Cuckoo!

Thoughts on recent remarks by IASB Chair Hans Hoogervorst

In the famous film The Third Man, Orson Welles’ character Harry Lime delivers the following meditation: “You know what the fellow said – in Italy, for thirty years under the Borgias, they had warfare, terror, murder and bloodshed, but they produced Michelangelo, Leonardo da Vinci and the Renaissance. In Switzerland, they had brotherly love, they had five hundred years of democracy and peace – and what did that produce? The cuckoo clock.” Not a fair commentary by any measure of course, but a stimulating one, proposing that mankind’s greatest achievements can hardly be separated from its most brutal, fraughtly complicated weaknesses. It comes to mind on reading Hoogervorst’s recent speech in Zurich, “Switzerland and IFRS,” in which he claims to “offer some perspectives on the causes of complexity and what (the IASB is) trying to do about it.”

The speech contains the following passage, which seems to me reasonable enough:

  • “…most of the complexity and length of financial reporting is a reflection of an increasingly complex economic reality. If we really want simple reporting, we should do away with derivatives, defined benefit pension schemes should go out of the window, companies should stop dressing up liabilities as equity instruments, companies should stop taking over other companies, insurers should stop mixing insurance with investment products and the list goes on.
  • Clearly, this is not going to happen, so complexity is a reality we have to live with. Having said that, not all complexity is a given. In the development of IFRS, the IASB is constantly confronted with trade-offs between our desire to give as much information as possible on the one hand, and our wish to keep costs for preparers manageable on the other hand…”

All right, but surely more is needed here. Some items – smartphones, say – are immensely complex, but not in a way that the user needs to know or care about: a great part of the complexity is in supporting the functional simplicity of the experience it delivers. Some other things – like the game of chess – could hardly be simpler if assessed by their core elements, but support almost limitless intellectual contortions. Financial reporting seems to have elements of both these – it synthesizes a large amount of data into a summarized form of communication, but unlike the smartphone, engaged users need to understand at least a little about how it does that. Some of the disclosure provided for this purpose no doubt isn’t ideal, and the recent amendments to IAS 1 are a good start in that regard. But the demands on issuers and users have to be assessed against the overriding object – whether their efforts do or don’t contribute to more risk-appropriate capital allocation decisions. If they do, then those demands are no more than an appropriate part of the price for participating profitably in the capital markets, and we should be embracing the complexity rather than apologizing for it.

Instead of going down this road, and perhaps driven by an excessive desire to play to the home crowd – Hoogervorst then reaches into Swiss GAAP to offer the following simplistic example of such a “trade-off”:

  • “…under Swiss GAAP, goodwill resulting from acquisitions can be directly written off against equity or else it can be amortized. This relieves reporting entities of the burden of yearly impairment exercises that is required under IFRS. We acknowledge that impairment testing is costly. That is precisely the reason why in the IFRS for SMEs we allow companies to amortize goodwill over time. But what is also evident from both academic research and our own outreach is that goodwill impairment contains very important information for investors. Amortization of goodwill, on the other hand, has traditionally been completely ignored by investors, and is immediately added back in their analyses.
  • So I believe that IFRS gives the investor more relevant information in this respect than Swiss GAAP, but I admit it comes at a price. In our Post-implementation Review of IFRS 3 Business Combinations, we will take another look at this trade-off.”

This seems to me quite inadequate. If there’s a good argument for amortizing goodwill (which I personally doubt, but for which some can argue rationally) it certainly doesn’t lie, as Hoogervorst seems to say, in whether or not the resulting accounting entries are commonly “ignored” by investors: no doubt goodwill impairment charges are frequently ignored too, along with much else. Certainly one can ask whether the mechanics of the goodwill impairment test might be amended (albeit that it’s hardly a “burden” in the big corporate scheme of things), whether disclosures in that area might be reduced, and so on. But to blithely suggest that such a core element of the financial reporting model might be overturned based on a reassessment of its relative “price” seems to me remarkably flippant and unprincipled, at least as it’s presented here.

Regardless that the example goes to one of the questions posed in the IASB’s request for information associated with its review of IFRS 3, Hoogervorst has a choice in what he does or doesn’t choose to highlight. If he had to bring this up at all (which he didn’t), it should be to convey the difficult parameters of the issue and to urge stakeholders to engage with its nuances (for example – shouldn’t any adequate amortization-based approach to goodwill encompass some ongoing form of accompanying impairment testing anyway, for the unamortized balance?), rather than to pander with notions of an easy way out (playing the cuckoo in his own nest, you might say). It makes you wonder whether he perceives financial reporting as anything more than a big bartering table.

I suppose he must though, because he goes on to defend the forthcoming lease accounting standard – which can’t possibly be a much cheaper proposition than the goodwill impairment test – as one for which “costs should not be exaggerated” and for which in any case is justified by the economic benefits. But given what preceded it, this seems like little more than infatuation with this year’s model. He concludes by saying “We are ready to act where we can, but I have also made it clear that we cannot compromise on our primary goal of faithfully reflecting economic reality” – which hardly chimes with the section I highlighted. Perhaps we should interpret this incoherence as Hoogervorst’s notion of the “realism” required for a financial reporting renaissance. But he needs then, like Harry Lime, to become a strategically eloquent defender of the necessary warfare and bloodshed….

The opinions expressed are solely those of the author

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