Tuesday, June 26, 2012

IASB Chair Says Board Will Examine Goodwill and Other Comprehensive Income Standards under Principles

In remarks at an Amsterdam accounting seminar, IASB Chair Hans Hoogervorst described pragmatism as practiced by the Board to be looking very carefully at any possible undesirable use of IFRS. Whenever the Board is confronted with a high degree of uncertainty, he averred, it will act with great caution. For example, if the standards were to provide too much room for recognition of intangible assets, the potential for mistakes or abuse would be immense. In such circumstances, he believes that it is better for the accounting standards to require more qualitative reporting than pseudo-exact quantitative reporting. The Chair said that it is nonsense to advise that accounting standards should not be set from an anti-abuse perspective.  If the IASB sees ample scope for abuse in a standard, he pledged, the Board will do something about it, adding that there are sufficient temptations and incentives for creative accounting as it is.

While the P&L is the traditional performance indicator on which many remuneration and dividend schemes are based, the meaning of other comprehensive income is unclear. It started as a vehicle to keep certain effects of foreign currency translation outside net income and gradually developed into a parking space for unwanted fluctuations in the balance sheet. There is a vague notion that other comprehensive income serves for recording unrealized gains or losses, but a clear definition of its purpose and meaning is lacking.

But that does not make it meaningless, said the Chair, especially for financial institutions with large balance sheets. Other comprehensive income can contain very important information. It can give indications of the quality of the balance sheet. It is very important for investors to know what gains or losses are sitting in the balance sheet, even if they have not been realized.

In the future, other comprehensive income will most certainly be an important source of information about insurance contracts. Recently, both the FASB and the IASB proposed that changes in the insurance liability due to fluctuations in the discount rate would be reported in other comprehensive income. Many of the Boards’ constituents requested them to do so.

Both preparers and users wanted to prevent underwriting results being snowed under by balance sheet fluctuations. As a result, other comprehensive income will become bigger and will contain meaningful information, such as indications of duration mismatches between assets and liabilities.

This decision for the use of other comprehensive income was not easy to make. Board member Stephen Cooper showed in what the Chair called  a ``razor-sharp analysis’’ that in this presentation, both net income and other comprehensive income, if seen in isolation, might give confusing information.

The IASB Chair said that the Board will try to tackle some of these problems with presentational improvements, but added that a full picture of an insurer’s performance can only be gained by considering all components of total comprehensive income. The Board will point this out explicitly in the Basis for Conclusions of the new standard.

More fundamentally, the Board will look at the distinction between net income and other comprehensive income during the upcoming revision of the Conceptual Framework. Board constituents have asked the IASB to provide a firm theoretical underpinning for the meaning of other comprehensive income and the Board will try to do so. For now, while it may not always be clear how important other comprehensive income exactly is, net income is not a very precise performance indicator either. Both need to be used with judgment, especially in the financial industry.

Finally, the Chair said that the Board will take another look at goodwill in the context of the post-implementation review of IFRS 3 Business Combinations. Although the accounting standards do not permit the recognition of internally generated goodwill, he noted, the standards do require companies to record the premium they pay in a business acquisition as goodwill. This goodwill is a mix of many things, including the internally generated goodwill of the acquired company and the synergy that is expected from the business combination.

Most elements of goodwill are highly uncertain and subjective, observed the Chair, and they often turn out to be illusory. The acquired goodwill is subsequently subject to an annual impairment test. In his view, these impairment tests are not always done with sufficient rigor. Often, share prices reflect the impairment before the company records it on the balance sheet, he cautioned, which means that the impairment test comes too late.