The IAS Plus Interviews – Peter Elwin, JP Morgan Cazenove
26 Sep 2011
Peter Elwin is one of the most respected analysts in Europe. In a wide-ranging interview with Robert Bruce he covers the whole range of current IFRS and financial reporting issues.
Peter Elwin is an influential and respected analyst. This year he was voted #1 rated analyst in the Extel European Equity Research Awards. As Head of European Pensions, Valuations and Accounting research at JP Morgan Cazenove he provides advice to institutional clients in Europe and the US and to corporate clients in London. He is a member of the UK Accounting Standards Board, the Corporate Reporting Users' Forum and the IASB's Analyst Representative Group.
We met shortly after the issuance of two significant publications by JP Morgan Cazenove, the first on financial instrument disclosure analysis, and the second on 'Impaired Greek Government Bond Impairments', and in the aftermath of the letter sent by the Chairman of the IASB to the Chair of the European Securities and Markets Authority. This letter was seen as an unusual step for the global standard-setter to be seen to be openly drawing the regulator's attention to the inconsistent application of the standard dealing with the accounting for available-for-sale sovereign debt.
ROBERT BRUCE: Hans Hoogervorst has now been Chairman of the IASB for two summer months, how do you think things have changed and how do you think the landscape will alter in the months ahead?
PETER ELWIN: That is an interesting question. I think one of the most dramatic changes we have seen is the letter to ESMA from the IASB. I don't think that the IASB has ever written such a letter before. It has always been one of the issues with the whole IFRS project that unlike US GAAP you do not have a central enforcer along the model of the SEC, either in Europe or around the rest of the world. You have national bodies trying to do the enforcement and that naturally creates a tension and a potential disconnect between what the IASB mandates as the rule and the way it eventually then plays out in particular company reports. So I think it is a very encouraging development. I think it is good to see the IASB effectively standing behind its standards and saying: "We believe that the standards are very clear in how they should be played out and how they should be interpreted and we are concerned that it is not being done".
The interesting question will be how ESMA reacts and how it then plays through to national regulators and the auditors and the audit firms but I think it is a very encouraging development and I suspect that is something that Hans was at least partly instrumental in organising, so I regard that as a very encouraging development.
RB: How do you think that will develop further, if that is the approach he is taking? Is this a completely different style?
PE: Well, I think it was always clear that David Tweedie was primarily a technocrat and came to the political angle on a secondary basis. He would be the first to admit that was the way he came to things. It is very clear that Hans Hoogervorst is somebody who is very aware of the way that the international structures work. He comes from a background of international regulation. He has worked within the Dutch financial system. I think he is a very astute political operator and that was the expectation of him when he arrived and I think that seems to be playing out. So my guess is that what the IASB Trustees wanted to do when they recruited him and Ian Mackintosh was to have both a political politician if you like, a politically astute operator, and a technocrat. It looks to me as though that is exactly what they have got and I think that is extremely necessary for the IASB going forward as an international organisation operating in a multinational environment.
RB: So you are optimistic?
PE: I am, yes. I think there are many, many challenges that lie ahead and clearly the Greek debt issue and the general sovereign debt crisis that we are going through at the moment is a significant challenge to accounting as well as economics and to regulation, and I think there are signs of stress in the system as there were back in 2008 and it remains to be seen whether we come through that better and stronger, or weaker and more disunited. So there are certainly risks but I think I am optimistic at this stage.
RB: How far are events like this in the hands of standard setters and how far can financial reporting, which is a crucial part of it, have a real effect?
PE: I think it is very, very difficult to say and I think it is one of the disappointing things in the sense that nobody has really worked out the answer to that question: to what extent does financial reporting matter? Does it lead the debate or does it just follow it? I suspect the answer as always with these things is a mixture. In the whole fair value debate, for example, nobody has really come up with a proper analysis as to whether fair valuing things is pro-cyclical and increases the fear in the market, or potentially increases the greed when greed is what is there, or whether it actually has a sort of an informing effect and therefore potentially a dampening effect in terms of the market overall undervaluing things. I do not think that anybody knows the answer to that and I think it is actually very important that we have more data before we proceed with too much enthusiasm down any particular path.
