6th July 2013

I am talking on this topic because a similar address last year by Hans Hoogervorst, Chairman of the International Accounting Standards Board (IASB), called "The Imprecise World of Accounting" was considered to be interesting. I have therefore taken some key points from his paper and will outline them, along with further thoughts from the perspective of the Financial Reporting Council (FRC).

My agenda for this presentation is:

  1. The role of the FRC
  2. What is financial reporting and why is it valued?
  3. How can accounting be considered imprecise?
  4. The future of financial reporting?

1. The role of the FRC

The FRC is the peak body responsible for overseeing the effectiveness of the financial reporting framework in Australia. Its key functions include the oversight of the accounting and auditing standards setting processes for the public and private sectors, providing strategic advice in relation to the quality of audits conducted by Australian auditors, and advising the Minister on these and related matters to the extent that they affect the financial reporting framework in Australia.

The FRC's objectives include encouraging the development of high quality accounting standards in order to facilitate the Australian economy and to maintain investor confidence in the Australian economy, including its capital markets.

To help shape its strategic advice, the FRC seeks views from a wide range of stakeholders, including users, preparers and auditors of financial reports. Among the stakeholders are the Commonwealth, State and Territory governments, standard setters and industry regulators, as well as professional accounting, business and investor bodies. Key stakeholder bodies are represented on the FRC as Members.

The Chairman of the Australian Accounting Standards Board (AASB) is a Member of the FRC. The AASB consults closely in its own right with stakeholders and is in regular contact with the IASB. The FRC is mindful of the AASB's independence and does not have power to direct the AASB in relation to the development, or making, of a particular standard. However one of the FRC's functions is to monitor the consultation arrangements used by the AASB and, consistent with this approach, the FRC is interested in your views, hence my giving this talk to you today.

2. What is financial reporting and why is it valued?

The answer to this question is probably obvious to you, given you are a finance professional however, as you know, many different interest groups are now interested in financial reporting and, because they have different perspectives, they are interpreting it in different ways. Therefore I thought it would make sense to go back to basics and answer the question.

Broadly, financial reporting can be said to be the periodic process of providing a financial report about the financial position and performance of a reporting entity to users who are external to that entity to assist them in making informed decisions about allocating scarce resources.

This is not intended to be a technical or complete definition of financial reporting, but it is one which is consistent with the Conceptual Framework employed in International Financial Reporting Standards (IFRS) which are used internationally, including in Australia, and which are designed as a common global language for business so that financial reports are understandable and comparable across international boundaries.

The Corporations Law in Australia requires a "financial report" and stipulates its contents as including financial statements, the notes thereto and the directors' declaration. Reports that do not fall within this definition, including the directors' report (as opposed to the directors' declaration), and the management commentary are outside of the financial statements and the scope of auditing.

When defining a financial report and reporting, the IFRS Conceptual Framework equates these terms with general purpose financial reports (GPFRs) and the act of presenting those reports.

Within the standards themselves, 'GPFRs' and 'general purpose financial statements' are treated as synonyms. IAS 1 then specifies the components of such statements to be presented (i.e. balance sheet, income statement, changes in equity, cash flows, notes, and comparatives).

Auditors take their cue from this and make the general purpose financial statements the subject of their opinions. They read 'other information' (i.e. information outside the financial statements but inside the periodic/annual report) to make sure it is not inconsistent with the financial statements.

It is hoped that the definition of financial reporting will receive further attention when the IASB revises the current conceptual framework, which it is planning as a priority project.

The adoption of IFRS by Australia in 2005 was part of a worldwide move towards a single set of global accounting standards, a trend that has coincided with other significant trends such as the globalisation of business, development of increasingly complex financial instruments, and a general push to greater transparency in reporting and disclosure to meet the needs of increasingly active investors.

Australia was one of the early adopters of IFRS in 2005 - and this is because of Australia's early recognition, that with the pace of globalisation, the movement to a global set of accounting standards is a logical transition. In a world where businesses and investments operate on a global level - companies, investors and other stakeholders all gain from having a set of high quality global accounting standards, an objective that the G20 has been seeking to achieve from its establishment in 2008.

As you would know, the G20 will be hosted by Australia next year. The IFRS Foundation Trustees are also planning a meeting in Sydney in April next year so expect more focus on financial reporting in 2014. Currently around 120 countries require or permit the use of IFRS.

Companies using IFRS should be able to access a lower cost of capital because investors can more easily understand and compare their financial information across jurisdictions. In economic terms, having one set of accounting standards allows the market to operate more efficiently - with the consequent benefits of an efficient market.

