Gradient Insights: Revised accounting standards can impact investor analysis

  by Rachel Annis
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

A common misconception is that accounting figures are always black and white, i.e., well known and precise. But in practice, there are many ways that the estimates and subjective judgement of management can color financial statements. Recent amendments to accounting standards address specific examples when companies have applied prior accounting guidelines differently from their peers. When this occurs, analysts are unable to compare accounting figures across companies without additional analysis. Further, differing accounting methodologies coupled with opaque disclosures may prevent analysts from ascertaining an accurate apples-to-apples comparison.

Here at Gradient Analytics, we specialize in forensic accounting research and consulting, and our analysts stay current on changes in the regulatory landscape, including crucial updates to disclosure requirements. Normally, we focus research on areas in which companies might be tempted to “manage” or overstate earnings, either by pulling forward future revenues or pushing out current expenses. Layer on more complexity from changing reporting requirements and it becomes clearer how a vital piece to the puzzle might slip through the cracks.

In this article, I provide details on updates to four accounting standards – and how they may shape financial statements with the potential to mislead investors. First, several Interbank Offered Rates (IBORs) ceased to exist at the end of 2021, and countries are transitioning to alternative reference rates. Second, the International Accounting Standards Board (IASB) revised guidance such that companies no longer may deduct certain items from the cost of property, plant, and equipment (PPE). Third, the IASB now requires that a proportion of production overhead must be included when reporting so-called “onerous contracts.” And fourth, the Financial Accounting Standards Board (FASB) issued a proposal to eliminate accounting for loans in modification through troubled debt restructurings.  Read on....

Several IBORs ceased to exist at the end of 2021:

For the past 50 years, banks, corporations, insurers, and investment funds have referenced Interbank Offered Rates (IBORs) in financial contracts (e.g., derivatives, bilateral and syndicated loans, securities, debt, and preferred stock). The transition away from referencing IBORs is well under way, which we discussed in a prior post. Starting at the beginning of 2022, some significant IBOR rates ceased to be published including the British pound, Japanese yen, Swiss franc, Euro LIBOR, and the one-week and two-month tenors of U.S. dollar LIBOR. Therefore, any challenges from this transition will likely arise during 2022. This not only affects IBOR referencing contracts, but also any valuation models for which companies may have incorporated IBORs into the fair value measurement process.

Consequently, most contracts based on variable interest rates will have to be amended. The International Swaps and Derivatives Association (ISDA) created a 2020 IBOR Fallbacks Protocol to facilitate the incorporation of robust rate fallback provisions into both legacy and new derivative contracts. The Alternative Reference Rates Committee (ARRC) has encouraged adoption of the Secured Overnight Financing Rate (SOFR) in the U.S. On 10/16/2020, counterparty clearing houses, clearing house members, and other impacted market participants successfully executed the discounting and price alignment interest (PAI) switch from federal funds to SOFR. The industry completed a similar switch from EONIA to €STR for the European Union on 07/27/2020. Likewise, Switzerland has switched to SARON, the U.K. to SONIA, and Japan to TONA. Companies with exposure to this transition are required to disclose the uncertainties and how the transition from IBOR to alternative reference rates is managed. As I mentioned earlier, this year will be key to detecting any specific challenges arising from this transition.

Amendment to curb understatement of PPE book value:

The IASB recently revised IAS 16 so companies can no longer deduct certain items from the cost of PPE assets. Previously, the formula to find the cost of PPE included costs of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items while bringing the asset to the state of its intended use. For example, a company constructing an underground mine would deduct the net proceeds from minerals extracted during construction from the cost of the PPE when the assets were put into service. Similarly, an oil exploration & production company would deduct net proceeds from the oil and gas extracted while testing wells before starting production. For some entities, the proceeds deducted from the cost of an item of PPE could be significant and even exceed the costs of testing. Further, some companies would only deduct the net proceeds from goods produced while the asset was being tested and others would deduct the proceeds from all sales associated with the asset before it reached its “intended use.” Beginning in 2022, companies can no longer deduct amounts received from selling items produced while the company is preparing the asset for its intended use. Instead, companies will recognize the sales and related costs on the income statement.

