Marked at 90%
F.A.O Mr Hans Hoogervorst
International Accounting Standards Board
30 Cannon Street
27th April 2014
Dear Mr Hoogervorst,
RE: Current Accounting issues with Fair Value Measurement and Net Income.
I have carefully considered the use of measurement in accounting and I am writing this letter to draw your attention to some of the contentious areas involved around the use of fair value measurement and other comprehensive income. I have also suggested alternative approaches that I feel the IASB could consider, to aid improvements in specific areas of accounting.
In recent years the IFRS have increasingly permitted the use of fair value measurement for assets (Mullet et al. 2011). As the Chairman of the IASB (Hoogervorst, 2014) you recognise that: “Profit or Loss is the primary source of information about the return an entity has made on its economic resources in a period”. Hence, as other comprehensive income is installed into the profit and loss account, fair value measurements then has direct implications on the return an entity has made from its economic resources. Power (2010:199) acknowledges that: “Policy concepts can be articulated in the abstract by regulators and accepted by industry before complex and messy issues of implementation come in play”. Evidence shows how certain levels of fair value compound the existing problems of accounting subjectivity, auditability and accountability (Zyla, 2012; IAASB, 2008; Power, 2010). This does not only cause difficulties for preparers and users, this also creates huge problems for auditors who then have to issue opinions based on subjective valuations open to manipulation (Zack, 2009; IAASB, 2008; Jeppesen & Liempd, 2011). Due to the nature of fair value generating unrealised gains and losses, it further fuels the agency problem and, in turn, reduces the reliability of net income figures. Therefore, it is of my opinion that unrealised gains and losses are not an appropriate approach to justifying the value of entities.
The financial crisis exposed the flaws of fair value accounting and made evident the ‘pro-cyclicality’ of fair values (Lefebvre et al. 2009; Kusano, 2012). For instance, in 2007-2008, due to the nature of IFRS mark-to-market rules, many large organisations were forced to reduce book values of their assets at a far faster rate than reality (Skinner, 2009). Consequently many firms had to sell assets at fire sale prices to preserve the value of their balance sheets (Merrill et al. 2012; Laux & Leuz, 2009). Skinner also identified that: “the assets that back those paper-based securities are still assets, and under fair value rules, the write-downs made in 2007-2008 were written back in 2009”. This highlights the contagion effect in times of crisis (Laux and Leuz, 2009) and demonstrates the volatility of fair value accounting and the implications that adverse effects in the economy can have on accounting. When bubbles arise in the economy, fair value accounting accelerates the rise of asset values and, subsequently, when these bubbles burst fair value exacerbates negative spirals. By using financial theories to value assets, it raises the question as to whether accounting is trying to be finance (Power, 2010). The reliance on finance theory creates an interdependence between accounting and finance, thus poor economic decisions can shift blame on to accounting procedures (Ciullar, 2012), in turn, damaging the reputation of accounting.
Bromwich (2007:46) argues that: “the appeal of fair value valuation to standard setters is its presumed ability to improve decision relevancy for investors and creditors”. However the emphasis of relevance comes at the expense of reliability (Laux & Leuz, 2009). Due to the three factor hierarchy in IFRS 13, consistency in valuations is unlikely to materialise. Market prices also may not reveal fundamental value due to liquidity issues or other circumstances (Allen & Carletti, 2008). For instance, if fair value is supposed to represent the value in the most “advantageous market” as stated by IFRS 13, then the value would be based on the maximum value that an arms-length market participant would pay for the asset. In the real marketplace with the existence of competition and available alternatives, it is unlikely that market participants would pay the highest price for assets (Jones, 2011). Power (2010) notes that: “level 3 valuations are in fact the engine or market themselves” as the valuations for these assets determine the market value of assets that can only be sold in ‘imaginary markets’. This allows firms to attach a value to assets communicating and constructing their perceived reality on others (Hines, 1988).
