Provisioning for losses

IRELAND’S CENTRAL BANK is toying with the idea of requiring its smaller compatriots to report expected losses. This would put them ahead of the curve when it comes to International Financial Reporting Standards and other users like the UK, which currently require only the reporting of incurred losses.

Furious debate has blown up again as a result, with IFRS-doubters triumphantly calling it proof of a lack of prudence, while critics insist the old UK GAAP’s loss provisioning requirements were essentially the same as those under IFRS.

The debate is technical, with disputes arising over semantics and the weight of the Companies Act versus accounting standards – essentially a question of which trumps which.

According to critics, IFRS allows banks to pay out on unrealised profits by not forcing them to make adequate provision for loans that could go bad. They claim UK GAAP required directors to make forward-looking provisions for these bad assets, whereas IFRS only requires reporting and provisioning for incurred losses, meaning crisis could be looming with no financial cushion in place.

Nay-sayers claim UK GAAP called for a similar level of provisioning and forbade crystal-ball gazing; they said the two standards would produce similar figures and it is madness to believe otherwise.

They argue both standards forbid predicting a crisis when one is not already happening. This means that, when looking at losses that may result from loans but have not yet been identified, only current economic and other factors affecting the business climate should be taken into account, rather than distant crystal-ball predictions.

UK GAAP-defenders turned to the Companies Act; in legislation governing large companies (such as banks) and provisioning, it says cash should be set aside for clearly defined liabilities and those which are “either likely to be incurred, or certain to be incurred but uncertain as to amount or to date on which it will arise”. This, it is claimed, is proof of the requirement to provision for expected losses.

However, IFRS supporters disagree. One Big Four partner noted that UK GAAP included a Statement of Recommended Practice (SORP) covering bank loan provisioning. A two-parter, it called upon banks to make specific provisions against loans that have already gone bad, plus general provisions “to cover the impaired advances which will only be identified as such in the future”.

On the surface, this seems like an exhortation to expected loss provisioning. However, the SORP underlined that general provision “relates to impairment already existing in the advances portfolio … it does not relate to advances which … are subject to no more than normal credit risk, but which in the nature of things may become impaired in the future”.

Supporters said this means it is essentially the same as IFRS – only incurred losses should be reported, and expected losses – divined by looking beyond current economic conditions at future projections – were not to be included.

It is here that the semantics become confusing. UK GAAP lovers said the old standard’s version of incurred loss covers “likely to be incurred” – essentially the same thing as ‘expected to be incurred’. IFRS supporters said not only do the two standards refer only to “incurred loss” provisioning, but also, IFRS’s incurred losses are no less extensive than UK GAAP’s as both required directors to consider only current financial and economic conditions when setting aside provisions.

Aside from the semantics, experts are also jostling over whether the Companies Act or accounting standards carry more weight. UK GAAP proponents say the legislation trumps all, while IFRS defenders point out that it is a requirement of the Act to follow the standards.

The complexity doesn’t end there. The Accounting Standards Board effectively overrode the relevant SORP in 2005, the same year as IFRS became a requirement for listed companies. The ICAEW continues to feature a link to the guidelines on its website, and commentators said this is proof that the institute prefers the old UK GAAP-inspired way of provisioning for losses.

What is certain is that both standards allow and require a degree of judgement when provisioning for losses. And what the debate seems to show is not that one standard or the other is more prudent, but rather, that the experts on each side have a different idea of what prudence means. Those fighting for UK GAAP seem to consider the banks fundamentally incapable of prudently making provision for losses – and blame IFRS for allowing them to get away with it – while their opponents trusts banks to adequately plan for their uncertain assets.

In the current climate the debate is loaded, and Ireland’s decision will no doubt add fuel to the fire. The next thing to keep an eye on is IFRS’s potential move to an expected loss model, a process that will not doubt draw furious commentary from stakeholders large and small.