Standards challenge for co-ops

Posted on October 2, 2011 · Posted in Co-operative News

Accountancy is regarded as a boring profession for boring people. This is very unfair. Indeed what was said about bankers, after the banking crash, is equally apposite to accountants. What the world needs now is rather more very boring bankers – and accountants.

As with bankers, accountants are society’s new ‘financial engineers’. (This reminds me of Stalin’s aspiration for artists to be ‘engineers of the soul’: the two concepts are equally dangerous.) It might seem at first glance that accountants are mere book-keepers, the people who compare the income with expenditure and then conclude whether the business has made a profit or a loss.

The reality is very different. Deciding whether a business is profitable or loss-making can come down to many matters of judgement. For example, do you treat the value of your assets as how much you paid for them, how much the market might pay for them today, or the average of recent transactions for similar assets in the recent past? And do you still use the same tests, even if you intend to hold onto the assets for the next 20 years and would not, in any circumstances, sell them?

These exact questions lie at the heart of how the financial system does, or should, operate today. Traditionally, accountants have reported asset values as the price they were bought. Profits were only recorded when assets were sold. But this meant that companies were often vastly more profitable than they appeared. And it opened the way to companies manipulating their accounts – for example, when executives’ pay was linked to company profits – by making overnight sales and re-purchases of assets in order to report higher asset values.

To overcome this, modern accounting principles – as applied in the International Financial Reporting Standards being adopted now in most of the world – take a different approach. With IFRS, ‘fair value’ is used for most assets. Fair value means the current market value of an asset.

But one problem with fair, or market, value is that as an asset class falls in value then companies must report that fall in their accounts. Even when a business is trading profitably, its accounts may show it entering heavy loss making territory, simply because the assets that it has no intention of selling have lost value. And asset value falls can become mutually reinforcing – a process that has been blamed as playing a key role in the recent financial crash.

There is, in the minds of many, no right or wrong answer about how to record profits, or asset values. But there is widespread acceptance that the whole world should take a common approach to how accounts are presented. Not least this reflects a globalised economy, where investors will want to understand whether funds will earn higher rewards if put to work in, say, China, the United States or the United Kingdom. Consequently, we have the International Accounting Standards project, which results in the IFRSs.

The adoption of IFRSs is of enormous significance to the co-operative movement. Housing co-operatives, for instance, are very exercised by the proposals contained in Financial Reporting Standards for Medium-size Entities, or FRSME (accountants’ lives are dominated by sets of initials and acronyms). Under FRSME, housing co-ops would have to report the value of assets and other investments at current market values. At present they report these at the lower of cost, or net realisable value.

“Co-operatives hold investments on a conservative basis and they do not form a significant part of operation or nature of the business,” explained the Irish Co-operative Organisation Society Ltd to the UK’s Accounting Standards Board (whose standards are also used in Ireland). “Also on a prudence basis, co-operatives don’t recognise investment gains until realised [ie the assets are sold]. The FRSME ‘Fair Value’ treatment of investments will now make co-operatives and other entities appear [as] if they have realised gains on which to distribute to Members and Shareholders, when this is not the case.”

And so it is made clear how the academic-type approach to accounting standards will have its impact on the reality of running a business – in this case housing co-ops. There is a second issue in the proposed changes to FRSME that affects both larger housing co-ops and other types of housing associations.

For these larger housing providers, the value of the assets they held could actually fall under the adoption of FRSME. This is because they would have to report recent falls in property values and they would have to remove some development costs in the reported value of their property portfolios. By potentially reducing the value of the portfolios, many housing providers could breach their banking covenants. (Financial covenants agree how a borrower conducts business: including the ‘gearing’, or ratio of assets to liabilities. As asset values fall, so a covenant might be breached.) And banks in recent years have had a distressing tendency to call in loans where covenants are breached – sending businesses that are sometimes trading profitably into administration and closure.

Housing co-operatives and associations are also very unhappy at the likely cost of moving to IFRS, which could lead to them being forced, between them, to spend tens of millions of pounds in buying new IT systems. Credit unions are similarly unhappy. They feel that they are being pushed to adopt the same standards, and be treated in the same way, as banks that hold billions of pounds of assets and liabilities on their balance sheets.

“We are concerned that what the ASB is proposing is disproportionate and is likely to see significant cost increases for our members without any equivalent benefit for anyone involved in credit unions – not the members, regulator nor credit unions themselves,” says ABCUL Chief Executive, Mark Lyonette. He adds: “If the ASB does not reconsider, we could end up in the sorry situation where credit unions are put out of business because of the costs they face in producing their end of year accounts.  We do not think this is the basis for sound accounting policy.”

Nor is this by any means a full list of the problems that IFRSs are causing the co-operative movement. Co-operatives UK has been very vocal for the last year or so about another unfortunate impact from proposed changes to accounting standards. Under a proposed IFRS, co-ops will be required to treat members’ dividends as refunds. This would significantly reduce their reported revenues.

Ed Mayo, Secretary General of Co-operatives UK, says: “This new standard may end up cutting profits as the rules want to treat the dividend as if it were no different to a sales promotion, rather than something fundamental to co-operative businesses since the pioneers – sharing the profit.”

Co-ops UK has raised the matter with the International Accounting Standards Board – the body leading on IFRS globally – but complains it has had difficulty in getting the IASB to understand how damaging the issue is to co-ops. The response of the IASB has been that while it is sympathetic, it is determined to adopt ‘principles-based’ standards and hints that it would be wrong for it to allow opt-outs for particular sectors because it affects them in specific ways.

Co-operatives UK is now working with members through its Co-operative Performance Committee to contest the proposed changes to accounting standards. It warns that a sector-wide campaign may be needed if the standard is not amended and that such a campaign should be international, given that IFRS will have their effects on co-ops around the world.

Consultation on IFRSs continues and there will be more meetings involving Co-ops UK in November. Meanwhile, the ASB’s consultation of FRSME in the UK and Ireland is now completed – though the ASB has made clear it understands the particularly difficult impact its proposed changes will have for the not-for-profit sector. As far as both sets of proposed changes are concerned, no final decision has yet been taken.

Ed Mayo puts these discussions into their correct perspective. “This is about accounting standards, but it’s bigger than that: it is part of the work Co-operatives UK, with its members, does everyday to create a legislative environment that provides co-operatives with a level playing field.”