Investor Update May 2022

In profile—Dr Kenneth Lee, Associate Professorial Lecturer at the London School of Economics and Political Science, and member of the Capital Markets Advisory Committee

IASB Investor Team: Can you tell us about your professional background and what got you interested in financial reporting and analysis?

Ken: It all started with my professional accountancy exams. The big employers when I graduated were the accounting firms. The banks were not as large, at least in Ireland at that time, so the obvious route into business was to follow the chartered accountancy examinations. I joined Arthur Andersen in Dublin and it was through the accountancy exams that I became aware of financial reporting. Once I qualified as an accountant, I left practice and moved to the UK where I joined BPP to teach graduates from universities who were completing their professional exams. From there, I progressed to teaching professionals in the city of London in how to use the accounts in valuation and performance analysis. This contrasted with the more detailed issues around how to prepare the accounts. This was the genesis of my interest in investment research and analysis— I was training analysts and investment bankers and was subsequently asked to work as one.

My role as an accounting and valuation analyst at the equity research division of the banks where I worked involved traveling to various asset managers across Europe to talk to fund managers about accounting issues. One of the most important research notes that I wrote while I was working for Citi investment research was about transitioning to IFRS Accounting Standards. The note talked about the first-time application impact to the accounts of these companies across all sectors. This was an amazing project to have been a part of and I travelled across the world to discuss our findings. Other topics that I published research notes on included pensions, which was an especially important theme in the late 90's and early 00's, stock options where the accounting change impacted tech companies, and accruals analysis for establishing the quality of earnings.

IASB Investor Team: Given your role as a lecturer at London School of Economics and Political Science (LSE) and as the programme director for the MSc Accounting and Finance and MSc Accounting, Organisations and Institutions, what can you tell us about how the curriculum has changed or been adapted to current professional requirements compared to the time you were pursuing your education?

Ken: LSE is a research-intensive institution and, therefore, our curriculum is not mapped directly to the content of, for example, the professional exams. At post-graduate level, we tend to be quite flexible, research driven and case-study and analysis orientated. For example, when we teach deferred taxes, we cover not only rules and key concepts but also talk about the analysis a user could do with the deferred tax numbers. In other words, we cover the topic from various perspectives (for example, preparer, user and regulator). There are a few implications of this approach to how we develop the curriculum—issues such as environment, society and governance (ESG), intangibles and deficiencies in the accounting system—all become important themes that get covered. In summary, I describe our curriculum as nimble, flexible, research driven and finally, user focused.

IASB Investor Team: What are your thoughts on the current landscape of corporate reporting and the changes/potential disruption emanating from certain themes. For instance, many stakeholders have pointed towards the growing importance of intangibles and cryptos. Should there be some standard-setting in these areas?

Ken: Accounting principles for intangibles has been a critical issue for many decades now. Six or seven years ago, I recall being in front of an asset manager on the US West Coast and discussing a buy-side analyst’s approach to intangibles’ amortisation. I was trying to understand if they had a policy for amortisation of intangibles, ie did they ignore it or was it treated like an economically relevant cost? What surprised me is that many on the buy and sell-side did not have a policy as such. If there was an approach out there, it was to add back the amortisation. This approach was justified on the grounds that the amortisation charge was related to acquired intangibles that had uncertain useful lives.

The accounting for intangibles has become an even bigger issue because of the growing dominance of the large technology companies with powerful brands. I am certain that intangibles is an area that we need to debate more about in the years to come. For me it is an item that sits on the top of the list of priorities that need to be addressed. Whether an investor is trying to compute meaningful return on capital ratios or trying to understand the true performance of companies, intangibles and how a company reports them is a critical issue. Whether reporting improvements can be done through further disclosures alone or whether improved recognition and measurement is needed is still up for debate. I have sympathy for those tasked with looking to develop principles or rules to address this gap. It is a difficult challenge.

