Back in January 2005, listed companies in the European Union must comply with the rules of the International Financial Reporting Standards (IFRS) elaborated by the London-based International Accounting Standards Board (IASB). Companies that are unlisted but have listed debt must comply with IFRS by 2007. For all companies, and most particularly those accustomed to old accounting standards, this is a challenge. Boards, CEOs, senior managers – in fact, all company employees – must appreciate that top-quality financial reporting is a hallmark of good governance. With about 80 countries implementing, or planning to apply, the new rules, IFRS has become a strategic accounting system on a global scale.
Implementers must appreciate that:
- Generally acceptable sound standards provide a dependable view of the company’s financial position and fundamental risks; and
- Viable and accurate accounting statements are critical not only to investment decisions of stockholders and bondholders, but also to decisions of the firm’s own management.
To the contrary, publishing intentionally inaccurate or misleading accounting statements is evidence of deeper flaws in an entity’s governance framework, and in its ethical standards. Creative accounting techniques subvert the spirit of fair play. They are designed to mask fraudulent activities undermining investor confidence and a company’s value as a whole.
Sound governance of the accounting process is an important safeguard in protecting the integrity of a firm. Beyond public disclosure, a rigorous and reliable accounting system provides management with critical information on which to base factual decisions that affect the company’s future.
Accounting is very much qualitative and judgemental. Let’s ask ourselves some questions:
- What is the appropriate allowance for bad debt?
- The proper reserve for legal risk, which may hit at any time?
- The right presentation of accounting results for planning and control reasons?
The rules that should guide accounting and financial reporting are not self-evident, standards boards have taken on the mission of defining them. This is a never-ending job because accounting standards must always be reviewed in the light of changes in the business environment, as well as of violations to existing financial reporting rules, as these arise.
At Enron, for example, management was up-fronting gains without any market evidence that gains exist. To stop such practices FASB is strengthening the statement of Financial Accounting Standard (SFAS) 133, taking account not only of Enron’s, but also of WorldCom’s and many others’ violations and novel ‘creative’ practices in financial reporting.
Comparing US GAAP (by FASB) Vs IFRS (by IASB), a major conceptual difference between those two is that the former is very prescriptive, while the latter keeps its accounting rules at general lines. “Our accounting rules are like the Ten Commandments”. said Wayne Upton, IASB’s director of research. By contrast, US GAAP has several hundred pages of implementation guidance.
According to Upton, IASB is constantly on the watch for the ability of people and companies to structure a series of transactions through solid accounting rules. By contrast, prescriptive details are a matter of implementation at each jurisdiction adopting IFRS. This is a sound strategy given:
- The many legal and regulatory differences existing among the many nations adopting IFRS; and
- The procedural and cultural issues arising in these nations, given the diverse historical precedents in accounting and reporting regulations.
Many experts believe that, in the longer run, IFRS will have a positive influence on management practices. It will impact not only goodwill and accounts for pensions, but also major governance issues. For instance, how companies recognize revenue. ‘At the end of the day what is important is the free cash flow’, said Alastair Graham, senior vice president of Moody’s, ‘Not just the cash flow or EBITDA’.
Generally, all corporate codes in Europe and America advocate that financial statements have to be accurate. The question is: ‘Under which rules?’ And, moreover, rules alone are not enough. The ‘do’s’ and ‘don’ts’ must be properly updated and steadily controlled by supervisory authorities.
Disclosures about capital and risk associated with financial instruments are useful to all stakeholders – regulators, investors, and entities that deal with, transact and hold financial instruments of another entity – not only to banks for their loans, underwriting of securities, and derivatives activities.
Deregulation, and most particularly innovation, has made it very difficult to satisfactorily differentiate novel derivative instruments from one another, regarding their aftermath. Whether for investment reasons, liquidity management purposes, wealth management or any other objective, transactions of a financial nature must be very transparent, and such transparency should be reflected in financial statements. Users of financial statements need information about not only capital levels but also in regard to risks arising from a transaction or portfolio position, including credit risk, market risk, operational risk and business risk.
Not only investors and regulators, but also the company’s board, CEO, and senior management need to know the ability of the firm and its counterparties to identify, measure, monitor, and control assumed risks. Therefore, disclosure standards must see to it that clear and consistent reporting requirements apply to all entities so that they operate on a level ground, and users receive comparable information about capital, transactions, and risks being incurred.
Those two reasons above tell why financial accounting and management accounting converge in their objective. They also explain why it is to the advantage of all entities to follow the same rules. Additionally, good governance would suggest that the same IFRS rules and regulations are used both for financial and for management accounting.
By definition, the primary objective of financial accounting is that of providing financial information to people and entities outside the company: shareholders, bondholders, bankers, regulators, and other parties. To a considerable extent the techniques, rules, and conventions according to which financial accounting figures are collected and reported reflect the requirements of these outsiders and, as its title implies, IFRS is primarily oriented to their information needs.