Evidence to date provides general support for the notion that adoption of IFRS has produced improvements in understandability, comparability and transparency of financial information. In addition, studies by academics provide evidence that IFRS have improved capital market efficiency and promoted cross border investment, particularly where there is effective enforcement.

3. How can accounting be considered imprecise?

Many consider that accounting should be precise because it is mainly about describing the past—to reflect faithfully what has already happened so, why does accounting cause such heated debates?

Sir David Tweedie, the first Chairman of the IASB, used to say that it was the job of accounting to keep capitalism honest hence it is to be expected that accounting standard setters would come under pressure. Some business models can thrive off a lack of transparency. At the IFRS Regional Policy Forum in HK last month I heard one of the speakers say that fair value accounting is both beauty and the beast—the beast when it does not tell the story that management want to tell!

When Hans Hoogervorst was appointed chairman of the IASB he said he was struck by the multitude of measurement bases that both IFRSs and US GAAP prescribe, from historic cost, through value-in-use, to fair value and many shades in between. He also said it is remarkable that accounting standards can cause one and the same asset to have two different outcomes, depending on the business model according to which it is held. For example, a debt security has to be measured at market value when it is held for trading purposes, but it is reported at historic cost if it is held to maturity. One of the biggest measurement dilemmas relates to intangible assets where the value of tangible assets is relatively limited, while the business concept is immensely valuable.

Valuation is viewed as an art as well as a science and the IFRS Conceptual Framework says: "General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help users to estimate the value of the reporting entity." Value is ultimately in the eye of the beholder. There is often not a clear cut answer to the question as to which measurement basis is most appropriate to capture it.

Given this situation, the use of common accounting standards, while not always leading to agreement on the precise numbers, is an essential ingredient of trust in our market economy. When so many parties are working with other people's money, high quality accounting standards that provide comparability and transparency to the market are of utmost importance. This is particularly the case in Australia where compulsory superannuation is an important part of our financial assets.

4.  The future of financial reporting?

Since the introduction of IFRS, the accumulation of accounting requirements and accompanying disclosures, the pace of change and the growing complexity of business, have led to calls for reductions in, and simplifications of, various requirements.

Last year the FRC set up a task force dedicated to reviewing ways to reduce complexity in financial reporting. Members quickly realised however that they could not reduce complexity - all they could do was to recommend ways to manage it given much of the complexity is related to increasingly complex businesses operations. A report was released with recommendations based on our consultation with stakeholders last year and follow up actions taken in relation to these recommendations are on our website so I won't cover them all today.

A key recommendation relating to the future of financial reporting is to make better use of developments in information technology and delivery-matters we can influence within Australia rather than needing to refer to the IASB.

Internet and company websites offer users a widely available, cost-effective, and efficient mechanism through which to manage the complexity of financial reporting. Report preparers should be able to move away from the constraints previously imposed by physical production, and focus on meeting users' needs, by providing information in a way that enables users to manipulate data interactively.

That is, while the current trend is for company reports to be provided to users on company websites only in a PDF format (which does not allow users to effectively navigate through particular sections of interest); companies should provide the information contained in Annual Reports to users in an interactive online format which allows users to not only be able to filter the specific information they require, but also be able to access the level of detail suited to their needs.

This approach can be considered as the 'unbundling' of the Annual Report into various segment and user reports. This would allow users to identify the information they require, and the level of detail of information most suited to their needs, without reducing the information available to the market.

Consideration should also be given to allowing companies to present information such as their governance policies on their websites. Then only changes to this information would be noted in the annual report. This may help to minimise the current boilerplate descriptions that are found in Annual Reports.

The ASX Corporate Governance Council, for example, is looking at ways to streamline governance disclosures and to give ASX listed entities greater flexibility to disclose their governance practices on their websites rather than in their annual report, picking up a recommendation of the FRC Managing Complexity Task Force.

Sir David Tweedie, the previous Chairman of IASB, is now Chairman of the International Valuation Standards Council (IVSC) Board of Trustees and is addressing some of the valuation issues I mentioned previously.

The IVSC is a private sector organisation acting in the public interest which has expanded its mandate in recent years to develop standards applicable for all purposes and all asset and liability categories, now including financial instruments as well as real property, intangible assets and business interests.

They aim to promote consistency and transparency throughout the valuation process and include explanations of common valuation methods and principles, as well as procedures that valuation professionals should follow during the conduct of an assignment. They are collaborating with other international organisations including the IASB. In summary the IASB sets the measurement basis and the IVSC helps its members with the measurement method.

