Director, Financial Reporting Policy, EMEA CFA Institute
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Standard setters: Please don’t deflate asset bubbles

Accounting should reflect asset bubbles, market growth trends, volatility and crisis as and when they unfold. The timeliness of financial information forms the bedrock of market integrity. Frontloading of losses (ie, prudence) does not represent reality, nor does it ensure the solvency of the underlying businesses.

25th Feb 2020
Director, Financial Reporting Policy, EMEA CFA Institute
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Accounting standard-setters need to revisit the purpose of financial statements. Accommodating broad stakeholders, especially prudential regulators, will not make financial statements more transparent for investors and readers. It will only make the information overly complex and increase criticism from advocates of historical cost convention.

In the past, self-reliant entrepreneurs kept accounts that were based on historical costs and prudent estimates. That made perfect sense – a negative shock could cause insolvency, whereas a positive shock could be used to pay off debts, reinvested to pursue growth; or distributed as a dividend.

In the modern era, the entrepreneur role has evolved to specialists. Managers run the business (agents), shareholders provide capital (principal), regulators set rules for governance and solvency (prudence) and standard setters set rules to report performance and financial position (accounting).

Following the 2008 financial crisis, standard setters have become more accommodating to regulators, but their compliant stance will create significant unintended consequences.

Accounting that pleases everyone is useful to no one

There is no place for ‘prudence’ in modern financial reporting. The accounts should provide ‘neutral’ information so that all participants can understand exactly what is happening in the markets. This neutrality helps policy makers spot trends and address problems accordingly.

Information about business solvency could be best provided by credit rating agencies or under separate prudential disclosures to financial reporting. Accounting that is trying to be both prudent and neutral does not fairly represent economics, nor does it depict insolvency risk.

In the case of Carillion, how the company accounted for goodwill was blamed for overstating assets and for permitting aggressive dividend distributions to investors at the expense of employees and creditors. But accounting was not to blame.

Instead, policymakers and regulators should answer a deeper and more pressing question: should we regulate non-financial corporate entities like the financial sector?

Policymakers and regulators are welcome to introduce new rules to regulate capital requirements. At a minimum, the distributable reserves could be updated, and maximum prudential adjustments could be made as regulators deem fit. For instance, regulators could require an immediate write-off of all intangibles and the inclusion of a provision for future expected losses.

These regulatory adjustments and disclosures should address ‘prudence’, but a tight prudential policy could discourage listings in the local stock exchanges from an ever-shrinking pool of global capital formation.

Investors would benefit from both sets of information – neutral financial statements and prudent regulatory disclosures. Financial statements including both ‘neutral’ and ‘prudence’ in accounting distorts reality and is helpful to no one.

A recent Financial Times article suggested that recent merger and acquisition (M&A) spree was encouraged by goodwill capitalisation. If we follow this logic, then a replacement rule to immediately write off all intangibles should encourage demergers.

The post-financial crisis rally is mainly, if not entirely, the result of central banks’ loose monetary policy. The M&A and share buybacks are just tools to inflate the asset bubble (see figures 1 and 2).

Figure 1: S&P 500 & Assets of Major Central Banks

S&P 500 & Assets of Major Central Banks

Source: Yardeni Research, Inc.

Figure 2: S&P 500 Shareholders Returns and Goodwill Build-up

S&P 500 Shareholders Returns and Goodwill Build-up

Source: FactSet, CFA Institute

Goodwill accounting

Goodwill accounting reflects the premium a manager believes is worth paying for an acquisition. Impairment accounting provides a basis to assess this premium. Amortisation serves no basis except for artificially deflating a balance sheet regardless of the economic reality. We believe amortisation would not add any decision-useful information. Instead, it will obscure the performance of the acquired business.

Without doubt, impairment accounting is untimely – generally, it is delayed for incumbent management and is premature for new management. This lack of timeliness, however, is not the fault of theoretical basis of impairment accounting, but rather is an application problem.

A move away from impairment accounting would give a pass to all those responsible for the timely recognition of impairment accounting. Nevertheless, impairments always catch up with reality, which is useful information for investors.

The timeliness of impairments could improve over time with the increased use of analytics on a wider pool of data, supported by reforms pending in the audit sector. Responding to these proposals, we argued that auditors should provide an analytical opinion surrounding goodwill impairment (like “optimistic” or “conservative” based on data analytics) instead of the binary true and fair view currently included in audit reports.

In contrast, amortisation of goodwill would in effect equalise good managers (good investments) with bad managers (bad investments). Bringing back amortisation would further remove pressure from management, auditors and those responsible for governance to recognise impairments at all, which would not be a step in the right direction.

Impairment accounting is not perfect. Comparatively, however, it is significantly better than a mechanical write-off model and is closer to economics.

Conclusion

The introduction of expected credit losses and now a potential change to reintroduce amortisation for goodwill is a move into unchartered territory considering the digital age we are living in where data is so easily available. Both changes could have unintended consequences on the real economy.

Standard-setters should avoid artificially deflating asset bubbles in financial reporting, which they did not create, and thus cannot remedy. Instead, the standard setters should push back on prudential regulatory influence and revert to neutrality.

Accounting should be a mirror that shows things as they are and should not be a tool to influence management behaviour or regulate capital (ie, by frontloading losses in accounting, which may or may not happen). If standard-setters decide to continue on a prudent path, then they need to be prepared to answer economic questions.

