Chairman's speech: Japan and IFRS Standards

When: 29 August 2018

Where: Keidanren Hall, Tokyo, Japan

Chairman of the IASB Hans Hoogervorst speaks at an event hosted by the Accounting Standards Board of Japan about adoption of IFRS Standards around the world and the Board's work on Goodwill and Better Communication.

Introduction

It is a pleasure to be here in Tokyo once again.

Tokyo has become a ‘second home’ for the International Accounting Standards Board. It is home to our only office outside of London, now led by Makoto Takahashi. Tokyo is also the city where I have spent more time than any other city since becoming Chairman of the IASB. This is my 11th visit in the last seven years and I always love to come back, since no other country is so passionate about accounting as Japan.

During my remarks this afternoon, I’ll talk about progress towards global standards, and what the world can learn from Japan's approach to IFRS Standards. I’ll talk in more detail about a topic of particular interest here in Japan—the accounting for goodwill. Finally, I’ll wrap up with a summary of other important projects on our work plan.

Let’s begin with global standards.

Progress towards global accounting standards

Most of you will be familiar with the IFRS story. Since 2001, an ever-increasing number of jurisdictions have adopted our Standards. The use of IFRS Standards now covers most parts of the globe and this progress may seem to have come almost effortlessly. The reality is somewhat different. Like a swan floating gracefully over water, it can take a lot of paddling beneath the water to keep everything moving forward, and in some cases to avoid going into reverse.

I became Chairman of the IASB in 2011. At that time, IFRS adoption was at a crossroads. A first wave of jurisdictions had followed Europe’s lead and decided to adopt from 2005 onwards, including Australia, Hong Kong and South Africa. The IASB and the FASB were working together to improve and converge IFRS Standards and US GAAP—towards a shared goal of a single set of standards.

However, when push came to shove, the United States became hesitant about transitioning from US GAAP to global standards. After being hit by the terrible tsunami of 2011, Japan also slowed down its adoption of IFRS Standards.

At the time, many questioned whether the US stalling on IFRS would lead to the whole IFRS project unwinding. Seven years later, that hasn’t happened. Far from stalling, use of IFRS around the world has continued to move forward.

Different jurisdictions have chosen different paths to IFRS. For most jurisdictions, the ‘big bang’ approach of adoption has continued to be the best approach. Since 2011, we have seen the G20 jurisdictions of Argentina, Canada, Korea, Mexico, Russia and Saudi Arabia all fully adopt IFRS Standards. Three quarters of the G20 have now adopted IFRS Standards. Our latest research of 166 jurisdictions shows that 144 have now adopted our Standards.

Other jurisdictions, such as China and India, have achieved substantial convergence between their national accounting requirements and IFRS Standards, although some differences remain. Especially China is now very close. Many of its big companies show identical results under IFRS and Chinese GAAP.

Japan took yet another road to IFRS adoption. Your country decided to ‘let the market decide’. It also provided the rest of the world with a very interesting economic experiment. When companies are given free choice, do they stick with national GAAP or US GAAP, or do they switch to international standards. And if they do switch, do they choose pure IFRS Standards or a version of IFRS Standards modified to meet local preferences? Unlike most jurisdictions, no Japanese company was forced to use a particular set of standards.

Your experiment delivered some truly fascinating results.

As of today, around 200 mostly big, multinational Japanese companies have chosen to adopt full IFRS Standards, representing more than 30% of the total market capitalisation of the Tokyo Stock Exchange. In addition, some very big Japanese companies are seriously looking at adoption of IFRS Standards. Before long, 50% of the Tokyo market cap could be IFRS-denominated. The number of Japanese companies using US GAAP has been steadily shrinking and is expected to be less than 10 soon.

As well as providing a path for Japan to move forward with IFRS Standards, the approach has provided policymakers and academics around the world with some very useful information.

First, it shows, given a free choice, companies are prepared to voluntarily incur the cost of transition in order to reap the benefits and international recognition that come with IFRS Standards. We suspected that may be the case, but now we have information to support that assumption.

Second, among those companies transitioning, 100% have chosen full IFRS rather than to use a version modified to meet local preferences.

