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Accounting

Stepping out of the Dark Ages

Monday, 27 November 2006

Financial reporting practices applied to date are no longer robust enough to deal with modern business practices. Steven Brice of Mazars suggests that 2005 will be the year when global accountancy properly realises that companies now operate in increasingly integrated global markets.
Although accounting itself has been around for several thousand years, the rate of development in accounting principles has traditionally been slow, considering the philosopher Confucius was using accounting as part of his job responsibilities in around 500 BC. In some ways accounting hasn't even changed since Luca Pacioli wrote the first textbook, The Summa, in 1494, but considering it included illustrations from Leonardo Da Vinci it was clearly a hard act to follow.

As the old adage goes, 'if it ain't broke, don't fix it' and while financial reporting is not exactly 'broken' it is clearly in need of a major overhaul. The IASB, in conjunction with other national standards setters, are the right team to undertake this daunting task. Indeed, they have set out to get the job done and have at no stage shied away from the challenge of ensuring financial statements reflect economic reality.

With International Financial Reporting Standards (IFRS) set to form the bedrock of financial statements for European Listed companies from 2005, now is the time for companies to go out with all guns blazing and embrace these new Standards with open arms as opposed to giving them the usual look of fear. Harmonisation of accounting standards across Europe is a major step forward and now, with considerable US input from the FASB, the IASB's mission to develop "a single set of high quality, understandable and enforceable global accounting standards" is also one step nearer.

Change clearly doesn't come without cost attached but one suspects that the cost of this change is not nearly as high as the cost to the global economy or the credibility of the audit profession were there to be another major corporate accounting scandal.

Standard setters have undoubtedly been struggling for some time now to cope with the growth and use of financial instruments that have become both increasing complex and more commonplace. Using financial instruments can rapidly transform a company's risk profile in a way that is not made apparent under present reporting practices. The current approach surely cannot be the long-term solution in this area, and contrary to George Orwell's novel 1984, ignorance is not strength in this instance.

It thus comes as no surprise that discussions concerning accounting for financial instruments have used up so much time and paper. The second of these is perhaps more worrying, not so much from the preservation of trees perspective, but more from the fact that the IASB/ASB advocate a principle-based approach and yet are still churning out volumes of rules in this area - FRED 30 Financial instruments with its three supplements is bigger than all current UK standards put together! Finance directors certainly have a lot of reading to do to keep up to date with accounting in this time of rapid change.

For many UK companies, 2005 may not be the 'big bang' that many doom-mongers prophesied as the UK's Accounting Standards Board (ASB) in the past few years has clearly made massive in-roads on many challenging areas not least in the areas of pensions (FRS 17), provisions (FRS 12), revenue recognition (Application Note G) and substance over form (FRS 5). The last mentioned Standard is one that should be elevated from UK GAAP to the international stage as one tiny paragraph in the IASB's Framework doesn't really do justice to this topic. Nevertheless, there are still some big gaps that need new or updated guidance, not least in areas such as leases, accounting for human capital and fair value accounting.

With financial statements having such a crucial role to play, it is imperative that the standard setters issue comprehensive accounting standards enabling companies to produce annual reports that mirror economic reality. Many users of financial statements would agree that two of the key objectives against which an entity should judge the appropriateness of accounting policies would be relevance and reliability. However, in today's fast changing environment getting both at the same time is not that simple. Still, it is fair to say that gone are the days of 'if you can kick it, it's an asset'. The financial statements of tomorrow will be inundated with more assets and liabilities than are currently recognised - indeed some companies may not even know they had them!

All in all, the days of using a traditional cost-based approach for accounting look to be numbered. The release in February 2004 of IFRS 2 share-based payment is a good illustration of this shift in approach, with companies now required to estimate the fair value of options granted and expense them over the performance period. In this instance, I believe this is a change for the better as the sooner companies realise that the granting of share options is tantamount to issuing a valuable instrument and not a 'free' incentive, the better. 2005 certainly looks like the year for accountants to wipe the dust off their old scientific calculators and find those exponential and LN function keys required for the Black-Scholes-Merton fair value calculation.

While a fair value measurement basis clearly has its merits, it may not necessarily be the most relevant attribute in all situations. For instance, whenever measurement at fair value is required on the basis of 'level 3' of the fair value hierarchy (no market observable, measurement based on a set of assumptions), there is more subjectivity involved than is desirable and thus there lies a clear risk of manipulation or loss of comparability of financial information. A move too far in this direction will mean interpreting financial performance will become even more of an art form best left to the experts than it is at the moment.

Nevertheless, unlike our learned philosopher Confucius, we must remember we are no longer living as he did in the second half of the Zhou Chou dynasty and accounting must move on. Fair value seems to be the way to go but clearly we need to tread carefully.