Investors supporting ‘prudence’ in general and goodwill amortisation in specific, need to rethink whether simplifying accounting at the expense of transparency is worth the shot.

Replies (7)

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Hallerud at Easter
By DJKL
26th Feb 2020 12:31

"Information about business solvency could be best provided by credit rating agencies"

Afraid post 2008 I am not convinced, their ability to rate the various say CDO tranches was not stunning. (Or maybe it was stunning, just not in a good way, more akin to being hit over the head by a very large object falling from a great height)

I appreciate the article but in essence I think it boils down to the purpose of accounts and their users.

When you get a packet of cold tablets it says on the box do not take more than x in a day etc, this x is never the real limit , it is the likely prudent limit (or very prudent limit), we accept this as it is to protect the user, why not similar re accounts?

In accounts we do have similar, those like myself flocking in and out the stockmarket try to make purchase/sale decisions based in part on reported performance, the market does not want a load of widows and orphans wiped out so we tolerate prudence as a partial protection, this may impact economic performance, it may sway business investment decisions, but it gives a small downside safety measure to these users of accounts- should this not be considered reasonable?

What you possibly are seeking is the Holy Grail of Accountancy, accounts that do everything.

These debates raged through the 1960s, 1970s and into the 1980s, I spent happy hours at university in the mid 1980s considering various models/ variants of revaluation in accounting, SSAP16 and other variants of same within academic articles (Thank you Professor Weetman, you were an excellent teacher of accounting thought as against mere execution) , but short of producing myriad different sets of statutory financial data (and we pretty much have that already with EPS measurement) I do not believe you can get all desired results .

The risk to me seems to be that once you decide on multiple reporting approaches you will have a dogfight re which set becomes the lead actor and which the supporting actors which may not end where the academics want it to, the market, not them,will then decide which reporting metrics they follow and which they more ignore (cast into the back of the cupboard) which may have unfortunate consequences.

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Replying to DJKL:
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By Kazim_Razvi
26th Feb 2020 23:59

Thanks for reading and commenting on my article.

Credit Rating Agencies or separate prudential regulatory disclosures.

In regards to your comment around 'prudence', I would like all users to have financial reporting providing them with current values and then a separate prudential disclosure which provides them with the most conservative view. I believe this will enhance transparency for all investors and provide them with a better visibility around measurement uncertainty.

My concern is that prudential regulators are influencing changes in reporting from financial stability perspective. They are welcome to implement these policies but these should be independent of accounting in a separate section.

Hope this helps.

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Replying to Kazim_Razvi:
Hallerud at Easter
By DJKL
27th Feb 2020 11:35

What are current values?

We studied a fair number of approaches to current cost accounting (in effect current values) at university, it was studied through the prism of the just past 1970s and its high inflation distorting reporting, whilst the individual approaches now escape me re detail the fact that there were lots of variants, and each impacted reporting in different ways, I do still recall.

For instance once you start are you revaluing stock at each balance sheet, dropping prudent lower of cost and NRV, are you happy for the impact of this adjusting through the I & E or do you want a reserves adjustment, what about plant, do you want to value at replacement value re it or current realisable, are you happy with impact on depreciation in I & E based on these different bases of asset valuation etc.

I am maybe old and cynical (not sure I need the maybe) but I rather like Dear Prudence (I even miss SSAP2) and think accounting would be poorer without her, I am also not fully convinced dual (or triple if we are possibly to include carbon) reporting is the correct way forward.

I do recall one book that gave a number of perspectives was Scapens, "Accounting in an Inflationary Environment" , must now see if I can pick up a copy as I promised myself that when I retired I would keep the gears ticking by actually doing so reading re accounting theory .

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Replying to DJKL:
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By Kazim_Razvi
28th Feb 2020 23:54

Please let me know you contact details - I am very interested to have a chat with you to discuss your points.

In regards to 'revaluing stock ' or 'revaluing PPE' at each balance sheet - as an investor - I would like to know both upside or downside swings, whatever the case maybe. What goes in measurment and what goes in disclosure is a separate discussion. And, I am very happy to chat about this as well.

Hope this helps.

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Replying to Kazim_Razvi:
Hallerud at Easter
By DJKL
04th Mar 2020 12:53

I will pm you

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By ShayaG
27th Feb 2020 09:25

I think the key sentence I disagree with is this one "Standard-setters should avoid artificially deflating asset bubbles in financial reporting, which they did not create, and thus cannot remedy. "

If we define a bubble as an unsustainably high market valuation of an asset, standard setters aren't actually trying to deflate those asset bubbles. As you rightly say, that's not their calling. All standard setters are looking to do is to ensure assets are reported at a more objectively correct valuation.

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Replying to ShayaG:
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By Kazim_Razvi
02nd Mar 2020 09:36

Thanks for reading and commenting on my article.

I think 'objectively correct valuation' has to be based on a standard. Those standards are set by IVSC. You are welcome to disagree and provide them feedback if you believe they need improvement.

Nevertheless, the key quesiton is should they faithfully and fairly represent what is happening in the market or should be restrained based on a prudent filter. This is where I am making a point that investors would find both set of information helpful but these two set of information should be kept separate in annual reports.

Hope this helps.

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