We assess the legal debate over the meaning of 'true and fair' in relation to international accounting standards
In 2013 a group of major investment funds commissioned a legal opinion from George Bompas QC to advise whether adopted international accounting standards (IAS) could satisfy the requirement, placed by Companies Act 2006 on directors, to only approve accounts showing a true and fair view of the assets, liabilities, financial position and results of a company or group of companies.
Following the publication of Bompas’ opinion on 8 April 2013 and the debate that it caused, the Financial Reporting Council (FRC) asked Martin Moore QC - who had already written an opinion for the FRC in 2008 on the relevance of the true and fair concept in financial statements - to consider and advise.
On the basis of Bompas’ opinion, the commissioning group of investors argued that International Financial Reporting Standards (IFRS), and in particular IAS 39, contain substantial legal flaws that have resulted in distortions in the financial statements of banks from the time of IFRS' introduction in 2005.
As a consequence, IFRS accounts are unable to present a true and fair view as required by UK legislation, making the dividends paid out illegal, as they are based on incorrect figures.
Section 393 of the Companies Act 2006 requires that directors only approve accounts that give a true and fair view; however, such a requirement is overarching and does not distinguish between Companies Act accounts (ie UK GAAP accounts) and IAS accounts that a company may choose or may be required to prepare.
Additionally, section 397 of the Companies Act requires directors to state that the accounts have been prepared in accordance with IAS where that is the case.
In particular, Bompas’ opinion concluded that in order for a director to comply with section 393 (only to approve accounts that show a true and fair view) and to make the statement of compliance with IFRS, as required by section 397, the adopted IAS should produce a true and fair view or, if they do not, a true and fair override should be possible to enable a company to produce IFRS accounts that show a true and fair view.
However, Bompas considered a number of reasons for which adopted IAS appeared not to produce a true and fair view, specifically:
a) failure by IFRS to distinguish between distributable and undistributable reserves, or realised or unrealised profits, for the purpose of capital maintenance
b) failure by IFRS to require prudence as a fundamental accounting principle
c) the recognition of unrealised mark-to-market or mark-to-model profits under IAS 39, which is contrary to the Fourth European Directive underlying the UK financial reporting requirements
d) the approach to provisions recognition in IAS 39 and other standards, which is limited compared to the mentioned Fourth Directive.
On the back of such true and fair shortcomings, Bompas also concluded that IFRS do not allow a route to a true and fair override, specifically IAS 1, and that if the adopted international standards fail to provide a true and fair view and the directors are not allowed to pursue a true and fair override to depart from misleading standards, then it follows that IFRS accounts would not give a true and fair view.
The opinion of Moore on the matters considered by Bompas was published on 8 October 2013 and, in a nutshell, confirms that accounts produced under IFRS are capable of producing a true and fair view, either by compliance with IFRS or by the use of a true and fair override in extremely rare circumstances, and that there is no inherent tension between the requirement of section 393 and section 397 of Companies Act 2006.
Moore confutes the specific conclusions in Bompas’ opinion. For instance, in respect of failure to disclose distributable reserves under IFRS, Moore points out that there is no requirement in statute to differentiate in the accounts between distributable and undistributable reserves.
Furthermore, the current actual position in terms of accounts prepared does not differ on such aspect between IFRS and UK GAAP accounts, especially taking into account the introduction of the fair value accounting rules under UK GAAP.
While it may be helpful to users of the statements if there was an indication of distributable reserves, such an analysis may pose practical difficulties so that directors may only need to form a view on whether profits are realised when they intend to use them for a distribution.
With regards to the absence of the principle of prudence in the Conceptual Framework for IFRS, which provides a context to the understanding and purpose of the international accounting standards and guides the development of the standards by the standard-setters and accountants where there is no standard on an issue, Moore concludes that the concept has not disappeared from IFRS but has rather been subsumed within the concept of neutrality, which is given more relevance in the framework for the purpose of achieving relevance and faithful representation.
Neutrality is the ability to achieve a depiction without bias in the selection or presentation of financial information.
The conceptual approach under IFRS is similar to the approach to neutrality and prudence taken by UK GAAP that requires the exercise of prudence in conditions of uncertainty about the existence and measurement of items in the financial statements.
On the other hand, UK GAAP prescribe that it is not necessary to exercise prudence where there is no uncertainty, and that doing so in such circumstances - for example, by deliberately understating assets and gains or overstating liabilities and losses - would result in accounts that are not neutral and therefore not reliable.
For Moore, the concept of neutrality has been given more relevance than prudence in IFRS for the purpose of preventing manipulation, or smoothing of financial statements, by the use of caution as its pretext.
However, the use of prudence and common sense is still very much ingrained in IFRS in the definition of items subject to uncertainty, mostly in the letter of the standards, and as such it cannot be used as a reason for arguing that IFRS are not able to result in a true and fair representation.
In respect of the inclusion of unrealised mark-to-market or mark-to-model profits under IAS 39, which were alleged to be inconsistent with the European Directive and therefore unable to show a true and fair view by Bompas, Moore points out that the new European Accounting Directive (2013/34/EU) expressly permits a deviation in the recognition of profits when fair value accounting is used.
Furthermore, such deviation has also made its way in UK legislation under the Accounts Regulations (paragraph 40 of S.I. 2008/410).
The criticism of the approach to provisions under IAS 39 and other international standards, which were alleged not to account for all foreseeable liabilities and likely losses irrespective of the time in which they arise, as required by the Fourth Directive then incorporated in UK GAAP, is also refuted by Moore, whose conclusions point out that the directive only refers to all liabilities arising in the course of the financial year concerned or of a previous one.
The effect is that only liabilities that have arisen at the balance sheet date should be recognised, while the consequences of future events that are speculative or hypothetical are not required to be recognised.
Finally, the suggestion by Bompas that IFRS may not allow a true and fair override facility is rejected by Moore, who argues that IFRS allow departure from compliance, specifically in IAS 1 paragraph 19, where such compliance would be so misleading as to conflict with the objective set out in the Conceptual Framework, ie that accounts should be useful by being relevant, reliable, comparable and understandable.
Moore argues that, although the override contemplated by IAS 1 does not directly mention true and fair, or fair presentation, the intertwining of the concepts of usefulness and true and fair in IFRS effectively makes the option under paragraph 19 of IAS 1 a true and fair override.
On the basis of the legal advice received from Moore, the FRC has confirmed the legality of IFRS as a financial reporting framework adopted by UK entities, and it has also confirmed that the concerns expressed by some investors in such respect are misconceived.
In the meantime, the Department for Business, Innovation and Skills has expressed a similar view to dispel the doubts raised.
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