Opening the Door to Liars Loans for Small Business

IFRS for SMEs came out this week, and I just don’t see how this is a good public policy.  We’ve seen what happens when lax underwriting practices allowed banks to make loans to homeowners who never should have been granted credit.  It was win-win for a while:  bankers and all the folks involved in the securitization process got to recognize huge fees and income, and people got to buy new homes (that many couldn’t afford).  Of course, that model was unsustainable, and…well, here we are.

My favorite ploy during the past few years was the so-called “no-documentation loan,” or “liar’s loans” as they came to be known.  Under this loan program, you didn’t need to provide any documentation that you earned what you said you earned.  You just stated it, said it was true, and the bank charged you a premium and gave you your money.

Earlier this week they came out with IFRS for privately-held companies, and from where I sit, you’ve basically legalized liars loans for business.

These new accounting rules contain many simplifications that are ripe for the next generation of Charles Keatings and Ken Lays of the world to exploit.

I think most people are honest, and most accountants would adopt IFRS for all the right reasons.  Here’s a great quote from the CFO magazine article on IFRS for SMEs

“I will consider adopting the new standard when the primary users of financial statements are fully educated in it and can intelligently evaluate it,” said Ron Box, CFO at Joe Money Machinery.

Right on. But the article goes on to note.

Box is concerned that, for example, a bank analyst who doesn’t understand the new accounting concepts might deny a credit request from an early adopter.

But of course, if adopting IFRS will make your company look worse, you wouldn’t adopt.  People will only adopt IFRS to make the company look better.  It’s only human, and the IFRS proponents strike me as being very naive and a bit defensive when subject of financial statement fraud is broached

We all know that banks are skittish right now, but that will change.  There will come a point again when they’re all ginned up to lend money, and they’ll lend it to any business that has a pulse, and that’s when you’ll get the marginal players looking to game the system.  And they’ll do that by taking advantage of lax accounting rules.

Which brings me back to public policy.

We’re very focused on publicly traded companies, and rightly so.  But this subprime meltdown and financial crisis that followed showed that there is a direct link between main street and wall street.  One guy with a liar’s loan on his privately-held business won’t bring down the entire system when it turns out that his financial statements weren’t a true portrayal of his company.

But when you have an entire financial system built on these types of loans, that’s when you’ve got a house of cards.

You wonder if, in hindsight it might have been a good idea for Treasury to pay closer attention to underwriting practices during the past 8 years.  Wouldn’t it have been interesting to have a metric that measured no-doc loans?  Do you think that might have told us something?

If I was looking at monitoring systemic risk, I’d have a little metric that tracked IFRS adoption.  Right now, the accountants like it because it’s simpler.  Soon, the crooks will figure it out, and they’ll like it because it will let them cheat.  That’s when you’ll see IFRS adoption really take off.

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