28 June 2018

IASB Chair's speech: IFRS Standards as enlightened self-interest

Hans Hoogervorst

 

When: June 28, 2018

Where: IFRS Conference, Frankfurt

Introduction

Good morning and welcome to our main European conference for 2018. It is always a pleasure to travel to Frankfurt, home of the European Central Bank and an increasing number of bankers escaping Brexit.

I would like to begin by thanking you all for your interest in our work. I also wish to thank Andreas Barckow and the members of the Deutschen Rechnungslegungs Standards Committees (DRSC) for their excellent cooperation. The DRSC has an influential voice in our standard-setting activities, and does a great job representing the views of German stakeholders.

We have a fantastic programme for you over the next two days. Around a third of our Board and most of our senior technical staff are with us during the conference. That is important, because we’ve got a lot of ground to cover. We have workshops on recently issued Standards, and we have a lot of discussion about projects on our work plan.

My job this morning is to set the scene, so let us begin. First, I will provide a brief update on the spread of IFRS Standards around the world. And then I will talk about what is occupying the thinking of the Board right now.

IFRS as a global standard

You have probably heard of the familiar curse: ‘may you live in interesting times’. Although this proverb is usually attributed to ancient China, it is actually nowhere to be found in Chinese literature. The closest Chinese proverb I have been able to find dates from the 17th century. It says: 'Better to be a dog in a peaceful time, than to be a human in a chaotic period.'

Whatever the origin of these words of wisdom, it is clear that both proverbs apply to current times. The world order as we knew it is evidently under pressure. Transatlantic relations have never been as rocky as currently is the case. Brexit was a rough reminder that an ever closer European Union cannot be taken for granted. While one of the main motivations for Brexit was for Britain to close free trade deals with the rest of the world, the prospects for such deals are worsening by the day. We are seeing a strong resurgence of protectionism and the rule based trade system of the World Trade Organization is in grave danger.

When global standards are under such pressure, it is fair to ask how IFRS Standards are faring in these difficult times. The answer to this question is: surprisingly well, but we cannot take our progress for granted.

Let me first say a bit more about the progress we have achieved.

Back in the 1970s, our predecessor body, the IASC, developed the first set of international accounting standards, known as IAS Standards. Many jurisdictions based their national standards on IAS Standards, but modified them to reflect local preferences. Problem was, different jurisdictions made different modifications to different standards. Like a Hollywood movie ‘based on’ a true story, national accounting standards often bore only a vague resemblance to the international accounting standards on which they were based.

Thankfully, this model of jurisdictions modifying international standards is largely a thing of the past, replaced by most of the world using a single set of high quality, globally accepted standards. IFRS Standards.

Of the 166 jurisdictions surveyed in the last few years, 144 have fully adopted IFRS Standards. IFRS Standards are now required for use by 95% of the surveyed African jurisdictions, 98% of European jurisdictions and by 100% of Middle East jurisdictions. Almost all of the Americas and many Asian countries are now fully on board. There are many fathers of this success, but it is important to mention IOSCO, the global organisation of securities regulators and of course the first movers to IFRS adoption: the European Union, Australia, New Zealand, Hong Kong and South Africa.

There are still a couple of gaps on the IFRS map of the world. The biggest gap is the country of US GAAP. While foreign issuers are able to use IFRS Standards on the American capital markets, American companies are still not able to do so. In 2011, even before the Trump era, it became clear that the United States would not be adopting IFRS Standards anytime soon. Fortunately, the rest of the world reacted just as it does now in the face of the American challenge to the global trade system: rather than following the United States in retreat, the use of IFRS Standards continued to spread around the world.

Indeed, we continue to see encouraging developments among key jurisdictions that are still on the road to adoption.

China is using national standards that are very close to full IFRS Standards and is committed to achieving full convergence over time. China has adopted without modification all of the new major standards—IFRS 9, 15 and 16—and is in the process of adopting IFRS 17.

More than 300 Mainland Chinese companies already produce IFRS-compliant financial statements for the purpose of their dual listings in Hong Kong. Their financial reports demonstrate that Chinese GAAP and IFRS Standards are nearly identical. Of those companies, more than 200 companies show no difference at all in the outcomes of their Chinese GAAP-based and IFRS-based financial reports. Of the remaining companies, the differences in outcomes are minimal. Given these results, achieving China’s stated aim of full convergence with IFRS Standards only requires a very small step.