I think where the IASB is going with its financial instruments project is probably sensible in the context of that knowledge, which is essentially to say: "Well we are not quite sure what the overall effect is; we think some things probably should be at fair value, we think some things arguably should be at frozen value, so let's have a mixed model and see where it takes us".
There are clearly some people out there who would say that fair value is the bane of their lives and the root of all evil and there are other people who would say if we had fair valued everything we would not be in the place we are today. I do not agree with either of those two ends of the spectrum so I am broadly in sympathy with where the IASB is heading but I do think that we need more research.
I think that is one of the primary things that I would like to see standard setters, and particularly the IASB, doing. I would like to see standard setters basing their activities much more strongly on evidence rather than on philosophy, if you like. I think in the past, and again I think David Tweedie in recent interviews has rather admitted this, that the IASC when it first started and then the IASB when it took over, was very much a sort of think tank. It was essentially trying to produce great standards on a rather individual basis that people around the world could then adopt, because they were just the best. A bit like producing an iPad or something like that and everybody goes "I want one". And it is only more recently that they have come to understand that actually what they are trying to do is to create a better way of communicating about finance, which is essentially what financial reporting should be.
But to go down that path you need to say: "What are the problems? Can financial reporting solve those problems? Do we have any evidence of the problems? Do we have any evidence that financial reporting might be able to provide a partial or complete solution? Okay, we think it could provide at least a partial solution. Right. Let's now gather some more evidence to see what shape the solution should take. There may be various alternatives, let's see if we can work out some of the consequences of going down those alternative paths and then we set out that body of evidence and that set of choices; and we probably, as a Board, set out our project choices. We say: 'We think this is the right direction to go in; we think these could be the probable consequences of going down that path; here are the alternatives'. Right, now could you constituents tell us what you think is best?" That should be the process.
You would have a much more intelligent and informed debate, whereas in the past I think it has very much been along the lines of: "We have come up with a great idea. We will put it out to the world and they will accept it because it is a great idea and then we will all sit back and see what happens". That seems to me to be a very sub-optimal way of actually getting to a better way of communicating about finance.
RB: What should the priorities be from an investor's perspective?
PE: Well, I think first and foremost, the priority should be to start gathering evidence. Recently I have done several reports which, for example, looked at the ways that banks actually account for their financial instruments. Now I have not seen many other pieces of work like that, and that seems to me to be surprising. It was extremely hard work, it was very tedious. At points in time we began to question why we had gone down that route but at the end of it you come out with a body of evidence that says that looking at 46 banks across Europe we find a large majority of those banks were using amortised cost to a very, very great extent. That surprised me. I had the sense that banks were much more neutral and it was more of a 50:50 split if you like. But the reality is that the majority of banks use amortised cost for the majority of their financial instruments. Now that is what it is. Then once you have got that evidence you can start talking about whether that is the right way for them to do it or whether it just happens to be the way they do it at the moment and they could be persuaded to do it better.
So, I think that has to be the starting point really for the IASB and also for the FASB as well, but they need to turn their processes completely around. Perhaps to be fair to them they need to continue the turning that has already begun and re-engineer the whole process so that it becomes much more like a proper product development process, where you start with evidence and you do beta testing and have a lot more interaction and debate with constituents rather than the current ivory tower model that I was describing earlier. I would put that as the absolute first priority. I think that once you have turned round your processes and reshaped them then you can go about properly assessing what is really needed. The priorities I would put out would be: financial reporting, as in performance reporting, the P&L and the cash flow and the balance sheet. They need a much more comprehensive rethink, and we really do need a total rethink of the way that performance is reported. So we need a reshaping of the profit and loss account; of the statement of comprehensive income as it was briefly called at one stage and we also need to think about how we report cash flows. Standard setters generally focus on the balance sheet, at least philosophically, because you can define assets and you can define liabilities. Nobody has come up with a decent definition of revenue. The revenue recognition standard starts by trying to come up with a sort of definition of a rather strange set of assets and liabilities and then sort of works out the answer from there. So I think we really need to think much more carefully about what we are trying to do with financial reporting in the round, and the profit and loss account and the cash flow are a big part of that.
RB: What would you like to see in terms of the impairment proposals? Do you think there is a place which will accommodate both IASB and FASB and lead to what we would call a high quality solution?
