You may recognise this volcano but what about recognising the revenue?

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It seems that a certain volcano in Iceland is going off again.

At the time of writing, a number of UK airports have had to close because of drifting volcanic ash. This, it seems, is likely to be an ongoing problem, especially for more northern European countries.

I have a flight booked in a couple of weeks’ time. I am innately cost conscious and so booked a non-refundable, non-changeable ticket.

Under the Framework definition of an asset and a liability, the airline has received my money and the only obligation that they have is to incur the marginal costs of flying me there, which are likely to be fairly small.  Using the logic of the Framework therefore (and the probable logic of the new accounting standard on revenue recognition that is likely to come through in a couple of years’ time), they would be able to book revenue at the time that the sale was made.

Under the approach of the extant accounting standard IAS 18, however, revenue can only be recognised when the service is provided.  This means that none of my cash is currently in the airline’s profit or loss.

That approach has always seemed excessively prudent to me, as the chances of having to refund the money to the customer has always seemed remote.  I’ve long believed that IAS 18 is in need of replacement with something that focuses more accurately on assets and liabilities.

Mount Eyjafjallajokull has made me wonder whether perhaps holding all revenue in deferred revenue as a liability until it’s sure that it’s no longer a liability might not be such a bad idea after all….

They’re merging with a competitor so surely it must be a merger? In fact it’s not a merger but…

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The troubled US airline industry is going through a period of consolidation.  Consolidation in the sense of companies getting together to reduce their fixed costs per transaction, not consolidation in the sense of producing group accounts.

This article, however, is about group accounts.  The circumstances of the Continental/ United merger do make it look like it’s a voluntary merger and the stock market was conspicuously unsurprised at the news.

The problem is that IFRS 3 requires that for all new business combinations (a new business combination is one that doesn’t arise from a reconstruction of a pre-existing group), an acquirer and acquiree is identified.  This company is then the parent.  Often, a merger happens by a share-for-share exchange and the new parent chooses to change its name to a suitably “merged” sounding name.  But as far as the rules are concerned, one must be the acquirer and the other the acquiree.

So a decision will need to be made about which company becomes the parent. It’s likely that this will be the company with the greater retained earnings.  It’s also likely that formal merger will happen on the first day of the parent’s accounting period, so that a full year of “merged” profits is consolidated.

The group retained earnings of the new group will certainly be less than the sum of their individual parts, since the acquiree’s pre-acquisition profits will not be consolidated.

This may seem harsh if it’s truly a genuine merger, since the idea of pre-acquisition reserves should perhaps be restricted to where there’s a genuine acquisition.  So why is this option not allowed?  You can probably guess – it was subject to creative interpretation of what constituted a merger.  The IASB stated that they believed genuine mergers would probably happen globally about once every five years.

Perhaps Continental/ United is one such genuine merger?

Historical costs deserve more friends.

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Historical cost accounting lies at the core of accountancy.  It’s derived from the simplicity of debits and credits and is therefore where we all start in our studies and practice of our profession.

The idea is simple; I pay some cash and that gives me either an expense or an asset.  With the exception of freehold land, all assets are simply future expenses, as all assets except freehold land wear out.  This means that sooner or later, they’ll all pass through profit and loss as an expense.

There are some well-known problems with historical costs.  Most notably, they begin to fall apart in terms of reliability during a period of inflation.  Depreciating the cost of a factory bought 20 years ago gives a lower depreciation charge than a factory bought last year.  If inventory is held for a long time before sale, historical cost accounting matches today’s revenue with yesterday’s costs; thus overstating profit.  All these things damage the relevance and reliability of financial statements and reliability is one of the core characteristics of what makes financial information useful, according to the IASB Framework.

Relevance and reliability aside, let’s face it; historical cost accounting is just not very sexy.  Dreary and reliable and borne of something as mundane as debits and credits, it’s hard to get excited about a balance sheet (SOFP) that shows its assets just as what was paid for them rather than what they’re worth.  So, enter revaluations and fair values.  Modifying historical cost accounting for revaluations means assets are shown at a more up-to-date, relevant (and frankly higher) value.  But it comes with a downside – your depreciation charges will now be higher, thus reducing profit.  Your eventual profit on sale will be lower, as the carrying value used to calculate profit will be higher.  Increasingly, you might come to have problems with investors not trusting the revalued amounts.  So perhaps we’ve substituted one form of plodding unreliability for a higher octane form of volatile unreliability?

