ACCOUNTABLE
International accounting standards may be a bitter pill for CFOs. But they may also be just the remedy needed.
By Abe De Ramos

"Nobody was ever meant,
To remember of invent,
What he did with every cent."

Probably, every accountant knows those words from Robert Frost's The Hardship of Accounting. Certainly, every accountant wishes the poet's witty attack on penny-pinching were true. The collapse of Enron and the disgrace of Andersen dealt a harsh blow to the credibility of financial statements, and the staggering amount of value that they destroyed has angered the public like never before. Faced with jaded investors demanding greater transparency and embarrassed regulators now wielding a heavy hand to foil fraud, CFOs - the guardians of corporate transparency - are again realizing that their title is synonymous with accountability.

Time will tell if CFOs will be up to the task, but for now one thing is certain: accounting will never be the same. The total assets in your balance sheet may look rock solid this year, but they may begin to erode in less than three years, not from economic changes, but from changes in the way assets are valued. Stock options are just the tip of the iceberg. Consolidation policy, revenue recognition, accounting measurements, and accounting for pension costs, leases, and intangibles are other major issues that will rear their ugly heads in months to come. (See box, Tweedie's List).

The man who will make sure the debate stays alive is Sir David Tweedie, chairman of the International Accounting Standards Board (IASB), the London-based standard-setter that wants to teach the world to account for financial transactions in perfect harmony. Tweedie knows his principles-based standards have a tough battle ahead, not least against IASB's rules-based counterpart in the US, where a listing in New York or on Nasdaq has become the ultimate stamp that a foreign company has arrived in the global village.

Nonetheless, Tweedie's target is to have globally-adopted, international accounting standards (IAS) by 2005. "This is really about a level playing field; there is no sense in having different rules," he says. "What we're trying to do is reduce the risk premium. The more we can eliminate differences in standards, the more we can reduce the risk." His argument is simple: investors put a price on uncertainty, and that includes uncertainty in accounting standards. If a rose by any other name would smell as sweet, why should the net income of one company smell sweeter in South Korea than it does in the US?.

Tower of Babel

Take Posco, for example. The US$10 billion a year steel mill, one of the largest in the world, posted US$644 million in net income in 2001 under Korean generally accepted accounting principles (GAAP). Its 20-F filing to the US Securities and Exchange Commission (SEC), however, showed that the New York-listed company made 17 percent less, or US$536 million. Net assets, on the other hand, are US$400 million smaller in US GAAP than in Korean GAAP.

The differences between the two national standards are legion, but for CFO Hwang Tae Hyun, the crux is in foreign exchange treatment, given that a quarter of Posco's sales are in currencies other than the won. Here, the divergence ranges from the marginal such as the conversion rate to be employed, to the substantial such as the deferral and amortization of foreign exchange gains and losses. Clearly, local standards are favorable to Hwang, but like a true global citizen, he claims to support Tweedie's drive for convergence.

"We know the importance of transparent accounting, and we want to become as transparent as a goldfish bowl," says Hwang. "We're very conservative in our accounting policy, and most of our current and potential investors already know us quite well. However, there are also those who are not so familiar with us." The need to be understood may be an earnest one for Posco, the poster child of Korea's post-crisis globalization. Fully privatized in 2000, Posco is now 60 percent owned by foreign investors, and no single shareholder holds more than 4 percent.

Mark Qiu, CFO of CNOOC, the US$2.5 billion a year Chinese oil and gas company, is equally eager to give his New York and Hong Kong-listed company a similarly diverse shareholding structure. But he feels that inconsistent accounting standards give him an unfair disadvantage. Even in an industry as important as resources, standards are fatally absent. "Under US GAAP, I am forbidden from reporting probable and possible reserves," he says, referring to the 500 million barrels of oil equivalent that CNOOC can potentially count as assets.

"But Australia and Canada are two countries which allow companies to report their reserve bases on a much more liberal basis," he says. "If you take two companies - one reporting under US GAAP requirements, and another under Australian GAAP - all else being equal, the Australian's book will show a much bigger asset base, so intuitively," Qiu laments, "you're getting a much better deal with the Australian, which is not true."

This situation couldn't have been described better by British MP Andrew Tyrie, when he questioned Tweedie in a House of Commons hearing on accounting standards in July. "Is this not an appalling state of affairs, that we have trading, buying and selling going on, on a massive scale in the world's major markets, on the basis of rather crude information?" asked Tyrie. The answer: "Absolutely."

