As you may know, I write the column on the development of IFRS for PQ magazine.
These articles are targeted at students trying to get a feel for current issues and their corporate social responsibility angle. Here are a few recent editions. Please keep up with the column by signing up to receive PQ at pqaccountant.com.
The articles are all aimed at giving P2 students a flavour of current issues, in order to give them the edge when addressing those tricky current issues questions in the P2 exam.
Winter 2012 Financial instruments and recycling
The ivory tower column is moving to quarterly reporting; after all if quarterly reporting is good enough for Tesco’s then it is good enough for me. So that means every quarter I shall bring you news from the rarefied atmosphere around the International Accounting Standards Board (IASB) in London. I think I shall use the extra space to solve practical problems to illustrate IASB developments.
I am going to start with Elton John. Imagine Elton John is thinking of coming back into football. He used to own Watford Football Club, you know. Well he decides he is interested in buying back the club he sold many years ago. But he knows things have moved on since the days that John Barnes was a young man in a Watford strip. He knows that his multiple millions are really small fry compared to the likes of Roman Abramovich. So he buys just 2% of the equity shares of Watford Football Club with a view to buying more and maybe all the equity if things work out. He pays £10k for the shares. By the year end the shares have risen in value to £13k.
In the new year he starts to question his investment and by the first month end in the new year has decided that he wants out of football. The shares are now worth
£14k. But perversely, because of the rising value, a buyer is hard to find.
Eventually a month later Elton sells for £16k. Let us have a look at how this should be accounted for and the current issue hidden in the numbers.
Firstly, I guess you know that the equity shares are financial instruments. FI are contracts that give rise to an asset in one entity and a liability or equity in another entity. Also I guess you can see that Elton has the asset (and Watford have the equity obligation). This means Elton must use the financial asset (FA) classification rules in International Financial Reporting Standard 9 (IFRS9) as follows:-
No
Yes
Cash flow characteristics test (Is the FA a simple loan?)
Of course, the equity investment is not a simple loan; it is not a loan asset at all.
So the equity is carried at fair value. Now the default recognition for gains and losses on fair value changes is the income statement, which the IASB somewhat perversely call “profit or loss”, giving us the expression financial asset at fair value through profit or loss (FVPL). But hidden in IFRS9 is a special option to carry strategic equity at fair value through other comprehensive income (FVOCI). The OCI is an ugly wart like performance report growing off the bottom of the income statement that accommodates gains that are not allowed through the p/l. The classic example is revaluation gains on property plant and equipment. But now you know that strategic equity gains go there too. But there are two recognition criteria for strategic equity:-
(1) Strategic
The entity must be able to show a strategic intent to keep the asset.
(2) Equity
The asset must be equity.
Clearly the shares in Watford fulfil both criteria and so will be carried FVOCI. But what does that mean in this case? It means the rise in value in the year of purchase of £3k (13-10) will go through the OCI. It also means that the first £1k (14-13) will go to the new year OCI. It is at that point Elton changes his mind about the investment and at that point that the equity no longer fulfils the
“strategic” criteria given above. So now the asset is classed FVPL and the final £2k gain goes into the income statement.
Now comes the development issue. The gain of £2k that went through the income statement will end up in an equity bucket on the balance sheet called “retained earnings” (RE). But the two earlier gains of £1k from this year and £3k from last year went through the OCI. So they have been accumulated in an equity bucket called “other components of equity” (OCE). Now in old fashioned language this accumulated gain of £4k is described as “unrealised”. But now that the related asset has been sold the £4k is “realised” and must move to RE. In the old days of awful IAS39 this £4k was realised by the long route. It was taken off the balance sheet put into the income statement and thereby it would drop in RE. This was the walkie talkie telephones of Vietnam movies. For those of you who work in the City of London you will know it is the big fat tower that is wider at the top than the base. And you will know that whilst progress has been fast since it got above mud level last year, the building is notably unfinished. The building is owned by an investment property company. So let us ask “can the property be classified as an investment property?”
The criteria for investment properties can be given by the following mnemonic:- I Investment
The property must be held for gain or rent or both.
C Complete
I think you can see straight away that the walkie talkie fails the middle criteria and so is classified as wip using construction contract accounting. Now that gets us started but to get into the weird twists and turns of property accounting it would be good to imagine two identical recently completed warehouses on an estate in Swindon. In this imaginary story both are owned by an investment company with a view to capital gain (let us call the company “Land”). The first building is full of building material owned by Land and the second is occupied by a retailer who use it as a distribution warehouse (let us say the retailer is Sainsbury’s). Both have risen in value by £100k during the year but Land want to carry both at cost. Land has the policy of carrying PPE property (property plant and equipment property) at fair value.