Japan is apparently an accounting standards petri dish, because Japanese companies can choose from four different sets of accounting standards. Japanese GAAP, US GAAP, full IFRS Standards and Japanese Modified International Standards (JMIS). JMIS is a modified version of IFRS Standards with two carve-ins relating to goodwill and recycling of equity investments. Interestingly, no Japanese company is forced to use a particular standard. It really is a case ‘of let the market decide’. 

So, what has the market decided?

As of today, around 200 mostly big, multinational Japanese companies have chosen to adopt full IFRS Standards, representing more than 30% of the total market capitalisation of the Tokyo Stock Exchange. In addition, some very big Japanese companies are seriously looking at adoption of IFRS Standards and before long 50% of the Tokyo market cap could be IFRS-denominated. The number of Japanese companies using US GAAP has been steadily shrinking and is expected to be less than 10 soon. Most interestingly, not a single Japanese company uses the Japanese modified IFRS. Even those companies who argued strongly for modified IFRS Standards have chosen not to use them.

Why is that? Well, according to a report by the Japanese Financial Services Agency, the top three benefits of IFRS Standards for Japanese companies are: the efficiency of being able to use the same standards in all subsidiaries around the world; enhanced comparability and better communications with international investors. The Japanese IFRS-adopters know that even limited modifications to IFRS Standards will undo much of these advantages. 

India has recently adopted accounting standards that are based on IFRS Standards. The new Indian standards are a great step forward, but they contain several modifications of IFRS requirements. India knows that these modifications mean that it cannot derive all the benefits of IFRS and therefore wants to remove them over time. A few might disappear through changes in IFRS Standards, but most will require action by India itself. This will not be easy, because modifications can be as hard to change as accounting standards themselves. But, as the Japanese experience suggests, the cost of maintaining them is probably higher than removing them.

All in all, the picture of IFRS adoption around the world may not be perfect, but the progress achieved in the past 15 years is nothing short of astounding. This progress is all the more remarkable given the fact that the IFRS Foundation is not an international treaty organisation. We are a private body and our Standards are not binding. We cannot impose anything and the adoption of IFRS Standards is nothing but the free choice of sovereign jurisdictions.

Given the voluntary nature of IFRS adoption, we like to believe that the adherence to our Standards is a reflection of the quality and inclusiveness of our work. More importantly, most of our stakeholders resist the temptation of modifying our Standards as a consequence of what the Dutch call ‘welbegrepen eigenbelang’. In English this means literally ‘well-understood self-interest’, but it could also be translated as ‘enlightened self-interest’.

Acting in ‘enlightened self-interest’ means foregoing a smaller self-interest to achieve a bigger self-interest. Even when our stakeholders may not agree with certain aspects of our Standards, they know it is not in their ‘enlightened self-interest’ to modify them. They know this could set in motion a process of gradual balkanisation of the world of IFRS Standards, undoing the benefits of a single set of global standards.

As many of you will know, the European Commission is currently conducting a Fitness Check on public reporting by companies. This Fitness Check covers a wide array of reporting issues and it also contains the question whether the European Union should have the ability to modify IFRS Standards. Clearly, this is a sovereign decision for the European Union itself to make. The fact that this is the third time in five years that the European Union asks itself this question means that we cannot take European adherence to unmodified IFRS Standards for granted.

Fortunately, the outcome of the two previous consultations was that Europe should forego making modifications to IFRS Standards. Of course, we hope that this third time around, Europe will again conclude that it is not in its enlightened self-interest to go in this direction. Especially in a time when global standards are under so much pressure, this would be a welcome outcome. The questionnaire of the Fitness Check is open until 21 July 2018 and we hope you will find an interest in participating.

Developments in IFRS Standards

So, what about the Standards themselves? What is occupying the thinking of the Board right now? I will leave it to my colleagues to cover the detail in the next two days, but I do want to talk briefly about a couple of areas that the Board is focused on.

Primary Financial Statements

The first of those is the Primary Financial Statements, or PFS project. This is an important project for us, and I suspect for many of you in the room, so it is important that we get this right. 

The objective of the PFS project is to provide better formatting and structure in IFRS Financial Statements, especially in the income statement. Currently the IFRS income statement is relatively form-free. We define Revenue and Profit or Loss but not all that much in between, while both preparers and investors like to use subtotals to better explain and understand performance.

