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02/16/2012

Implications of New Accounting Standards


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Accounting standards are modified on a regular basis and several changes will affect your analysis of financial statements in the coming months.  To put them into perspective, you might first ask yourself some other questions:

  • How does your organization approach such changes in accounting standards?
  • What does that say about your investment process?

Before we consider those questions and some of the impending modifications, let’s look at a concrete example of the use of accounting information at your firm. When communicating estimated and reported earnings, do you adopt the treatments used by sell-side analysts and market data providers, whether they are GAAP or non-GAAP, or are there internal standards that are applied?

At many firms, there is an attitude of laissez-faire regarding questions like these, with the thinking that however alpha can be generated (and using whatever numbers), it is valuable. On the flip side, the lack of a common approach can prove to be sand in the gears of decision making, with the interpretation of information not as straightforward as it could be.

Whatever the practice might be for your organization, it illustrates one facet of a collective judgment about the relationship between accounting information and investment analysis. Similarly, your reaction to the promulgation of new accounting standards says much about your process.

Do you have in-house experts? Many firms, even sizable ones, do not have accounting specialists. As a result, there is a reliance on others to put new standards into perspective. The information might come from accounting organizations, consultants, or brokerage and rating agency analysts. Where do you get the expertise that you need?

Then—and this is the most important question—what do you do with the information? How do you judge the impact of the changes on asset prices and on issuer behavior going forward? How do you adjust your processes in light of them? What kind of training do you provide about them?

As you think about those larger issues, the immediate business is familiarizing yourself with the new standards and judging the implications for your work. A good place to start is the Financial Accounting Standards Board (FASB) website, specifically its most recent update for financial statement users. It provides a concise summary of the upcoming changes—as well as an update on the convergence of accounting standards globally—and there are links to documents that provide more detail.

Among the new standards is one requiring improved disclosure regarding multiemployer pension plans. Given the severely underfunded status of many plans and the ripple effect that has had on the financial performance of some firms, there is increased attention being paid to the burden of plan obligations. The new disclosures might cast the long-term financial health of some companies in a different light.


TJB-Research


Other changes include a simplification of the testing for goodwill impairment and increased disclosure about items that are to be stated at fair value. A couple of standards could have meaningful effects on the reported results for specific industries: the recognition of net patient-service revenue will be altered for some health care companies and insurance firms will face new rules on the capitalization of costs related to the acquisition of contracts.

Still on the drawing board are changes in standards involving revenue recognition, the capitalization of leases, and the valuation of financial instruments that are impaired. Each has the potential for a notable impact on the work of analysts and the pricing of assets.

That is why every new standard should be evaluated in the context of your investment process. When the numbers change solely because of a change in standards, how do your methods change?

A simple illustration demonstrates the challenge. Let’s say that you invest based entirely upon the relationships of some financial ratios. A new standard dislodges those ratios from their historical context. There would be a great deal of effort involved in restating them and in many cases it wouldn’t be possible. Consequently, your frame of reference has changed and so has that of other market participants.

Of course, the impact depends on the asset class in which you are investing, your particular style, and the nature of the accounting modifications. There are risks and also opportunities.

A forthright consideration of new standards should be a routine aspect of your investment process, as should ongoing assessments of accounting risk and evaluations of the informational quality of reported numbers versus adjusted data. How your organization filters and uses accounting data has an impact on whether you are able to produce outstanding returns, and each new standard has the potential to change the dynamics of the analytical structure on which you rely.

What could be more important?

–Tom Brakke, CFA, provides consulting services to investment organizations on decision making and the communication of ideas. He also writes about investment processes on the research puzzle blog.

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