Let us start by testing the first warehouse against the ICE criteria. This property fails the E criteria. Of course, the property does not need to be literally empty; but it does need to be empty of the group. This first warehouse is occupied by Land stock and so is classified as PPE property. PPE can be carried at cost or fair value (IAS16). There is a choice. But this choice must be applied consistently across a class of assets. And Land has already made their choice by selecting a fair value policy for PPE property. So the first warehouse must be capitalised then depreciated then revalued and the revaluation gain must go to the lower performance statement called Other Comprehensive Income (OCI).
Now let us look at the second warehouse occupied by Sainsbury’s. All three of the ICE criteria are fulfilled. So the second warehouse is an investment property. In theory investment property can be carried at cost or fair value (IAS40). In theory there is a choice. But unlike in PPE, this choice is purely theoretical. The worldwide culture of carrying investment property at fair value is so strong that to deviate from this is to be seen as a maverick. So this too is carried at fair value. But there is no depreciation and the gain goes to the income statement.
Well that is all the financial reporting sorted. Now let us travel to the Ivory Tower of the International Accounting Standards Board (IASB) and find out some of the things that drive them nuts about the property accounting that has been inherited from these old standards that themselves reflect older cultures.
The first issue is choice. The choice of policies for PPE introduces inconsistency and the choice that is not really a choice at all for investment properties is just plain silly. So there should be no choice between alternatives in the standards.
The second issue is the performance reporting and this is the one that really drives the IASB crazy. In the above, there are two property gains of £100k. The figures are the same because the two properties are identical. And yet one gain goes boldly and directly into the income statement (the investment property gain) and the other gets hidden away in the other comprehensive income (the ppe revaluation). This defies all logic and it was an area into which the IASB tried to
Summer 2013 Contingent liability inconsistency
I have just won over £1 billion on the galactic lotto and foolishly I decide to sink some of the cash into football. So I buy Liverpool Football Club from Fenway. Not unreasonably, Fenway want to get some return if Liverpool get into the top four next season and qualify for Europe. They argue that any outstanding performance next season must be partly down to Fenway management. I accept, but I also want equivalent protection from an awful first season. So Fenway and I agree the following terms:
£250m now in cash.
£220m in one year if Liverpool finishes in the top half of the table next season (80%).
£121m in two years if Liverpool finishes in the top four next season (15%).
The probabilities are given above and the net assets are valued at £230m at acquisition. I buy all the shares and so there is no non-controlling interest. The cost of capital is 10%. That is plenty enough information to calculate the goodwill which requires both consideration and net assets to be valued at fair value. I am not a massive fan of double entry but I think it will help me make my point. So here goes:
Dr Consideration 425
Cr Bank 250
Cr Current liability (220x80%/1.1) 160
Cr Non-current liability (121x15%/1.12) 15
You probably know that the two liabilities represent contingent consideration liabilities and as said previously that is measured at fair value. So the goodwill is measured as follows:
£m
Fair value of consideration 425
Fair value of net assets (230)
___
Goodwill 195
___
So far so good. But what I have not told you is that litigious claimants are trying to get their grubby hands on my winnings. There are two in particular. The first has an 80% chance of getting £220m in one year’s time and the second has a 15%
chance of getting £121m in two years’ time. The timing and the probabilities are identical to those above for the contingent consideration. But these two are simple contingent liabilities and are not valued at fair value. Instead these liabilities use an on off switch style of recognition where probable outflows (>50%) are recognised in full and others are not recognised at all (being either disclosed or ignored altogether). So I ignore the second liability and recognise the first in full as follows:
Dr Cost 200
Cr Current liabilities (220/1.1) 200
So when I draw up my balance sheet a few days after the acquisition I find that I have inconsistency between my liabilities. Of course, identical liabilities should be recognised the same but they are not. How did this ridiculous situation arise?
What we have hit upon is the clash between IFRS3 on business combinations and IAS37 on provisions. The newer standard, IFRS3, was developed with getting a fair value for goodwill in mind and as a result used fair value for contingent consideration. The International Accounting Standards Board (IASB) thought nothing of this as it was both logical and in tune with a wider aim of getting all contingencies at fair value. But when the IASB actually came to roadshow their ideas on contingencies at fair value then a riot broke out in the ivory towers of financial reporting. The IASB thought maybe that it was the way that they had presented their ideas that was the problem. So they withdrew the project and later reissued a simplified proposal. But again it was roundly thrown back in their faces.
So that was it. Game over. We now find ourselves in the bizarre situation where two identical liabilities are recognised differently depending on whether they are tied up in an acquisition or not.
Autumn 2013 Revenue
The revenue project is hotting up again as it comes to a close. It has been a long and winding road to this point and I do not think any of us would benefit from a historical recap. But a little reminder of the issues and the proposal does seem to me to be overdue. So here goes. As usual I will use a question and answer to illustrate my points.
