Professor Eamonn Walsh on the pre-2007 limitations of accounting regulations and how the banking sector can avoid the same mistakes

Just a handful of years ago, few people cared about corporate risk and financial statements. These were issues for the world of commerce, while the rest of the world went about its daily business. In 2008, however, the global economy toppled over and slid out of the pudding bowl. Suddenly the average person on the street knew all about the importance of financial stability.

The expertise of academics like Eamonn Walsh, the PWC Professor of Accounting at the UCD College of Business, became vital. “I’d spent ten years working at New York University during the 80’s and 90’s, focusing on the economics of financial statements which is, essentially, how balance sheets and profit and loss accounts can be best used from the perspective of investors,” Walsh recalls. “This was an area of research that, although a hot topic in the United States – the world’s largest capital market by a long stretch – had received very little attention in Europe.”

One of his specialist areas is taking reams of accounting information and helping investors and companies to make sense of it. To what end? “If you’re an investor, you need a way to identify companies that are undervalued or overvalued. It’s about trying to find what pieces of information are there to assist you.”

Pre-2008, investment firms wanted the information, but there was little public interest in this work. “The broader impact was zero,” says Walsh. “Reading through financial statements to see, for example, how derivatives affect performance, was done behind closed doors.” In 2008, a huge global recession brought the importance of this information noisily crashing through the walls of virtually every household in Ireland. It became clear that private commerce affects society and the state; Professor Walsh’s nsight has been to apply the lessons from private companies to the wider public sphere.

In February 2015, he appeared before a parliamentary banking inquiry in Dublin to share his insights. “The rules used to compile this information are still not generally well understood. I told the inquiry that the set of rules used by banks have still not changed, so banks using standard accounting measures can still appear profitable even if they are in deep difficulty. These rules will change from 2018.”

As part of his expert submission to the enquiry, Professor Walsh outlined the limitations of IAS 39 (International Accounting Standard 39 “Financial Instruments: Recognition and Measurement”, the key accounting standard for banking entities as their balance sheets are dominated by financial instruments) which contains the guidance on loan impairment.

“With respect to bank lending, provisions for loan losses are the most challenging accounting problem. If one had certain knowledge of future losses, it would be straightforward to decrease bank profits to reflect these losses. For example, if a bank engaged in more risky lending, then one would increase the provisions and decrease income (and hence capital). However, certain knowledge is not available and some judgement is necessary in order to establish the provision for loan losses or loan impairment.” He quotes the guidance directly (IAS 39, Para.59): “Losses expected as a result of future events, no matter how likely, are not recognised.” Professor Walsh expressed that “This is a very conservative definition of impairment since it requires objective evidence that a loss has been incurred. As a result, one could argue that impairment accounting is procyclical. In periods of expansion, as a bank expands its loan book, the bank will appear far more profitable since profit measures exclude expected loan losses.” “These accounting issues are well known to informed users of bank financial statements. It is also fair to say that uninformed users may be forgiven for failing to understand that increased bank profits during a growth phase are almost inevitable.

However, disclosures to the financial statements are a key part of understanding the impact of these issues. In my opinion, there was inadequate disclosure concerning the increased risks that were faced by banks. Through the lens of 2002 balance sheets in the sector, users could have concluded that increased profitability was synonymous with increased ‘cushions’. Through the lens of 2007 balance sheets, it would have been much easier for a sceptical observer to understand the underlying sources of these profits. If one were seeking a financial reporting failure, it was the absence of detailed requirements to disclose credit risk prior to the 2007 fiscal year when IFRS7 became effective (IFRS 7 “Financial Instruments: Disclosures” became effective for annual periods commencing on or after January 1, 2007).

It was very difficult for outsiders to comprehend the seismic shift that had taken place in bank balance sheets prior to 2008. In summary, I believe that the real challenge for external users of financial statements was understanding the changing nature of the risks on aggregate bank balance sheets until 2007. Had users fully understood the increased exposure to commercial and speculative lending – and that it was concentrated among a relatively small group of borrowers – it would have been far easier to realise that the quality of profits had declined and that mattresses rather than ‘cushions’ were required.”

Overnight, Walsh, having worked in the US where he had gained an understanding of these issues at a time when they were not widely understood, became one of the most influential academic financial analysts in Europe. “Before 2007 and 2008, people didn’t see these issues as important. That has changed utterly. Now there is a general interest in the consequences of allowing banks to fail, the balance sheets of Central Banks, the accounting numbers for regulating banks and what was needed to run a bailout programme. Governments and the public need to know if a financial system will collapse. I hope my work helps to do this.”

Professor Eamonn Walsh was in conversation with Peter Maguire, a journalist with The IrishTimes