A single measurement basis is necessary for accounting, but it must follow that management estimations do not form these resulting values (CFA, 2007). Accordingly, I propose the adoption of confidence accounting as a potential improvement. Confidence accounting involves expressing figures as probability distributions rather than a single discrete value (Mainelli, 2012). The proposed benefits of this approach include a fairer representation of the risks associated with an entity’s securities (ACCA, CISI & Long Finance 2012). Barthe (2007) contests the reliability of fair value measurement, claiming that just because an amount can be calculated precisely; it does not essentially mean that these figures are accurate. The use of confidence accounting can eliminate the unreliable nature and volatility associated with fair value measurements by recognising a range of values of the assets. Furthermore, asset values can be affected by market conditions and liquidity issues; therefore it is extremely likely the value of the asset in these circumstances will still fall within the range. I agree with the ACCA, CISI & Long Finance (2012) that this proposal will allow ‘systemic stability centre stage’, through providing fairer representations in the financial statements of the riskiness of asset portfolios held by entities. The use of confidence accounting is no panacea as there is still an element of judgement involved, however, by ensuring that users are fully aware of the risks associated with the valuations of assets, it can prevent any over confidence in financial information.
Despite fair value having been mandated for some assets and liabilities under IASB and FASB (Penman, 2007), management still have the choice of valuation method for certain assets. Thus, the openness to manipulation arises due to alternative valuation methods which can be used to price assets at the optimal value. The existence of information asymmetry coupled with the agency effect, can lead to mounting pressure on management to value assets at the highest possible price, subsequently, resulting in increased comprehensive income and, in turn, a healthier profit and loss account. This will allow firms to benefit from gains that are not physically there, enabling them to distribute income that has not yet been realised. The distribution of unrealised gains can be risky as it can result in cash flow and liquidity problems (ICAEW, 2006). Whittington (2008:146) notes that: “the change of language is the replacement of reliability by faithful representation”. Thus, in order to sacrifice reliability, independent valuation expertise is necessary to ensure relevance through ‘faithful representation’. I therefore suggest the use of contracted independent valuators to value the assets of companies. The use of contracted valuators is essential to reduce the risk of exposure of confidential information. Thereafter, the auditors can audit the valuations put forward by the contracted valuators. I believe this can eradicate aspects of the agency problem, removing the opportunity for managers to have a hands-on approach when valuing their assets which are susceptible to manipulation for their own self-interest.
Issues also arise due to unrealised gains being incorporated into the profit or loss under other comprehensive income. The profit and loss is commonly used by unsophisticated and professional investors (GAAP, 2014: Hoogervorst, 2014). Hence, it is important that users are supplied with quality accounting information when using the profit or loss account of entities to make investment decisions. Quality of accounting income should be the degree to which reported earnings faithfully reflect Hicksian income (Schipper & Vincent, 2003). This means a company should only be able to spend an amount that will not leave them worse off in the following period. Evidence also indicates that there is a positive relationship between earnings management and the value of a firm (Jiraporn et al. 2008). Other comprehensive income inclusion in the profit and loss account exacerbates the existence of earnings management, which allows management to produce financial reports that paint a superior picture of the company’s activities and financial position (Hines, 1988). Firms are then able to carry over unrecognised income from previous years to smooth out net income figures in challenging years. For instance, General Electric were able to smooth its earnings growth through massaging its quarterly earnings through the use of reserves for many years (Fox, 2009). Ultimately this can result in further information asymmetry and adverse selection as investors can suffer losses due to being unaware of the current issues an entity might be experiencing.
Cauwenberge and Beelde (2007:1) find that: “Exclusive reliance on a single concept of income is untenable”. Thus, I suggest the use of a dual income display for the income report. This would mean that the income report would include both historical cost values and fair value comprehensive income. As a result, users would have no incentive to rely on one income measure more than another (Cauwenberge and Beelde, 2007). Accordingly, the profit or loss account would show a division between historical cost income and fair value income. There would be a sub-total displaying income based on historical cost, while the total comprehensive income would include income from fair value revaluations (Newberry, 2003; Barker, 2004). This will also separate unrealised gains from realised gains which will prevent the emphasis on elements of unrealised gains being the underlying emphasis on the value and performance of the entity.
