Does SOF Override GAAP

Does SOF override GAAP?

I was astounded to read in Business Day recently that the IASB does not apply rigid thresholds but focuses on substance over form and allows the exercise of judgement. Having been misquoted in the media in the past, I can only assume that they got the wrong end of the stick from the person they interviewed.

Let’s look at the facts:

1. AC101.11 states that financial statements should present fairly the financial position, financial performance and cash flows of an enterprise. It goes on to state that the appropriate application of Statements of GAAP results, in virtually all circumstances, in financial statements that achieve a fair presentation.
2. AC101.12 states that if financial statements claim to be in compliance with Statements of GAAP they should comply with all the requirements of each applicable Statement and each applicable Interpretation.
3. AC101.13 strengthens this point by stating that inappropriate treatments are not rectified either by disclosure of the accounting policies used or by notes or explanatory material.
4. AC101.14 only permits non-compliance with GAAP in “extremely rare circumstances”. In such cases, onerous disclosures are required.
5. AC101.21 states that management should select accounting policies that comply with Statements of GAAP and the Interpretations. Only if there is no specific requirement in such a statement may the enterprise resort to “economic substance of events and transactions and not merely the legal form”.

When AC101 was in the process of development, there was a large school of thought that wanted paragraph .14 taken out of the statement. The feeling was that if we open the door ever so slightly, there would be a stampede to widen the gap. In fact, I understand that certain countries that adopted IAS 1 deleted this paragraph from their version of the statement.

Just imagine what will happen if SOF was allowed to override statements of GAAP. Here are a few ideas:

1. Internally generated goodwill and brand names meet the definition of an asset and the economic reality is that they are assets so ignore GAAP and capitalise them.
2. Economic reality tells us that a liability should be measured at its discounted amount. We should, therefore, discount deferred tax: the statement got in wrong.
3. Foreign exchange losses incurred after the arrival of inventory or plant is, in reality, part of the cost of the asset so should be capitalised.
4. LIFO definitely gives the better economic measure of profitability so should be used for interchangeable items of inventory.

One could write a book on the possibilities!

Having presented workshops around the country to asset managers, I get the message that they would much rather have financial statements that are drawn up in accordance with pre-determined rules (together with full disclosure). There are no measurement standards for “economic reality”. Give ten accountants a problem to solve using this concept and you will probably get five different answers. Give the problem to someone whose pay packet depends on the size of the profits and you will definitely get biased solutions! And just imagine the poor auditors trying to defend an alternative point of view where economic reality judgement are the only guidelines to work on.

A misconception is being repeated around the world that principles are better that rules. I find it amazing that such an illogical thought can gain acceptance so quickly. It is just like a stock exchange bubble: say it often enough and everybody will believe it. The argument goes: “You can structure deals in such a way as to avoid a rule.” But have you ever thought what you can do with a principle? Here are two of many examples to illustrate:

Our AC111 states that revenue from services should be recognised “by reference to the stage of completion”. The statement goes on to state that the stage of completion “may” be determined in a variety of ways. It then gives some vague guidance. This leaves the door wide open. In the US they have rules for every type of service revenue so there is no doubt about how to account for revenue and the users can have confidence that, if the rules are adhered to, different enterprises with similar revenue will be comparable.

Our AC412 states that special purpose entities should be consolidated when the substance of the relationship between an enterprise and the SPE “indicates” that the SPE is controlled by the enterprise. The statement goes on to state that control “may” arise . . .” I have been in structuring meetings where bankers have advised clients that the statement is far too vague to be of any effect. Contrast this with the US statement that specifies exactly when an SPE should be consolidated and when not. Yes, Enron was able to structure deals to avoid consolidation. However, in those cases it would probably have been wrong to consolidate the SPEs as it would not have made sense to do so. Contrast this with not bothering to consolidate at all because the statement is so vague that one can do virtually anything.

If you have ever tried to work out what development expenses to capitalise under the statement on intangible assets, you would have wished for some rules to guide you. Because of the vagueness of this statement, analysts are inclined to write off capitalised development expenditure as they do not trust the judgement of those who prepare the financial statements.

Many years ago during the pre IASC meeting banter, the UK delegate turned to the US delegate and said something like: “Your problem is that you need rules because you can’t think.” The US delegate’s retort was something like: “You don’t want rules because you want to arrive at the answers that suit your own agenda.” As a budding analyst, I would definitely choose rules over principles. To break a rule you’ve got to be a crook. You don’t even need to taint your soul to arrive at the desired answer when GAAP is governed by vague principles. And if you think that it is easier to structure deals to get around rules, think again. There is a whole industry in SA based on structuring deals to get around Statements of GAAP.