By contrast, management accounting is concerned with accounting information that is useful to the firm’s own management for its plans, decisions, and control action. Whether financial accounting and management accounting should base themselves on the same rules is an important recurrent theme. The answer is ‘yes’, because the most crucial problems are no different. In terms of management accounting, a crucial issue concerning the board, CEO, CFO, and all of the company’s management levels is use of accounting figures in recognition, and timely solution of operational problems.
Furthermore, at the same time the company’s managers are responsible for the content of financial accounting reports. It follows that governance can be improved if the same principles, rules, and conventions are used for financial accounting and management accounting – which means that IFRS could, and should, be made a strategic initiative for the entity’s own internal accounting management information system (IAMIS).
As advice based on a recent experience, this strategic initiative should capitalize on the five pillars of IFRS: derivatives, goodwill, intangible assets, pensions, stock options.
Here is a brief explanation of what comes under each of these headings:
Derivatives – The company’s balance sheet must show the current market value of all derivative instruments which it contains. This is the fair value principle. Accruals has no meaning with derivatives.
Goodwill – Companies can no longer amortize goodwill from acquisitions. Instead, they must conduct an annual impairment review, taking charge if the asset’s value falls – no matter what may be the reason.
Intangible assets – Management must both disclose and quantify the value of assets like patents, software, customer lists, trademarks, research, and development projects. These can no longer be lumped into goodwill.
Pensions – Companies must appreciate the financial impact of pensions. For this, they need to account in full for pension liabilities and assets on their profit and loss statement of the year. Pension liabilities must be funded.
Stock options – Management can no longer bury the cost of stock-based compensation as notes to financial accounts. In its financial statements, the company must show full value of all options granted to employees.
While every pillar implies changes in at least some of the established practices, the biggest one is the switch from historical cost accounting, where all items on the financial statement are based on accruals reflecting their original cost, to fair value accounting. The fair value method recognizes gains and losses in value on an ongoing basis, based on marking to market.
Additionally, IFRS rules unveil items that many European companies either buried as footnotes in their financial reports or simply did not reveal at all. Examples are pension liabilities. These and other changes in financial accounting have profound effects on balance sheets and Profit and Loss Statements of 7000 listed European companies that have to switch their books to IFRS.
Still, some experts reckon that:
- It will take up to two years before analysts and investors fully come to grips with what the changes mean in terms of company valuation; and
- When this happens analysts and investors will have a much better understanding of a company’s financials, because IFRS forces every entity to disclose more information than ever before.
Not everybody, however, sees it this way. Many companies fought IFRS tooth and nail, most specifically International Accounting Standard (IAS) 39, and its fair value requirement. To put it mildly, this has been a case of distorted self-interest because, as the preceding paragraphs documented, the greater is the detail and accuracy of financial accounting and IAMIS, the better is the quality of governance.
The task faced by IASB, in establishing the new rules and regulations, has been substantial. “One of the difficulties we encounter is dealing with the other prudential regulators (Wayne Upton, 20 September 2005). “Supervisory authorities usually have different priorities, as well as a large range of agendas”. Some of the differences lay in a long cultural tradition.
Many regulators are fully supportive of transparency. An example is regulators of Nordic countries. Others, however, think they should have information the market must not have. This is a largely paternalistic approach. The surprise is that even the US Federal Reserve, which is known for its open mind, has taken a view which recommends much less transparency in regard to hedge funds.
There is also a significant difference in the structure of regulatory bodies, from country to country, which finds its way into their response. In the UK, nearly all supervisory functions of a financial nature are integrated under the Financial Services Authority (FSA). In the United States there is the Fed, the Office of the Controller of the Currency (OCC), Federal Deposit Insurance Corp (FDIC), Office of Thrift Supervision (OTS), 52 state regulators (including District of Columbia and Puerto Rico), and 52 insurance regulators.
As far as regulatory bodies, and their functions, are concerned, beyond this comes the fact that some supervisors are endowed with direct authority, while others have to work by inverse delegation. In the general case, globalization has seen to it that the regulatory agenda includes a wide variety of frequently unspoken local agendas, as well as an enormous range of competencies. At the end of the day this:
- provides different interpretations, by jurisdiction
- aggravates the home–host problems in terms of regulatory coordination, and
- makes difficult global integration of supervisor activities, which affects negatively companies operating trans-border.
Legal, cultural, and procedural differences that exist by jurisdiction inhibit effective coordination, which is quite worrisome in a global market. Take a loan’s front fee as a case in point. If, for example, the loan is $10 000 at 4%, the front fee may be $200. The client gets $9800, but pays 4% on $1000. Some 20 years ago, in the United States, Statement of Financial Accounting Standards (SFAS) 91 normalized this practice. IAS 39 did so in 2005. But in many jurisdictions, who adopted IFRS, this is an alien concept which they now have to apply.
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