Wayne van Zijl offers insights into our preferences for certain accounting treatments
The development of accountants has come a long way. We have sophisticated degrees designed to provide prospective accountants with the technical and theoretical foundation that they need to understand, interpret and apply IFRS Standards. We also have entrance criteria, exams and training periods before someone can become a registered CA(SA). With this rigorous training, and putting potential biases aside, why do we still find that honest and competent accountants so often disagree about the accounting treatment of new transactions? That is what this article will begin to unravel and, hopefully, you’ll learn something about yourself and why you think the way you do in the process.
We begin by going back to the basics. What are the objectives of IFRS-compliant general purpose financial statements? The answer may seem obvious, but taking a deeper look at the objectives can illuminate how different accountants think and act.
Broadly speaking, there are two distinct views on what the objectives of annual financial statements (AFS) are. We call these the stewardship and neoliberal objectives. The order in which these objectives arose is important, and I’m going to tell you a short story to help it all make sense.
Stewardship, the first and centuries-old objective, arose long before there were billions of people investing individually immaterial amounts in large, listed corporations. Imagine a time when the world was sparsely populated and people rarely came into contact with one another. Now imagine a cattle owner who can no longer look after his own cattle. He appoints a steward to watch over his herd for him. The steward would take the cattle grazing far and wide, such that the owner only sees his flock a few times a year. When the steward comes home with the cattle, the first thing the owner wants to know is how his herd is. The owner has a vested interest in understanding how his herd is. As such, the owner requires that the steward bear account of his actions over the period to the owner. Importantly, the owner requires reliable historical information about his herd (entity-specific and not a hypothetical market herd). This is so that the owner can judge the steward’s actions and hold him accountable by either rewarding or punishing the steward.
In my tale, the various villages cannot interact with other villages due to the geographical spread of villages. This means the owner cannot compare his steward’s performance to that of other stewards. In addition, the owner cannot sell his cattle and invest that money into another owner’s cattle farm. Because of these limitations, owners are forced to focus solely on their herds and managing their stewards so that the owner’s herd performs reasonably. There is no way to determine what the maximum performance of a herd could be; so a reasonable return is pursued. This is the stewardship objective. To receive reliable, historical and entity-specific information so that the owners can judge the management team’s actions and hold them accountable for their actions. This is why stewardship users prefer cost-based and entity-specific information. Cost is reliable and helps users to understand what the management team actually did with the capital provided to the entity; for example, what did they pay for this and that asset. Assets consumed in the business, for example, PPE to make inventory, must be held at depreciated cost (not market value) so that the actual amount paid for the equipment is allocated to the inventory which it produces in order for the users to assess the return the company is making (the matching concept). Holding these assets at fair value would reduce users’ ability to judge management as it becomes difficult to understand what performance and balances are due to the management’s actions and which are not.
Now fast-forward to post Word War II where we see the rise of computers, finance-centric accounting research (think EMH, CAPM and NPV), a global economy and a significant increase in both disposable income and the number of people with disposable income. Unlike in our cattle example, where there were only a few people wealthy enough to be owners, we now have millions and then billions of people who want to invest surplus cash. These individuals do not have so much cash that they can purchase significant shareholdings in corporations. Instead, they end up buying fractions of a percentage of the company. Because of this immaterial shareholding, these shareholders have no loyalty to focusing on the company they have invested in to make it work. As a result, understanding and judging management’s actions directly at AGMs is not a priority. No, these investors simply want to maximise their wealth (sound familiar?). They can do this by buying, selling or holding shares in pursuit of generating the maximum return possible. This is the neoliberal objective – wanting information that facilitates comparing companies at a point in time to determine which will provide the maximum return.
To determine which company to invest in at any point in time, users need up-to-date (current) information that easily facilitates comparing companies in the same and different industries − and even different countries. Cost models fall short against this objective as it is, firstly, out of date, reducing the user’s ability to determine the current return. Secondly, it makes comparing companies difficult as assets purchased at different times will have different costs, cost allocations to inventory and carrying amounts. This is why neoliberal users typically prefer fair value measurement for most transactions and events. It is current and, as all assets and liabilities are measured using the same model, it facilitates a current comparison among companies regardless of when assets were purchased. Lastly, it ignores how the company is currently using an asset in favour of reflecting the value that represents the highest and best use of that asset in the market.
Where’s the problem? Well, research tells us that many assets and liabilities simply do not have observable fair values, especially non-financial elements. This means management often needs to estimate fair values, making them unverifiable and less reliable than historical figures and models. In addition, these fair values incorporate market factors into the company’s financials, potentially reducing a user’s ability to judge management’s stewardship over company resources. This is especially a point of contention for stewardship users who believe that measuring assets used in the production of goods and services at fair value (equivalent to a sales price) distorts the financials and further reduces stewardship users’ ability to understand and judge management’s actions.
Accounting commentators have also argued that the IASB favours the neoliberal agenda and that this is why the IASB have increased the number of standards that permit and mandate fair value use. Some have gone so far as to argue that the IASB amended their Conceptual Framework to justify increased fair value use (I love a good conspiracy story). These commentators argue the change to relevance and faithful representation as fundamental qualitative characteristics, and the removal of reliability explicitly laid the foundation for the unverifiable, but more ‘relevant’, fair value regime.
The removal of stewardship explicitly from the 2010 Conceptual Framework led to fierce resistance. However, the IASB later clarified that they felt stewardship is still present but is included implicitly. To show how important this issue is, the IASB formally returned the stewardship as an explicit inclusion in the 2018 Conceptual Framework.
With the storytime over, take some introspection time and consider which objective resonates with you. It is unlikely you sit firmly at either of these opposites. You are more likely sit somewhere between the mid-point and either the stewardship or neoliberal objective side. Well, which is it? What do you feel the objective of financial reporting is and does this help you to understand your inherent preferences? How about your colleagues? Play a game at the (virtual) office where you each try to guess one another’s leanings. Then compare your guess and tally up the points. Games aside, knowing your colleagues and clients’ views can help you tremendously in business. It may help you be more aware of your biases and understand where your colleagues or clients are coming from during heated debates. If you understand their perspective, this article has hopefully given you the tools to better communicate and resolve your disagreement with your colleagues or clients.
Finally, what about those people who genuinely don’t seem to have a preference or inherent bias? These people do exist and are referred to as ‘flexible adherents’. But that is an article for another day.
1 Efficient market hypothesis.
2 Capital Asset Pricing Model.
3 Net present value.
Author: Wayne van Zijl CA(SA), Senior Lecturer, School of Accountancy, University of the Witwatersrand