One Ring to Rule Them All

To be sure, international support for convergence is strong, notably in Europe where regulators first agreed to adopt IAS by 2005. Australia and Canada are two of the seven countries helping the IASB search for the best national standards that may be applied on a global scale. In Asia, standard-setters in three of the most developed markets - the Hong Kong Society of Accountants (HKSA), the Korean Accounting Standards Board (KASB), and the Disclosure and Accounting Standards Committee (DASC) of Singapore - have each vowed to stay in line with every IAS standard.

Given their different economic systems, however, whether or not these countries will follow the IASB in toto is a subject of debate - as it will be in the US. On September 18, IASB and the Financial Accounting Standards Board (FASB) signed what Tweedie calls an "historic" pact to harmonize their accounting rules by 2005. Tweedie is almost certain that deadline can be achieved for the expensing of share-based payments. Pension costs and consolidation policy may or may not make the date, but leases and revenue recognition would most likely drag on a year or two. (See box, Rules of Engagement)

"[Revenue recognition] will be an issue that we'll want a lot of help on in the debate, to make sure that people are comfortable with what we come up with," he says. "Some of the scandals that we've seen in recent months have a lot to do with revenue recognition: have you actually created an asset, and can we measure it reliably," he says of the basic principle behind the elusive standard. In the debate, Tweedie challenges CFOs to step up. "When an exposure draft comes out, don't neglect it."

For Marilyn Pendergast, chairman of the ethics committee of the International Federation of Accountants (IFAC), the search for unified standards is not just an imperative as more business transactions cross boundaries; it is also a chance for accountants and finance chiefs to bring ethics into their professions. Introducing ethics, she says, ensures that financial reports reflect the "economic reality" of the business - nothing hidden and nothing overdone. "There are several areas where you cannot get a definitive amount," she says, "and CFOs and accountants have the ethical responsibility to make certain that all the facts are there, and are weighed in a fair way."

Of course, economic reality is just another way of saying that accounting standards should be based on the old principles of truth and fairness, and as principles go, they are highly relative. No surprise, then, that some of the rules that the IAS is advocating and pursuing - and which local standard-setters have professed to follow - will be hard to swallow. This guarantees that Tweedie's efforts will only be met with limited success.

Murder by Numbers

In Hong Kong, for example, the HKSA has deferred a decision regarding the revaluation of investment property due to "significant concerns" expressed by property companies, which dominate the local business landscape. Given its political system, no property in Hong Kong is owned by a private enterprise; it is all under lease from the government. The same is true of China, which leases property under the term Land Use Rights. Under the IAS, no leasehold property may be revalued; in fact, it should not be called property at all.

"The amount paid for the property is actually prepaid lease," says David Sun, vice president of the HKSA. "A prepaid lease, on the books of an enterprise that holds the lease, can only be accounted for on a cost basis." This presents two problems: the first on the reporting of the numbers, and the second on the actual impact of the revaluation on the company's profit and loss account.

To get around the first problem, some companies have resorted to presenting their financial accounts in two columns - the first in strict accordance with IAS, and the second in accordance with IAS as modified by revaluation of leasehold properties.

The first has been partially addressed; the IAS recently decided to allow certain types of leasehold property to be recognized as freehold property. "Our understanding is that from next year it will be possible to revalue investment property interests held under lease properties, which should mean that Hongkong Land does not need to present financial accounts in two ways," says Normal Lyle, finance director of Jardine Matheson, the London-listed conglomerate that owns Hongkong Land (HKL), the biggest landlord in the administrative region's Central district.

"This is particularly important in Hong Kong where there have been very significant gains in property values over the long term," says Lyle. True enough, strict IAS compliance values HKL's net operating assets at US$401 million as of June 30 this year, and not US$5.5 billion under modified IAS.

The issue of charging revaluation against the profit and loss account, however, remains sticky. Hong Kong allows these adjustments to be taken from reserves, which does not impact the P&L. But following the IAS rule "could cause significant volatility in the earnings of companies" in Hong Kong, says Sun. To this, Tweedie says, "I personally sympathize." But that's about it - IAS40 is categorical in taking to income the changes in the fair value of an investment property.
A less than perfect alternative to explaining Hong Kong's special situation would be through notes to the accounts. "As a general principle, it is preferable for disclosures to be included on the face of the accounts and where necessary supplemented with notes," says Lyle.

