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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.

IFRS 9 released. This is a biggie.

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On 12 November 2009, the IASB issued IFRS 9 “Financial Instruments”.  This is the first stage of a three stage project that will probably make or break the international reputation of the IASB and its deeply impressive chairman, Sir David Tweedie.

The IASB inherited IAS 32 and IAS 39 from its predecessor, the IASC.  IAS 32 and IAS 39 have been rather markedly unloved ever since their introduction.  IAS 39 in particular has been criticised for taking fairly complicated financial transactions and making them more complicated still with piecemeal rules for different types of transaction.  Although it definitely had its supporters, many people said that the perceived complexity of IAS 39 made it insufficiently understandable by most people to be much real use.

Here at ExP, we believe that IAS 39 has had a slightly unfair press over the years.  It does have its faults for sure, but it also has a decent logic at its core.  The new IFRS (which will come in three parts over the next year; the next two stages to deal with impairments and the third phase to address hedging rules) has a tough job.  Make the rules simpler and it will create loopholes that will be exploited by creative accounting.  Close every possible gap and it will result in an accounting standard that puts on weight each year with minor amendments and ends up not understandable.

The attempts at simplification are honourable.  We’ll wait to see with interest how well they work.  But well done to the IASB for keeping calm in the global financial crisis that many commentators blamed the accountancy profession for making much worse.  They were under huge pressure to make change and they appear to have done a good job in the time they had available.

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.

Was the audit evidence sufficient and appropriate?

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It could be very interesting to see how this one develops!

A UK accountancy group signed off the 2007 accounts of one of their audit client companies, having accepted the valuation of £11 million for one of its assets, a ruby known as “The Gem of Tanzania”.

In the previous year’s accounts, a different firm of accountants had accepted the valuation of the same stone at £300,000.

On the basis of the £11 million valuation the owner of the company, came to the rescue of another company Wrekin Construction. Wrekin Construction was subsequently put into administration earlier this year and the administrators, Ernst & Young, looked to have the ‘ruby’ valued.

It turned out instead of being the world’s most valuable ruby, it was in fact a lump of anyolite worth in the region of £100!

Bet those previous auditors are not sleeping very well right now.

Still it would make a really nice paperweight!

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 ?