In summary, the issues of fair value and other comprehensive income should not be ignored. Although, it will be difficult to a find a solution to the issues that arise through measurement; I feel the IASB need to consider alternative options to attempt to improve current accounting complications. The use of confidence accounting can help users of accounts to understand the risks involved with assets values in financial statements which should prevent over confidence in the figures provided. External independent valuators could be made mandatory for organisations to eliminate aspects of the agency problem and encourage fairer representations of asset values. Lastly, by adopting a dual income display I believe it can reduce the incentive for users to only consider unrealised gains through fair value income as the income statement will also display the value at historical cost.
Thank you for the opportunity to express my concerns with current accounting practices. If you would like to discuss any of the aforementioned further, please do not hesitate to contact me, Claudia.firstname.lastname@example.org.
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International Accounting Standards Board
30 Cannon Street
28th April 2014
Dear Mr. Hoogervorst,
I am writing to ask you to consider whether using a principles based approach to global standards is appropriate for every country around the world. With an increasing amount of firms internationalising their operations and the globalisation of financial markets, there is definitely a need for uniformity with accounting standards (Carmona & Trombetta, 2008). However it must be considered that one set of standards may not work for every country with respect to the diverse cultures and reporting traditions. I will now explain to you the reasons why some countries may need more of a rules based set of standards and in particular why the principles based International Financial Reporting Standards (IFRS) may cause more problems than it is trying to solve.
Firstly, I believe that the focus of a uniform set of standards should be that they paint a full picture that is true and fair rather than whether they are principles or rules based (e.g. Tweedie, 2008; Suzuki, 2003; Hines, 1988). For example companies may use standards of a principle nature to reduce income volatility by smoothing out inherent economic fluctuation (e.g. inflation) (Schipper, 2003). This is not giving users of the financial information a fair or true picture and thus will mislead investors.
By trying to make countries converge to a single set of standards there will inevitably be a temporary lag of quality in financial reports during the transition, which will give companies the opportunity to represent their financial statements unfaithfully (Schipper, 2003). An example of convergence was when Daimler Benz AG reported a net income of DM615m in 1992 under German GAAP which turned into a net loss of DM1,839m under US GAAP (Carmona & Trombetta, 2008). This shows that even though historical financial reports are not very comparable to present day reports due to external factors such as inflation and the relative size of the business, changing countries accounting standards may unnecessarily add to their incomparability. This also brings to light the problem of, which standards are right, if any? How can we say which one portrays a fair and true picture?
I understand a strict rules based accounting standards may impose a uniform treatment for many firms operating under very different circumstances, but this uniformity will increase stability and security in financial reporting and global financial markets in the long term (Carmona & Trombetta, 2008).
I propose that you look at using a mixed approach to standard setting where the focus is on attaining a fair and true picture and not on achieving a principle/rule based IFRS. This could make the standards easier to converge too and thus reduce the problem of firms adopting the IFRS “label” but then using its flexibility to retain their own accounting policies (Carmona & Trombetta, 2008). Harmonisation will also increase investor confidence in emerging countries because IFRS accreditation projects an image of confidence and respectability (e.g. Kotlyar, 2008; Carnegie & Napier, 2010). This will give undeveloped countries the chance to attract foreign investment from global markets as understandability and stability of their accounts will be enhanced globally.
Moreover a mixed approach may decrease the time it takes for countries to converge which is vital because during this transition phase, financial standards, as explained before, are less reliable. In this time investors are more hesitant to invest while they are waiting for the ramifications of the switch on the markets (Weigel, 2008).
The question that must then be asked is how much information should international accounting standards give?
