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Financial Reporting Brief - March 2014

Read accounting and regulatory updates: March 2014 edition

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Revised proposals on accounting for leases and insurance contracts

Read our July 2013 financial reporting brief for commentary on accounting and regulatory developments during the second quarter of 2013

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New accounting framework for Irish companies

Read our April 2013 financial reporting brief for details on the most significant development in accounting of our generation

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The new Irish GAAP

Read our March 2013 special edition financial reporting brief to learn more about FRS 102 Ireland – The Financial Reporting Standard applicable in the UK and Republic of Ireland that will replace the current Irish GAAP

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Perspectives

Financial Reporting Brief - April 2014

This months article: Sustainable investment – accounting a concern?

Welcome to our financial reporting brief for April, our opportunity to update you on recent developments with our featured article which discusses 'sustainable investment – accounting a concern?'

Sustainable investment – accounting a concern?

The economic and financial crisis has affected the ability of the financial sector to channel funds to the real economy, in particular to long term investment.

In Europe, banks have historically provided two thirds of investment funding, compared to one third in the US.   With the deleveraging of banks, there is less funding available to all sectors of the economy.  It is clear that the sources of long term financing for sustainable growth must be addressed and broadened.

The European Commission announced on 28th March that it has adopted a package of measures to stimulate new and different ways of unlocking long term financing and support Europe’s return to sustainable economic growth.  The measures build on the responses to the Commission’s Green Paper consultation of March 2013 and include measures which question certain aspects of accounting, particularly in relation to fair value.

European measures
The EC announced its measures by way of a Communication on the long term financing of the European economy proposing:

  1. Mobilisation of private sources of long-term financing
  2. Better use of public funding
  3. Development of European capital markets
  4. Improvement of SME’s access to financing
  5. Attraction of private finance to infrastructure, delivering the European 2020 strategy
  6. Enhancement of the wider framework for sustainability finance.

Long-term financing embodies some key features:

  • It finances productive activities which support growth by reducing costs, diversifying means of production and creating jobs in a smart, sustainable and inclusive way
  • It is patient, in that investors take into account the long-term performance and risks of their investment, rather than short-term price fluctuations
  • It is engaged, in that investors take a longer-term perspective such as environmental, social and governance (ESG) issues into account in their investment strategies.

The Commission also presented, with the Communication, a proposal to revise the Institutions for Occupational Retirement Provisions (IORP) Directive to support the further development of occupational pensions, a very important class of long-term institutional investor in the EU.  Occupational pension funds have over €2.5 trillion of assets under management with a long-term horizon and 75 million Europeans depend largely on them for their retirement pension.  Occupational pension funds are at the junction of the combined challenge of pension provision for an ageing population and of investing long term to create sustainable growth.

The Communication addresses the various potential avenues of sourcing potential long term investment, including the financial services sector, private sources of funding and making better use of public funding.  Actions are put forward in each of these areas.

The development of European Capital markets, considered to be relatively underdeveloped and currently insufficient to fill the funding gap, is a key priority area.  Appropriate financial investments are required to allow financial markets to play an active and effective role in channelling funds into long term investment.

Sustainable business environment
The general business and regulatory environment is fundamentally important for investment and the ability to attract long term financing.

Effective corporate governance is key to aligning the incentives for institutional investors, asset managers and companies on their long term strategies and mitigating concerns around short-termism, speculation and agency relationships.  There is also substantial evidence about the importance of Environmental, Social and Governance (ESG) issues for the longer-term sustainable performance of companies.

There are a number of accounting issues also under review, including:

  • Fair value accounting
  • Whether the EU endorsement criteria are still appropriate and adequately robust for Europe today and into the future
  • The accounting  treatment of SME’s,  both listed and unlisted.

The tax and legal aspects of the environment are also under review, with a need to ensure consistency as regards the overall treatment of the various classes of finance that may be made available to the market.

Fair value
The Green Paper explored the question of balancing the accuracy of information given to investors with sufficient incentives to hold and manage long term investments.  In this context fair value accounting has been criticised by a range of stakeholders for introducing market volatility in financial reports and therefore favouring short term behaviour.

The IASB has commented on this apparent criticism of fair value accounting.  While accepting that fair value accounting may contribute to short-termism, the IASB emphasises that in some cases there is no alternative as only the fair value can capture meaningful information about financial instruments with complex cash flows.  The IASB is not seeking a full fair value model for all financial instruments.

The IASB further explains that IFRSs seek to report economic performance as it happens which also includes the need to not hide or reduce volatility in an artificial way when volatility reflects the actual economic conditions.  Even long-term investors require shorter-term, reliable and unbiased performance measures to keep track of their investments and to hold management to account.

Conclusion
Accounting standards came in for much criticism at the outset of the financial crisis with dissatisfaction expressed in many areas where it was considered there were, at a minimum, gaps in the accounting framework.  These included such areas as financial instruments, particularly impairment, fair value and the consolidation model.  While the criticism was well made in certain respects, in others it was undoubtedly a distraction from deeper seated issues with regard to capital management, transparency of reporting and overall control and governance.

The IASB has made changes to its standards, introducing some new standards while substantially amending others.  While progress is painfully slow in some areas, including impairment, there is no doubt but that the IASB has diligently made efforts to address shortcomings.

With green shoots emerging and economies showing signs of recovery, no doubt different issues will emerge and perhaps other chinks may be perceived as appearing in the accounting armour, albeit that with work done in recent years on standards, the accounting framework should be more robust.

Let us hope that any criticisms raised are not a smokescreen or a distraction from what are more likely to be areas to address.in relation to control and governance  

 

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