Cryptos is another difficult area for financial reporting and analysis. Investors are still grappling with how these things should be valued and the accounting comes second to that. You cannot put the burden on the accountants and Generally Accepted Accounting Principles (GAAP) to find a solution to the valuation problem. If people are still not convinced about using this asset class, then the accounting is much lower in the list of things that need to be clarified. I understand that several companies hold cryptos and the regulators are looking at this area closely, which makes it a publicised issue. But the fact is that this asset class is still quite new and there are many peculiarities to it. For example, the market for cryptos never shuts. It trades 365 days of the year. In other words, the market for cryptos does not stop or pause so that the market participants can digest a price. The valuation of these things needs to settle down before the accounting can get a grip on it. While the accounting for cryptos is very much at a nascent stage, I do think the IASB’s approach to allow some limited impairment reversal, in common with other intangibles, is an example of a sensible piece of accounting.

IASB Investor Team: Should certain IFRS Accounting Standards (for example, those dealing with provisions, impairment, intangible assets) be examined again considering recent concerns relating to ESG risks and opportunities, and should these be jointly worked on with the ISSB? Or should ESG factors be an area dealt with strictly outside the accounts given their subjectivity/complexity/forward looking nature?

Anyone who is cynical about ESG risks probably does not understand them very well. These are real risks and governments have made commitments to, for example, decarbonise economies, which signals impending change. Companies should already be applying IFRS Accounting Standards in a way that incorporates ESG risks. Having said that, like intangibles and cryptos, ESG risks and opportunities are challenging to incorporate into the accounts. In terms of joint standard-setting by the IASB and ISSB on certain topics, I am open to debate on whether it is better to develop corporate reporting standards jointly or whether some things need to stay in their own ‘lanes’.

IASB Investor Team: What should the IASB do to support the growth in automated data extraction tools (for example, the use of the IFRS Taxonomy for automated extraction of corporate filings data)?

Digitisation of accounting information and access is an important theme. I am currently working on a research paper for the Institute of Chartered Accountants of Scotland with two academics from Glasgow and one from Australia. In the paper, we are looking at the demand from investors and analysts for real-time accounting information. One of the findings through this work is that there is much more hunger for digitisation and consistency of accounting information than there is for real time high frequency data.

IASB Investor Team: What are some emerging areas of accounting research that you think will have an impact on corporate reporting, standard-setting or the accounting profession in the years to come?

Ken: I am keen to understand whether investors respond differently to information that is presented in different locations (for example, the face of the financial statements, the notes, or other parts of the corporate reporting package). To better understand the costs and benefits of developing new accounting standards, it could be useful to understand how users perceive and differentiate between the information presented in different locations. Some academic work already looks into this area but there needs to be more, and it should feed into how corporate reporting standards are developed. In general, although I respect the sophistication of research focused on share price impact, I am personally much more interested in talking to investors and other users about specific issues. Take IFRS 16 Leases, for example; I am keen to understand how the new information presented by companies from the application of the Accounting Standard has impacted user behaviour. There are some fascinating theories from sociology or behavioural science that can be used to further this research.

IASB Investor Team: How did the research analysts who worked for you respond to the changes introduced by the big new IFRS Accounting Standards (eg. IFRS 9, IFRS 15, and IFRS 16)? Do you teach students about these or other Accounting Standards in your programmes? How easy is it to teach, for instance, the IFRS 9 expected credit loss model (ECL) or the IFRS 15 revenue recognition model to students?

Ken: When a new IFRS Accounting Standard comes into effect, analysts are very excited to say that the accounting does not affect cash flows and hence it does not matter. What analysts and other users forget is that forecasting earnings is an essential step in forecasting cash flows. A reason analysts forecast earnings and not cash flows directly is that there are just a few pages of disclosures for cash flows but reams of information on accrual earnings. So, it makes sense for analysts to use the extra information to forecast earnings. Therefore, if a new Accounting Standard impacts earnings then it has importance for (at least) the mechanics of forecasting.

IFRS 15 Revenues from Contracts with Customers is a great example to cover this question. It is a difficult Accounting Standard to wrap your arms around as an outsider. The way it is applied often depends on the nature of the entity’s contracts and there was not a great deal of information about contracts available to investors before the Accounting Standard was applied. So, users depended on companies providing information about the impact of the new standard and it was exceedingly difficult for users to independently estimate the impact beforehand. The disclosures about revenues in the notes are the most interesting aspects of the Accounting Standard and are also not well understood by many analysts. For example, the distinction between contract assets and receivables and the journey from one to the other and then finally to the receipt of cash can be an important piece of analysis. The Accounting Standard is hard to explain to students as well because how it is applied can vary so much from one company to another. I do cover with my students the broader aspects of the model such as the concept of performance obligations, often with an example of a bundled contract from, say, the telecom sector.

