamic provisions to be treated as an appropriation of profits
in a similar fashion to dividends.

Steve Maslin, head of external professional affairs at Grant Thornton, says:
‘Dynamic provisioning is a sensible prudential measure that should not affect
the accounting statements. If dynamic provisioning did affect results, there is
a danger of a return to the days of banks creating secret reserves. This would
make it difficult for shareholders to see the underlying business performance
and make it more difficult for accounting standards to serve their purpose.’

Maslin points out that extant accounting standards during this business cycle
allowed companies to set aside funds for the impact of worsening economic
conditions. He said: ‘There is nothing to stop a non-distributable reserve being
created during the business cycle with clearly identified transfers between it
and other reserves.

‘Importantly, this would allow companies to prepare for the bad times without
affecting the financial statements and additional reserve notes would aid
transparency to shareholders.’

He adds that banks could have done what might be thought of as ‘dynamic
reserving’ but added there had been ‘no regulatory agreement on how to calculate
such reserve transfers fairly and accurately’.

Turner’s proposals include backing a special ‘economic cycle reserve’ as a
means of making accounting practice more counter-cyclical.

Maslin warns that ‘people need to be on notice that there is a risk
politicians will destroy financial statements to the detriment of shareholders’.
He believes that British politicians and regulators have ‘bought in’ to the
dangers of altering the thrust of financial statements and making them
counter-cyclical.

Whether the G20 achieves consensus on this is open to doubt.

Maslin adds: ‘There is less optimism that all other jurisdictions outside of
the UK have got the message. For instance, comments have been attributed to
certain European finance ministers suggesting that accounting regulators need to
help promote financial stability – this is very worrying.’

Hitchins says financial regulators were among constituent groups involved in
the standard setting process. He urges that, whatever the upshot of the G20,
accounting bodies must remain the ‘ultimate arbiters in setting standards’.

Making a point

He is eager that any changes in accounting regulation post-credit crunch
don’t miss the point that financial statements are primarily prepared for
shareholders as a record of performance and not to meet the objectives of other
interested parties.

He says: ‘I think it is doubtful that the needs of a prudential regulator and
investors can be reconciled in the same set of accounting rules.’

In light of the G20, Martin hopes standards can be changed to meet the needs
of both regulators and standard setters. He adds: ‘Where the interests of both
parties diverge, then the interests of shareholders should take precedence and
standard setters should maintain this focus.’

If politicians and regulators push for some form of dynamic provisioning,
this could create significant issues for senior directors and auditors. Martin
says: ‘There are very few forward-looking statements in the annual report and
accounts from directors. Dynamic provisioning is likely to force directors to
disclose the forward-looking assumptions underlying the provisions. This could
ultimately open directors to fresh potential legal challenges.’

Many fear that politicians’ desires to tighten financial regulation could
lead to knee-jerk responses that risk undermining the value of financial
statements. Maslin thinks the desire for a more counter-cyclical approach
‘should be driven by prudential ratios and regulation, not accounting
standards’. Hitchins and Martin agree that prudential regulation is far more
preferable to radically different standards and practices.

There were calls last week from William Rhodes, vice chairman and president
of Citibank, for the G20 to deliver concrete results and for reforms that
include a common set of standards. There is support from regulators, politicians
and some banks for some form of dynamic provisioning within such reforms.

Fortunately for standard setters, dynamic provisioning can only be introduced
at the start of a business cycle.

The next cycle looks some way off, providing a breathing space for all
parties to thrash out a compromise.