A plenary session of the European Parliament has passed a potentially damaging report on the activities of the IFRS Foundation and the International Accounting Standards Board (IASB).

The own-initiative report of the Parliament’s Committee on Economic and Monetary Affairs (ECON) lends weight to criticisms made by leading investors of the International Financial Reporting Standards (IFRS).

Although the report is non-binding and lacks legislative force, it comes at a difficult time for the IASB as leading UK investors challenge the legality and financial-stability impact of its new financial-instruments accounting rules.

Tim Bush, head of governance and financial analysis at Pensions & Investment Research Consultants in London, welcomed the report’s findings, which in the UK could pile further political pressure on the IASB and its supporters.

“The Motion of the Parliament sets out the correct endorsement criteria, which, like the written answer from Lord [Jonathan] Hill, demonstrates that EFRAG (European Financial Reporting Advisory Group) and some member states of the Accounting Regulatory Committee have used the wrong criteria due to writing the law down wrongly.

“Each link in the endorsement chain seems to have involved the UK Financial Reporting Council, its immediate alumni, or its secondees.”

The ECON report also lends weight to the argument advanced by the Local Authority Pension Fund Forum (LAPFF) in the UK that the so-called true and fair view requirement for accounts under EU law applies to specific components of the accounts and not just to the accounts as a whole.

Specifically, in accord with the LAPFF’s view, the ECON report states: “The annual financial statements shall give a true and fair view of the undertaking’s assets, liabilities, financial position and profit or loss.”

The report further notes that “this purpose relates to the capital adequacy function of accounts … that both creditors and shareholders use … as the basis for determining whether a company is ‘net asset’ solvent and for determining dividend payments.”

More damagingly for the IASB, the ECON report finds that the IASB’s understanding of the principles of prudence and stewardship is at odds with the legal position under European case law and the Accounting Directive.

Major long-term investors have argued that the concept of prudence, or caution, plays an important role in ensuring that a distribution to shareholders is lawful and backed by real profits.

These investors believe defective IFRS accounting rules, particularly IAS 39, which deals with financial instruments accounting, enabled major banks to book illusory profits in the run-up to the financial crisis of 2008.

But, having distributed these profits, the banks were then forced to take a major hit to shareholder equity when losses suddenly mounted on impaired financial assets.

The IASB has now finalised IFRS 9, a replacement standard for IAS 39, which it argues will force banks to set aside greater provisions against future losses.

Meanwhile, contrary to the Parliament’s position that the principle of prudence “should be accompanied by the principle of reliability”, the IASB has recently tentatively voted to reject the reintroduction of prudence as a bias toward conservatism.

The board, however, has yet to commit to paper its understanding of the relationship between prudence and its preferred accounting concept of neutrality as part of its conceptual framework project.

Elsewhere in the report, the European Parliament calls on the IASB and EFRAG “to strengthen their impact analyses.”

More action is needed, the MEPs warn, “notably in the field of macroeconomics, and to assess the different needs of the wide variety of stakeholders, including long-term investors and companies, as well as the general public.”

The issue of macro-prudential impact of accounting standards was recently brought into sharp focus when it emerged that the European Systemic Risk Board had yet to carry out a stability assessment of IFRS 9.

This picture emerged despite the production of a series of studies by academics at the University of Mannheim supporting the endorsement of IFRS 9 for use across the European Union by major banks.

The ECON report now calls on the Commission “to remind EFRAG to strengthen its capacity to assess the impact of new accounting standards on financial stability”.

In September last year, the LAPFF argued that EFRAG misapplied EU law in its endorsement advice on IFRS 9.

Then, in December, both the LAPFF and EFRAG wrote to the EU’s internal market commissioner, Jonathan Hill, to clarify their position on IFRS 9.

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