Different countries standards will have a varying amount of detail in their guidance which shows the challenge of how much detail should be provided (Barth, 2008). I recognise that if standards are too comprehensive and cover numerous scenarios they become complicated and admit the vast amounts of different treatments available which they are trying to avoid (Tweedie, 2008). But some countries (e.g. developing) may need additional guidance on how to apply the standard, which principles cannot give them. For that reason you should consider different emerging economies accounting standards, such as China, when setting new standards. However, converging too many standards together may lead to more confusion, less uniformity and less comparability.
Another reason why rules based standards may be more suitable is because in-depth regulation can protect against legal action (Schipper, 2003). Tweedie (2008) explains that principles are still defensible but they leave scope for firms to interpret them how they want. Principle based standards rely on professionals to use their judgement, which could lead to creative accounting. This issue is of particular importance to investors wanting to invest in a foreign country, as companies can unfaithfully portray their firm’s financial position and so investors can lose out in global markets.
Principles based standards rely on the judgement of individual companies and auditors to process transactions, which can lead to a wide disparity in treatments depending on both company and country (The Tokyo Foundation, 2011). This could lead to window dressing or companies being excessively conservative in handling their accounts in fear of a lawsuit. Accountants therefore have a great, and sometimes hidden, power of portraying and constructing reality (Hines, 1988). They are responsible for the many estimations they make when processing accounts from which investors, with faith, use to base decisions in hope that the financial statements have been represented truthfully and fairly (Joannides, 2012). Accountants are skilled professionals and hence standards should be broad enough to allow for them to use their own judgement but sometimes they can present a picture of a healthy company which then fails (Hines, 1988). This is exemplified by Enron in 2001, which led to not only their collapse but of Arthur Anderson, their auditors (Carnegie & Napier, 2010).
Detailed guidance, in a rules based approach, provides preparers and auditors with a common knowledge base and a common set of assumptions, which should reduce the differences in measurements (Schipper, 2003). This additional guidance increases comparability as it reduces the effects of differences in professional judgement, but I acknowledge that if the guidance is too strict, this will only be surface comparability (Schipper, 2003).
By the implementation of principles across the world, the role of regulation will increase because less guidance means more room for judgment, which is problematic (Carmona & Trombetta, 2008). Previously, as Tweedie (2008) explained in his speech at the ICAS conference, aggressive corporate chiefs were unchecked by auditors which meant when accountants used their judgement in an unfaithful way, regulation did not correct them (Enron and their auditors, Arthur Anderson). So what stops auditors from not being influenced by accountants who will use the scope of a principle based standard to represent their accounts falsely?
Furthermore the type and amount of expertise required to use just principles will rise for preparers and auditors and some countries will need to significantly change their training and educational programs (Carmona & Trombetta, 2008). This could lead to huge costs as accountants who are trained in local standards will have to retrain and master new standards which will be especially difficult for countries that are converging from rules based standards to the principles based IFRS as more judgment is needed (Weigel, 2008). Implementation costs can also be unrealistic for many developing countries as well as smaller companies as they would have to retrain their existing accounting staff.
By choosing to do IFRS in a principles based approach, the emphasis has been on achieving uniformity and not whether the standards are actually appropriate for every country which is a problem because business environments differ widely and therefore there is no guarantee a principles based approach is best for all countries (The Tokyo Foundation, 2011).
I propose that every time a new standard is to be implemented, IASB should do a quick test with a few professionals from a range of countries and see if by using their own judgement they come up with similar answers. By doing this you can eventually incorporate other countries view on standards, as proposed earlier, into developing a truly global set of standards, which may make them easier to converge too when the time comes.
If the IASB feel like they do want to continue to develop the IFRS instead they should look to changing the requirement of retroactive application (restate the financial report for all periods presented) to the prospective approach (standards are only applied to new transactions) (Schipper, 2003). Even though this would reduce consistency and comparability for a period of time, which is inevitable in the convergence phase anyway, costs will be dramatically reduced which could mean the voluntary adoption of IFRS could increase.
