The Complex, Contentious, and Changing Nature of Financial Reporting Standards

Posted by Robert Eccles (Oxford University), and Kazbi Soonawalla (Oxford University), on Tuesday, July 26, 2022

In The Long and Winding Road to Financial Reporting Standards we reviewed the history of how accounting standards came to exist in the U.S. as Generally Accepted Accounting Principles (U.S. GAAP) issued by the Financial Accounting Standards Board (FASB) and international Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). We showed that it took years and was simultaneously tedious and contentious. Such is the world of standard setting of any kind. Here we examine the state of financial reporting standards today to draw some lessons for the work of the International Sustainability Standards Board (ISSB) which has just begun.

As our previous piece made clear, standards are social constructs, not something grounded in the laws of physics. While there may be technically worse answers there is never a single “scientifically correct” one. Standards enable and influence the dialogue between the companies who use them for reporting and investors who use the reported information for decision making. Human judgement and compromises are involved. The process takes place in a broader regulatory context which is itself nested in a political context of competing interests.

People who are unfamiliar with financial reporting assume it’s all pretty cut and dried. Their belief is that the clear standards which have been around for decades make it easy for companies to know how to report and straightforward for auditors to know how to audit. Most of all they assume that reported figures like revenue, profit, liabilities, and assets are absolute, and that a true and calculable measure of company “value” exists.

This is far from true. Take for example, the reported number for Other Comprehensive Income (OCI). IAS 1 Presentation of Financial Statements lists the seven elements comprising a financial statement. Here is one of them:

“a statement of profit and loss and other comprehensive income for the period. Other comprehensive income is those items of income and expense that are not recognised in profit or loss in accordance with IFRS Standards. IAS 1 allows an entity to present a single combined statement of profit and loss and other comprehensive income or two separate statements;”

OCI comprise those revenues, expenses, gains, and losses which are excluded from net income, typically because they are yet to be realised. They arise from a number of categories such as changes in value of available for sale securities and cash flow hedges, actuarial gains and losses, foreign currency translation, and revaluation gains and losses. They are usually presented after net income and when added to net income provide “Total Comprehensive Income.” So there’s the bottom line and the other bottom line and they can be reported separately or combined.

FASB has the same concept and issued a report in June 2011 updating its standard saying “The objective of this Update is to improve the comparability, consistency, and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income.” It also explained that it wanted “to facilitate convergence of U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS),” and consistent reporting of OCI was one such way.

The assumption is also made that materiality, an extremely controversial topic in sustainability reporting, is well-defined. An amusing example of this is the views of the Libertarian SEC Commissioner Hester M. Peirce. But the opposite end of the political spectrum has strong views as well—and very different ones. Illustrating the challenges facing the ISSB, it will be attacked from both the Sustainability Taliban and the Sustainability Flat-Earthers.

But this simple clarity about financial reporting standards and their audits is far from the case. As the ISSB does its work, it’s important for both its supporters and detractors to put this work in perspective. We illustrate this by showing how complex, contentious, and changing the world of financial reporting is.

For example, consider the accounting treatment for financial instruments.

IAS 25 Accounting for Investments was issued by the IASC in March 1986 and IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions in 1990. After much consultation IAS 25 was morphed into IAS 39 Financial Instruments: Recognition and Measurement in 1998. In December 2003 the IASB issued a revised IAS 39. It was further amended in March 2004, June 2005, July 2008, October 2008, and March 2009, with a number of additional modifications in between.

In August 2005 the Board issued IFRS 7 Financial Instruments: Disclosures superseding IAS 30, and in July 2014 the controversial IFRS 9 Financial Instruments was issued superseding parts of IAS 39. Consequently, the disclosure requirements that were in IAS 39 were moved to IFRS 7. IFRS 7 and IFRS 9 continue to be the subject of much deliberation, with numerous amendments issued since they became effective.

Both IFRS 9 and IAS 39 were amended by the Board in September 2019 by issuing Interest Rate Benchmark Reform. This was followed in August 2020 by Interest Rate Benchmark Reform―Phase 2 which amended requirements in IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16 . Based on this history, it is highly unlikely that there won’t be further revisions in the future.

And on top of all this, when endorsing IAS 39 Financial Instruments: Recognition and Measurement for use in Europe, The European Commission imposed two “carve-outs.” These carve-outs related to the use of full value accounting and hedge accounting. Even in situations where there are not explicit exceptions and carveouts, considerable variations in interpretation, and therefore practice persist. In our previous post we refer to the variation in national standard setters, and the distance national standards may have from IFRS.

Or consider what would appear to be a much simpler standard to establish how to value physical assets. Discussion about the measurement of assets has been on-going for decades with the central debate between historical cost vs. fair value accounting. There are arguments in favor of each measurement method. Arguments in favor of historical cost cite its reliability and auditability for contract enforcement and stewardship. Proponents of fair value accounting cite the importance of using market valuations to capture underlying economic value. However, these situations are not straightforward. It is well acknowledged that within fair value there is no single “correct” valuation that captures “accurate” economic value. Considerable judgement combined with complex valuation methodologies means that fair value estimates can vary. This is particularly so when we move away from physical assets to valuing non-liquid assets and complex financial instruments, as revealed in the paragraphs above.

