International Financial Reporting Standards – how did we get ourselves into this position?
International Financial Reporting Standards (IFRS) have become extremely complex over the years and even the most sophisticated of preparers and users of financial reports battle to come to grips with the complications. Some have questioned how useful some of these standards are in portraying economic reality, whether standard setters are focusing on the right issues and whether the proliferation of accounting standards we have at present actually enhance the efficiency of capital markets.
Adrian Dadd, technical partner at PricewaterhouseCoopers SA, says that there are accusations that financial information does not focus sufficiently on transactions and flows and there is an overemphasis on balance sheet values. “Users also frequently highlight the need for data presented to be both consistent over time and comparable across companies and indicate this is being hindered by an increasingly ‘through the eyes of management’ approach to standard setting.”
Dadd says South African listed companies, the press and analysts place an extraordinary emphasis on Headline Earnings numbers, which strip out many transactions that would be included in the IFRS Earnings number. What compounds matters is that nearly every company publishes some sort of normalized HEPS ratio to try and explain its own interpretation of its performance.
Dadd says there are one or two good spots among the criticisms of the current state of accounting standards. “Some analysts have applauded the introduction of standards on accounting for stock options and other equity-based remuneration. This was a market-driven standard, very much needed, and users have commented that such reporting requirements have ‘restored economic sanity.’”
Dadd says The International Accounting Standards Board (IASB) is hearing these criticisms and one response has been to release a discussion paper that analyses the main causes of complexity surrounding the reporting of financial instruments, along with suggestions for tackling the problems. “The IASB’s paper, Reducing Complexity in Reporting Financial Instruments, represents the first step in the board’s project to replace the financial instrument standard with a simpler ‘principles-based’ standard that reflects economic reality.“
Dadd says the IASB acknowledges that current reporting requirements for financial instruments are difficult to understand and apply, and argues the long-term solution is to measure all types of financial instruments within the scope of the standard in the same way. “The IASB viewpoint is that fair value seems to be the only measure that is appropriate for all types of financial instruments covered by the standard.” But before accounting for financial instruments can be simplified in this way, Dadd says a number of problems need to be addressed, such as the volatility of earnings arising from changes in fair value and the presentation of unrealised gains and losses in earnings.
Dadd says the IASB is well aware that financial instruments remains one of the most contentious topics on its agenda, and has effectively challenged its detractors to support the project, or come up with a better idea which may even be more appropriate than the single fair value measurement approach.
IASB chairman Sir David Tweedie says the board is determined to simplify and improve the financial instruments reporting standard by creating a principles-based standard and those who believe in reducing complexity in accounting standards now have the opportunity to shape the way ahead.
Dadd says that a general focus towards more principles-based standards will help in the effort to reduce unnecessary complexity in accounting standards. “But there is an opposing argument that principles-based standards, which on the positive side more closely reflect economic reality, on the negative side could cause more income statement volatility. But Dadd argues that economic volatility is a market reality and one should give investors full disclosure of volatility rather than obscure it through the use of detailed rules. The argument is that if investors eventually view volatility as a normal part of markets and business, we could hopefully see a change in mindset which de-emphasises short-term earnings measures and prioritises the underlying fundamentals that drive business value.”
Dadd says the global accountancy profession is considering a ‘higher-level rules’ approach. “This means having standards that apply to a broad range of similar transactions with few exceptions, if any. But there may be some confusion regarding this aspiration. CEOs are calling for principle-based standards that require the use of judgment - but we need to clarify what we mean by judgment. One logically assumes that more detailed rules mean that there is less need for judgment because everything is clearly laid out. But this defies US experience where the complexity of rules means that experts spend huge amounts of time assessing ‘when’ to apply which rule, rather than ‘how’ to apply them, because there are so many rules that apply to a narrow set of circumstances. We argue this is not the type of ‘judgment’ we are looking for and the solution is rather to have higher-level rules and for the judgment to be around ‘how’ best to apply them.”
Dadd says it is key that International Financial Reporting Standards setters clarify their vision, and in the short-term. “Otherwise we run the risk of adopting an excessive amount of US Generally Accepted Accounting Principles as if they are IFRS guidance and it will be difficult to regain this lost ground.”
