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

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

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

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

Related reading

Fiona Westwood of Smith and Williamson.