Were they thinking about us when they wrote the standards?

By Geoffrey Townsend

Overview

• Financial reporting is just one way of looking at complex economic “reality”; it is a two- dimensional depiction of a four-dimensional world.

• IFRS is an attempt to move financial reporting to a better depiction of economic reality. Comparability is a desire of users in an increasingly globalized economy; but comparability entails compromise; compromise involves balance.

• The IASB has limited resources and cannot do all things at once. Progress is piecemeal. Prioritization takes place, and the prioritization is driven by the OECD economies.

• IFRS may be the best game in town, but it is not the golden bullet. We should have realistic expectations.

• Users should be careful when comparing IFRS financial statements from different economies.

• Are users as sophisticated as we are told? Introduction

The purpose of general purpose financial statements is “to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making financial decisions” (IAS 1.7). Such financial statements could be seen as a “logical view” of the entity at a point in time and of the events which have occurred in the reporting period.

The “real situation” is multi-dimensional and is influenced by: • Events within the entity; and

• Transactions between the entity and the outside world (suppliers, customers, workforce, government agencies, etc.).

However, the real situation is also influenced by:

• Developments in the industry (competitors, development of alternative products); • The actions and plans of suppliers, customers, employees;

• The status of the national economy(ies) in which the enterprise is active; and • The status of the global economy.

Many of the “things” which the entity buys, owns or sells have their primary unit of measurement not in monetary units, but in physical units such as ton, litres and metres. Thus, a milling machine which is a fixed asset “is” primarily “a machine” which has certain performance characteristics rather than a certain sum of money.

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Geoffrey Townsend was formerly a Partner of KPMG in Frankfurt and Moscow. He is an English Chartered Accountant (ICAEW) and was a German licensed auditor (Wirtschaftspruefer). He now works as an independent consultant.

In addition to the physical characteristics, the “things” may involve a time dimension, for example “for delivery on…”

The entity also has legal rights and obligations which may be measured in money or in some other physical units, often also including a time dimension.

And then we have intangible “things” which may be of great value to the entity such as, for example, a trained workforce, know-how and intellectual rights.

All of these “things” can be subject to a further variable, which is “probability”. However, when we draw up financial statements, we use a currency unit as a method of depicting the position and performance. The balance sheet, profit and loss account, and cash flow statements are essentially tables of numbers; in theory, if the direct cash flow method is used, then the items shown in the cash flow statement have monetary units as their prime unit of measurement, but the other two “tables” contain items for which the primary unit of measurement is not money. The notes to the financial statements, whilst containing narrative explanations, also tend to be full of money values.

In creating the financial statements, we have carried out “a transformation” in which all sorts of “things” are represented by monetary amounts. The methods used for transformation form part of the definition of the “logical view”. The definition of the logical view may also partially or wholly exclude certain “things” from the view; for example, financial statements generally ignore events which have not yet happened.

An analogy can be made to an architect’s drawings of elevations of a building; he will design a three-dimensional object, but will depict it through a series of two-dimensional elevations. An elevation is a logical view which truly represents the reality according to various conventions; a floor plan will afford a further logical view. To obtain a good understanding of the plans, it is necessary to see several logical views.

Looking at the past, or looking at the future?

We are told that investors, advised by financial analysts, base their calculations of the amount they are willing to pay for a company on a calculation of future cash flows, which is then adjusted for existing debt and cash; the whole is discounted using a rate which reflects the risk- free cost of capital plus a series of premiums for various risk factors, some of which are under the control of the company and some of which are associated with the industry, the country in which it operates and some global considerations.

This is a logical view which is very much biased towards the future. The mechanics are very much influenced by business models which are used to evaluate various scenarios, and which are used in the preparation of business plans and budgets.

Traditionally, financial reporting has taken a logical view which almost totally ignores the future element. One could paraphrase the conceptual framework of financial reporting systems by saying that the income statement reflects events which have taken place in the past and which have been completed (ruled off), whereas the balance sheet represents events which have one foot in the past and one foot in the future (unfinished business). The cash-flow statement is a past- oriented statement, although loans received and made do have a future dimension in the form of repayment.

If this is true, why is so much emphasis placed on financial reporting? There is a huge volume of laws, standards, professional infrastructure, regulation and even litigation dealing with

the preparation and verification of a historically-oriented logical view, whereas what the punters want is a future-oriented logical view; an area which is subject to comparatively light regulation. Is this a successful confidence trick perpetrated by the accounting and auditing profession? “We are very important, and you should appreciate our status and pay us lots”?

Historic cost, fair value, and hybrids

Historic cost accounting has been with us a long time. In its purest form, it is driven by recording monies paid and monies received. Fixed assets purchased, loans made and received, capital contributed or withdrawn are treated separately because the cash flows are expected to have consequences in the future. The advantage of historic cost accounting is that it is largely about events in the past which can be easily verified. It has the benefit of low production cost and a high degree of objectivity and verifiability.

Historic cost accounting has then been “improved” by use of the accruals principle. A profit is deemed as realized when the goods have been delivered, and not when they have been paid for. It is deemed that the settlement of the debt can be assumed with a high degree of probability, and therefore it is “safe” to already account for the profit.

It is worth mentioning at this point the concepts of realization and recognition. A profit is realized when the transaction is over and the fruits have been gathered; it is recognized when it appears in the profit and loss account. It has become generally accepted that you can recognize a profit on a sale when you have delivered the goods, and the delivery becomes not only the point of recognition, but also of realization. This can be seen as a first step on the way from “pure” historic cost accounting to fair value accounting; the accountant has taken a view that the customer’s debt will be paid.