This letter has shown the main problems of why one set of principles based global standards may not be appropriate for every country. These were that financial statements should be focused on giving a true and fair picture which principles based standards may not give enough guidance for, how much detail should global standards give and can we truly rely on accountants to use their own judgement to portray accounting information faithfully when they only have principles to use? I have explained several proposals you could implement which may help create a truly global set of standards which will benefit many organisations and countries, so I hope you consider these carefully.
Thank you for your time.
Mary Wallace FCA
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ed at 77%
Marked at 70% - a report
The importance of the report to financial reporting……....................................... 3
Relevance of financial reporting in investment decision making..………………. 3
Evaluation of suggested improvement to the quality of information
presented to shareholders……………………………………………………… 4
Conclusion …………………………………………………………………… 5
References ……..……………………..……………………………………. 6
This report will critically evaluate a report titled “A Comprehensive Business Reporting Model: Financial Reporting for Investors” published by the CFA Institute, Centre for Financial Market Integrity in 2007. The CFA Institute is a global, nonprofit organisation comprising the world’s largest association of investment professionals (CFA, 2012). According to CFA (2007) “the business reporting model is the lens through which investors perceive and understand the wealth-generating activities of a company and the results of those activities”. The CFA report identified some issues in accounting and also provided suggestions that can further improve the quality of information provided to shareholders as presented in published financial statements. This critical review will explore the importance of the CFA report to financial reporting, the relevance of financial reporting in investment decision-making and the evaluation of suggested improvement to the quality of information presented to shareholders.
The importance of the report to financial reporting
The CFA report is important to financial reporting because it pointed out areas that needed to be improved on in the accounting standards in order to improve the usefulness of information provided to investors. For instance, the CFA argued that a consolidated financial statement does not provide disaggregated information, which is a disadvantage to investors because they need to know the risk associated to each subsidiary. In a report by Ernst & young (2011), it was noted that the IASB issued a new standard that is expected to address this issue. The IFRS 12 Disclosure of Interests in Other Entities includes all of the disclosure requirements for subsidiaries, joint arrangements, associates, and structured entities (Ernst & young, 2011). The new disclosures will help users determine the risk associated with each subsidiary within the consolidated financial statements and the impact this may have on the group as a whole. In summary, there appears to be some substantial changes to financial reporting since 2007 and although arguable, it may not be unconnected to the CFA report.
Relevance of financial reporting in investment decision making
According to Beest et al (2009), information is relevant if it adds to the decision making process of an economic user. Looking at the financial reporting framework there are sometimes different measurement techniques of measuring the same asset. According to the CFA report, this allows managers to manipulate the information they present to investors. Considering the financial crisis most of the mangers acted in their selfish interest, this was possible because they had power over how they wanted their investors to see their company. Before the crisis the CFA report suggested that companies should communicate information faithfully with their investors using Warren Buffet as an example. Another principle that was covered in the CFA report is that financial reporting must be neutral. This means that information has to be free from error or should not be influenced by managerial selfish interest. If we look at what happened in the case of Lehman brothers the executives manipulated balance sheet and financial reports when investors started losing confidence in them. The flexibility the standard provides might have given them the opportunity to be able to manipulate information. They decided to choose the method of reporting that showed their financial report in good light.
The chairman of IASB as at the time of the crisis agreed that “the crisis demonstrated the truly global nature of capital market and that there was urgent need for a global mechanism to regulate the markets, including a single set of global accounting standards” (CFO, 2012). The CFA report agreed with the convergence prior to the crisis but it seemed that the IFAC is taking too long to implement it. However, since the financial crisis they have put more effort into the convergence of the FASB and IASB accounting standards to produce a global accounting standard. This will reduce the challenges faced by analyst and investors globally as a result of differences in accounting standard. The importance of financial reporting to investment decision-making is clear given the lesson learnt from the financial crisis, which showed that investors