Accounting Animagus?

Posted on October 16, 2020

As hordes of Harry Potter fans will tell you, an Animagus is a witch or a wizard that can transform into an animal and back again at will. In these fictional tales, the physical appearance of the animal resembles its human counterpart. For example, when Professor McGonagall turns herself into a cat, the markings around the cat’s eyes are reminiscent of the Professor’s glasses.
 
As investors, we have an advantage over most Harry Potter fans – we know what the witnesses of an Animagus’ transformation feel like. Many of the changes to accounting rules leaves us to deal with an animal that bears little more than an eerie similarity to what existed before. The frequency and scope of the changes naturally leads to a myriad of questions, such as:
 
Why do accounting rules change?
 
There are many reasons that accounting rules change, only some of which the rule-makers will admit to. A crisis frequently sparks change, where the 2007-2008 crisis has led to sweeping changes for financial services companies, for example. Another reason could be to reduce the risk of accounting fraud. Recent academic research lists less conservative accounting rules as a potential cause of increased accounting fraud. Typically, more conservative accounting rules lead to higher expenses and liabilities for the same underlying transactions – the new lease accounting rules has exactly this impact, for example. Taking a long-term view, the increased conservatism of these rules could therefore be an attempt by accountants to combat the current upward trend in accounting fraud.
 
There are, of course, many more reasons why accounting rules change. However, in practice, investors are more concerned with the consequences (as opposed to the causes) of these changes.
 
How are these changes implemented?
 
When a new accounting rule is made, the standard setters generally consider two options for implementation.
 
The first option allows companies to make a once-off adjustment at the start of the current year (which does not affect profit) and apply the new accounting rule going forward. This can raise some concerns, as (i) profit numbers for the current year will no longer be comparable to that of the previous year and (ii) it can provide companies with scope to manage their financials ahead of the rule change.
 
The second option is to require companies to go back and change the numbers for previous years. However, this frequently causes practical problems. For example, the necessary information to change the numbers for previous years might not have been collected in the past. In addition, it is worth noting that determining trends will still be challenging, as companies are rarely required to change more than one or two prior years’ financials under this option. For this reason, most accounting rule changes are implemented through the first option.
 
Instinctively, most people initially perceive this as the wrong outcome, preferring the second option. However, we should also consider that changing the accounting numbers of previous years costs money (and lots of it). As investors, I suspect we would be the first to complain about the wastefulness of expending millions to reproduce accounting numbers that already exist. Therefore, the more important question is how changes to the accounting rules impact on the investment process.
 
What is the impact of these changes on investors?
 
Changes to accounting rules impact on any investment process that uses accounting numbers. As an example, consider the changes wrought by the new lease accounting rules. The impact (in general) is an increase in gearing (more liabilities), a decrease in profit and an increase in operating cash flow. All of these changes occur, even when the underlying transactions have not changed. If, for example, the investment process excludes companies with high gearing, investment decisions will change even if the business has not.
 
This means that, for example, the underlying indices for passive funds that track accounting fundamentals would need to be reconstructed. In addition, investment processes that depend on artificial intelligence would require significant recalibration. Such changes will be time-consuming and, more importantly, comes with high risk, as these investment processes rely heavily on historical relationships which may no longer be valid. This highlights the importance of constructing investment processes that are robust to changing accounting rules.
 
In practical terms, this means identifying and tracking the real value drivers of a business. Frequently, even existing accounting rules give little insight into the operational performance of a business. Over time, investors in companies that are most affected (e.g. financial services or mining) have developed other measures to value these businesses. Significantly, these measures will remain relevant, no matter what the latest accounting rules are. These are the measures investors need to identify for every company invested in. Moreover, investment decisions should use a range of different inputs and valuation models that are not equally sensitive to changes in a single accounting number. When the investment process is not reliant on a single driver, it is far more likely to remain valid over the long-term.
 
All evidence suggests that the Accounting Animagus is here to stay. However, as with so many investment conundrums, a thoughtful and robust investment process is the best defence.
 
This article was originally published in the 36One Newsletter. Read the original article.
- Author Wessel Badenhorst
Published by Liesl Oosthuizen

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