What if accountants are no longer ‘reliable’?
Umar Saeed, Special to Financial Post | December 18, 2014 7:07 PM ET
A subtle word change in the IFRS accounting handbook could undermine the traditional role of accountants
The moral hazard is alive and well. Companies constantly look to paint a rosy picture of performance by using whatever discretion is available in the accounting handbook. Often, management benefits personally from good company results. We rely on accountants and auditors to provide a check on management. Empowered by accounting rules written with the moral hazard in mind, auditors are armed to push their clients’ optimism back into line. Society expects accountants to produce reliable information because lenders, investors and other stakeholders depend on the final numbers to make decisions. Debt covenants, regulatory requirements, management bonuses – are all separate contracts that depend on accounting numbers. So why then is the international accounting handbook being re-written to eliminate this decades-old check on the moral hazard?When accountants exercise judgments in grey areas, they look to something called the “conceptual framework” for guidance. This is what holds judgment-based accounting systems together, such as International Financial Reporting Standards (IFRS). The perceived benefit over rules-based systems (such as the American handbook) is that rather than to prescribe a rule for every situation, the conceptual framework will outline principles to guide us in the face of accounting ambiguity. But the International Accounting Standards Board (IASB) has altered the IFRS conceptual framework. It has removed the word “reliable” as a desirable feature of financial information. “Prudence” or “conservatism” no longer applies. Instead, the Board believes accounting information should be free from bias and faithfully represented. Items in the financial statements should be objective and understood for what they are; whether or not they are reliable is no longer the priority.
It seems like a subtle word change, but it has the potential to change the face of financial reporting. While the academic community has expressed its concerns, the general business community should take note that this is not strictly an academic issue. Take goodwill, for example. There is no truth about the value of goodwill assets. Goodwill is created when companies pay a premium to acquire a business. We assume that companies are rational and not overpaying, so by default, the premium paid represents an intangible asset. Research shows management avoids writing off goodwill until it’s convenient or too late. Rather than prudent auditors demanding a write-off, management can leverage the new conceptual framework – prove to me that goodwill doesn’t really exist.
The proposed change is inspired by a new view toward information. Today we enjoy unprecedented access to market values. It is the age of information. Market values are observable by all and thus objective. This means that accountants simply need to find the best market values possible. But the problem with the new view comes when there’s no visibility into the market or when there’s panic. With no visibility, management can manipulate. We’re paying for a judgment about performance, and not actual performance. Distressed markets also provide unreliable information. During the height of the financial crisis (spring of 2009) the Financial Accounting Standards Board changed its accounting rules on the fly because lending ratios based on market values were shrinking the American money supply. Financial asset values reverted to cost because it was more reliable.
The balance struck between relevant and reliable information speaks to a fundamental truth about information in general; in order to produce reliable information, its relevance must be sacrificed. This problem is not specific to accounting. If the police hear a rumour about a wanted criminal, they can act on this rumour, tying up resources based on unverified information. Or they can try and confirm the report before taking any action, risking time while the criminal flees. In accounting, relevance must often be sacrificed for reliability because society depends on financial information to settle contracts. Audited statements are society’s opportunity to account for the moral hazard. If there is a compromise to be struck between relevance and reliability, auditors should be obligated to produce reliable information.
Audited financial statements are not delivered in time to be relevant by today’s standards. If you’re waiting for audited statements to find relevant values on the balance sheet, you’ve waited too long. The real value of audited statements is that they confirm a company’s expectations on performance. It’s harder for management to lie about future results if they know it’s going to be independently vetted. Accountants provide a check on behaviour more than they provide new information.
The new IFRS framework wants accountants to produce information that is free from bias. But to ask for bias-free information is to seek objective truth where there is none. We should expect companies to push financial results in their own favour. To counter this bias, we need an accounting handbook to arm auditors and allow them to push the company back in line. Judgment in accounting is not about finding the truth; it’s a bargaining zone where management and auditors settle on values that everyone can live with.
Access to market values has thrown a wrench in what has traditionally been a sound system for producing reliable financial information. But society doesn’t rely on accountants to provide up-to-the-minute advice on buying and selling stocks. It counts on them to produce numbers that it can lean on. If the IASB wants to write an accounting handbook for the world, it should consider how it’s going to be used.
Umar Saeed is a CPA based in Toronto. This commentary is based on a paper co-authored by Mr. Saeed and Professor Patricia O’Brien of the University of Waterloo and Assistant Professor Andrew Bauer of the University of Illinois. Their paper, “Reliability Makes Accounting Relevant,” was published recently in Accounting in Europe.