Who understands equity accounting?

Tom Ravlic

Most people would not have noticed an announcement made by the Australian Accounting Standards Board in a newsletter that hit inboxes last Thursday afternoon. It revealed the standard setter is having a look at three key research areas during its annual research shindig later this year.

One of the research projects deals with equity accounting and another with the implementation of the leasing standard, which, of course, was most controversial at various point of its development because it bulked up assets and liabilities in company financials amongst other things.

It is the third of these topics, however, that merits a bit of reflection because it is one that deals with an issue that seems deceptively simple: the understandability of accounting standards.

This is an area that might sound somewhat arcane to readers because it relates to documents that are not exactly as interesting as an Alistair Maclean novel but need your detailed attention if you are required either to comply with them or explain requirements to others.

The importance of such a research project should not be underestimated just because it may appear a curiosity on the fringes of corporate reporting or a minor consideration in the middle of a global pandemic.

Researchers face a challenge in looking at this area and one of those issues is the scope of a topic like this that can be taken in several ways. The first step must be to define the audience for which the accounting standards are written.

An initial question must be: What is the audience for the accounting standards that set down the requirements for the preparation and presentation of financial statements?

It is a long time since accounting relied solely on the price paid for something in a transaction. We are in a regime at the present time where there are different ways to measure carrying amounts for the purposes of reporting to shareholders and other users in financial statements.

The material contained in the standards will by its very nature be better understood by those that have a heightened understanding of financial reporting requirements.

Some accounting is complex and language that explains that complexity may be difficult for many people to grasp. This ultimately means that experts – or as somebody put it to me the other day, elites – are in the box seat when it comes to fully comprehending what is issued.

Banks and other financial institutions along with the analysts that have been pulling their hair out over the past couple of years are familiar with this thanks to the leasing and financial instruments changes that have flown through the accounts.

Anybody hoping for simpler times in accounting regulation needs to keep that ambition in check because accounting standards do not have an equivalent of an IKEA illustrated assembly guide for that flat packed package with complementary allen key you just bought.

Are the standards written for understandability or readability? A research paper looking at understandability and readability of accounting narratives by Malcolm Smith and Richard Taffler was published in 1992.

That paper, which focuses on the understandability and readability of accounting disclosures, provided a useful reminder that ‘if the message intended by the preparers of accounting disclosures is to be successfully conveyed the receiver must be able to both read and understand it”.

The same is true for accounting standards. It will be important for the researchers dealing with this project to consider whether the standard setters’ intent is clear and also capable of being understood.

Various researchers have used fog indexes and other methods to look at the issue of understandability and readability in different contexts relevant to accounting.

One exercise conducted by a team of academics in the 1980s on an accounting pronouncement in the United States resulted in a recommendation that the standard setters reduce the number of lengthy sentences and attempt to cut unnecessary technical jargon.

Does readability and understandability necessarily mean consistency of interpretation and application will occur where there are identical fact patterns in two entities with different boards of directors, management and a different team of external auditors?

Interpretation is where the conflicts will occur between preparers and regulators domestically and across the globe. Anybody thinking about understandability must consider whether the words describing certain accounting requirements result in unacceptable variability of treatment by those preparing accounts.

Laws need to be as user-friendly as possible for their primary audience. Projects such as this provide an opportunity to reflect on how regulations are presented and whether the way laws, regulations or standards are written fulfils the ultimate goal of achieving compliance.