This should improve the usefulness of financial statements to users by more faithfully presenting the cost of PPE. Understating the asset cost lowers the depreciable value of the asset, which decreases the depreciation expense recognized over the asset’s useful life. This in turn, also impacts the usefulness of financial metrics, such as return on assets, that use the asset’s carrying value. However, companies now must distinguish between costs associated with producing and selling items before the asset is available for use versus costs associated with making the asset available for its intended use. The devil is in the details, and making this allocation involves significant estimation and subjective judgement. For many companies in the extractive industry, this involves isolating and monitoring costs at a more granular level. Under U.S. GAAP, deducting proceeds (but not a loss) from selling items before PPE is available for its intended use is only permitted if the PPE is being developed for rental or sale. So, the amendment better aligns accounting for incidental income to that under U.S. GAAP, except when PPE will be rented or sold.

Costs to fulfill onerous contracts may increase:

The recent amendment to IAS 37 illustrates another example of how the judgement of management can influence the presentation of financial statements. An “onerous contract” is one that will cost a company more to fulfill than it will receive in payment. Previously, when reporting an onerous contract, some companies would include a proportional share of production overhead in the costs basis while others did not. The key perspective to consider is that of the user of the financial statements. Would it be more helpful to the user (e.g., an analyst or investor) to only consider the incremental costs of fulfilling the contract (e.g., direct labor and materials)? Or would it be more helpful to consider all costs that directly relate to the contract, including a share of production overhead? The IASB decided to require entities to include all costs that directly relate to the contract, including a share of overhead.

For companies that previously only considered incremental costs, this update may cause an increase in the number of contracts categorized as onerous and will likely cause recognition of larger provisions for onerous contracts. For example, say a company considered a contract to be potentially onerous but concluded in 2021 that it was not as that the incremental costs of fulfilling the contract did not exceed the expected benefits. Now, assume that if the company considered all costs relating to the contract, including a share of overhead, then it would become an onerous contract. In 2022, the company will need to recognize a provision even though it did not the year prior. This also has the potential to impact the provision for contracts that were previously considered onerous. Those contracts will now need to add some overhead to the cost basis, resulting in a higher provision under the revised guidance. U.S. GAAP does not have a general requirement to recognize a loss in advance of performance for onerous contracts.

What will become of troubled debt restructurings?

Looking forward, the FASB issued a proposal to eliminate troubled debt restructurings (TDR) for creditors that have adopted the most recent methodology to account for the credit loss reserve, ASC 326. Creditors offer loan modification through TDRs to borrowers experiencing financial difficulty when the creditor no longer expects to collect all amounts due. The implementation of ASC 326 added complexity to accounting for TDRs. Under ASC 326’s Current Expected Credit Losses (CECL) methodology, companies are required to recognize all credit losses expected over the life of the loan. Therefore, once an entity begins applying CECL, the required accounting and disclosures for TDRs no longer provide decision-useful information.

ASC 326 made the process of accounting for TDRs separately no longer relevant as the effect of expected credit losses that occur from TDRs now will already be included in the provision for credit losses. Further, under ASC 326, creditors must record any concessions given to a borrower in a TDR through the allowance for credit losses. As above, the devil is in the details. The analysis to determine the precise dollar amount of concessions can be challenging, especially when considering collateral and any guarantees. Also, certain concessions can be captured only through a discounted cash flow model.

The new proposal includes a tradeoff of disclosures. Even though companies would no longer report the value of TDRs, there would be enhanced disclosures for modifications and refinancings made to borrowers experiencing financial difficulty. Creditors would need to disclose the types and magnitude of modifications provided along with their success in mitigating potential losses. Entities would be able to choose whether to disclose modifications that result only from an insignificant delay in payment.

In summary:

Because of updates to accounting standards, companies are transitioning away from IBORs to alternative reference rates. Further, some companies that adhere to international financial reporting standards (IFRS) may report higher PPE asset values as well as higher provisions for onerous contracts. Looking forward, investors no longer will be able to separately analyze loans modified in troubled debt restructurings but should have enhanced disclosures surrounding the type and magnitude of modifications as well as success in mitigating losses. Clearly understanding these types of details is important to accurately interpret information communicated through financial statements.

Changes to the methodology used to report asset values and define expenses can obfuscate the underlying economic health of a company. In some cases, this can allow firms “on the margin” to skew reported earnings. While most firms still will present a fair representation to investors, understanding the shifting accounting landscape could make a big difference when trying to evaluate a bad egg.

I hope that this brief primer helps to show how a careful investor can consider the assumptions used by management to form an educated opinion on how conservative or egregious the reported financial results are. The Gradient Analytics’ analyst team will continue to vigilantly alert our clients of critical updates. Our buyside clients use this information either to support their thesis of the company as a possible short candidate or to avoid a hazardous long position.

Disclosure: At the time of this writing, the author held no positions in the securities mentioned.

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