PE: I think a high quality solution at its heart would have to be a solution where you get the same answer from the same set of circumstances, whether you are a US bank or a European bank, or an Australian bank or whatever. In financial instruments particularly, because of the nature of the financial institutions that are using the instruments and reporting their usage of those instruments, I think a converged solution is absolutely essential. There are relatively few multinational banks in number. In value terms, in market cap terms, they are obviously very significant. In terms of their linkage, in the way that they influence the financial system for the whole world, as we have seen over the last four years, they are incredibly important and we have absolutely got to get one common set of rules for them. So I do not really care if different manufacturing companies are doing lessor accounting slightly differently in the US or elsewhere. That does not worry me too much because the way that the world investment community looks at those companies is much more on a sort of regional basis. But with these big financial institutions, particularly big banks and big insurers, they are absolutely a part of the financial system, systemically important, and we need a unified solution.
That would be the first point. We have got to have the same set of impairment rules across the world. In terms of how they should work, well, they have obviously had several stabs at it and it is very interesting looking at this recent sovereign debt crisis playing through, I think I have begun to rethink my ideas as to what good impairment rules would be. Talking to a lot of investors I find they have been very, very surprised and very disappointed by the fact that banks have not provided against their, in this case, Greek debt, at all until the first half of 2011, the June half year results, and prior to that there was no movement at all whereas in the market, the market was assuming that the probability of Greek default in some way was going up and up and up over the last 18 months. Again that comes back to the whole pro-cyclicality / anti-cyclicality debate but I think the general feedback from investors that I have had is that it is very unhelpful that banks are not reflecting the risks in their numbers; and the risks have increased, however you measure it and whatever you think the actual path going forward will be, there is more risk and we are not seeing that reflected in accounting, which seems bizarre. So I think that would be the primary thing, clearly we have an incurred loss model at the moment and we need some sort of model that allows you to look further forward. You cannot wait until you have actually crashed into the wall before accounting for the fact that you have crashed into the wall. It would be better to say: "It's dark, It's raining, I'm drunk, I'm driving too fast, there is going to be an accident at some stage, not quite sure when or how big it will be, but there is a very increased risk". We have to have a model that allows you to do that.
In terms of what you then do with it, there is a broad debate in terms of whether you then smooth the provision that you are going to take, and effectively book it over a number of years, or you take a big hit now and then probably mark up over the next few years. I am still a little undecided about that. I think the way that the IASB is talking about the current three bucket approach, certainly the way that I have seen David Tweedie describe it, where you say: "Well there is a good book but we know from history that generally speaking you only get 99% of the good book back on average so we will take a 1% hit; and then there is a book we are worried about because of the underlying components. We cannot identify particular components that have gone wrong but we think a number of them may do so and so we are going to take a bigger hit there; and then there is the bad book, where we actually know the specific names of the individuals, we know they no longer live there, we've got our guys in dinner jackets looking for them, and we will provide accordingly.
That sounds conceptually sensible and I think it aligns with the way that banks actually run their businesses. Quite what that means then in accounting consequences I am not sure yet and I think this is one of the other basic issues with standard setting that I would really like to see change. At the moment what standard setters tend to do, even if they have gathered a large body of evidence, is put out an exposure draft that says: "These will be the rules". And you look at the rules and the rules will look perfectly sensible, but what it will very rarely have is any numerical examples and, particularly, it will never have: "Here is Bank A or Manufacturing Company B before and here is what they would look like afterwards – take their 2008 numbers and do a pro forma reworking on a very high level – this is the information set you would get; this is the way earnings would change or net asset value or whatever". And that is essential to get a proper discussion amongst investors, who are far too busy to really think about the philosophy, to get a proper discussion from them we have got to have some numerical examples, to try and generate discussion. So in terms of impairment, we do need to see more impairments earlier and we do need a solution that is global.
RB: How do you see the relationship between regulators and standard setters and standard setting and prudential regulation?
