Audit in turmoil over ‘derecognition’ standard

Auditors, standard setters and investors stand in disagreement over new
accounting rules which guide when companies can remove assets from their balance

The international debate on the standard called ‘derecognition’ has opened
fissures within the accounting world with two of the UK’s largest bank auditors
disagreeing on fundamental underlying principles, and the world’s two most
prominent standard setters heading in different directions.

Derecognition rules set out when listed companies “derecognise” items from
their balance sheets. The issue has taken on a political dimension in the last
10 years following the Enron scandal, when the US energy provider was found to
have channeled its debts through a tangled network of off-balance entities.

More recently, collapsed US bank Lehman Brothers was accused of covering up
its true balance-sheet position through the use of repurchase transactions.

The tactic enabled the bank to shift $50bn (£34bn) from its balance sheets
during sensitive reporting periods.

The fervour over derecognition reached such heights that in September 2009
G20 leaders discussed it during meetings in London and recommended improvements
to “accounting standards for provisioning, off-balance sheet exposures and
valuation uncertainty”.

The comment spurred the International Accounting Standards Board (IASB) into
action. In March 2009, it drafted new rules on derecognition.

The proposals attracted mixed responses from the accounting community. At the
heart of the debate sat two competing concepts – “risks and rewards” and

Current rules use the “risks and rewards” model. This allows a company to
remove an item from its balance sheet only if the risks associated with the item
are also removed.

This model requires finance managers to exercise their own judgment, which
can result in vastly different results and can lead to over-recognition, where
the same asset is recognised on the balance sheet of multiple companies.

The second approach, “control”, is often seen as restrictive and vulnerable
to misuse. Companies can remove items from their balance sheet if they can prove
they have lost “control” of the asset.

The two ideas have split two of the UK’s leading audit firms.

While KPMG urged the IASB to continue using the “risks and rewards criterion…
to be the primary filter for determining whether financial assets are
derecognised”, PwC supported proposals to “establish control as the principle
underlying the derecognition assessment”.

The pair, who made their comments in submissions to the IASB last year, count
Barclays and HSBC among their clients.

When asked again, KPMG declined to comment on the subject last week, while

Pauline Wallace, head of public policy and regulatory affairs with PwC, said
both approaches had merit.

“There is a strong case for saying that the control model is preferable
because this is consistent with the fundamental principles of accounting.

“On the other hand, the risks and rewards model is more intuitive and gives a
better answer for repurchase transactions,” she said.

The issue was brought into sharp relief on 11 March when Anton Valukas, the
court appointed examiner into the collapse of Lehman Brothers, said the bank had
manipulated the definition of control to repaint their balance sheet with
brighter numbers.

In the subsequent congressional hearings, following the report, Robert Herz,
chairman of the Financial Accounting Standards Board (FASB), submitted a
statement detailing the technicalities of the control principle where he noted
the “ongoing work with the IASB to develop a joint standard on derecognition of
financial assets”.

What he failed to mention was that the IASB and FASB were potentially heading
in different directions on the subject.

While the IASB seems to be walking away from its risks and rewards model, to
one which uses a control principle, FASB is being urged to abandon its control
principle for a risks and rewards option.

The CFA Institute, a key US accounting institute, whose ideas tend to be
reflected in FASB rules, said, in a submission, the risks and rewards model “is
essential to fully understand which entity is in control of the transferred
financial assets or financial liabilities”.

Meanwhile, the IASB last year put forward a model which uses control as the
primary test for derecognising assets.

The UK Accounting Standards Board (ASB) signaled their concern for the rule
in July, outlining five key issues in a submission letter.

Last week, the ASB felt compelled to write again, this time in a standalone
letter sent to Sir David Tweedie, chairman of the IASB.

In the letter, ASB chairman Ian Mackintosh raised concerns that the IASB’s
“proposals on derecognition, based on the control model, would increase the
scope for financial engineering”.

The IASB, however, points out the control principle aligns with risks and
rewards in key areas, and exceptions have been made for repurchase agreements,
which were at the heart of Valukas’ accusations.

The body also points out that discussions are continuing and no firm
decisions have been made yet.

They also claim the control method would lead to more consistency and stop
companies placing assets on their books that cannot be readily realised.
The board has until June 2011 to finalise its standard, and harmonise it with US
accounting rules.

There is also opposition from within the IASB, with two board members
threatening to write dissenting opinions if the control method is adopted.
It also faces opposition from investor groups who say the current derecognition
rules will make it easier for companies to “engineer” their accounts.

“It is somewhat perverse to say the impact of liabilities should not be
reflected because there is a lack of control – lack of control does not reduce
the implications of liability,” said Michael McKersie, which has members of
investment affairs at the Association of British Insurers.

The IASB is discussing the project now and aim to release a final standard by
the first quarter of 2011.

Further reading:

Standards tug of war risks
more Lehmans-style accounting

Related reading

Fiona Westwood of Smith and Williamson.