(As an aside, I note that under Soviet accounting and the early years of post-Soviet Russian Federation accounting, sales were realized when the cash was received, with goods despatched but not yet paid for held on a sort of “consignment” account at cost until payment had been made.)

At the other extreme, we have what the users of financial statements would probably really like — an estimate of future cash flows for all time, including transactions which have not even yet been budgeted to customers who have not yet been identified for goods from plants which have not yet been built.

Such transactions do find their way into company valuations. They are absolute anathema to accountants and auditors because of the huge amount of judgement required. We are out of the realms of verifiability and into plausibility. I think I can buy something for $5 and sell it for $10; can I book the profit now, please?

Fair value accounting is a little more objective than that. The balance sheet includes things which have at least some root in the past, but this can be a little tenuous. At the more solid end of the objectivity scale we have, say, the valuation of a futures contract which will be marked to market, and this represents the market expectation of the contract value when it matures. Somewhat flakier is the valuation of a fixed asset on the basis of the net cash flows which it will generate — this probably does involve taking a view on future transactions with people we do not know yet; great care has also to be taken to ensure that there is not a double or multiple counting of the same “cash margins” when various stages in a production chain are evaluated (a problem known today when evaluating an upgrade of a production facility).

So at one extreme we have historic cost accounting which is very objective and easily verifiable, though maybe not very useful when considering future performance. But it does provide a solid base of verifiable facts. (And we must remember that accounting has objectives other than just the production of financial statements, including providing a record of stewardship and meeting a number of legal needs; historic accounting may be appropriate for these purposes.) Over the decades, we have seen amendments to financial reporting standards and accepted practices which have introduced elements of fair value accounting; these amendments have gone a little way towards meeting the requirements of the users as represented by the financial analysts. The process has been slow, and there have often been objections.

Maybe one could make the case that financial reporting has introduced fair value methodologies when there has been a large consensus that this is a good thing to do — but not before.

The result could be seen as a hybrid system based on the concepts of historic cost accounting with certain elements of fair value accounting when the historic cost convention has produced results which are “clearly daft”.

Pressure against the fair value reforms has typically come from:

x The preparers of financial statements, who usually complain about the costs of preparation and sometimes argue that there are no real outside users who require this information. Financial statements are usually prepared by accountants, and generally speaking, they are nervous about making judgements which may well turn out after the event to be wrong.

x The auditors of financial statements, who are usually worried about the subjectivity of the application of judgement. They fear an increased risk of litigation.

x The justice authorities, who may be concerned about recognized but unrealized profits being used to pay dividends with negative effects for creditors should circumstances change. This can be seen as a capital maintenance argument.

x The tax authorities, who may worry that the aggressive use of judgement can lead to a deferral of taxation, and, on a more philosophical basis, that the use of judgement undermines the principle of equality of taxpayers.

The concerns of the taxation bodies and the capital maintenance lobby can be relatively easily addressed by using the concept of logical views. It is possible to present different logical views to various users designed to fit their purpose. The capital maintenance lobby can be given a logical view in which profits are recognized when they are realized and not before; the tax authorities can be offered a logical view defined by the taxation legislation (i.e. tax return), for example, using tax depreciation rates or capping the amount of provisions. This would allow the investors and analysts to be presented with their own logical view, which is closer to their requirements. (Please note that the European Union (through the Regulation on Consolidated Financial Statements) and the Russian Federation (through its draft law on consolidated financial statements currently under consideration by the Duma) have both accepted that the logical view presented to the users of consolidated financial statements can be different from that used in statutory financial statements of legal entities which may be used in the control of capital maintenance.)

By way of historical note, I list some items which introduce elements of fair value accounting into a newer hybrid financial reporting (Some of the older changes have now become “so generally accepted” that one may wonder why they were ever controversial.):

x Accruals;

x Bad debt and inventory provisions;

x Translating foreign currency balances at closing rates; x Fixed asset impairment;

x Revaluation of fixed assets;

x Marking forward contracts to market; and x Marking financial instruments to market. Setting the reform agenda

Financial reporting reform is usually a reaction to a demand from users for more relevant and/or comparable information. The demand may arise from:

x Scandals;

x Changes in business practices (e.g. increasing use of financial instruments); or x Changes in the economic environment (e.g. widespread inflation in the 1970s).

The IASB has to prioritize its work, and it is natural that it will take a global view when setting those priorities; it will normally give a lot of consideration to the global capital markets. And the global markets are dominated by companies operating in the OECD countries.

Thus, problems which can be very important to a non-OECD country, but which are of lesser importance from an OECD perspective, may get placed at the end of the IASB agenda. I would argue that there are aspects of the Russian economy which have a very material impact on the IFRS financial statements of Russian companies, and which lead to extreme effects or strange situations which may not appear frequently in the financial statements of companies from OECD countries. The problems are, of course, not limited to the Russian Federation.

I am not suggesting that national standards are the solution. The problems described below, whilst maybe being inadequately addressed by IFRS are even less adequately addressed by Russian standards of financial reporting.

Specifics of the Russian Federation situation

• Two bouts of hyperinflation and continuing high, but not hyper-inflation; • Post-Soviet price realignment (still ongoing);

• Ongoing effects of privatization — atomization and the subsequent formation of industrial groups;

• Dominance of resource extraction and basic industries;

• Developments in investor confidence — improved performance or improved perception? Two bouts of hyperinflation and continuing high, but not hyper-inflation

Since 1991, the Russian Federation has experienced inflation in which prices have multiplied by a factor of around 15,000. The periods 1992–1995 and 1998–2001 were