New Accounting Standards

Financial accounting has traditionally been a mix of formality and fluidity. Some rules are quite rigid, and they're enforced using complex and detailed guidelines. At the same time, interpretation can be "fluid" as when interpretation is adapted to meet business needs. Market pressure has raised the needs for standards that are better aligned with business needs, yet at the same time provide consistency and control required to ensure reliability and comparability.

In 2005 new IFRS reporting standards were introduced for public companies ("full IFRS"). These were followed in 2009 by an IFRS standard for private companies. About 100 countries in Europe, South America and Asia are now using IFRS. One of the objectives is to increase transparency of financial reporting, which fosters confidence of investors. Yearly reports should become more comparable. Stakeholders demand better internal controls, better corporate governance, and insight in results.

1. Accounting Is Not Exact Science

Although many lay people assume that accounting is exact, bound by clear rules and guidelines, experience shows it isn't. Because judgment plays such an important role, the question may arise how to enforce "proper" accounting rules. Auditors find clarity and comfort in rulings, as their work can hardly be challenged (when conducted ethically). There is much less certainty in a principles based system.

Traditionally the American system has been regulated more by explicit rules pertaining to clearly defined domains. New IFRS standards, on the other hand, are principles based. They provide guidelines that should be followed. Specification about what exactly is or is not allowed arises as individual cases or examples are reviewed and/or brought to trial.

2. Accountancy Rules Impact Financial Stability

The London based International Accountancy Standards Board (IASB) has been in charge of reworking the rules that cover financial reporting. After the recent financial crisis, regulators are keen to (re)establish financial stability. Basel III has been directed towards this same goal.

In particular marking at "fair value" (=market prices) remains controversial. The intent of that rule change was to improve transparency. Because assets move along with market dynamics, it should make clear how much a company's holdings are 'really' worth, at any given pointing time. During the meltdown, this mark-to-market practice triggered massive swings due to write-offs, exacerbating the effects of the crisis because capital buffers evaporated (in particular greatly leveraged assets). "Fair value" pricing proved especially tricky for assets that aren't traded frequently enough, or where "market prices" aren't publicly available. When the only available market prices are from distressed sales, they undervalue these assets, reinforcing this loop and potentially contributing to instability.

3. It's Not Investors Or Regulators, But And/And

Some of the "political" debates on accountancy rules reforms suggest (or at least imply) that rules either support investor interests or protect regulators' interests. As if this is a zero sum game. It isn't. Clear information attracts investors, and thus raises stock prices by increasing the pool of interested buyers, as well as lowering the cost of capital. Transparent rules that are uniform across the globe are in investors' best interest. Regulators, from their part, need global rules so that policies can actually "work", and not chase multinationals to move their activities in accordance with local or regional advantageous rule setting.

A whole different question is how politicians' involvement (which seems only fair after scandals in recent years) should be juxtaposed against the necessary independence of standards setters. Setting rules that can be executed, enforced and audited is (largely) a technical matter, albeit one that might affect politicians at the helm…

4. Accounting Standards ≠ Auditing Standards

Because accounting is so closely associated with auditing, it isn't surprising that their standards are sometimes confused. Apart from the fact that separate and independent boards set these standards, they have a rather different basis as well. For the US the Financial Accounting Standards Board (FASB) has overseen US GAAP (Generally Accepted Accounting Principles), Europe has the International Accounting Standards Board (IASB). The International Auditing and Assurance Standards Board (IAASB) sets international standards for auditing (ISA's).

The essential difference between auditing and accounting is that accounting standards are in essence algorithms: they stipulate which numbers should be added, subtracted and divided, etc. Auditing standards, on the other hand, are guidelines on how to behave, e.g.: how to check whether books can "pass" or not.

5. Adoption Of XBRL Expedites Financial Consolidation

Considerable (data) integration work goes into producing financial reports. Especially in large companies, multiple ERP systems may be in use. Several financial systems may be in place. When XBRL has not been adopted, yet, chances are that financial results have not been booked consistently across business units (BU's). Line items of financial transactions then first need to be "normalized" into a common set of definitions. After consolidation across systems and/or BU's has taken place, you might need to include non-financial items like budgets, head count, or changes on stock. Finally, these are combined into financial reports for internal management and control, external reports, and maybe regulatory requirements.

