My professors at the Graduate School of Business Administration, UCLA, taught their students that the majority of accountants believe they exist to give a true and fair picture of a company’s performance during a given period of time. This conforms to the seminal work by Luca Paciolo5 and goes beyond the more lim- ited view of accounting, which is to account for transactions – a reason why accountants are often called ‘bean counters’.
Paciolo, who was a Franciscan monk and mathematician, did not invent account- ing. Rather, as Euclid had done with geometry, in the late fifteenth century he compiled work on the art of keeping accounts, and in 1494 he published Summa da Arithmetica Geometria Proportioni e Proportionalita, which became the bible of accounting. (More on the seminal work of Paciolo in Chapter 2, section 3.) The broader view of accounting which we are taking today is justified by the fact that what is really being recorded is the economic and financial life of an enter- prise, which is ever-changing. Even if one wanted to stick to the more limited view and narrower role, the question ‘Which transaction is recorded? Simple or complex?’ would need to be answered.6
● Simple transactions begin and end on specific dates, a process which coin- cides nicely with the concept of historical cost – hence accruals.
● By contrast, complex transactions, like those involving compound finan- cial instruments, do not fall into this simplistic pattern – and, beyond that, they have a dynamic price behaviour.
A frequently encountered form of a compound financial instrument is that of a debt product with an embedded conversion option (embedded derivatives are discussed in Chapter 5), for instance, a bond convertible into ordinary shares of the issuer. The sophistication of such instruments goes beyond the confines of parochial accounting systems. IFRS requires the issuer of such a financial prod- uct to present separately on the balance sheet the:
● Liability component, and
● Equity component.
On initial recognition, fair value of the liability component is the present value of the contractually determined stream of future cash flows. These must be dis- counted at rate of interest applied at the time of transaction by the market to sub- stantially similar cash flows. (The algorithm for discounting is presented in Chapter 12.) The fair value of the option comprises:
● Its time value, and
● Its intrinsic value (if any).
IFRS requires that on conversion of a convertible instrument at maturity, the reporting company derecognizes the liability component, and recognizes it as equity. The challenge is that complex instruments, like the example which has just been given, continue multiplying; making the daily practice of accounting more coordinated. These are cases a simple accounting system finds difficult to handle.
Accounting, for instance, for stock options or pro-forma accounts, requires the use of more advanced tools than first in/first out (FIFO) or last in/first out (LIFO) concepts, both based on historical costs. Today’s complex transactions, innova- tive financial instruments, and products subject to dynamic pricing cannot be handled through such approaches. If they do, this will end in accounting num- bers that are simply meaningless.
This does not mean that the new accounting rules characterizing IFRS (and US GAAP) are beyond reproach. Critics of fair value mechanisms, and of accounting procedures that go with them, say that ‘the supposed superiority of market value over historic cost is riddled with problems’. For instance:
● Which market?
● Which value?
● At which time?
Theoretically, such critics have a point. Practically, these are arguments for the birds for the simple reason that the company’s assets find themselves in the market not on Cloud 9, and market value is king. Marking to market has, of course, a down- side – except that this not the one the critics say. The problem most frequently pres- ent with derivative financial instruments traded over the counter (OTC) is that they do not have an active market. They are practically priced only twice:
● When they are sold, and
● When they come to maturity.
In between, they have to be priced through models and, sometimes, marking to model is like marking to myth. That is why US GAAP has introduced the concept of management intent. Figure 1.1 shows that along with effectiveness of execu-
CORPORATE STRATEGY
RISK MANAGEMENT
EFFECTIVENESS OF EXECUTION
INTERNAL CONTROL MANAGEMENT
INTENT
A&L POSITIONS
Figure 1.1 Management’s intent is a dominant force in valuing the company’s inventoried assets and liabilities (A&L) positions
tion and internal control, this concept is one of the pillars in governance. Under certain conditions, US GAAP allows use of historical value:
● Ifmanagement intends to keep the instrument to maturity. In this case, it can be accounted for through accruals.
● If, however, management earmarks this instrument for trading, then it must be marked to market in financial reporting.
This is the accounting rule set by Statement of Financial Accounting Standards 133 (SFAS 133) by the Financial Accounting Standards Board. Other rules look into bal- ance sheet reporting practices, and they aim to provide equal treatment, in spite of the fact that modern business has a growing number of products and transactions which defy uniform rules. For instance, to serve the aim of a level ground, IFRS requires financial disclosure of carrying amounts of each item in the following list:
● Financial assets, at fair value through profit or loss
● Held-to-maturity investments
● Loans and receivables
● Available-for-sale financial assets
● Financial liabilities at fair value through profit or loss
● Financial liabilities measured at amortized cost.
An entity which has designated a financial liability at fair value through profit or loss must disclose the amount of change in fair value that is not attributable to changes in a benchmark interest rate; also, the difference between its carrying amount and the amount the firm would be contractually required to pay at matu- rity to the holder of the obligation.
Under the rules of IFRS, the practice of minimum disclosure is acceptable if the laws of a jurisdiction permit it, andif basic accounting principles characterizing a prudential and rigorous financial reporting policy are observed. (More on mini- mum and maximum disclosures in Chapters 3 and 4.) Policies and practices recording economic reality must:
● Reflect assets and liabilities, financial position and profitability in an accu- rate manner
● Account for all balance-sheet events under the principle of materiality, and
● Observe the going-concern principle in all aspects of financial reporting.
Both accuracy and precision are necessary in income recognition. IFRS also pro- vides for qualitative exposures describing management’s objectives, policies, and
processes for managing the enterprise as a whole, and its risks. Other qualitative disclosures aim to contribute information about the extent to which the entity is exposed, based on its internal control.
Qualitative information also includes the entity’s objectives, policies, and processes for managing its capital, as well as data about observing capital targets set by regulators all the way to consequences of non-compliance. Quite often, qualitative information contributes a useful insight into how a company views and manages its risks. In many cases, qualitative information has more predictive value than quantitative data, because it gives insight into the entity’s ability to:
● React to adverse situations, and
● Adapt to changes in risk patterns, managing ongoing developments in the external environment.
The inputs described in the above paragraphs magnify the information contained in financial statements. While classically in financial reporting qualitative dis- closures were done in footnotes which nearly nobody read, with IFRS they are upgraded to constitute integral and vital parts of financial statements. Such dis- closures involve important information that complements and explains the quantitative information.