Europe

• Debate on international standards intensifies
• Internet tax
• Scale of pension fund deficits becomes clearer

Debate on international standards intensifies

Conflicts over the adoption of international accounting standards in time for use from 2005 increasingly seem like a game of poker being played while a steamroller bears down on the cardplayers. Interventions by France�s President Chirac and European internal market commissioner Frits Bolkestein have had the effect of dramatically increasing the stakes.

Chirac�s intervention was through a letter to European President Romano Prodi, urging the Commission to row back from the complete adoption of International Accounting Standards for 2005. There would be �nefarious consequences for financial stability� if the standards were adopted in full, warned Chirac.

This action was apparently backed by Bolkestein, who asked the International Accounting Standards Board to act with more transparency. �There is growing unease concerning the standard setting process itself,� Bolkestein wrote to the IASB. �The perception seems to be that there is a lack of willingness on the part of the IASB to move away from theoretical concepts and to accept solutions that are based on solid, practical experience.�

European ministers, meeting as the European Council, supported this approach by only adopting 2001 versions of most standards, and not adopting at all the crucial IAS 32 and 39. The Council urged the IASB, banks and insurers to �pursue an active and open dialogue to reach an acceptable solution on IAS 32 and 39�. Bolkestein told the Council that the EU should become more involved in the standards setting process and that the Commission needed to consider how to strengthen the role of the European Financial Reporting Advisory Group.

Bolkestein went on to warn the IASB that �future IAS-endorsement will become more difficult unless ways and means are found to ensure that the standard setting procedures become more open�. Paul Volcker, chairman of the International Accounting Standards Foundation, responded by promising Bolkestein that consultation procedures would indeed be reviewed.

The French concerns appear to be based around the way that fair value will be used for accounting for banks� derivative deals, which Chirac believes will increase the volatility of banks� trading positions and share values. In this, the French are echoing the opposition to new standards which is being voiced increasingly loudly by insurers around the world. The French banks have complained that the IASB has not properly consulted them and has taken more notice of existing standards in the United States. Meanwhile, European business groups are growing ever more worried that the 2005 deadline may be too close for full implementation on time.

Standard setters have responded by making some concessions, but less than the banks had hoped for. Following a series of meetings between the IASB and the European Banking Federation, the IASB proposed amendments to IAS 39 to enable fair value hedge accounting to be used more readily for a portfolio hedge of interest rate risk - the so called �macro hedging� practice. The IASB said that the exposure draft proposing the changes retained the basic principles behind IAS 39, while aiming to reduce the cost of compliance.

But the IASB asserted that the need for such guidance was undiminished, driven by the still growing use of financial instruments for risk management and other purposes. At the end of 2002, the Bank for International Settlements estimated that the total notional amount of over-the-counter derivatives contracts stood at US$141.7 trillion; the gross market values of those contracts was $6.4 trillion, pointed out the IASB.

�Without a standard such as IAS 39, the use of derivative contracts for an individual company�s accounts would be unknown to investors,� said an IASB statement. �Financial instruments would be shown in a company�s financial reports either at cost - which is generally zero - or not at all.�

The IASB and the UK�s ASB - which simultaneously produced its own exposure draft on macro hedging - reaffirmed their continued commitment to a set of core principles when considering the use of derivatives. All derivatives should be measured at fair value; a hedging relationship must be clearly defined, reliably measurable and effective; an ineffective hedging relationship must be recognised immediately in the profit and loss account, as must the gains from an effective hedge; and only items that meet the definitions of assets and liabilities should be recognised as such in the balance sheet.

Sir David Tweedie, IASB chairman, said: �A standard on financial instruments is an essential element of any complete set of accounting standards. Implementing IAS 39 certainly poses challenges, but this reflects the fact that derivatives today are complex instruments, and IAS 39 bridges the world of traditional cost accounting and a model that relies more on market values... We will be actively working with interested parties in the months ahead to ensure that we ultimately reach a well-respected, high quality solution.�

Mary Keegan, chairman of the UK�s Accounting Standards Board, told accounting & business that, despite the pressure being placed on them by European politicians, standard setters remained determined to assert their independence. British success in avoiding the severity of corporate scandals that had happened particularly in the United States was in part the result of politicians not being involved in standards setting.

�My view is that we have been well organised and lucky in the UK,� Keegan said. This reflected politicians� willingness for standards setters to get on with it, with the profession, the firms and business working together. �We have been lucky to be� free of political interference in standard setting,� she added. �We are the standard setter in the UK by virtue of being recognised by the Secretary of State for Trade and Industry. It would take a nuclear explosion to change that. There is no direct interference in the process.�

Keegan said that she regretted the same situation did not apply in Europe. �When the system of international accounting standards was approved we were assured they would be adopted in Europe,� she said. �My fervent hope is that this will happen. The IASB must take all opinions into account, but it is critical it is independent.�

Sir David Tweedie was reported in the Australian Age newspaper as saying that the Board would not back down in its reform programme under pressure from politicians. Failure to adopt tougher standards was likely to lead to more corporate scandals, the undermining of the audit profession and the possible collapse of more of the largest firms, added Sir David.

