It is sometimes said that the scariest sentence in the English language is: "I am from headquarters and I am here to help you". This reflects that, despite the probable good intentions of senior managers, they are far removed from daily operational problems. Consequently, it is often very difficult, or even impractical, to implement their decisions. This causes frustrations with which we are all only too familiar.
In the investing world, the accounting standard-setters are the equivalent of “headquarters” in this scary sentence. Many countries require listed companies to report under International Financial Reporting Standards (IFRS), which have a stated objective of ensuring that financial reporting information is useful for making investment decisions. However, despite the well-meaning intentions of the accounting standard-setters, new accounting requirements often seem to create more frustration than relief for investors. The number of incidences where investors feel the need to adjust IFRS information before they can make investment decisions bears testimony to this.
For example, the last amendment to IFRS with wide-reaching impact was IFRS 16, which changed the accounting requirements for leases. The objective in changing the lease accounting requirements could be naughtily described as wanting to reduce accountants’ fear of flying. Under the old accounting rules, the intersect of business and contracting considerations meant that very few aeroplanes existed in financial reports. The accounting standard-setters wanted to eliminate this outcome and its chair at the time, Sir David Tweedie, famously joked: "One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet".
Essentially, the accounting standard-setters were attempting to align financial reporting with what the accounting standard-setters understood the requirements of investors to be. Because the old accounting rules required only some leases to be recognised as liabilities, many valuation texts argued that investors should adjust financial reports with “as-if” liabilities for other leases. Only then, it was argued, would comparisons between companies be meaningful. Based on the assumption that investors were creating liabilities for all leases, accounting standard-setters tried to help by requiring companies to do so on investors’ behalf. However, many companies around the world continue to report what results would have been if the old accounting rules for leases had still applied (i.e. if some leases had not been recognised as liabilities). This suggests that the theory in valuation texts about what investors should do differed from what investors were doing.
The impact of new accounting standards that became effective after IFRS 16 has been more limited. For example, IFRS 17 had the aim of making insurance accounting more comparable and understandable. As this was limited to a single industry, only the insurance specialists were particularly affected. Furthermore, the impact of the recently issued IFRS 19, which aims to reduce the disclosure burden for entities that do not operate in the public eye, is unlikely to affect most investors.
However, another attempt of accounting standard-setters to help investors, namely IFRS 18, is likely to have far greater impact. The most important consequence of the new accounting rules in IFRS 18 is that firms will have to revamp the way in which they report income and expenses. The accounting standard-setters appear to have been primarily motivated by a desire to standardise what is meant by “operating profit”. As a result, the income statement will now be presented in a way that groups income and expenses into operating, investing and financing categories. This is argued to create an intuitive feel for income and expenses, as cash flows are already separated into similar categories in the cash flow statement.
Nevertheless, although the terminology may be the same under the new accounting rules, classifications will differ between the income statement and the cash flow statement for some items. Therefore, an operating expense will not necessarily be classified as an operating cash outflow. This means that it could become more difficult to assess cash generating ability, because profits and cash flows will not necessarily interrelate as might be expected from the terminology used.
IFRS 18 only becomes effective for reporting periods starting on or after 1 January 2027. However, investors should already be paying attention to these changes for several reasons. Firstly, we should be identifying the key information that we currently use to make investment decisions. It is important to understand whether the availability or content of this information could change under the new accounting rules. For example, if we make use of comparisons between a profit and cash flow number, we need to consider whether historical trends will remain relevant.
Secondly, IFRS 18 allows companies more flexibility in choosing how income and expenses are shown in the income statement (where this flexibility is currently relegated to the notes). More specifically, where current accounting rules force companies to choose between “function” and “nature”, IFRS 18 permits companies to mix these approaches for income and expenses within the operating category. Investors should be using management engagements ahead of the changes in accounting rules to lobby for relevant information about income and expenses to become more accessible.
Finally, companies will start preparing for the new accounting rules no later than 2026, because they need to collect information to present comparative information under IFRS 18 from 2027. This may cause companies to incur significant costs, depending on the complexity of the business, its existing systems and its financial reporting processes. Consequently, IFRS 18 implementation can easily become a scapegoat for all manner of unrelated losses and costs. Responsible investors should be holding management to account to ensure that the consequences of management’s decisions are not too easily blamed on “headquarters”.
“If you fail to plan, you are planning to fail!” – Benjamin Franklin