To make all these mappings and consolidations consistent and robust, some meta structure is required. You can integrate this structure by embedding it in all (financial) reporting tools. A common framework has been devised, and it's called XBRL (see also a previous newsletter). XBRL is geared to the differential reporting requirements across multiple internal and external stakeholders.

6. How 'Fair' Is "Fair Value" Accounting?

One of the cornerstones of IFRS accounting innovation is "fair value" accounting. Previously, companies would record assets at the price they were bought (historical cost). Under "fair value" accounting, the market price should be used, which is commonly referred to as "mark-to-market" pricing. This should be an unbiased estimate of the current market price. Under US GAAP (FAS 157), this explicitly excludes liquidation sales.

Assets that are infrequently traded show (relatively) big swings in their prices. When the "market price" trails the 'true' (rational) value, a gap arises between the technically defined "Fair Value", and the observed "market price." This has been the center of much heated debate on the current accounting innovations.

7. "Off-Balance Sheet Entities" Exist Anyway

For an outsider, it seems counter intuitive how assets that are held by a company, and may contribute to liabilities can be moved on and off a balance sheet. The now infamous "Repo 105" deals by Lehman Brothers were such a move that –in hindsight– appeared to be largely driven by attempts at window dressing (Lehman's Repo's flattered the accounts because they suggested lower leverage ratios). Only after their collapse which sent a shockwave through international markets did the "true" nature of some of these deals become clear.

Needless to say, what assets must, or need not be reported is determined by accountancy rules. Which is exactly why the current changes in rules is making some (in particular very large) companies so nervous. Newly proposed IASB rules require greater disclosure of these off-balance sheet entities. Leasing is another one of those off-balance constructions that is hotly debated. Isn't it odd that airlines don't have airplanes on their balance sheets (they're all leased)?

8. You Can't Make It Any Simpler Than It Is

IFRS has been criticized for making results more difficult to interpret. There are certainly more numbers that need to be reported. Reports have gotten markedly thicker. And their meaning is not very clear to most outsiders.

Another way of looking at this, is by concluding that the desired transparency calls for increased complexity, simply because telling the whole truth is complex. As Einstein said: "Everything should be made as simple as possible, but not simpler."

9. Will We Live To Tell "Real-Time" Accounting?

There is a disconnect between publishing results in the rhythm of our Gregorian calendar, and the more dynamic, fluid manifestation of a company's financial well-being. Current reporting practices, in conjunction with shareholder dynamics of publicly traded companies effectively "force" CFO's to "iron out" set backs and gains. This effectively (in part) conceals their operations rather than disclosing them.

In the internet era, and technologically facilitated by XBRL (See tip# 5), we have come to expect information anywhere, anytime, at the tips of our fingers. Then why not for accounting? The big four accounting firms (PwC, Deloitte, KPMG, and Ernst & Young) have made calls for this. And XBRL makes this (technically) possible. It would also allow for simultaneous presentation of broader as well as simpler measures to report on companies' well-being.

10. Which Are Safer: Rules Or Standards?

Historically, accounting has been rule-based. The introduction of IFRS marked a change towards principles based accounting. This makes work a bit more uncertain as accountants themselves are then responsible for judgment and interpretation. Accountability needs to be contained within the profession and pushed back, all the way up to the CFO. The US has had a history of rules based accounting, and much more involvement from lawyers. Introduction of the Sarbanes-Oxley ruling (SOX, in particular sections 404, 406 and 407) makes CEO's of US listed public companies responsible for the accuracy of their reports. A defense line "I didn't know about this!" (even if it were true) will not keep you out of jail.

One reason why principles based accounting has caused sleepless nights is because a mishap can lead to a damages claim. That would be devastating for any accounting firm, and could ultimately destroy it or at the very least undermine it's brand. Principles put responsibility for judgment where it belongs: with the accountant. Whether they like this or not.

Further reading

Some excellent books on New Accounting Standards:

Smoke & Mirrors, Inc.
Nicolas Véron, Matthieu Autret & Alfred Galichon (2006)
ISBN# 0801444160