�You need auditors who aren�t invertebrates,� Sir David was reported as saying. �They are going to have to have bags of backbone. If they can�t now stand up to clients, the profession is finished. You could almost say: �Why do you need an audit?�

�It was the market that killed Andersen. People just pulled away from it and it couldn�t defend itself and the parts of Andersen that weren�t affected just dived for cover with somebody else. That�s going to happen to any other firm, and one of the big dangers is that there are only four of them left. There must be a risk that some time in the future, one of them collects two or three [scandals] on the trot and away it goes. It�s in their interest to be tough.�

The firms showed their acceptance of this approach by backing the adoption of tougher international standards, but have expressed growing concern that the political disagreements were making it harder to meet what is now a very tight implementation timetable. KPMG referred to the Commission�s partial approval of the new standards as �a key milestone� - Bolkestein also referred to it as an �important milestone� - but urged the Commission to go further by resolving what to do on financial instruments.

�The requirement to use IFRS [International Financial Reporting Standards] in Europe must mean all IFRS,� said Mark Vaessen, head of KPMG�s IAS Advisory Services. He was concerned that IAS 39 was to be further reworked. �Time is getting on, so this, and the remaining new standards, will need to be endorsed swiftly if the required conversion to IFRS by 2005 is to succeed.�

Vaessen added: �The endorsement of the EU confirms the importance of a comprehensive accounting framework for Europe. Whilst it has not endorsed some standards due to their ongoing revision, a complete set of international accounting standards must apply from 2005. There can be no half measures... This is a challenge for the IASB to complete its current projects and for the European Commission to endorse the results swiftly. Without forthcoming standards, in particular concerning financial instruments, insurance contracts and share-based payments, the desired transparency and consistency across the EU will be impaired.�

PricewaterhouseCoopers endorsed the earlier publication by the IASB of its proposed phase 1 standard on insurance contracts, ED 5, to enable the insurance industry to move towards the full adoption of IAS 39.

ED 5 would increase transparency in an industry where, historically, insurers operating in different countries had used very different accounting treatments, reflecting different requirements by national regulators driven, in many cases, about concern that insurers have sufficient cash to meet potential liabilities, said PwC. The adoption of IAS 39 would enable the performance of insurers to be better understood by the global capital markets, the firm added. But it warned that adopting the new standard would be a severe challenge for insurance companies and lead to significant changes in the reported results and financial position of insurers.

Ian Wright, global corporate reporting leader at PwC, commented: �ED 5 would materially change revenue recognition for those changing to IFRS from national GAAP, because contracts currently defined as �insurance� and included in revenue, may be re-classified as financial instruments or service contracts. Thus, they disappear from premium income - traditionally a measure very closely followed by the analyst community. Existing IFRS preparers will need to identify which contracts move in the opposite direction, from financial instrument to insurance classification, as the new definition is wider than before.�

Detailed analysis of all existing contracts issued by insurers and other financial institutions will be one of the biggest challenges emerging from ED 5, said PwC. New systems will need to be put into place to identify and measure certain embedded derivatives that IFRS requires to be separately fair valued, the firm added.

The need for greater transparency in the insurance industry was apparently underlined by the worsening crisis afflicting the Australian life assurance giant, AMP. The scale of the company�s losses - one of the worst performances ever by an Australian corporation - were made worse by a A$2.6bn (£1.1bn) write down of UK assets, leading to a A$2bn half year loss. AMP is in the process of demerging its UK operations - including Henderson Global Investors and Pearl Life Assurance - but there remains confusion about the real scale of its potential liabilities. Further adjustments to AMP�s asset valuation appear likely, with Henderson to be demerged at fair market value rather than book value. Its UK life operations continue to generate large operating losses.

Internet tax

Significant differences in tax policy between the United States and the European Union have emerged, with the implementation of an EU directive imposing tax on on-line transactions. Meanwhile, the US is adamant that the Internet must remain a tax free domain if the continued growth of on-line commerce is to be maintained.

While companies within the EU already had to charge VAT on digital goods sold and delivered on-line, businesses based outside the EU have previously been exempted from charging any sales tax. Now US and other non-EU based providers must charge VAT when providing digital goods to EU customers. Supplies affected include downloaded music, mobile ring tones, software, Internet service provision and on-line auctions.

VAT rates to be applied are according to those applicable in the customer�s country, unless the supplier is based within the EU - in which case it will be the rate applicable in that member state. With Luxembourg at the lowest rate in the EU, at 15%, it has already attracted AOL to establish a European distribution centre - to avoid charging higher rates in other member countries including the UK. AOL had been exempt from VAT under the previous rules. However, AOL said that it would not be increasing its prices and would absorb the tax within its costs. But eBay, the leading on-line auction house, is increasing its charges and warned that its expansion and profitability would suffer.

