Risk & Compliance

The Imprecise World of Accounting

Although you need math to make accounting work, you shouldn’t count on mathematically precise outcomes, the chairman of the International Accountin...
CFO StaffJune 20, 2012

Today, Hans Hoogervorst, chairman of the International Accounting Standards Board, addressed the International Association for Accounting Education & Research conference in Amsterdam on the challenges of setting accounting policy. An edited excerpt of his remarks follows.

Accounting should be the most straightforward of topics for policymakers to deal with. It is mainly about describing the past—to reflect faithfully what has already happened. This should be dull business, better left to “bean-counters.” Surely counting beans cannot cause too many problems?

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Yet, over the years, many securities regulators have told me of their surprise upon finding out that accounting policy is one of the most difficult and controversial topics to deal with. It is the same around the world. Just ask the Japanese Financial Services Agency, the U.S. Securities and Exchange Commission, or the European Commission.

Why is it that accounting is the source of such heated debates?

There are many reasons why this is the case. Sir David Tweedie, my predecessor as chairman of the IASB, used to say that it was the job of accounting to keep capitalism honest. It is no wonder that accounting standard setters come under so much pressure! Some business models can thrive off a lack of transparency. Just think of the pre-crisis Special Purpose Vehicles in the banking industry.

There is second reason why accounting can be so controversial: the inescapable judgment and subjectivity of accounting methods. Put simply, there is a lot to disagree about.

When I became chairman of the IASB in July last year, I knew enough about accounting to know that I was not entering a world governed by the iron rules of science. I knew that accounting has the same problems as its sibling Economics: you need math to exercise it, but you should not count on outcomes with mathematical precision. In short, I did not have naive expectations of accounting. Or so I thought.

One year later, however, now that I am well ahead on a steep learning curve, I must admit that I may have been a bit naïve after all. Let me give you a couple of examples that served to open my eyes.

First of all, I was struck by the multitude of measurement techniques that both international financial reporting standards (IFRS) and U.S. GAAP prescribe, from historic cost, through value-in-use, to fair value, and many shades in between. In all, our standards employ about 20 variants based on historic cost or current value. Because the differences between these techniques are often small, the significance of this apparently large number should not be over dramatized.

Still, the multitude of measurement techniques indicates that accounting standard-setters often struggle to find a clear answer to the question of how an asset or liability should be valued.

It is also remarkable that our standards can cause one and the same asset to have two different measurement outcomes, depending on the business model according to which it is held. For example, a debt security has to be measured at market value when it is held for trading purposes, but it is reported at historic cost if it is held to maturity.

In that case, the business model approach certainly provides a plausible answer. Still, some may find it counterintuitive that a government bond held to maturity would be valued at a higher price than the same bond held in a trading portfolio, where it may be subject to a discount. In the exact sciences, such a dual outcome would certainly not be acceptable.

One of the biggest measurement dilemmas relates to intangible assets. We know that they are there. While the value of Facebook’s tangible assets is relatively limited, its business concept is immensely valuable (although 25% less immense than a month ago).

Likewise, the money-making potential of pharmaceutical patents is often quite substantial. However, both types of intangible asset go unrecorded (or under-recorded) on the balance sheet. Under strict conditions, IAS 38 Intangible Assets allows for limited capitalization of development expenditures. But we know the standard is rudimentary because it is based on historical cost, which may not reflect the true value of the intangible asset.

The fact is that it is simply very difficult to identify or measure intangible assets. High market-to-book ratios may provide indications of their existence and value. However, after the excesses of the dot.com bubble, there is understandable reluctance to record them on the balance sheet.

Although our accounting standards do not permit the recognition of internally generated goodwill, our standards do require companies to record the premium they pay in a business acquisition as goodwill.

This goodwill is a mix of many things, including the internally generated goodwill of the acquired company and the synergy expected from the business combination. Most elements of goodwill are highly uncertain and subjective, and often turn out to be illusory.

The acquired goodwill is later subject to an annual impairment test. In practice, those impairment tests do not always seem to be done with sufficient rigor. Often, share prices reflect the impairment before the company records it on the balance sheet.

In other words, the impairment test comes too late. All in all, it might be a good idea if we took another look at goodwill in the context of the post-implementation review of IFRS 3 Business Combinations.

What Is Income?
It is not only the balance sheet that is fraught with imprecision and uncertainty. We also have a problem defining what income is and how to measure it. We report three main components of income: the traditional profit or loss or net income, other comprehensive income, and total comprehensive income. Total comprehensive income is the easy part: it is simply the sum of net income and other comprehensive income, or (OCI). Not too many people seem to be paying attention to it, even if they should.

The distinction between net income and OCI, however, lacks a well-defined foundation. While the P&L is the traditional performance indicator on which many pay and dividend schemes are based, the meaning of OCI is unclear. It started as a vehicle to keep certain effects of foreign currency translation outside net income and gradually developed into a parking space for “unwanted” fluctuations in the balance sheet. There is a vague notion that OCI serves for recording unrealized gains or losses, but a clear definition of its purpose and meaning is lacking.

But that does not make OCI meaningless. Especially for financial institutions with large balance sheets, OCI can contain very important information. It can give indications of the quality of the balance sheet. It is very important for investors to know what gains or losses are ‘sitting’ in the balance sheet, even if they have not been realized.

During the upcoming revision of the Conceptual Framework [IASB’s joint standard-setting agreement with the U.S. Financial Accounting Standards Board, we will look at the distinction between net income and OCI. All of our constituents have asked us to provide a firm theoretical underpinning for the meaning of OCI and we will try to do so.

For now, while we may not always know how important OCI exactly is, we can be sure that net income is not a very precise performance indicator either. Both need to be used with judgment, especially in the financial industry. 

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