In general, the curriculums at most universities cover accounting concepts that are sector agnostic. What I mean here is that you often discuss the accounts for a retail or a transportation company, or if you were to push it to the extreme you could discuss the accounts of a pharma company. A bank or an insurer is rarely discussed because the accounts are just so different, so it probably doesn’t help to discuss such entities when we are trying to explain how the accounting works in general. Students are more interested in covering the 'middle of the road' type of companies. Having said that, loan provisioning is a concept that we cover with students but more from the perspective of dynamic versus static provisioning and less in terms of the actual workings of the IFRS 9 ECL model. In contrast, banks’ analysts are very much interested in how the ECL model works.

IFRS 16 Leases is the easiest of the three new Accounting Standards you mention to talk about with students and analysts. It is the easiest because the impact on the financial statements of companies can be compartmentalised and therefore understood with more ease. For example, analysts were able to make a calculated guess about what the numbers would look like on first time application. IFRS 16 has an important implication for reported cash flows and not all users understand the difference between reported and actual cash flows. The Accounting Standard also results in changes to leverage, which can have a direct impact on valuation (through cost of capital calculations).

IASB Investor Team: As an author of several books on valuation using IFRS Accounting Standards, how important is it to educate investors on IFRS Accounting Standards in a language that they speak? Do you have some thoughts on what the IFRS Foundation could do to improve investor education on IFRS Accounting Standards and on new ones the IASB proposes?

Ken: I think free access to high quality recorded sessions on various accounting topics that focus on user analysis could be an interesting idea for the IFRS Foundation to pick up on. I think it would be a great idea for the IFRS Foundation to pick up on some of the responsibility of publishing materials that are available free of cost to readers.

It is important to think about how you can engage with younger analysts who may like to see short 15-minute-high quality ‘vignettes’ on a variety of accounting topics. It may be helpful for the Foundation to have an education officer and an overall education strategy. The Foundation could also look to partner with university professors to develop materials across a number of chosen topics such as taxes, leasing, stock option accounting etc. It may be an exciting initiative to undertake that would enhance the reputation of the IFRS Foundation.

IASB Investor Team: What are some areas of financial reporting and analysis that you think investors struggle with and could benefit from more educational content? From your time as a leader in the equity research divisions of the big banks, what were some of the financial reporting and analysis topics that you spent most time on, or areas of disclosure that were challenging because companies did not do a great job of implementing IFRS Accounting Standards?

Ken: To be honest, when I was the head of research at a large bank, even though the analysts knew that I was focused on accounting and valuation, my door did not see a constant stream of people with accounting questions. This should not be misconstrued to suggest that accounting is not important. The fact is that accounting is just one of the many issues that analysts must spend their time on when they analyse companies. They face the pressure from clients and their competitor peers which means that they must tackle the issues most relevant to the companies they cover, which is not the accounting in most cases.

If I were to name one area of concern, it would be segmental reporting. To some degree, this is because analysts just can never get enough information on segments because it is so vital to their forecasts of performance. This makes segment disclosures a potential source of constant dissatisfaction.

IASB Investor Team: We thank Ken for taking the time to share his views with us and our readers.

Resources for investors

Articles

Article: Extractive Activities project update

IASB Member Tadeu Cendon explains the IASB’s decisions on the Extractive Activities project’s scope and objectives after feedback from a variety of stakeholders from different jurisdictions.

Webcasts

Webcasts explaining the IASB’s Exposure Draft Supplier Finance Arrangements

Watch two short webcasts that provide background to reverse factoring and other supplier finance arrangements, and illustrate how the IASB’s proposals aim to enhance the transparency of supplier finance arrangements.

Webinars

Webinars explaining the IASB’s Exposure Draft Supplier Finance Arrangements

Watch two webinars that provide an overview of the ISSB’s recent published exposure drafts, as well as a Q&A section with attendees.

IASB Updates and podcasts

April 2022—IASB Update and Podcast
March 2022—IASB Update and Podcast
February 2022—IASB Update and Podcast
January 2022—IASB Update and Podcast