This is a debate that has two valid sides to the argument.  But recent stock market falls and pervasive impairment losses mean that we suspect that the familiar world of pure historical cost accounting might start to look more attractive again.  It might be a bit dull, but at least people know what it means.

Is it a boat? Is it a plane? No, it’s the world’s biggest non-current asset?

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I just read that Royal Caribbean have recently entered the World’s largest passenger ship – the Oasis of the Seas – into service.  It is enormous, with elevators to carry passengers up and down the 18 passenger decks.  To my old fashioned tastes, it looks rather like a floating housing estate, but I think that’s just age.

Whilst watching an online tour of the ship, I found myself being rather accountant-like about it.  What’s it’s design life and is its useful life going to be shorter?  Do cruise ships go out of fashion before they become too unreliable to sail?  Will it generate more revenues in the early years than the later years?  So should sum of digits/reducing balance depreciation be used instead of straight line?  Of the cost of £800 million to build it, how much is down to the hull of the ship itself and how much to the decoration?  The decoration is no doubt ideal for its target customers just now, but it’s bound to look hopelessly dated in twenty years’ time.  So what’s their policy for “unbundling” the ship into separate components and depreciating each over a different life?

There is much criticism of ship owners sending their decommissioned ships to developing countries to be broken.  As a cruise company, this ship will no doubt not suffer that fate, as to do so would damage the company’s public relations.  So there might be a constructive obligation to decommission the ship in about 30 years’ time at a loss.  Have they recognised that as a liability and discounted to present value?  They should have done, because IAS 37 requires it.

Finally, the interview with the CEO of the company starts by admitting that 2009 has been “horrible” and 2010 doesn’t look much better.  Evidence of impairment right at launch perhaps?  IAS 36 only allows companies to project revenues five years into the future when valuing assets (unless an extension to this period can be justified). Will the global recession be over by then?

So whilst other people see a big ship, I see a floating cocktail of accounting and audit issues.  Is this normal?

BA and Iberia to merge. Except not.

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British Airways is a big airline and so is Iberia; the flag carrier airline of Spain.  Both have experienced considerable difficulties in recent years with the global recession greatly reducing revenues and causing operating losses.

For nearly two years, the two airlines were in discussions about merger, in order to share routes and operating fixed costs.  The deal was finally announced in mid November 2009.

The deal is that the two airlines will fuse to create a new business with the working name of Topco. Topco’s capital will be 55% owned by BA’s shareholders and 45% by Iberia’s shareholders. The board will meet in Spain and the CEO of BA will become the CEO of the new business.

For accounting purposes, mergers don’t exist. There is always an acquirer and an acquiree; respectively being the controlling party and the controlled. In this situation, we accountants see it that BA has just done a deal to acquire a new subsidiary, called Iberia.  Assuming that Iberia’s shareholders agree to sell.  And before that happens, there’s the minor issue of BA’s huge deficit on its defined benefit pension scheme to sort out. IAS 19 produces some deeply unattractive pension liabilities on BA’s statement of financial position.

When is a discontinued activity not a discontinued activity?

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General Motors has had a difficult time of late, but things appear to be getting better.  Dogged by poor sales in its core US market, it was forced to raise cash by drastic means.  This involved agreeing the sale of its European subsidiaries (Opel and Vauxhall).  The sale of both to a consortium including Russian banks and Canadian car spares manufacturers. There were legal formalities to complete, but the deal had been announced, largely supported by the German government and looked certain to go through.

At the start of November 2009, it was announced that the board of General Motors had met after a mammoth session and decided not to do the deal to sell its European businesses.  The environment for GM had improved more rapidly than expected and a sale no longer looked necessary.

A discontinued activity is defined in IFRS 5 paragraph 32 as a separate business unit that (a)represents a separate major line of business or geographical area of operations,(b)is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations or(c)is a subsidiary acquired exclusively with a view to resale.  Vauxhall/Opel sounds like it would fit this definition.  It may have been presented as a discontinued activity after being reclassified as held for sale.

It’s unusual for a volte face this big to happen, but it occasionally does. It can produce odd effects in profit, as items are written down to expected sales value and then reclassified at their previous carrying value.

Xerox Corporation and Affiliated Computer Services (BPO world leader) unveil planned new business combination

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Everybody is calling it a merger, but do mergers really exist? And from what date does the combination happen?

Key aspect 1: Determining if IFRS 3 applies and identifying the acquirer.