Those Days are Over

In South Korea, the land of chaebols or mega-conglomerates, a move by the KASB to restrict consolidation of sales of subsidiaries has resulted in an uproar, enough for the local standard-setter to bring the issue to a public hearing. Under current accounting standards, holding companies can count the sales of subsidiaries as their own. Starting next year, this is no more. "When a company does not have the risk of ownership of inventories, we do not allow it to record the sales of those goods," says Kim Kyung-Ho, vice-chairman of the KASB.

Most likely to be affected are the holding companies of chaebols. Samsung Corp, for example, will no longer be able to count the sales of its largest unit, Samsung Electronics as its own, too. Other victims include department stores, which even now account for the sales of their tenants, even if they all they do is provide shop space. "We told them that only the net portion of the service fees should be accounted as sales," says Kim.

The rules officially take effect at the start of 2003. Chung Kee-young, chairman of the KASB, says as a result, sales of holding companies and department stores will be drastically lower than in previous years. He does not, however, expect the change to trigger volatility in the local stock market. "I think the market has already discounted this special case; if ever, only a residual effect will manifest," says Chung. Angelo Corbetta, chief investment officer at Pioneer Investments in Singapore, lauds the changes. "Accounting standards in Korea are quite lax, although they have improved significantly from where they were a few years back."

One area where the KASB is lagging in toeing the IASB line is accounting for investments in securities. Currently, IAS39 requires companies to revalue financial assets, including equity securities, at fair value; financial assets with no reliable measure of fair value, such as those with no quoted market price, should be carried at amortized cost. Korean GAAP has practically no provision on this.

"We have a standard that says, if possible, all securities are marked to market," says Kim. "But for unlisted firms with short history, it is very difficult. If professionals like chartered accountants judge that it is impossible to get a fair value, we allow them to stick to the historical cost."

This will take Posco's CFO Hwang a step farther from economic reality. Following local GAAP means the value of Posco's stake in Powercomm, an auction-bound, loss-making state-owned utility, will not show in its income statement - and therefore spare Posco from taking a loss when the government eventually sells its stake. Hwang declines to comment on Powercomm, but Morgan Stanley analysts say that even in the case of a successful auction, Posco will not mark-to-market its price. "This means we are unlikely to see the Powercomm losses reflected in the income statement until the listing of the company, which is not foreseeable," the analysts say in a report.

Goodwill Hunting

Not everything the IASB will change will prove a bitter pill to swallow. James Siu, chief compliance officer and member of the audit committee at Li & Fung, a Hong Kong-based US$4.2 billion a year supply chain manager of consumer goods, is counting on the IAS to follow FASB's lead on the treatment of goodwill from acquisitions.

Prior to 2001, the HKSA allowed companies to write off goodwill from acquisitions against reserves, or to capitalize goodwill as an asset and amortize it over its useful economic life. To be in line with IASB, however, the HKSA imported IAS22 which banned the first option, and set a 20-year limit on the second; any excess of 20 years would have to undergo an impairment test.
The new standard is detrimental to acquisitive companies. Li & Fung, for example, buys companies not for their hard assets but for their clients, and as such it historically paid expensive premiums. Until 2001, Li & Fung did not mind such high goodwill given that it could be written off against reserves - which meant that the equity base shrank, and consequently, return on equity (ROE) jumped.

A Merrill Lynch report said had Li & Fung applied the rule in 2000 and 2001, its ROE would have been 12 to 13 percent versus the reported 27 to 30 percent. Siu says the rule change did not discourage Li & Fung from further acquisitions, but "in my mind, [amortization] destroys the performance trend of the company."

"Amortizing goodwill is inconsistent with pricing policy," he adds. Goodwill, Siu explains, takes into consideration the future profits of the business acquired. If, for example, the clients of a company Li & Fung bought performed badly after acquisition, the value of the business would have rightfully diminished. "But if the business you acquired performs very well, the intrinsic value of the business grows, so amortizing [goodwill] over 15 years is arbitrary - it just doesn't make sense," he says.
The FASB was the first to introduce a standard calling for an impairment test every financial year, which measures how much the value of the goodwill has changed over time. The IASB is preparing an exposure draft - and Hong Kong is expected to follow suit - even as it continues to look for a clear method of impairment testing. "We're concerned about the impairment test, and how rigorous it would be if we used impairment only to write down goodwill," says Tweediet.

