Current Accountancy Practice increases risk

CormacButler 141Current Accountancy Practice increases risk by Cormac Butler

A major source of risk facing banks in Europe relates to solvency reporting. In broad terms, a bank is deemed to be solvent if the value of its assets exceed that of its liabilities. If they do, and the gap is large, a bank may be able to withstand losses in bad years. Unlike companies, the value of a bank’s assets must exceed the liabilities by a certain margin. The difference, known as Tier One capital is a requirement of the Basel Accord, a set of regulator rules designed to make sure that banks do operate safely. Since the financial crisis of 2008 regulators require a widening of the gap between assets and liabilities. The goal of these requirements is to make banks safer in order to prevent catastrophic collapses that impact the economic well-being of countries.

In Ireland and the UK a problem exists. Under current European Central Bank (ECB) rules issued in 2005, firms are allowed to overvalue their assets. In plain English, if a bank lends out £1,000,000 to a customer and then concludes that the loan was a mistake and will not be fully repaid, the bank may claim that under current rules that recognition of that loss can be delayed. The bank effectively values the loan on the balance sheet at £1,000,000 even if the prospect of recovery is remote. This misleads shareholders. It also gives an unrealistic valuation of the firm for outsiders considering loans to that bank to inject working capital.

Some corporate governance experts consider that the ability to hide losses under ECB Guidelines is not only illegal but also damaging to the economy. A realistic valuation of a firm’s balance sheet has always been a critical part of governance and risk management. Some European Governments are endangering their Country’s economic prospects by blind trust, on a large scale, of dubious asset reporting. Citizens beware!