IF company directors want to pay a dividend out of corporate profits, do they rely on the words in the Companies Act 2006, or do they rely on the Financial Reporting Council’s guidance?
This spat between the UK’s accounting watchdog and long-term investors such as pension funds and insurers has now acquired added piquancy with the European Union mulling a request from the International Accounting Standards Board to endorse IFRS 9, Financial Instruments, for use across the EU.
The IASB finished its work on a replacement for its existing financial instruments literature, IAS 39, in July 2014. If endorsed, preparers must apply it from 1 January 2018. But for the IASB to put the project to bed, it must first satisfy the three endorsement criteria in the IAS Regulation 1606/2002.
These say, first, that a standard must fulfil the “true and fair view” criteria set out in the accounting directives. Second, it must satisfy the so-called qualitative criteria. This broadly means that the application of an IFRS must result in numbers that are understandable, relevant, reliable and comparable.
The qualitative requirements are intended to assist users of financial statements to reach economic decisions and to assess management’s stewardship. And third, an IFRS must be conducive to the “European public good”.
The stakes are high because at no point since the EU began using IFRS in 2005 have these criteria been under such intense scrutiny. The reason is quite simply that IFRS 9 and its new forward-looking impairment model are supposed to right some of the accounting wrongs that helped to plunge global markets into meltdown almost a decade ago.
This stems largely from the fact that impairment of financial assets held at amortised cost, as well as the use of fair value – especially mark-to-model fair values – have both figured widely in the post-Lehmans post mortem. Moreover, IFRS’s detractors in the UK argue that long-term investors were poorly served by the IFRS accounting model.
Proof of that dissatisfaction emerged in November 2013, when a letter from the Association of British Insurers, the Investment Management Association and the National Association of Pension Funds to the FRC was leaked to the press. In that letter, the investors underscored the importance that they attach to the true and fair view override and prudence in accounting. Collectively, the three organisations manage in the region of £7tn of assets.
In tandem with this development, the Local Authority Pension Fund Forum obtained an opinion from commercial silk George Bompas QC. He aired the notion that IFRS financial statements might well have played a much bigger role in fuelling the Financial Crisis than had previously been thought.
Many long-term investors broadly argue that IFRS accounts provide insufficient protection for shareholders and creditors. By investor protection they mean the notion that financial statements should give sufficient support to lawful profit distributions. At the same time, the accounts should confirm that a company’s net assets do not fall below the amount of its share capital. Put bluntly, a company should be solvent when it pays out a dividend.
Academics’ opinions sought
Meanwhile, in a bid to clarify the conflicting views around the suitability of IFRS 9 for endorsement across the EU, the European Commission engaged two academics from the University of Mannheim Business School – Jannis Bischof and Holger Daske – to assess the standard against the EU legal framework.
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Perhaps unsurprisingly given the high stakes, the academics conclude that IFRS 9 does indeed satisfy the endorsement criteria. But equally noteworthy is their analysis of prudence in accounting, not least because it lays bare the cultural and expectation gulf between the UK investors and supporters of IFRS 9.
Bischof and Daske bluntly dismiss the view that IFRS 9’s use of fair value is inherently imprudent. “There are extremely restrictive interpretations of the prudence principle in the academic literature that seem to suggest that fair value accounting per se is an imprudent reporting practice,” they write.
They continue: “Not only are these interpretations purely theoretical, but they are also inconsistent with the general consensus in the accounting literature of what meaningfully constitutes a prudent (‘conservative’) accounting system.”
Their conclusion is damning for investors such as the ABI and their argument that prudence is a state of mind that runs through the process of preparing accounts. They write: “Overall, we are not convinced that current EU legislation or available ECJ jurisprudence require annual accounts to comply with the prudence principle to achieve a TFV.”
Friends in high places
In any event, IFRS 9 has friends in high places. Alongside the support of the academics at the University of Mannheim Business School, both the EBA and the ECB – which is responsible for banking supervision in the EU – have come out in favour of endorsing IFRS 9. Notwithstanding this, the row over IFRS 9, and IFRS more generally, has now spilled over into the UK – leaving the FRC at loggerheads with many of the UK’s biggest investor interests.
Their private misgivings became decidedly public on 20 November when the Local Authority Pension Fund Forum released a letter sent to the chairman of FTSE 350 companies warning them to ignore the FRC’s 2014 accounting guidance on distributable profits and the true and fair view. That guidance, LAPFF argued, could mean “UK listed company accounts are at risk of being contrary to the requirements of the law”.
Prompting the move was a further opinion from George Bompas QC. He concluded that accounts which do not refer specifically to “what is or is not available for distribution by reference to amounts stated in them” cannot give a true and fair view of a company’s “assets and liabilities, financial position and profits or losses”.
A true and fair view
Central to this claim – indeed, the whole dispute between the FRC and LAPFF – is section 393 of the Companies Act 2006, which requires a company’s accounts to give a true and fair view of “the assets, liabilities, financial position and profit or loss”.
LAPFF argues that the FRC’s latest guidance on true and fair view relies on a wrong-headed reading of section 393. The LAPFF argues that the words in the FRC’s guidance do not reflect the specific words found in s393(1) of the Companies Act 2006.
Cllr Keiran Quinn told Financial Director: “Both EU and UK law is clear on the object to which the true and fair view of S393 attaches, which is specific basic numbers in the accounts ‘assets, liabilities, financial position and profit or loss’. It is not ‘the accounts as a whole’ more generally, nor ‘the state of affairs’.
“The law is also clear on the statutory purpose for that standard, which is member and creditor protection. Standard setters have got the purpose of the law wrong, and have got the object of the standard for that purpose wrong, when in law it’s a true and fair view of the specified numbers.”
The FRC, meanwhile, slammed the LAPFF move. In a statement, the FRC said in December: “[We are] aware that the LAPFF has written to company chairmen. Their letter deals with a very narrow point of company law in terms which we cannot support and raises uncertainty unnecessarily. The FRC and the government have confirmed that the Companies Act 2006 does not require the separate disclosure of a figure for distributable profits.”
The Bischof and Daske paper is yet another hint that the EU will ultimately endorse IFRS 9. If it indeed does, FDs might well be calling their lawyer. After all, as LAPFF wrote to company chairman last November, the issue has “significant implications going forwards for you and your colleagues”.