PE: I think the two are separate and should be kept separate. I am certainly in the camp of people who believe that accounting is for the purpose of conveying information and that you are informing a variety of possible decisions, and actually you do not know quite who you are informing, so you give an information set and then let people do with it as they will, rather than saying: "We are designing an information set for a particular purpose, ie., regulation, and this is what the regulators want to see so we will make companies deliver that to regulators". I think it is much better to have a neutral information set to be kept as simple as possible and then have regulators do what they do. Where I think we need clarity, and sometimes we get it and sometimes we do not at the moment, is you need to have a very clear understanding of what the regulator wants, and a clear understanding as to what the financial accounting rules require companies to provide and then a reconciliation from one to the other. So at the moment better banks will give you a reconciliation statement showing how they get from shareholders' equity under IFRS to Core Tier One Capital under Basel II.
But I would like to see standard-setters and regulators remaining separate. Clearly they need to communicate with each other because there may be information that the regulator requires which would be very easy for the accounting rules to require banks to provide and naturally the investment community would be equally interested in that data.
RB: What are your views on the current reviews that are being carried out into the Monitoring Board of the IASB and the Trustees and whether the Monitoring Board could play a much greater role, particularly where you have got jurisdictional and other organisations disagreeing with each other?
PE: I think it is probably one of those organic situations where at the moment we have two bodies, the Monitoring Board and the Trustees, and there is a slight degree of overlap and conflict and lines of authority and communication still need to be a little bit clarified but I suspect that will work its way through over time. I think you clearly need a Monitoring Board in the sense that we need to have this independent quango, which is essentially what the IASB is, with no direct link into the political system of any of the countries that it is in many senses writing law for. We have got to have a link into the political systems at a global level and then hopefully that feeds down to the regional and local. I think the Monitoring Board can very usefully provide that function. You need to have an independent set of Trustees because you have to try to maintain the independence of the IASB to set standards without fear and favour, as it were, and the Trustees can help with that. I am encouraged that both bodies are doing reviews. It is a shame that they started out in a slightly uncoordinated fashion but that seems to be improving as the process goes on. So I am optimistic that they will actually come up with a better result and come out in a better place than they are at the moment.
RB: How helpful has the convergence process been?
PE: Convergence is a bit like motherhood and apple pie. It is one of those things that everybody says is a good idea until they have to do it. Then they find it means giving up the way they do it to do it the way the other guy does it. I think there is a general agreement amongst investors that the IFRS project in Europe has been helpful rather than a hindrance on a net basis. Sure they had some difficulties and lost some bits of information and that sort of stuff; but, in overall terms, investors are now better able to analyse, compare and invest in European companies as a set, whereas previously it was a blind invest in French or German or whatever. And so I think convergence in broad terms is really helpful. Where I think I have been concerned by the convergence project, and I can entirely understand why the IASB has done this, is that on occasions convergence has become the primary goal and quality, thinking about what the outcome will be in terms of the standard, has taken second place. From what I can see as an outsider to the process it feels to me as though that pressure to converge has abated somewhat and that the IASB is now being a lot more measured and thoughtful in its agenda-setting going forward. Clearly the US has, again, become a lot more measured in its approach to convergence. I think the financial crisis pushed a lot of different regulators back to a much more local agenda rather than an international one, which is a problem in some ways.
So I think convergence is a good thing but it needs to be convergence where it makes sense and I think it needs to be done at an appropriate pace.
RB: Should it be entirely done between the IASB and FASB or should it involve others, national standard setters, regional standard-setters and so on?
PE: I think it all depends really on what you mean by convergence. I think if you are looking at two big economic blocks which historically have accounted for similar transactions in really rather different ways, then I think you clearly need convergence between those two economic blocks in terms of the way they account, and you need a continued effort to maintain that cooperation going forward. I do not know where the US will end up, whether they will decide to either mandate or allow large companies to use IFRS or whether they decide to completely walk away from it, who knows where that will get to, but I suspect that we will have US GAAP for a long time to come being used by a pretty large body of companies and that investors will want to compare some of those companies with companies using IFRS. So it will be very helpful for investors if the two rule sets were broadly similar and produced broadly similar outcomes.
