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What can be Expected from Accounting Standards?

Gilbert Gélard

At a time when the issues surrounding accounting standards in Europe and worldwide grow in importance in a way unknown before now, it is worth questioning why our leaders and governments are suddenly interested in a subject matter that has been somewhat despised until now. Even the President of the French Republic has expressed his anxieties that certain accounting standards would lead to an excessive “financialization” of the economy. The debate may soon turn to politics or even party politics, which does not encourage serenity. Behind this new word, one can see looming the idea that the economy is too much the servant of the markets, which are whimsical, irrational, too volatile. They favour short-termism and work as a disincentive to long-term, stable investment etc. There is a long list of arguments, more often used when markets are falling than when they are rising. Not all these arguments are without merit, though.

General de Gaulle is said to have once declared: “the policies of France are not dictated by the market”. That may have been true. However, it is on that market that the French state at present sells its holdings in its state-owned enterprises. This is also where it borrows, and its financial soundness is then scrutinized like that of any borrower.

True, the ups and downs of the markets in recent years are not commonly perceived as having been dictated by a pattern of rational behaviour. As any theory, that of efficient markets, on which globalization is based, does not in all cases appear to match the facts. However, a theory should only be abandoned for a better one which does not yet appear to be available.

If an efficient market is one that reacts in an optimal way to all the information available to it, one can see that the key to efficiency is in the provision of relevant information to that market. The hard core of this information is financial accounting information. A public company must present financial statements enabling investors to make the most rational choices possible.

The European Union has realized that a single financial market cannot work without a single accounting language. But what is true of Europe, as a region of the world, is also true worldwide. Markets operate around the clock and the only thing that is beyond our reach is to suppress time differences. It is therefore essential that this single language be adequate to the task.

1. TARGETING THE USER

The problem is that financial and accounting information works within a series of constraints, and one has to accept that trade-offs are necessary between conflicting objectives: readability versus completeness; general principles versus detailed rules; short term versus long term; belated precision versus rapid estimate; transparency versus confidentiality; past versus future. Financial statements cannot cater for the needs of everyone. Financial reporting by listed companies must target its public, i.e. define a particular type of external user, for whom periodic financial statements are the main, if not unique, source of verified financial information concerning the enterprise.

This hypothetical user, the “average prudent investor”, cannot be an accounting illiterate. He (she) must be able to understand the financial statements, including all accompanying disclosures. Brevity will often conflict with completeness; clear and elegant communication with wealth of information. Certain market participants, professional analysts and the press often make it worse by an excess of simplification in focusing on certain key figures and ratios that soon get the status of “sacred cows”: above all, net income, but also the debt/equity ratio or gearing, various other ratios and of course turnover or sales. However, none of these figures is any more than a mere accounting convention. Although such conventions are mostly rational and reasonable, they are also formulaic and simplifying. The resulting information content is poor and may be misleading. The widespread over-use of p/e ratios is typical of the problem of this low quality information.

2. THE TYRANNY OF NET INCOME AND RATIOS

Analysts using financial statements know that the net income of a period is a very partial indicator; it should be used with utmost care, analysed and completed by many other accounting indicators. Accounting indicators themselves are only a small part of the data that an analyst uses to rate a security. Yet facts are stubborn: net income remains the key figure, and as a consequence it is the one most submitted to stress when it comes to writing standards or to modifying the standards applicable to it. A recent illustration of this is the debate about the IASB project on “Performance Reporting”. Resistance to change is, in such a case, rooted in fear of the unknown, a psychological factor, rather than on sound technical grounds.

In addition, this is also the ratio that managements are most tempted to manipulate through a contrived or sometimes plainly dishonest application of existing rules. When this is not practicable or when the net income figure is far too bad to be embellished, the enterprise will focus on some type of “income before deducting certain expenses”, such as EBITDA, going sometimes so far as trying to ridicule the importance of net income and the relevance of the applicable standards.

The other recognized key figures – (1) debt–equity ratios, (2) the distinction between liabilities and equity, and (3) turnover or sales – are submitted to almost as much pressure as net income. The first two nourish a financial engineering industry, one goal of which is to help entities circumvent the spirit of accounting standards. This also fuels the debate between principle-based and rule-based standard-setting. For the third one, the occurrence of recent scandals about a measure that was thought to be so straightforward shows that neither the standard setter, nor the auditors and market authorities can take anything for granted.

In such highly sensitive areas, the accounting standard setter must be particularly convincing. Any technical change also has cultural and political dimensions. Nowhere has the tension been so great as on the debate on stock options awarded to employees. In this area, it is very clear that the refusal to consider the value of these options as expenses to be deducted from net income is not rational. It is based, however, on the quasi-sacred character of net income and of its perceived (and to an extent real) impact on the value of shares. If one simply follows the sequence of accounting entries when a company grants stock options, the equity, including the net income of the period, is unchanged by the granting of stock options, as the value of the option credited to equity is offset by an equal decrease of the profit of the period. From this point of view, the accounting is as “harmless” as it can be. But the Sacred Cow cannot be touched. Therefore, any bad reason will be used to try to discredit the only sound accounting conceivable, and any shameless lobbying will be used.

3. THE CULTURAL DEBATE ON VOLATILITY

The “financialization” of the economy is a fact of life for listed multinational companies and the CAC 40 French companies have a substantial proportion of foreign shareholders. This is a form of “relocation” of capital which has some similarities with the “relocation” of employment. They are the two sides of the same coin called globalization. When a government tries to favour a national champion in a transnational merger, it had better understand that it cannot control permanently either of these two “relocations”.

Any linkage between this economic mutation and the (more or less extended) use of market values or fair values in the financial statements would be confusing two different things. It is perfectly true that measuring assets and liabilities at fair value instead of historical cost increases the volatility of income and equity, but it is equally true that it portrays the entity in a more faithful way.

The combination of historical cost and of the principle of realization would be prudent, some say. What is clear is that it allows the management of net income in such a way that it progresses smoothly, but often this involves artificial or contrived transactions and lack of transparency. It can conceal real volatility that the market should be aware of if a correct allocation of resources is to be achieved.

The debate between historical cost and fair value will continue, but in the meantime the real question is to assess whether volatility in accounting results has a significant, measurable and lasting impact on volatility in share prices. This is far from being proved. In the atypical period of the New Economy bubble, the most volatile shares were those of companies which did not even prepare financial statements, but only published dreams of fairy-tale future sales. In more settled periods and for better established companies, when a company presents two sets of accounts, say one at historical cost (continental European or Japanese) and another more “volatile” (US GAAP), the share price is the same on both markets. The markets are not blind.

Even if a correlation was proved, a fundamental debate would remain open: is volatility good or bad, is there a good volatility and a bad one? That is another story.

The task of the global accounting standard setter, who is only one part of the chain that ideally leads to good financial reports, is very complex. It must work in serenity, while being attentive to the considerable social and economic impact of its work, which is all the greater in a complex world without boundaries. One cannot expect simplistic nor immediate solutions to issues that become increasingly complex. An effort of persuasion and education at all levels is required. It cannot be achieved by the standard setter alone.

The guiding lines for its actions should be relevance and transparency. Market players should be treated like adults who will understand that the more transparent they are, the better they serve their stakeholders. Financial reporting for a global market is still in its infancy. The standard setter should not detract from its recognized framework. It must itself be transparent. Calling a spade a spade has certain virtues.