The steps taken by the EU are likely to lead it into another conflict with the United States. Congress appears on the verge of making permanent a previously temporary approval of Internet services being free of tax. A bill to this effect had been brought forward by US Commerce Secretary, Don Evans, and Treasury Secretary, John Snow, who said: �As policymakers, we need to encourage the roll-out of new Internet services and not stifle innovation by imposing new taxes.�

But this leaves unresolved the more significant issue of whether sales conducted over the Internet should remain tax exempt in the US. While President Bush�s administration seems sympathetic to this, individual states are looking to the imposition of an on-line sales tax as one means of bridging their own fiscal deficits. California, which has a severe budget crisis, is thought to be losing $1.7bn annually by not imposing taxes on Internet sales, while also discriminating against shop front retailers.

Scale of pension fund deficits becomes clearer

The scale of the pensions deficit crisis is becoming ever clearer and ever larger, as the combination of FRS 17 and the fall in the equities markets makes its impact. Throughout the world, the pressure on employers� defined benefits schemes has risen to a point where it seems likely that they will become extinct other than in a few special cases, such as directors� only schemes.

Analysis of the FTSE100 companies conducted by actuaries Lane Clark & Peacock concludes that they only hold 80% of the assets needed for their FRS 17 liabilities. The stock market would have to rise by 50% to fill the gap. The growing deficit is in spite of rising declared assumptions of the rate of return on shares held in most of the funds.

But this is by no means a crisis created by FRS 17. BP�s pension fund is now in deficit by £3.4bn, but even using the FRS 17 basis for valuation, the company�s fund had held a surplus of £1.5bn a year before. It will now contribute an exceptional £1.5bn into the fund during the later months of this year to correct some of the imbalance.

Looking at all the FTSE100 companies, Lane Clark & Peacock assessed their collective pension fund liabilities at £55bn. Analysis separately conducted by pensions consultants, Mercer, came up with the even higher figure of £70bn for the FTSE100 companies, £90bn for the FTSE350 and £150bn for all UK schemes.

The difference between the figures arrived at by the two firms arises in part because Mercer not only examined pension fund liabilities, but also examined the UK companies� liabilities in overseas operations. This includes requirements in Germany and the United States to contribute to employees� health care costs. But, says Mercer, the UK�s total employer liabilities rise to an astonishing £300bn if the cost is taken into account of securing insurance policies to ensure viability.

Mercer also calculated that the number of final salary schemes that were still open had fallen from 65% to just 40% in the space of a single year. Average pension costs for FTSE350 companies have now risen from 6% of gross profits to 8%.

The impact of this fall in net profit will severely damage corporate investment and UK Government tax revenues, says the Confederation of British Industry. It believes, using what it describes as a �conservative� approach, that companies will increase pension contributions from £8bn in 2003 to £12bn in 2004 and to £16bn in 2005. The CBI says the rising cost of these contributions coincides with a period of great reluctance by companies to borrow.

Ian McCafferty, the UK Confederation of British Industry�s chief economic adviser, said: �The magnitude of the pension deficit has become a serious concern. It leaves companies caught between a rock and a hard place. It is not the only explanation for low investment, but it is a huge part of the problem. The economy will suffer, with the effects rebounding on the Government through lower tax receipts.�

The CBI estimates the loss to the UK Government in corporation tax receipts will be up to £2bn a year for three years - blowing a big hole in the Treasury�s own figures. Growth in the UK economy could be pegged at a likely 3% annually, much lower than in previous periods of economic recovery.

Specific serious problems are likely to damage SMEs, according to KPMG. The firm believes that this will lead to virtually all final salary schemes run by SMEs closing. The alternative for most of them, says KPMG, is that the businesses themselves will go to the wall. �Unless solutions are found, the pensions crisis could effectively throttle many SMEs,� said Mel Egglenton, head of KPMG�s Middle Markets.

The pensions crisis is just as severe across the world. In the United States, the Pension Benefit Guaranty Corporation (the insurance scheme for funds) has been badly damaged by the high number of funds that have defaulted and may need emergency federal support. Increasing numbers of companies in the US, too, are considering closing defined benefit schemes. Funds are also moving away from equities into bonds, as has been the trend in the UK, further damaging the stock markets and raising the cost to companies of investment.

It is now estimated that the total pension fund deficit in the US may be $350bn. An example of the severity of the problem can be seen at General Motors, which has a fund deficit of more than $19bn, about $15bn of which the company has promised to eliminate by 2007. GM is to issue $10bn in bonds and other securities to raise most of the contributions.

Many US corporations could find their liabilities further increased by a recent judgement against IBM. The computer giant was one of many corporations to convert its pension scheme to a �cash balance plan� in the late 1990s, with the effect of reducing the benefits for older workers in order to enhance the value of the scheme to younger staff. A federal court has now ruled that in IBM�s case this breached age discrimination laws. Hundreds of companies and millions of employees are potentially affected by the case.

The judge also expressed concern at the way that IBM had used pension fund earnings to boost corporate profits - a very common corporate practice in the US. While this is permitted under accounting rules it has drawn increasing criticism from analysts and politicians.

Europe and the United States are adjusting to financial and demographic realities which have already been accepted in Japan. Over three years ago Japan passed new laws restricting pension entitlements in the private sector. As well as suffering a recession for more than a decade, Japan has a severe problem with a rapidly ageing population. But the initial legislation only delayed pensionable age from 60 to 65, and Japan, too, may yet be forced to adopt a tougher response.