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June 2011


By Uday Chitale | Murtuza Vajihi
Chartered Accountant
Reading Time 4 mins
In the UK, the House of Lords report on audit published in March this year created headlines on competition and choice in the audit market and on the audit of banks. While their Lordships made many of their remarks specifically in respect of bank auditing and bank accounting, there were criticisms that were more generic, stemming from the rules-based nature of IFRS and the evidence suggesting that IFRS was an ‘inferior system’, which limited auditors’ scope to exercise ‘prudent judgment’. They went on to recommend that the use of IFRS should not be extended until the ‘long and uncertain process’ of achieving general agreement on IFRS was complete.

Considering that all publicly-held companies in the UK are required to report using IFRS, these are damning criticisms and ones that bear wider examination. While there is a general agreement that IFRS is a theoretically sound framework for financial reporting, practice suggests that all is not well. The reality is that companies are effectively using their own individual financial reporting frameworks when they communicate with the market. GAAP measures tend not to be broadcast, but frequent reference is made to ‘adjusted (EBITDA) (Earnings Before Interest, Taxes, Depreciation and Amortisation)’. The more cynical might suggest that everyone adjusts their EBITDA to suit themselves and that it forms a sort of ‘earnings before the bad stuff’. However, many auditors insist that GAAP figures have equal prominence with non- GAAP measures, the reality is that analysts and the media reflect other measures, such as free cashflow and maintainable earnings.

There are also a number of areas where business people intuitively distrust IFRS and those tend to relate to areas where the economics implicit in accounting judgments fail to reflect the business decisions behind them.

For instance, in IFRS, the excess of the acquisition cost over the individual net tangible asset values of a business acquired represents a number of intangible assets, whereas under UK GAAP it was all bundled together as goodwill. The values attributed to brands, customer lists and other such intangible assets, all require separate valuation exercises using theoretical models and a number of variable inputs.

The resulting values can vary greatly, depending on the inputs used. I have rarely met anyone in business who ascribes values to intangible assets in such a way, when considering a business acquisition or otherwise, and it is hardly surprising that doing so for accounting purposes causes a degree of the financial reporting outputs to be distrusted.

This distrust of formal financial reporting has contributed to the annual report becoming more a document of record than a live source of information. Companies are now more sophisticated and have a number of channels through which information is given to the market. When taken in conjunction with the blandness and sheer volume of narrative reporting and disclosures in annual reports, it is little wonder that some now see them as anachronistic.

What is to be done? On IFRS, I remain convinced that it is the nearest thing to a conceptual framework that can work globally and scalably for different sizes of companies. However, there are areas where it has become overly complex and produces results that just do not make sense to people in business. These need a long hard look, particularly around asset and liability valuation, impairment, intangibles, share options and deferred taxation. It should be fundamental that an accounting framework is scalable so that we can actually have comparability between companies that have different ownership characteristics, but which might otherwise be identical. IFRS can be put in this position if its complexities are resolved and if its rebalances use fundamental principles to give weight to prudence, comparability, reliability and understandability.

If the Lords’ report can start a sensible debate around IFRS and financial reporting more generally, it will have been worthwhile, irrespective of its sharp analysis of the competitive framework of audit.

[Source : James Roberts, Accountancy, May 2011 (excerpted)]

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