IFRS 3 applies only to combinations as a result of which an entity (identified as “the acquirer”) obtains “control” of “the acquiree”. Is that the case?

Yes: Xerox is set to acquire 100% of ACS, with ACS expected to “continue to operate as an independent organisation” (branded “ACS, a Xerox Company”) and with Lynn Blodgett (ACS CEO) reporting to Ursula Burns (Xerox CEO).

Key aspect 2: Determining the acquisition date

IFRS 3 requires the combination to be acquisition accounted for at the date when control is obtained. Is the “acquisition date” determinable based on released information?

Not quite: the agreement was signed by the two boards on 28.09.09, but the transaction is “expected to close” by the end of Q1-2010.

Key aspect 3: Recognising and measuring the consideration transferred

IFRS 3  requires consideration transferred to be fair valued at acquisition date, with any transaction costs being expensed and not included as part of the consideration. How does it work in the case?

Xerox is set to pay $18.6 in cash and issue 4.9 shares in exchange of 1 ACS share. Considering share prices on the eve of the deal being announced, such consideration would have amounted to $6.2 billion. However, due to the subsequent fall in Xerox’ share price , the fair value of the agreed consideration went down to $5.5 billion. By the “acquisition date”, the fair value of this consideration may again vary. As to the costs of issuing the new shares raising the $3 billion expected to be needed to finance the deal, IFRS 3 would want them expensed in acquirer’s books and NOT considered as part of the consideration paid (and, therefore, potentially capitalised as goodwill).

Are accountants to blame for the global crisis?

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A few accounting standards arguably have an unfortunate tendency to exaggerate the economic cycle.  During a time of economic downturn, the chances of a company having impaired assets is increased.  This has the unfortunate effect of taking poor trading results and augmenting them with impairment losses.  In other words, accounting conventions take a bad situation and make it worse.

Or so some people would say.

Some financial instruments are also shown at fair value.  Fair value is primarily decided by reference to market values. During a slump, this also makes reported results worse.

The argument advanced by many is that we ought to amend accounting standards to introduce some sort of dampening effect – requiring companies to impair assets or make provisions during times of boom and release these provisions during a slump.  This, it is argued, is only the equivalent of making hay while the sun shines.

There’s only one problem with this idea of “dynamic provisioning”. Mostly, it flies in the face of the definition of a liability in the Framework. Also, it’s precisely the opposite of what IAS 37 and IFRS 4 (insurance contracts) aimed to do. Fiddling with the accounts to save people from unjustifiable optimism and excessive, groundless pessimism might be politically popular in the current  market turbulence, but arguably it would only reduce the reliability of financial reporting in the long term.  Investors ought to be smart enough to use other information provided to them, such as the statement of cash flows, before reaching judgement on the desirability of a company’s shares.

We hope that the IASB stick to their guns and resist the pressure to codify creative accounting and massaging figures by bogus provisions. We’re confident that they will.

The largest single property deal in UK history, both in form and…in substance

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Sale and leaseback of a very noticeable building by a very noticeable bank! Is this a sign of a bank needing cash flow to shore up its solvency? Or just a good opportunity at a good moment in time? And how do we tell the shareholders about it?

In 2007, HSBC sold and leased back its iconic headquarters in London, the 1.1 million square foot, 210 metre high, tower at 8 Canada Square, Canary Wharf.

Imagine yourself in a top floor office as a proud HSBC accountant about to book this transaction in the bank’s IFRS statements.

The buyer-lessor was a wholly-owned subsidiary of Metrovacesa, S.A. one of Europe’s highest profile property companies. Under the terms of the agreement, HSBC sold the tower for £1.09  billion and leased it back for 20 years (with an extension option for a further 5 years) against an annual rent of £43.5 million. HSBC had moved in 2002, having incurred some £500 million in tower’s construction costs.

So, how would you account for it?

First, you need to determine the nature of the lease: finance or operating? Based on available information, the lease has fair chances to be operating, as (a) the term is 20(+5) years, with the building (the useful life of which may exceed 40 years) being only 5 years old on lease inception, and (b) the present value of the agreed annual rents probably falls significantly below the upfront selling value.

If that would be the case (operating lease-back), you would (a) take the building out of HSBC’ balance-sheet at its carrying amount, (b) recognise upfront the profit made on disposal, and (c) subsequently take the incurred rental costs to operating expenses, on an accruals basis.

Fairly straightforward, isn’t it ?