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Standard setters: Please don’t deflate asset bubbles

Accounting standard-setters need to revisit the purpose of financial statements. Accommodating broad stakeholders, especially prudential regulators, will not make financial statements more transparent for investors and readers. It will only make the information overly complex and increase criticism from advocates of historical cost convention.

In the past, self-reliant entrepreneurs kept accounts that were based on historical costs and prudent estimates. That made perfect sense – a negative shock could cause insolvency, whereas a positive shock could be used to pay off debts, reinvested to pursue growth; or distributed as a dividend.

In the modern era, the entrepreneur role has evolved to specialists. Managers run the business (agents), shareholders provide capital (principal), regulators set rules for governance and solvency (prudence) and standard setters set rules to report performance and financial position (accounting).

Following the 2008 financial crisis, standard setters have become more accommodating to regulators, but their compliant stance will create significant unintended consequences.

Accounting that pleases everyone is useful to no one

There is no place for ‘prudence’ in modern financial reporting. The accounts should provide ‘neutral’ information so that all participants can understand exactly what is happening in the markets. This neutrality helps policy makers spot trends and address problems accordingly.

Information about business solvency could be best provided by credit rating agencies or under separate prudential disclosures to financial reporting. Accounting that is trying to be both prudent and neutral does not fairly represent economics, nor does it depict insolvency risk.

In the case of Carillion, how the company accounted for goodwill was blamed for overstating assets and for permitting aggressive dividend distributions to investors at the expense of employees and creditors. But accounting was not to blame.

Instead, policymakers and regulators should answer a deeper and more pressing question: should we regulate non-financial corporate entities like the financial sector?

Policymakers and regulators are welcome to introduce new rules to regulate capital requirements. At a minimum, the distributable reserves could be updated, and maximum prudential adjustments could be made as regulators deem fit. For instance, regulators could require an immediate write-off of all intangibles and the inclusion of a provision for future expected losses.

These regulatory adjustments and disclosures should address ‘prudence’, but a tight prudential policy could discourage listings in the local stock exchanges from an ever-shrinking pool of global capital formation.

Investors would benefit from both sets of information – neutral financial statements and prudent regulatory disclosures. Financial statements including both ‘neutral’ and ‘prudence’ in accounting distorts reality and is helpful to no one.

A recent Financial Times article suggested that recent merger and acquisition (M&A) spree was encouraged by goodwill capitalisation. If we follow this logic, then a replacement rule to immediately write off all intangibles should encourage demergers.

The post-financial crisis rally is mainly, if not entirely, the result of central banks’ loose monetary policy. The M&A and share buybacks are just tools to inflate the asset bubble (see figures 1 and 2).

Figure 1: S&P 500 & Assets of Major Central Banks

S&P 500 & Assets of Major Central Banks

Source: Yardeni Research, Inc.

Figure 2: S&P 500 Shareholders Returns and Goodwill Build-up

S&P 500 Shareholders Returns and Goodwill Build-up

Source: FactSet, CFA Institute

Goodwill accounting

Goodwill accounting reflects the premium a manager believes is worth paying for an acquisition. Impairment accounting provides a basis to assess this premium. Amortisation serves no basis except for artificially deflating a balance sheet regardless of the economic reality. We believe amortisation would not add any decision-useful information. Instead, it will obscure the performance of the acquired business.

Without doubt, impairment accounting is untimely – generally, it is delayed for incumbent management and is premature for new management. This lack of timeliness, however, is not the fault of theoretical basis of impairment accounting, but rather is an application problem.

A move away from impairment accounting would give a pass to all those responsible for the timely recognition of impairment accounting. Nevertheless, impairments always catch up with reality, which is useful information for investors.

The timeliness of impairments could improve over time with the increased use of analytics on a wider pool of data, supported by reforms pending in the audit sector. Responding to these proposals, we argued that auditors should provide an analytical opinion surrounding goodwill impairment (like “optimistic” or “conservative” based on data analytics) instead of the binary true and fair view currently included in audit reports.

In contrast, amortisation of goodwill would in effect equalise good managers (good investments) with bad managers (bad investments). Bringing back amortisation would further remove pressure from management, auditors and those responsible for governance to recognise impairments at all, which would not be a step in the right direction.

Impairment accounting is not perfect. Comparatively, however, it is significantly better than a mechanical write-off model and is closer to economics.

Conclusion

The introduction of expected credit losses and now a potential change to reintroduce amortisation for goodwill is a move into unchartered territory considering the digital age we are living in where data is so easily available. Both changes could have unintended consequences on the real economy.

Standard-setters should avoid artificially deflating asset bubbles in financial reporting, which they did not create, and thus cannot remedy. Instead, the standard setters should push back on prudential regulatory influence and revert to neutrality.

Accounting should be a mirror that shows things as they are and should not be a tool to influence management behaviour or regulate capital (ie, by frontloading losses in accounting, which may or may not happen). If standard-setters decide to continue on a prudent path, then they need to be prepared to answer economic questions.

Investors supporting ‘prudence’ in general and goodwill amortisation in specific, need to rethink whether simplifying accounting at the expense of transparency is worth the shot.

 

 

©2021 Sloane

 

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