IFRS – Part of the machine

Public companies in the United Kingdom have now reported their results and
financial position under International Financial Reporting Standards (IFRS) for
a number of years. The IFRS framework and individual standards are
intellectually rigorous and they provide detailed rules with the aim of
promoting transparency and comparability.

However, experience is beginning to suggest that there are some potentially
damaging consequences emerging from the implementation of IFRS in the UK, which
companies and investors should consider (along with the accounting profession)
before IFRS becomes universal in one form or another.

There appears to be an increasing disconnection between how businesses seek
to present themselves and how they are required by law to report.

The use of non-GAAP (generally accepted accounting practice) measures, such
as adjusted EBITDA, are commonly the focus of press releases, preliminary
statements and presentations to analysts and investors. These are measures that
are entirely defined by each company, who will seek to present themselves in the
best possible light. The use of the more comparable GAAP measures becomes less
prominent and comparability between companies declines as a consequence.

The process of preparing financial statements is in danger of becoming an
increasingly compliance-driven exercise that is of diminishing benefit both to
investors (who now rarely receive accounts directly as a consequence of the
changing nature of share registration) and to companies, who have approached the
increasingly technical demands of accounts preparation with a suitably technical
response. That is to say, the ownership of the statutory reporting process is
increasingly being devolved to financial controllers, who will take a more
technocratic approach to it than the more broadly-based business-driven chief
finance officer and his or her board colleagues.

As well as the burden that current standards may be placing on many
companies, there is underlying concern that the conceptually sound principle of
fair value accounting does not hold water once it moves away from active and
liquid markets into dealing with assets that are not highly transferable and are
not often traded. The principle that relevance takes precedence over reliability
is distrusted by companies in these cases and the standard setters’ response of
additional disclosure is ultimately unhelpful. The inclusion of input data in
financial statements, with a view to investors being able to go away and work it
out themselves, is not very tenable – most will be unable to interpret and use
such information.

It could reasonably be argued that many severely affected are in the lower
end of the quoted company market, and there would be some justification in this.
However, the expected introduction of IFRS for smaller enterprises, which is
anticipated to have significant differences from full IFRS, suggests the loss of
a consistent conceptual framework. The standard setter might do well to go back
to first principles and think about what financial statements are for. There
still seems to be a good argument that what they are about is, firstly,
stewardship and, secondly, about giving information that helps predict future
performance. It is a bit of a stretch to look at the fair valuing of assets and
liabilities as a pre-requisite for the former and it could be suggested that
reliable information about corporate performance indicators may give a better
guide to future performance.

An unintended prospective effect of the wide spread adoption of a more
rules-based regime and fair value accounting is the effective marginalisation of
directors’ and auditors’ judgment and experience when reviewing and assessing
financial statements. There is perhaps some echo here of the Treasury Select
Committee review of the banking crisis and its comment that auditors rather lost
the big picture in a sea of detail. It would seem to be unfortunate that the
accounting profession should become less attractive to intelligent people as
they became less able to approach accounting or auditing other than in a
mechanistic rules based way.

The Operating and Financial Review is the only place where a company can
truly present its performance and underlying run rate in a way which makes
commercial sense to the normal shareholder. Here, age old principles such as
matching, substance over form and even prudence can be adopted (and extraneous
non-trading charges excluded) so long as the figures can be reconciled back to
the IFRS statements. But, how sad is it when all the primary statements in the
statutory accounts are known to be flawed; the P&L account is a poor place
from which to assess future profitability, the cash flow statements are a
technical jungle with an imperfect start point and the assets/liabilities in the
balance sheet are calculated in an inconsistent way and often don’t reflect
reality. Many of the principles behind IFRS are conceptually sound, but its
practical application can cause, and is appearing to cause, strains in the real
world. Increasingly, companies are making up their own measures and
comparability is being diminished. Financial reporting runs the risk of being
marginalised. It is time for a rethink from first principles.

James Roberts is a partner at BDO LLP


Particularly for the smaller listed company and AIM companies, there is
resentment surrounding the costs inherent in reporting. It may be a fair
response to say that it is the price you pay for being a public company, but the
burden of technical accounting, additional disclosure and more frequent
valuations (as well as theoretically increased audit costs) does all add up.

Related reading

Fiona Westwood of Smith and Williamson.