Having set that framework, then you have got the IASB and the IFRS community and you have got the countries around the edge of that, who are either partially using IFRS or IFRS equivalent standards already, or who are contemplating moving in that direction. I think the IASB now has got to the place where it is essential that it tries to develop consensus with all those interested parties. Now it won't achieve that because that is not possible because there are too many of them, but it has to engage in the debate. National standard setters is a very easy way of engaging with like minded people who speak the same sort of technical language and, one hopes, have good local networks to people in the real world. I sit on the UK Accounting Standards Board and I think we have excellent contacts with our constituents and the staff of the ASB are very, very effective at going out and actually engaging the people on the ground. So that puts us in a very good position to be able to then go to the IASB and say: "Well our constituents think this, oh, and by the way, we have also thought about it from a technical point of view, and we think, given our constituents' views and our own technical input, that this might be a good way of going forward".
And I think that sort of input to the IASB can be incredibly helpful because they are just not resourced for the task that they face so they have to rely on other people. That's actually is a good thing. It is a good thing to have them lean and mean and a bit hungry and a bit lacking in resource because then they have to go out and rely on the support of others. It forces them to engage, which is something they are very happy to do, but I think it is a good position for them.
So I think National Standard Setters remain a very, very important part of the process going forward.
RB: What do you think is going to happen with the SEC? What do you think is going to be the outcome?
PE: I have no inside knowledge at all, but if I was the SEC, where I would get to is I would say: "Well there are very large US multinational companies which would probably benefit from producing their accounts under the same rule set as their peer group based in Germany or eventually Japan, Australia etc. And I think I would mandate it rather than making it an option, because you want a comparable data set. So I would say that companies of above a certain size defined by market cap or headcount, or turnover or however you want it, or a variety of those things, have to do IFRS. And then you would probably have a mittelstand where you potentially give them some option so that you would allow a certain sort of flexibility for companies who were either hoping to transition up to the big end of the spectrum and they could prepare themselves by doing IFRS early; or if they happen to be quite small but they just have a large international peer group they could do IFRS. But there will be a lot of other US companies that really are operating in the domestic US market, which of course is actually massive, and they would carry on doing US GAAP which is designed by FASB and mandated by the SEC. I think that is where we would end up.
Potentially, you then start also creating the possibility of having a much lighter form of US GAAP for the smaller companies, which, of course, is something that is already being debated by the IASB and being debated in the UK by the ASB as well.
RB: What do you think would happen if the SEC did not follow that route?
PE: I think it would be pretty unfortunate. If we take the unlikely scenario that the SEC says: "We do not think IFRS would be beneficial to any US companies and we are not going to allow US companies to use it". That raises the possibility that actually they then say: "Well actually we think all companies filing in the US should now redo the reconciliation". I do not think they would do that.
So let us imagine a scenario where they say: "You are international so you could file with IFRS and you are domestic so you have got to do US GAAP". Now it immediately begs the question, why do we have a lot of US representatives on the IASB? For technical merit, sure. But actually there is a geographic flavour to the IASB as well, so they would not be replaced with US equivalents when they go. The same would be true of Trustees on the Trustee Board and the IASB's relationship with FASB would automatically become more arm's length. It will always be quite strong because FASB is very well resourced and thinks about things in a very imaginative and detailed way so they will always want to have a dialogue with them, but it would just become a lot more arm's length. They would effectively not be in the IFRS camp and I think that would be a negative result going forward because the SEC and FASB have a lot to offer to the standard setting process. It is much better to have them inside the tent rather than outside. I think they would end up outside the tent if they made that decision.
But I strongly believe that they will come up with adopting IFRS for some companies at some point but it will probably be a smaller set than perhaps we were thinking it would be three years ago and it will be a longer time frame for adoption than we thought it would be three years ago.
RB: In more general terms, how do you think financial reporting is going to develop around the world? And do you think integrated reporting would be a useful development?
PE: To deal with XBRL first, XBRL appeals to people like me and a whole variety of other investors, who love to create spreadsheets comparing things. But the reality is I have been involved in a number of IT projects over the last x many years and they invariably over-promise and under-deliver, invariably come in over budget rather than under, and usually they are generally disappointing and I am quite convinced that XBRL would be in that camp. So XBRL may be a marginal improvement and a marginal help in some ways but at the very heart of it lies the problem with: You have got a piece of data, how do you tag it? Now if you can find a way of making every single company tag it in exactly the same way, okay, you may have gotten some way down the track. But a piece of data in isolation is virtually meaningless and I think my concern is that at the end of the day I think financial reporting is about story-telling with numbers. It is about communicating. It is not just about saying: Here is our general ledger, pick whichever line items you like and stick them in a spreadsheet and see what you can do with it. It is actually about management saying: "This is what we have achieved over the last year or over the last ten years; this is where we are currently: these are the risks and the potential rewards in the business; and this is where we think the path is going forward".
