An end to the neo-soviet nightmare

There is an old saying that those who fail to learn from history are
condemned to repeat it. Thirty years ago, the great inflation accounting debate
was in full swing. Its most striking feature, however, was not the rich variety
of alternatives on offer, but the neo-Soviet tactics adopted by the inflation
accounting experts in order to impose their views on the profession.

The various rival systems were compared on the basis, not of the quality of
the information they provided to the consumer, but of the alleged superiority of
the techniques by which they were produced. In typical neo-Soviet fashion, the
inflation accounting experts refused to consider the obvious question: will the
accounts present a ‘truer and fairer view’ of a company’s return on capital –
which is number one on the ASB’s recent list of ‘key performance indicators’.

Thirty years on, and the IASB seems intent on thrusting its ‘fair value’
wonder-drug down the throats of its patients – again without conducting any
clinical tests.

Yet even the simplest test is sufficient to show that fair value accounting
can have lethal results: fair value gains can be reported even when the returns
from the firm’s assets fall; fair value gains can be reported even though the
firm’s credit-rating is downgraded; the accounts of firms generating higher
actual returns for investors can indicate lower fair value returns than the
accounts of firms generating lower actual returns.

Since the IASB can hardly claim ignorance, the question arises of the
criminal liability of its members under section 17 of the Theft Act 1968 on
false accounting. Insofar as fair values represent market opportunities at the
balance sheet date, their disclosure is a development to be welcomed. The
objection is to the treatment of changes in fair value as ‘gains’ or ‘losses’.

The very fact that an item appears on a balance sheet proves that it has not
been exchanged at the balance sheet date.

The fair value therefore represents an opportunity that has been rejected – a
transaction that could have taken place but did not in fact do so. Nowhere does
the IASB provide any argument to support its requirement in IAS 39 that the
difference between two non-existent transactions ‘shall be recognised in profit
or loss’ as a gain or a loss.

The IASB has been remarkably successful in conveying the impression that it
occupies the ‘theoretical high-ground’. From time to time, there are hints at
consistency with concepts like economic income, business income, and deprival
value.

Despite their distinguished pedigree, however, these sacred academic cows are
riddled with fundamental theoretical flaws. It is not simply that they do not
work in practice – they do not work even in theory.

Consequently, the existing conceptual framework is liable as a matter of
normal routine to produce serious errors in the calculation of the return a
company obtains on the resources it controls – not only in retrospect (financial
reporting) but also in prospect (investment analysis).

Perhaps the most astonishing aspect of modern investment theory is the
prevalence of the neo-Soviet assumption that the directors of public companies
(described by Adam Smith as ‘the managers rather of other people’s money than of
their own’) should act as enlightened central planners, not in their own
self-interest, but altruistically in the interests of a multitude of investors
whose (often conflicting) preferences and opportunities they cannot possibly
know.

Standard textbook theory typically involves a discussion of the relative
merits of net present value and the internal rate of return as techniques of
appraising investment projects. But, even in an ideal world where everything
turns out according to plan and the cost of investors’ capital is known,
investment projects that are acceptable by both conventional DCF criteria can
actually make investors worse off.

The conventional wisdom is therefore fundamentally flawed in two crucial
areas. Discounted cash flow analysis is liable to generate the wrong choice of
investment projects even in perfect conditions where everything goes according
to plan. The error is then liable to be covered up by an accounting system which
cannot by its very nature be relied upon to give a ‘true and fair view’ of the
results.

The IASB’s claim that such information ‘is useful to a wide range of users in
making economic decisions’ can only widen the ‘expectation gap’ between what the
public commonly considers the auditors’ report to represent and what it actually
does represent.

Irresponsible claims and the use of labels like ‘fair value’ are contributing
to the perception of auditors as ‘insurers of last resort’. The audit fee is
regarded as an insurance premium against business risk, and, if things go wrong,
anyone who suffers damage feels entitled to compensation from the auditor.

What investors are entitled to expect is reasonable protection against the
risk of fraud and error. What they are not entitled to expect is protection
against business risk.

That is something the auditor does not provide, cannot provide, and, above
all, should not provide. It is, after all, the acceptance of business risk that
makes the economic world go round.

A company’s assets are, to some extent, lottery tickets in the game of
business. It is the auditor’s duty to verify the existence of the tickets, not
to give a guarantee that they will be winners.

In 1976, the US Financial Accounting Standards Board launched its conceptual
framework project with the express instruction that there should be a fresh
start without preconceptions. The project was almost immediately derailed by
powerful vested intellectual interests within a small section of the academic
establishment. For the past thirty years the main effort has been concentrated
on patching up the accounting system in order to protect the existing c
onceptual framework. The result is a bureaucratic nightmare of regulations and
an ine xorable drift towards Sarbanes Oxley type legislation.

The neo-Soviet trend needs to be reversed. That means refusing to tolerate
the neo-Soviet attitude of standard-setters who impose their products without
regard to their customers; the neo-Soviet presumption that corporate management
can measure economic advantage on behalf of investors instead of providing
information to enable them to do so for themselves; and the neo-Soviet
proliferation of regulations so complex that no-one can understand the results.

In its draft of proposed amendments to IAS1 presentation of financial
statements, the IASB states that its purpose is ‘to enhance comparability both
with the entity’s financial statements of previous periods and with the
financial statements of other entities’. It also states that the proposed
amendments ‘affect the presentation (but not) the recognition, measurement or
disclosure of specific transactions and other events required by other standards
and interpretations’.

How does the board expect to achieve its stated purpose by amending the
presentation, when the real problem is the content?

What is needed is an alternative conceptual framework combined with
recognition that the only feasible route to effective corporate governance is,
not by regulation, but by market forces. There is, however, an essential
precondition: the discarding of old academic baggage.

Anthony Rayman is the author of Accounting Standards: True or False?,
published by Routledge (2006), £19.99. Accountancy Age readers can order the
book at a 20% discount by e-mailing [email protected], quoting code
ASAA0506

THE GOOD OLD DAYS

Over-complication

In the 1960s, Britain’s accountants had to make do with a mere hundred or so
pages of ‘recommendations on accounting principles’. Today (courtesy of the ASB,
APB, and IASB) they can rejoice in over 8,000 pages of SoPs,
SSAPs, FRSs, UITFs, SORPs, FREDs, SASs, ISAs,IFRSs,IASs,(in font sizes
mercifully small enough for older members of the profession to be unable to
read).

The impact on the finished product has been remarkable. Financial reports are
now so complex that leading finance directors have complained of being forced to
present numbers that defy explanation.

Under the direction of the IASB, accounting figures have become a greater
mishmash of fact and speculation than ever before. Some are based on records of
transactions which have actually taken place in the past; some are dependent on
the outcome of transactions which may or may not take place in the future; and
some are made up of an unidentifiable mixture of both.

Over-complication
Faced with increasing evidence that this is a product that its customers do not
want, do not need, and do not understand, the IASB’s neo-Soviet response – to
insist on delivering more of the same in ever more complex detail – serves only
to bring the profession into disrepute.