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Radical change: tax & accounting; mispriced complex financial instruments
Radical change in UK's taxation of acquired intangibles:
In recognition of the new accounting standards, the UK instituted a fairly radical change in the taxation of acquired intangible assets, which change took effect on April 1, 2002. The convergence in accounting standards between US GAAP (Generally Accepted Accounting Practice) and the International Accounting Standards has reflected this fairly radical shift in the fundamental basics of accounting - from an historical cost basis to fair value - and now also applies to practically all countries in the world including the UK.
A crisis in the Accountancy Profession?
But very worrying from a strategic standpoint is that many in the accounting profession, including the academics in most, if not all, the universities and business schools, appear to have largely ignored the implications of this shift from historical cost accounting to fair value accounting despite the fact that this shift has been taking place over the past 15 years or so. Of course, current courses do offer fairly comprehensive introductions to the new accounting standards, but these tend not to address the underlying valuation-related concepts underpinning these new standards. For example, although many universities offer courses in option pricing, within the accounting faculties these courses tend to be offered only at Masters' degree level. As a consequence of this situation, most new graduates emerging from our Universities with a degree in accounting or business administration, and most recently qualified accountants from any of the professional accountancy institutions, have little or no training in how to adequately value acquired intangible assets or share-based payments such as employee share options with complex performance conditions attached.
Even the United States itself is affected:
Concerns have been expressed by senior figures within the accountancy profession regarding this situation in the United States itself. An advisory group to the USs accounting watchdog, the PCAOB, has urged the PCAOB and the audit industry to look into auditors lack of education in the various valuation methods. A member of this advisory group said, moreover, that accounting students werent learning fair-value concepts in the USA1, and the advisory groups members have suggested that the US's Certified Public Accountants' program should include training on fair-value so that the industry did not have to rely only on valuation specialists. In this context, it is worth bearing in mind that the United States has many hundreds of qualified and trained business appraisers, so placing it in a very advantageous position compared to practically all other countries in the world with the possible exception of Canada.
Is the future of the new accounting standards in jeopardy?
ADOPT Training believes the situation outlined above to be sufficiently serious as to place the future of the new accounting standards in jeopardy. This is because the situation appears not to be confined to the UK and, as intimated above, is being replicated in many other countries as well. It would be a great shame were the new accounting standards to fail, as they were evolved in a genuine attempt to address serious shortcoming in the previous standards.
Not only were these standards often very different between countries but were often completely incompatible with one another. This made it very difficult to value investments in similar companies but in different countries, and significantly added to the costs incurred by companies wishing to reach potential investors in other countries than their own home base.
One significant recent development has been the fairly radical proposal floated by the Securities & Exchange Commission in the United States of America to adopt International Financial Reporting Standards. This represents a major change in previously held positions and there remain significant objections and obstacles to overcome before this proposal is likely to gain any traction.
Mispriced complex financial instruments:
More recently, dramatic turmoil in the financial services industry has been directly linked to the mispricing of complex financial instruments such as CDOs or "collateralised debt obligations". This mispricing was a consequence of not only technical (i.e. programming) errors but also a series of policy errors made by Rating Agencies when rating bundles of sub-prime mortgages in the USA over the period from the late 1980s through to mid-2007. Such policy errors included the lack of and/or abandonment of "diversity scores" which prevented securities with homogenous collateral pools from winning the highest ratings, as well as the adoption of changes to the basic rating methodologies to allow prior ratings to be maintained in the face of technical errors having been identified and corrected2.
The knock-on effects of the above developments manifested themselves progressively during 2008 in a world-wide credit crunch, as a number of banks around the world began to fail, and both share prices and commodity prices collapsed in many markets. Nevertheless, even prior to the more extreme developments which took place during 2008, concern had been expressed at the highest levels of government, around the world, at the turmoil that had broken out in the summer of 2007 following an exceptional boom in credit growth and leverage in the financial system. In October 2007, the G7 Ministers and Central Bank Governors had asked the Financial Stability Forum (FSF) to undertake an analysis of the causes and weaknesses that had produced this market turmoil.
The FSF set out its recommendations in its report issued in April 2008 and entitled: "Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience". In its report, the FSF had emphasized the importance to market confidence of reliable valuations and useful disclosures of the risks associated with structured credit products and off-balance sheet entities. Somewhat unfortunately, however, the FSFs recommendations were strangely light on the actual mechanics of how reliable valuations might be performed and how the risks associated with such complex financial instruments might most usefully be assessed, and reported. Instead the emphasis was placed upon recommending that the International Accounting Standards Board strengthen its standards to achieve better disclosures about valuations, methodologies and the uncertainty associated with valuations. Nevertheless, the FSF did make a number of helpful suggestions regarding appropriate accounting disclosures which could be made and concerning the information and various analyses which would be helpful to anyone wishing to assess such risks.
Notes
1 Accountancy Age, 26 June 2007, quoted in: “Understanding fair value will take up to 30 years of education”
2 Financial Times Weekend Magazine, October 18/19 2008, "When junk was gold", investigation by Sam Jones