Now, that leads on to the other part of your question about integrated reporting. What investors look at when they are analysing companies is they look at the financial data set in detail. They actually do use annual reports as a very, very important source of information and as a coherent data set established at a point in time covering a period of time which they can then use as a bedrock for a lot of their other analysis. So the annual report and that annual reporting process is incredibly important.
But emphatically that is not just what investors' look at. If you take a simple example: If I am looking at a supermarket then I will want to try and identify like for like sales and I will want to think about that going forward. I will be looking at GDP growth rates. I will be looking at consumer spending. I would be looking at product innovation. I would be looking at the competition. There are a whole variety of issues that I would be looking at, none of which are reported in the annual report and relatively few of which would be reported by the company around that because a lot of these data points come from other people. So I do not think financial reporting should ever set out to provide the total answer. I think what it needs to be is a credible, reliable, comparable data set that can be used with ease by investors. Now, within that, I think there is room for having a closer linkage between some of the narrative stuff, the sort of management chat, and some of the non-GAAP measures the companies like to talk about. I would certainly like to see those more integrated with the financial numbers. I am very, very keen to see non-GAAP measures reconciled to GAAP so that I can establish the linkage with an audited, hard number rather than a softer number. But I would not want to restrain management's ability to communicate and flex their communication to suit the circumstances. One of the problems with financial accounting is that it is always sort of driving fast, looking in the rear view mirror. Like all regulation, we are always solving the last problem and not necessarily thinking about the next. Whereas management, in their communication, they can do that.
So, again, with the banks for example, GAAP does not require you to disclose the individual country sovereign holdings. A lot of banks are now doing that, either in their presentations or, indeed, in their results because that is what the market wants. So I would not want to constrain that but I do want to see more linkage. Where things go wrong is when management are allowed to put out a load of optimistic puff in their presentation and then actually own up to all the stuff that is going wrong at the back of the annual report. That is where the problems come about.
RB: Can we talk about leasing? What is going to happen with the leasing standard? Is it moving in a useful direction? What are the key impacts likely to be?
PE: Well, it is actually quite a difficult one again. David Tweedie always made the joke that he wanted to leave office having been able to fly on an aircraft that was on the balance sheet. I mean, he did not quite make it in timing terms, but we are clearly getting down that path.
I think the majority of investors will try to take account of leases as a form of debt for a company if they are reasonably long term and do commit a company to paying cash, irrespective of its business activity, over a number of years. So I think that broadly moving the boundary from where we are at the moment, where an awful lot of things are not on the balance sheet, to a place where many more are, I think that is very sensible. And certainly from a risk perspective and a credit analysis perspective, seeing more of these liabilities reflected as liabilities is definitely an improvement.
Where I think it gets more difficult is how you then reflect the assets side – I mean, what is it actually? What is the asset? What accounting consequences does that have? Now at one stage the IASB were developing two alternative P&L models, which meant additional complexity. At the moment the rule is simple: it is basically everything is a finance lease and that has great simplicity about it. For a lot of investors that does not necessarily fit with the way they view the company so they may well say: Yes clearly it is a cash obligation, but actually I rather think it is part of the operations of the business. So to run a coffee franchise you have got to rent a shop at Gatwick and you have got no choice – you have either got to be there or you cannot be there, and if you want to be there and run your business you have got to pay the rent, there is no other way of doing it. So that really is an operating cost. And it is all very well to think about that as a liability, which it clearly is because you have signed a four year contract on that lease, but really from an investment perspective it is not so much about the cash obligation you have got if you imagine the business is ongoing and successful, it is actually the extent to which your coffee sales can exceed the rent that you have agreed to pay. And the extent to which you are obliged to pay more rent if you do better.