We may introduce around 4 or 5 additional subtotals, including subtotals which come close to Operating Profit and Earnings Before Interest and Tax, or EBIT. We are also thinking about defining some new line items, especially regarding financing and investing activities. This is important work, because nearly everyone reports operating profit and EBIT, but they are not always covering the same things. 

Standard definitions of these terms will provide investors with greater comparability among income statements. They will also help creating more discipline around non-GAAP measures by providing more anchors in the financial statements to reconcile to. We may also require preparers to explain and reconcile commonly used non-GAAP measures (management performance measures) in the notes – making them more understandable and subject to audit while creating a central place to find them.

The PFS project will also help as more and more of this financial information is produced and consumed digitally. The greater the amount of data consumed by investors, the more important that data is properly structured, consistently defined and tagged.

To understand the importance of this, look no further than the so-called ‘Hathaway effect’. Back in 2012, US researcher Dan Mirvish noticed a correlation between the news stories mentioning Hathaway, and a spike in the stock price of Warren Buffett’s Berkshire Hathaway. Not entirely surprising, until you realise that many news stories related not to Berkshire Hathaway, but to the Hollywood actress Anne Hathaway.  The same thing happened each time an Anne Hathaway film came out—six occasions in two years—too much to be a coincidence. 

Poorly configured algorithmic trading systems were rumoured to be at fault, buying Berkshire Hathaway stock whenever Hathaway was mentioned in the news. It is a great story, because it highlights the problems with using unstructured data sources with algorithmic trading, especially when the trades are made by a computer that cannot tell the difference between Anne Hathaway and Warren Buffett.

IFRS 17

Now that I have explained the success of Warren Buffett, let me move to his favourite investment, which is the insurance business.   

We issued IFRS 17 one year ago, and it comes into effect in 2021. The standard has already been endorsed in Australia, Canada, Hong Kong, Malaysia, New Zealand Singapore, South Africa and Switzerland, and it is very close to endorsement in China and South Korea (and who knows when North Korea may follow!).   

IFRS 17 will bring huge benefits in terms of standardisation and quality of information. By creating better insight in the risks and performance of insurance activities, the Standard will also contribute to financial stability. We are also confident it will benefit insurance companies themselves by providing better management information and by enabling more investors to understand insurance companies, thus increasing their confidence to invest. 

At the same time, we recognise the significant implementation challenges faced by insurance companies transitioning to the new Standard. That is why we are devoting considerable resources to support implementation. These include webinars, educational materials, helping to prepare the market by running investor education sessions, and through the work of the IFRS 17 Transition Resource Group, or TRG. 

The TRG is a public forum for discussions among preparers, auditors and regulators. It is a great concept, having everyone round the table and working through the practical challenges of implementing the new Standard. It is also a great way to help educate other implementing the Standard. The discussions are also useful for us at the IASB to see if any action is to assist with education, to address unforeseen issues of inconsistencies, lack of clarity or unforeseen complexities when implementing the new Standard.

The experience with the previous Revenue Recognition TRG has made clear that sometimes it can be necessary for the IASB to consider amendments to address questions and indeed we have considered some for IFRS 17 last week. Of course we hope to keep the number of amendments as limited as possible so that we do not disrupt implementation, but we stand ready to act if necessary.

Wider Corporate Reporting:

Next, there is a lot going on in the world of wider corporate reporting. There is increasing interest in trends like sustainability reporting, integrated reporting and reporting for public policy interests.

Any organisation need to remain focused on its core competencies, and for us that is financial reporting for capital market actors. So while we recognise the importance of these other forms of reporting, many of them fall outside of our competence.  

That said, we do acknowledge that there is a lot of broader financial information that is not adequately captured in financial statements: intangibles, business model, economic environment and increasingly sustainability issues (climate change).

The natural place to consider these developments is within the management commentary section of the annual report. Back in 2010, we created non-mandatory guidance on management commentary, and the plan is to now update that guidance to reflect new developments in integrated and sustainability reporting, and particularly the growing interest in long term value creation.

Financial Instruments with Characteristics of Equity

Finally, I’d like to mention a consultation we have kicked off today. This morning, we published a discussion paper on financial instruments with characteristics of equity. This research project is looking at ways to help companies issuing financial instruments to determine whether those instruments are liabilities or equity by providing a clear rationale for this distinction, while also providing investors with better information about them. These are early-stage proposals and we’re looking forward to hearing your views. 

All of these topics, and much more, will be discussed in the next two days. I hope you will find your participation in this conference rewarding and wish you two enjoyable days.

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