Balance sheets for traditional bricks and mortar companies will predominantly report assets at historical cost net of depreciation, for banks and financial services the percentage of assets reported at fair value will be higher. No two companies, even those with very similar underlying assets and liabilities, will have similar reports because their starting points and measurement bases may be fundamentally different. For example, two companies might own similar property in the same location. But if one of them bought the property 50 years before the other and both are reporting at historical cost, the book values will be hugely different.

The difficulty in not having a single “correct” way to measure and report economic transactions has often manifested in the development of alternative methods to account for the same or similar economic activity. The history of standard setting is littered with “choice” and choices are based on the exercise of human judgment which must reconcile the views of the companies who prepare the accounts and the users of the reported information. Purchase and pooling methods for business combinations, equity method and proportional consolidation for joint ventures, and capital and operating leases are a few such examples. The persistence of some alternatives are steeped in historical practice, others in ideological beliefs of one method being “better” than another. Some choices persist for decades thanks to intense corporate lobbying and politicization of the issues – accounting for leases probably being the most high profile one.

But overall, the persistence of alternatives highlights that, at best, accounting rules and guidelines are crude and clunky attempts to capture the intricacies and economic complexities of business transactions. In the interest of uniformity and harmonisation FASB and IASB have tried to eliminate choice, most notably through the convergence efforts of the Norwalk agreement, as we previously discussed. The underlying fact remains that often alternatives exist because of the highly subjective and discretion-driven nature of financial reporting, and the acceptance that no single method accurately and adequately captures underlying “true economic value” satisfactorily.

Indeed, even the overall architecture of financial reporting standards is not fixed as seen by the relatively recent introduction of the cash flow statement. Whatever a company’s profit and loss statement and balance sheet show, in the end if a company runs out of cash it’s dead—even if it is reporting profits. Cash is king! Yet the cash flow statement was only introduced in the U.S. in 1988 (although the Northern Central Railroad published one in 1863). IAS 7 was introduced in December 1992 as Cash Flow Statements and, after some revisions, was retitled Statement of Cash Flows in September 2007.

Some problems are fundamentally intractable. For example, take the case of goodwill accounting. Discussion around it has been ongoing since the middle of the 20^th century. Treatments have varied from immediate write off (against reserves) to amortization over periods as variable as five to 40 years. The deliberations around this were impassioned, revealing conceptual differences and misunderstandings on whether goodwill is an asset or an arithmetic adjustment, whether it systematically diminishes (wasting asset) in value or not, and whether it can be measured and valued with any degree of reliability.

After a lengthy process involving multiple consultations, first U.S. GAAP and then IFRS eliminated amortization completely, thereby treating goodwill as a non-wasting asset, and replaced it with an impairment testing regime (to test whether the value of goodwill has diminished for any set of reasons). But many believed this was a compromise, in part caught up in the wider issue of the elimination of the pooling method (where the assets and liabilities are line-by-line combined at book value with no goodwill arising) when accounting for business combinations was reformed. Despite (or perhaps because of) extensive debate, the accounting treatment for goodwill as initially issued by the FASB in 2001 and by the IASB in 2005 was never resolved in a satisfactory manner. Many concerns were expressed about the complexity and cost of the impairment process amongst other things.

Almost 20 years later the standard setters decided to revisit the issue with discussions around the possibility of reinstating amortization. In March 2020 the IASB reached a preliminary view to retain an impairment-only approach, and in December 2020, the FASB tentatively decided to reintroduce amortisation of goodwill. While the IASB retains this project on its agenda with a focus on more informative disclosures and further discussion on impairment vis a vis amortization, in June 2022 the FASB decided to end the four-year project that had aimed at simplifying how companies calculate goodwill impairments.

Variations in accounting practices exist at an industry level as well. Certain industries have specific organizational elements and business models, and often accounting standards, guidelines, language, exceptions, and interpretations have developed to cater to these. We see these in the case of the oil and gas, real estate, insurance and financial services, and software to name a few. The stated objective of the IASB is to reduce some of these discrepancies, particularly when some of the industry specific practices are perceived as opaque and inconsistent. Principles-based standards like revenue recognition explicitly work towards eliminating these industry specific practices.

The lessons to be drawn for the ISSB from the domain of financial reporting standards are clear. The expansive domain of issues covered by the ISSB that will require a broad range of metrics (vs. some currency as is the case with financial reporting), and the lack of an underlying framework like double entry bookkeeping suggest that the standard-setting process will be even more difficult. In March 2022, the ISSB issued “[Draft] IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information” and [Draft] IFRS S2 Climate-related Disclosures.” Comments on these exposure drafts are due on July 29, 2022. The ISSB is in its very first stages of building standards, although it has a strong foundation on which to do so. The sustainability issues it is addressing are complex, the standard-setting process will be contentious and it is almost guaranteed that the standards as originally issued will be revised, and revised, and revised again.

Does this mean it shouldn’t be done? Of course not. For all their limitations, and we will explore more in our next piece “Putting Financial Reporting Standards Into Practical Perspective” the capital markets depend upon financial accounting standards. The markets demand that these expand to incorporate sustainability reporting standards as well.