Question: One Direction
Simon Cowell has asked your company to make a movie about the boy band “One Direction”. The movie will be a mix of footage and interviews. The contract is for
$2m but it is broken down into components. $600k is payable after the filming has been shot. Another $600k is payable after the editing is completed and approved by Simon Cowell. The final $800k is payable once the head of studio has agreed the film is ready.
All the filming has been completed and most of the editing has been done. Simon Cowell is happy with the vast majority of the movie but would like a little more of Harry Styles and his bouncing bouffant in order to get the girls into a frothing frenzy. You have agreed and it will only be a few days before that content is in the movie and Simon approves and the film can go to the head of studio for final approval.
However, the year end has fallen and you are required to recognize revenue for the current year. As mentioned all the hard work has been done. So you recognize 80% of $2m as revenue in what you see as a prudent estimate of work done.
Required
Discuss the above in the context of current and proposed revenue recognition.
Answer
Intuition
The two models are described as sale of goods and sale of services but really the pair are just the “at” model and the “over” model. IAS18 encourages preparers to use either model for goods or services depending on intuition and the circumstances of the revenue.
You
You have selected the “over” model. The reference to 80% means that you are recognizing the revenue over the period of the service and have concluded that 80% has been done. Perhaps without realizing it, you have drawn a parallel with constructing a movie over a period and constructing a hotel over a period. This is absolutely fine and accords with IAS18.
Others
But other companies with similar revenue recognize that revenue at the point that risks and rewards flow. And of those that use the “at” model, some will recognize at the point that Simon Cowell approves and others will recognize at the point that the head of studio approves. This is also true in the hotel building industry. Some hotel construction is recognized at the point that the customer accepts the new hotel.
Problem
And of course this is the point. IAS18 actually works quite well for preparers. But because it is so subjective there is great inconsistency in application leading to incomparability and creative accounting.
Solution
So the IASB propose to harden up revenue recognition. They are trying to replace subjectivity with objectivity. The IASB see the current focus on the performance statement as the issue and propose that the focus should move to the position statement. In essence they propose that the revenue should be measured by measuring the growth in the asset.
Asset
So as your opening asset was zero at the year start and your closing asset is $600k then your revenue would be $600k under the proposed rules. But more significantly anyone else looking at your revenue and using the proposals would get the same answer thus showing that the subjectivity has gone leaving cold hard objectivity.
Conclusion
There it is; the revenue proposals in a nutshell. But I should be honest. I have stripped away all the fancy layers of complexity in the actual proposal to give you
Winter 2013 Integrated Reporting
Everybody is talking about “integrated reporting”. There is even a funny little arrow symbol invented to jazz up the abbreviation as follows: <IR>. I am not one to refuse a bandwagon. So here goes my two pence worth.
The International Integrated Reporting Council (IIRC) tells me that “<IR> is a process that results in communication by an organization, most visibly a periodic integrated report, about value creation over time. An integrated report is a concise communication about how an organization’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value over the short, medium and long term.”
That is a lot of fancy words, but what does it mean? Well essentially the IIRC are talking about the published annual report. Currently there is a culture of publishing the statutory financial statements in a pdf document with a management commentary appended. As the name suggests, the management commentary is the commentary of management on the fs plus their wider comments on strategy and corporate social responsibility (CSR). All the IIRC are doing is trying to encourage companies to publish annual reports that are “integrated”; in other words, annual reports that tell a clear useful story in a document that hangs together. Some entities like BP on the London Stock Exchange are brilliant at this already, perhaps because of a defensive reaction to their “dirty business” image.
Some are improving like Telefonica the parent of O2 on the Madrid Stock Exchange.
And some businesses are awful like Omnicom quoted on the New York Stock Exchange. Omnicom in particular have no excuse as they are the world’s biggest advertising agency and so should know how to tell a story.
So what is new? Well this is the thing. As far as I can see, nothing is new, except maybe one element. This push for improved corporate reporting seems to have really captured the imagination of a few hard core believers; then spread to the press who have picked up on the story and now everybody is talking about it. I have not seen so much interest in annual report presentation since the management commentary first burst on the scene in the 1980s. In the 1980s companies like Sainsbury’s hit on the idea of explaining their numbers in a commentary. Of course the city boys and girls loved it and so there was a visible rise in the Sainsbury’s share price. So everybody got interested and soon everybody was doing it. But the commentary grew like a wild unmanaged garden
So what is new? Well this is the thing. As far as I can see, nothing is new, except maybe one element. This push for improved corporate reporting seems to have really captured the imagination of a few hard core believers; then spread to the press who have picked up on the story and now everybody is talking about it. I have not seen so much interest in annual report presentation since the management commentary first burst on the scene in the 1980s. In the 1980s companies like Sainsbury’s hit on the idea of explaining their numbers in a commentary. Of course the city boys and girls loved it and so there was a visible rise in the Sainsbury’s share price. So everybody got interested and soon everybody was doing it. But the commentary grew like a wild unmanaged garden