21 February 2013

IASB: Answering 10 great misconceptions about IFRSs

The IFRSs have been criticised by some on the Paris Market, including the President of the ANC and a representative from KPMG France, as illustrated by several press articles published about IFRSs. Mr Danjou responded to some of the recurrent criticisms against the international standards. A listed corporation leader, a director, who report in accordance with IFRSs, a creditor, a portfolio manager, an individual shareholder, or an employee (who is possibly also a shareholder) are legitimately interested in accounting developments in France. They have a right – and a moral obligation –to learn more and to benefit from the direct insight of someone involved in setting the IFRSs.

Sometimes, these criticisms are voiced by commentators who have a limited knowledge of accounting issues, and this memorandum will hopefully fill them in. Mr Danjou has thus opted to approach the subject from a technical perspective, without entering into unnecessary detail, as there is a need to set the record straight about the content of IFRSs in order to hold a constructive debate.

Mr Danjou reviews and then comments on the 10 following assertions, which he believes are unsubstantiated or overstated by the French commentators (and possibly also by some in other jurisdictions):

1. IFRSs implement “fair value” widely
2. The purpose of IFRSs is to reflect the aggregate financial value of an entity
3. IFRSs deny the concept of accounting prudence
4. IFRSs give precedence to economic reality over legal form
5. With IFRS financial statements, business leaders are confused
6. IFRSs do not reflect the “business model”
7. Treatment of business combinations is an aberration
8. Financial instruments will soon be stated at “full fair value”, which will increase the volatility of earnings
9. “Fair value” is always defined as a “market value”, even when markets are not liquid
10. IFRSs create an accounting volatility not reflecting economic reality.

IFRSs implement “fair value” widely

IFRSs do not require, nor does the IASB plan that they will require, that all assets and liabilities be stated at fair value. The IASB has clearly confirmed a preference for a mixed system of measurements at fair value and measurements at depreciated historical cost, based on the business model of the entity and on the probability of realising the asset and liability-related cash flows through operations or transfers. The same is true for the classification and measurement of financial instruments. A “mixed model” has been in use since 1989 under IAS 39: it will be maintained under the new IFRS 9.

The purpose of IFRSs is to reflect the aggregate financial value of an entity

The (limited) use, under IFRSs, of an accounting measurement of certain assets and liabilities at fair value is often mistaken for a so-called desire to reflect, in the book shareholders‟equity, the aggregate financialvalue of an entity. Moreover, as IFRSs do not allow to recognise, in the balance sheet the intangible assets generated internally by business operations, any attempt to state the aggregate value of the business would fail. A business entity would be accounted for as a whole at its market value only when it is acquired and consolidated by another entity.

IFRSs deny the concept of accounting prudence

Transactions and economic events should be reflected in the financial statements in an unbiased manner, without emphasising a “principle of prudence” which would actually consist in introducing a systematic negative bias of measurement and in setting up hidden reserves, understating the earnings for a period, and then overstating the earnings for a subsequent period. The role of IFRSs is not to act as a prudential or as an economic control instrument, beyond ensuring financial transparency, which is a condition for the proper operation of markets. However, prudence remains very significantly incorporated in the various IFRSs, which are, in many areas, more prudent than the French standards.

IFRSs give precedence to economic reality over legal form

The standards do not deny the significance of an entity's legal environment, including how the courts may interpret commercial transactions such as contracts with customers. IFRSs are based on principles and must adapt to an international environment which cannot take into account all the characteristics of national laws. These standards focus on the analysis of the economic reality of commitments, so as to provide a complete and relevant vision of the risks and benefits of the entity, sometimes extending beyond the legal form of a transaction.

With IFRS financial statements, business leaders are confused

The scope of the IASB's standard-setting work covers information reported periodically by publicly traded entities about their financial situation and financial performance. The IFRS Conceptual Framework identifies the main audiences for financial reporting (external capital providers, i.e. the shareholders and the creditors) and the type of business decisions this information must support. More generally, this Framework considers external users who do not have access to internal data: financial information is thus useful to customers, suppliers and employees. It is not therefore information to be used primarily by companies' management, who have free access to information derived from internal management reporting. The prudential regulators require the filing of specific reports based on their needs. Tax authorities are not interested in consolidated statements. The determination of taxable income and dividends is still linked to the individual statements, generally prepared in accordance with the national accounting rules. It is however fair to say that all these concurrent accounting, prudential and tax reference standard sets are a complicating factor; however the IASB should not be blamed for this situation.

IFRSs do not reflect the business model

Some business leaders criticise the Conceptual Framework for allegedly focusing on a “balance sheet based” approach and not reflecting correctly the business model or the operational reality of business entities. Does the Framework really require measuring financial performance as being equal to the change in the net financial position between two successive balance sheets? This is both true and false. True as in double-entry accounting, the aggregate performance is affected by the changes in value of the assets and liabilities stated in the balance sheet. But this is also false, as a change in the net asset value will not always be reflected in the net income for the period. The recently-initiated revision of the Conceptual Framework will also focus on a review of the role of the business model in financial information reporting, while preserving a balance with the objective of inter-company comparability.

IFRS 8 on segment reporting is strongly orientated toward the business model as it requires the reporting of performance information on the various business segments “through the eyes of management”.

Treatment of business combinations is an aberration

The international accounting rules (IFRS 3) and the French accounting rules (CRC 99-02) are practically equivalent: these require that the identifiable assets and liabilities of a corporation be stated in the consolidated balance sheet at fair value at the time of their acquisition. The difference between the net value of the identifiable assets and liabilities and the fair value of the consideration given (the purchase price) is goodwill. Goodwill shall be written down if the expected results do not materialise.

Financial instruments will soon be stated at “full fair value”, which will increase the volatility of earnings

The IASB decided to maintain a mixed model for the measurement of financial assets. Therefore, conventional bank assets (loans and other receivables) and the bond investment portfolios held to maturity, which comprise the majority of the balance sheet of a bank, are still stated at amortised cost. The financial liabilities (deposits, interbank financing, and borrowings) are still stated at historical cost, subject to a fair value option in a very limited number of cases. On the other hand, the derivative instruments (swaps, options, etc.) are still valued, as under IAS 39, at market value since these generally do not have an entry cost and as only their market value is likely to reflect fairly the financial risk for the contracting business entity. The hedge accounting mechanisms neutralise the volatility induced by the mark-to-market value of the derivative instruments, provided these mechanisms are used as part of a hedging strategy.

“Fair value” is always defined as a “market value”, even when markets are not liquid

Released as a response to the questions which were raised during the 2008 financial crisis in a context of illiquid markets, IFRS 13 describes the fair value concept and how to implement it. As it applies when another IFRS requires (or permits) the application of the fair value concept, this standard does not extend the scope of fair value in accounting. Fair value is not always identical to market value, even though priority must always be given to observable data why using a mathematical model to estimate fair value.

IFRSs create an accounting volatility not reflecting economic reality

For the IASB, it is not appropriate to hide, or to mitigate artificially, the volatility of income when this reflects the actual economic conditions. To state clearly the financial position of a business entity, the financial statements must emphasise the business aspects generating, or subject to, volatility. Lessons learned from volatility depend on the strategy (and the self-control) of the players (business leaders and financial statements users), and on the prudential rules for the financial intermediaries. The accounting information is only one ingredient in the decision-making process.

Full paper

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