The consistency of application of IFRS is also being addressed by regulators. The International Organisation of Securities Commissions (IOSCO) now has a database which is used by over 50 jurisdictions to improve consistency of application of IFRS. This database facilitates co-operation between securities regulators in sharing decisions on IFRS regulatory interpretation and enforcement.

The Australian Securities and Investments Commission (ASIC) has had a key role in promoting, creating, implementing and the ongoing maintenance of the IOSCO IFRS database and the IOSCO IFRS emerging issues forum.  Indeed an Australian representative currently chairs the IOSCO subcommittee responsible for these initiatives and his team moderates the database.

The IOSCO database is not only open to IOSCO members but also to other regulators who are primary regulators of issuer financial reports in their jurisdictions and meet certain other criteria.

Consistency of application of IFRS will also be aided by the recent publication by the IASB of profiles about the use of IFRS in individual jurisdictions around the world. Currently, profiles are completed for 66 jurisdictions, including all of the G20 jurisdictions plus 46 others. Eventually, the IASB plans to have a profile for every jurisdiction that has adopted IFRS, or is on a programme toward adoption of IFRS.

Hans Hoogervorst has said that it is the IASB's job to push back the grey areas in accounting as far as possible and that they will be guided by three terms in doing so: Principles, Pragmatism and Persistence. He described these terms as follows:

Principles: IFRS are primarily principles based rather than rules based, hence requiring use of judgement- another reason that accounting is not an exact science. That said these principles need to be clear to be well understood — hence the need to review the Conceptual Framework including consideration of issues such as the reporting entity, measurement, presentation and disclosure.

Pragmatism: Given there is not always a precise answer to every question, the IASB's work needs to be grounded in pragmatism and common sense.

Pragmatism also means the need to look very carefully at any possible undesirable use of the standards-it is better for the standards to require more qualitative reporting than artificially exact quantitative reporting.

Persistence: In the face of continual pressures persistence is viewed as an important quality for standard setters. Accounting standard setting should be sensitive to legitimate business concerns, but should also be firm and independent in the face of special interests. According to Hans "Many times, doomsayers have predicted their business would come to an end as a result of accounting standards. Just as often, the industry in question miraculously seemed able to survive our rules very well indeed." The IASB recognises the need to listen, but also that it has to take decisions, based on an independent view.

The IASB has highlighted that the investor's view needs to be heard more loudly and clearly than currently is the case. While investors are the IASB's prime audience, there is a concern that their voice is too often drowned out by business interests. One issue that investors have clearly communicated since the GFC is the need for organisations to tell their story beyond the financial statements through integrated reporting.

Last year the FRC also set up an Integrated Reporting Task Force and we recently agreed a response to the International Integrated Reporting Council's (IIRC's) discussion draft of the Integrated Reporting Conceptual Framework.

According to the IIRC, integrated reporting is a process that results in communication, most visibly a periodic "integrated report", about value creation over time. An integrated report is a concise communication about how an organization's strategy, governance, performance and prospects lead to the creation of value over the short, medium and long term.

The FRC firmly believes that integrated reporting and financial reporting must go hand in hand. Audited financial statements prepared in accordance with robust accounting standards are a critical part of the governance and accountability framework for reporting organizations and an important component of the information mix that the providers of financial capital and their professional advisers need.

Aligning the target audiences for integrated reports and financial reports will help provide an efficient mechanism for delivering an integrated report, namely, via the annual management report that would ordinarily accompany a financial report.

Indeed, in Australia's case, we can see the type of information called for in an integrated report fitting neatly into the "operating and financial review" (OFR) required under Australian law to be included in listed company annual reports. Investors in Australian entities would therefore receive an annual report comprising (amongst other things) an integrated report, in the form of an enhanced OFR, and a general purpose financial report.

In conclusion I hope you now have a better understanding of the benefits of financial reporting using IFRS.

I also hope that you take the opportunity to provide input to the ongoing efforts to improve the financial reporting system. For example, a discussion paper on a revised conceptual framework was released by the IASB last week. The AASB has issued an Invitation to Comment and will undertake an outreach program (including forums, targeted for October) to obtain feedback on the areas covered in the IASB discussion paper and I hope you contribute.

Australia, having been a leading country in adopting IFRS, aims to continue to influence financial reporting positively and we would appreciate your interest and support for our work in the public interest.

Thank you.