So I am not convinced that the leasing proposals will be an enormous leap forward. I think there will be an improvement. A lot goes down to disclosure but the way that the process has gone so far has seen a lot of moving forwards, moving backwards, moving sideways, changing decisions. I am really waiting until I see the new exposure draft before making up my mind on that.
RB: What about revenue recognition? Where will the main impacts be?
PE: I think revenue recognition is the classic example where we have got what looks like a good idea on paper and absolutely no information about the consequences that would come about if it was actually put into action.
So with revenue recognition I think we just do not know the consequences. And that concerns me greatly because the equity market and, indeed, the credit market are very, very sensitive to changes in the top line. People believe that revenue is a really hard reliable number, when actually auditors and accountants know that it is just as flexible as any of the other numbers in the P&L. But anything that changes the top line almost invariably has a share price impact and I am quite concerned that there might be companies out there where under the new standard they would have to reflect their revenues very differently and that the market would not understand that transition and would penalise them accordingly. Or perhaps as the market has been incorrectly over-valuing those sorts of shares at the moment it would correctly mark them down. But we just do not know and that concerns me a lot. So I am very much waiting to see the new exposure draft for revenue recognition but I really hope the IASB will actually come out with some proper numerical examples and in an ideal world will have a number of different companies doing before and after analysis.
RB: Are there any other financial reporting issues that we have not talked about that you would like to talk about?
PE: I think the other obvious one coming down the pipe is the pensions standard, which I regard as an improvement. I think getting rid of the corridor rule is extremely helpful and will avoid investors being confused about balance sheet numbers. I think the P&L side is a sensible compromise answer to a very difficult question and at some stage we will have to really think about the whole thing much more carefully; and we will probably have to do that in the context of insurance, which is another big project that we have not touched on at all. I think insurance is incredibly difficult. At the moment, in Europe, we have a lot of companies doing a whole variety of different things and obviously not just doing GAAP, they are also providing regulatory capital numbers and they are doing embedded value statements in the various different formats. So, you can very easily have three or even six different earnings numbers for one set of results. You can have a company report it under three different versions; you can have the analyst expectations under three different versions; and then you can have their re-jigged estimates going forwards. So you can have a virtual matrix just from one results statement, which is incredibly difficult, I think, for investors to really interpret and understand.
So I am hopeful that the insurance project will actually end up improving things but I think it still has got some way to go.
RB: A lot of what we have been talking about is things becoming more and more complicated and harder and harder for investors to really understand and be able to sit back and say: I've really got a grip of this. Is this is going to continue to get worse? Or will it get better?
PE: Well, it will get worse because the business world, certainly in some sectors, is complicated. We have seen with the financial crisis that banking and quasi-banking is complicated. Some of that complexity clearly was unhelpful complexity but it was genuine business and legal complexity, nothing to do with accounting, and, in fact, the accounting had not really caught up with it. If the accounting had been as complicated as the business activity we might have looked at it and gone: "What on earth is happening there? Why is this so complicated?" And the problem was that a lot of the time it was being presented as very simple and the reality was much more complicated.
So, I think that accounting complexity where it reflects business complexity is helpful, in the sense that it tells you what it is. If you are getting accountancy complexity that is driven by some philosophical idea of the pure way of doing accounting or is simply a consequence of badly written standards, which I think perhaps would be the case in terms of IAS 39 as it stands at the moment, then I think that complexity is certainly something that should be stamped out.
I think the solution is that you have to have a set of rules which adequately disclose and capture and manage the complexity of the business and will also allow management to highlight the things they think are really important. But I think that you should not be designing financial reporting for the lowest common denominator. It is all very well to say: "But the man or the woman on the street won't understand this". Well, I am not sure they ever have and I think when they felt that they did it was simply because they were being misled. Somebody said: "Look, our price earnings ratio is good because our earnings are fantastic". Then they bought the shares and it turns out it was the sort of bubble in the South Seas or some sort of tulips in Holland. So, I do not think that is the right way to go. I do not think you can improve things by creating a falsely simplistic picture of something that underneath is very complicated. It does rather go back round to this whole question of what influence does reporting have. And, again, I would go back to what I said at the beginning, that I do think we need to have a clearer understanding of how behaviour is affected by the supply of information. And we need to think that one through a bit more carefully.