My August 2006 article on the IFRS convergence fiasco generated emails indicating that mine is not a lone voice in questioning the direction that financial reporting standards are taking. I am prompted to revisit the topic from a transatlantic perspective after reading recent papers by Ross L Watts of Sloan School, MIT, and Roy Ball of the University of Chicago Business School. What follows is a brief distillation.
When I started writing for this esteemed journal more than three decades ago I noted that it is the role of accounting to reflect economic activity. As an objective recorder of transactions driven by market forces, accounting’s natural role is therefore passive. It should not seek to influence the very activity it purports to record.
the incidence of the tax itself must not cause even a marginally viable field to become sub-marginal.
There is a principle here. An analogy may help. When the Select Committee on taxation of North Sea oil first approached its task of devising a system for taxing oil revenues they wisely spelt out that principle: any oilfield that is economically viable at a pre-tax level must also be viable post-tax. In other words, the incidence of the tax itself must not cause even a marginally viable field to become sub-marginal.
Accounting, like a good tax, should thus be neutral in its incidence and application. Yet changes in the way that economic activity is reported suggest that this principle of accounting neutrality, the bedrock of financial reporting, is being overlooked. The danger is that decision-makers and stakeholders will find it increasingly difficult to make sense of the proliferation of “soft” and unverifiable numbers generated – and accounting enters the arena as an active ingredient rather than a passive catalyst for business.
Markets disregard unverifiable numbers
When the market finds the figures unserviceable it adapts by applying selectivity when assessing which data is meaningful, and which must be disregarded as nebulous, unverifiable, or both. In effect, it finds its own way to meet demands for financial reporting.
This is not new. Borrowing contracts, to the extent that net assets feature in covenants, have invariably excluded intangibles such as goodwill, which reflects no separable, discrete worth. Goodwill represents future super-profits and is not susceptible to periodic valuation without valuing the entity that owns it – an exercise for which traditional financial statements have never been suitable. Further, and more relevant from a user’s practical standpoint, when a borrowing entity is in danger of violating debt covenants the value of goodwill is likely to be close to zero, regardless of what the balance sheet says!
Fair value (or “marking to market”) has so far been adopted with discrimination. Where fair values result from present value (DCF) methods that relate to reliable future cash flows, such as apply in lease accounting, the market does not demur and such an approach has become generally acceptable. But now fair value options (or requirements) are applied to almost any tangible fixed asset, including investment properties; intangibles; financial instruments; share-based payments; minority interests. They have also been interposed as an impairment criterion right across the board.
Wholesale capitulation to fair value accounting would alienate the very user interests that depend crucially on financial reporting. Even market liquidity as a fair value indicator is far too volatile when spreads are large. Companies holding positions in commodities and financial instruments cannot “cash out” simultaneously at bid prices, and when liquid market prices are not available recourse is had to estimates susceptible to undetectable managerial manipulation. Fair value accounting on such a scale has never been tested by a major corporate collapse. As Profession Ray Ball puts it in “IFRS: Pros and Cons for Investors” (June 2006), in a financial crisis lenders might discover that “fair value” turns out in practice to be “fair weather value”!
Accounting as a discipline
Accounting’s true function has always been to “discipline” other sources of information. Of the variety of sources available to capital markets, accounting’s relative advantage lies in its ability to produce conservative, auditable, “hard” numbers. In his April 2006 paper “What has the invisible hand achieved”?” Ross L Watts puts it like this: “soft accounting standards …. will generate market reactions. Any reduction in the usefulness of financial reporting will provide incentives for private alternative systems to appear”. He cites as an example Standard and Poor’s search to identify and report “core earnings”.
Examine any contemporary plc report and accounts and see if you can find anything that you would be happy to point to as core earnings.