The Human Touch

NUltimately, standard-setters agree that no rulebook can solve the mysteries of financial reporting, as there are items that lie on the borderline of precise accounting. Corbetta echoes many fund managers who say that companies in the region are generally aggressive in items where estimates are used, such as reserves and provisions for bad accounts. Likewise, equity analysts give Asian corporations low scores on their disclosure of related party transactions. In these cases, a move towards greater disclosure could become a powerful tool.

One of the most common yet trickiest accounting shenanigans to pin down in Asia, say standard-setters, is the use of cookie-jar reserves - or excessive accrual of potential liabilities in good earnings periods, with the intention of writing them back when earnings turn sour. "Any reasonable CFO would be inclined to try to smooth out the income a bit, but I don't think it's necessarily a concern, as long as it's not blatant," says Sun of HKSA. Adds Chung of KASB: "Those kinds of income-smoothing may exist here, but we have no evidence." The spy job often rests with the securities commissions, which, like the US SEC, are often under-funded in Asia.

Analysts have raised the question of earnings-smoothing to Kuah Boon Wee, CFO at ST Engineering, the US$ 1.4 billion a year defense contractor arm of state-owned Singapore Technologies. At the end of 2001, Kuah set aside S$227 million (US$128 million) in provisions for warranties, and wrote back an estimated S$50 million in the course of 2002. One analyst said the practice was unusual for ST Engineering.

Kuah says, however, that these doubts could be addressed by disclosing how the estimates were arrived at and how much the warranties were eventually used, and being consistent with the use of write-backs. "It has absolutely nothing to do with profitability. If that logic is true, then you only have write-back provisions when you have very good years," says Kuah. "The reason why there was a write-back is partially in recognition of the fact that the historical level of provision that we kept was well in excess of what we needed going forward," he says.

And in cases like this, auditors become the final arbiter. "Trying to overestimate some of the provisions deliberately is not appropriate, and that's where the auditors come in, to evaluate the judgment of the CFO," says Sun. "An auditor's function is to keep the CFO honest." That may be. But Tweedie is hoping that the IAS standard against abusive or "big-bath" provisions would gain wider adoption. Under IAS37, patterned after the British rule, provisions are not allowed unless a company has an absolute obligation to pay out. "If it's just a case of you intending to pay, that's not good enough. You've got to have complete commitment," he says.

One country that could adopt this is the US, where big-bath charges topped former US SEC chairman Arthur Levitt's list of the five most used earnings management techniques (the others are creative acquisition accounting, cookie-jar reserves, materiality, and revenue recognition). "It will also ban acquisition provisioning," says Tweedie. "If you want to recognize the acquired company, you can't bring that in as acquisition provision, as a post-acquisition charge to the income statement."
How much is enough?

Given the broader range of business risks at present, Tweedie also envisions that the use of notes to the accounts would play a greater role in accounting transparency. This is especially true of disclosure of related party transactions - a central figure in the case of Enron and its special purpose entities, as well as in Asia, where there is usually a disregard for arms' length relationships between same-group companies. Acknowledging the weakness of IAS24 - which simply requires disclosure of the nature of relationships where control exists - the IASB is putting out a draft to improve it.

Not surprisingly, where estimates are used such as pension discount rates, Tweedie supports the proposed rule of the US SEC - which Singapore is also considering - to require CFOs to expand the management discussion and analysis section of financial reports. The proposal would require CFOs of companies listed in the US, such as Posco and CNOOC, to disclose what-if scenarios if they used different accounting estimates.

"When we're talking about sensitive disclosures, this [MD&A] is where they're going to start to appear," says Tweedie. "Companies are going to have to say, 'Here are the numbers, let me tell you the assumptions behind them, let me tell you what we're trying to do with these, let me tell you about next year's - I think that's where we're headed in accounting."

Not an easy task for the preparers of financial accounts. "It's silly," says Hwang of Posco, even as he says that Posco will not seek exemptions from compliance with the Sarbanes-Oxley Act, the powerful corporate reform act that became law in the US in August. To be sure, Hwang is not alone in harboring reservations about it - the US SEC was deluged with angry retorts from CFOs worldwide saying the proposed rule would result in an information glut.

"We intend to follow US requirements, but when the discrepancy with local standards is too much," Hwang trails off. After all, the world of accountability sometimes dictates that CFOs may occasionally have to digest a bitter pill.

Abe De Ramos is executive editor, Hong Kong, for CFO Asia