Written by Robert Kugel Posted on November 28, 2007
Robert Kugel, CFA, is Senior Vice President and Research Director for the Finance Performance Management practice of Ventana Research. He has been an equity research analyst at several firms, including First Albany Corporation, Morgan Stanley, and Drexel Burnham, as well as a consultant with McKinsey and Company. Rob was an Institutional Investor All-American Team member and on the Wall Street Journal All-Star list.
On November 15, 2007, The Wall Street Journal published the following letter I wrote in response to an op-ed piece written by James Turley. Mr. Turley, Chairman and Chief Executive Officer of Ernst & Young, advocates the United States adopt IFRS (International Financial Reporting Standards) in lieu of US GAAP (Generally Accepted Accounting Principles). Subscribers to the Wall Street Journal Online can find this article here.
Here's the text of the letter:
"I agree with James Turley the U.S. ought to adopt IFRS in lieu of U.S. GAAP, but the homogenization would come at a time when information technology can make this point moot. XBRL (eXtensible Business Reporting Language) makes it possible and practical for companies to simultaneously present their results in multiple standards: U.S., IFRS, or one devised by securities analysts to best reflect the nature of a specific industry. This is not all that different from what is happening to banks under Basel II with cross-border operations in Europe. While there is a high degree of commonality, each country's regulators have their own idiosyncratic requirements, so the same results are presented in slightly different ways in each country. XBRL simplifies the process of preparing statements to conform to multiple standards. When the SEC goes from a voluntary to mandatory use of XBRL for U.S. filers, it will have the ability to authorize reporting under a dual standard. Companies wanting to court international investors would be able to present results in ways that conform to the rest of the world's approach far more easily than in the days before XBRL."
Here are some additional thoughts I'd like to offer on the subject of accounting standards and XBRL:
Bookkeeping is a matter of facts; accounting is a matter of opinion. Bookkeepers record transactions precisely, but assembling the mass of these transactions into a fair and accurate representation of a business requires interpretation and opinions. Generally accepted accounting principles (GAAP) are a way of ensuring that these interpretations conform to rules driven by core accounting standards (such as conservatism). While having an accounting standard is a good thing, the challenge with these standards is that no single one adequately satisfies all of the needs of all consumers of financial data all of the time. XBRL not only makes it practical for companies to report their results in multiple national GAAPs, it also could be used to make financial reports more relevant to the industry or the needs of specific users.
In practice, some of the interpretations and opinions that go into a company's financial statements can be based on objective statistical observation. For example, the average percentage of receivables that ultimately are not paid or the rate at which equipment or fixtures wear out. Very likely, none of these assumptions are going to be precisely accurate, but with enough experience estimation can be very close. (From time-to-time, of course, these assumptions will fall apart when recessions cause bad debts to soar or technology advances instantly renders equipment obsolete.)
On the other hand, some accounting treatments are purely a matter of opinion. Debits can be either an expense or an asset. Companies spend billions on advertising -- is that an expense or an asset? Accounting rules say it's the former, but for many consumer packaged goods, all of that advertising is a vital component to creating brand equity. What about R&D? Way back when, research and development was not necessarily treated as an expense -- it could be an asset. Today, R&D must be expensed. For successful companies, though, the cumulative impact of all that R&D is an important asset. Only when another company comes along and buys that firm does the value of the accumulated R&D (as well as marketing and advertising) show up -- in the form of an intangible asset called goodwill.
We have generally accepted accounting principles for two reasons. One is to enable people outside the company to compare the results of a company to others and to assess the state of the business using standard metrics. The second is to thwart cheats who would (and, despite standards, do) twist the facts and bend opinions to overstate the health of the business.
As national economies have become increasingly integrated by free trade and rising wealth worldwide have drawn the international financial markets closer, there is the need to apply consistent standards worldwide. The national accounting idiosyncrasies were tolerable in the past; today they are much less so. People invest worldwide and companies have far more latitude than in the past of where they choose to have their equity and debt instruments traded. A single GAAP system would be valuable for the same reason that a single temperature scale is useful. Two dominant systems of GAAP may be less bothersome than a multitude, but just like Fahrenheit and Celsius, it can be difficult for people used to one scale to be able to relate to the other.
Yet, there is a fundamental problem with GAAP in the sense that it is a common denominator of business rules that are applied to a very diverse set of businesses. All businesses have their own customs and economic characteristics. Even though many of these can be accommodated easily in GAAP, there are still others that cannot. The accepted fiscal time period is one year -- a feature with deep roots in an agrarian economy. For almost all industries the year is a useful time span. However, some businesses such as shipbuilding, aerospace, and construction operate in multiyear time frames. A great deal of estimating and interpretation goes on to try to fit one year of results of multiyear projects into some notion of annual profit and loss.
The difficulty of applying a single standard of interpretation can be illustrated by analogy by looking at the 2005 US GAAP commercial and industrial XBRL taxonomy. That taxonomy was best at describing basic goods and manufacturing companies but required substantial custom tagging for services companies or firms that had different business models. Of course, it is possible to have a taxonomy that has tags for just about everything, but industries vary. In painting the picture of the state of a business, there are times when a single standard does not do a very good job.
Moreover -- and even more importantly -- the analysis of the business will often differ considerably depending on the question one is trying to answer. Bond and stock analysts look at the world differently because they are fundamentally assessing two separate issues: risk of default versus opportunity to grow. Applying one analytical approach may be very inappropriate. For instance, in 2002 an analyst at a major Wall St. firm grabbed headlines by asserting that Amazon was likely to go bankrupt. The reporters covering the story missed the fact that the analyst behind this prediction specialized in bonds. He used the same approach for assessing Amazon's future that one would use for mature businesses and made judgments that looked to limit risk, not find opportunity.
Sometimes it's the equity analysts that could learn something. Many stock analysts following Enron failed to do the balance sheet and cash flow analysis that bond analysts do as a matter of course, which might have made them suspicious at an earlier date. (Of course, toward the end, Enron's management failed to publish the balance sheet and cash flow statements when it released earnings -- in retrospect a dead giveaway. When challenged by an analyst on an earnings call as to why the balance sheet was not available when the earnings were announced, then CEO Jeff Skilling famously called the analyst an a**hole.)
Just as debt and equity analysts look at the world in different ways, some numbers are more important than others when it comes to specific businesses. This will change depending on the state of the economy and the financial system. Focusing on free cash flow, for example, may be a key measure in assessing some capital-intensive businesses, especially when debt-equity ratios differ materially between companies. But what you include in "free cash flow" can differ. For some analyses it may be before capital spending; for others it is after.
Accounting standards may be universal, but there ought to be room for standardizing the presentation of specific kinds of business in order to provide the right context. In other words, as an investor I certainly want to see the numbers presented using IFRS, but it would be handy if there were a standard set of reports that can present the results of the business in the business-specific context. Going back to the idea of a standard temperature scale, it's good to know it's 13 degrees Celsius (or 55 degrees Fahrenheit) but what does that mean? Is it too hot, too cold or just right? This depends on context. If you are storing ice cream, it's too hot, if you want to go swimming it's probably too chilly (for most of us) but if you're serving a Beaujolais wine it's just right (to my taste, at least).
The beauty of XBRL is that it can consistently (and relatively easily) present a company's results from multiple perspectives. These may be high-level national standards (US GAAP and IFRS, for example). At the same time, they may be a set of presentation standards for certain types of businesses developed by independent experts and managed by some professional sanctioning body such as the Institute for Chartered Financial Analysts (ICFA).
In fact, it wouldn't be a big thing to have multiple standards of presentation to recognize that in analyzing a business there is no single truth, just a single truth in context. The beauty of XBRL is that it makes it practical to do this. Standards are important, but XBRL has made the need for a single "standard" a moot point.