Third, Japan has now explored a ‘third way’ for jurisdictions to move forward with IFRS Standards, in addition to the existing ‘adopt’ and ‘converge’ models. This approach allowed the larger, more international Japanese companies to apply IFRS, without forcing all Japanese companies to switch. This could be an interesting option for other jurisdictions for whom IFRS-adoption for all companies in one go might be challenging, if only because they may need time to build up IFRS expertise. For this reason, a few Asian countries are looking seriously at the Japanese model of IFRS adoption.

As the world grapples with the challenges of increased nationalism and economic protectionism, it is great to see Japan’s continued commitment to an international approach. Not only in accounting, but also evident from Japan’s leadership in rescuing the Trans-Pacific Partnership and the recent free trade agreement between the EU and Japan. It covers almost a third of the global economy and is seen as a thumbs-up for international trading and a clear stance against protectionism.

Goodwill

Let me now turn to the more technical part of my presentation.

I would like to start with the accounting for goodwill. With the adoption of IFRS 3 Business Combinations in 2004 the IASB abolished the amortisation of goodwill, relying instead on the impairment-only approach. In Japanese GAAP, amortisation of goodwill still exists. Many Japanese stakeholders like the conservatism of goodwill amortisation and it is one of the two IFRS modifications in Japanese Modified International Standards.

As you know, the IASB has been discussing the issue of goodwill following the Post-implementation Review of IFRS 3. Initially, the Board did not intend to revisit the idea of re-introducing amortisation of goodwill. We felt there was insufficient new evidence to merit investigating such an idea. However, the Board decided in its July meeting to include a comprehensive analysis of the accounting for goodwill in our upcoming discussion paper, including a discussion of the possibility of re-introducing amortisation. So, what caused the Board to change its mind?

The Post-implementation Review identified a couple of problems with the impairment-only approach to goodwill. Some of these shortcomings were already known: the annual impairment test is both costly and subjective. Often, the projections of future cash flows from cash generating units tend to be on the rosy side. Impairment losses therefore tend to be identified too late. And when an impairment loss is finally booked, the resulting information has only weak confirmatory value for investors.

Our staff did some excellent research to look for possible ways to make the impairment test more effective. They showed convincingly how goodwill tends to be shielded by what they called a ‘headroom’ of internally generated goodwill. Before I explain what we mean by this, let’s take a step back to look at the impairment test as it is done currently.

So what do we do today? In broad terms, an company measures the value of a unit of business—often by looking at expected future cash flows. Subsequently, it compares that value with the carrying amount of the business for accounting purposes—the book value. Goodwill impairment is only recognised if the value of that unit of business is less than the carrying amount of the business on the balance sheet.

Often businesses are acquired and combined with existing businesses. So when impairment is tested, the value of the business being tested for impairment includes not only the value of the new business but also of the old business. Let’s assume an acquirer has a very successful existing business they have built up over time. Its economic value would be well in excess of its book value because there is significant internally generated goodwill which isn’t recognised for accounting purposes.

Now the company makes an acquisition that is added into that existing business. Even if that acquisition is truly terrible—as long as the value of the old part of the business remains high enough, the value of the combined business may stay above its book value, protected by the headroom of the internally generated goodwill from the old business. In such cases, no goodwill impairment will be recognised.

Our staff referred to this pre-acquisition—and therefore unrecognised—goodwill as ‘headroom’. In practice, a company must burn through all of this headroom before the acquired goodwill becomes visibly impaired. Since the headroom can be quite substantial, our staff research made it clearer than ever before that it is almost inevitable that the results of the impairment test will be ‘too little, too late’.

Given that IFRS 3 relies completely on the impairment test to ensure that goodwill really exists, this is a far from satisfactory situation. The risk is that goodwill just keeps on accumulating over time even when the economics do not justify this. In such cases, the balance sheet may give an overly optimistic representation of a company’s financial health. Although sophisticated investors should be able to see through inflated goodwill numbers, others may not. For example, I was recently surprised to see how crude ‘book-to-value’ indicators seem to be commonly used in automated factor investing without making any adjustments for goodwill.

These are all good reasons for us to bring the question of re-introduction of amortisation of goodwill back to our stakeholders in the form of a discussion paper. Before Japan puts out the flags, however, let me warn you that it is far from a foregone conclusion that this discussion paper will lead to a re-introduction of amortisation.

After all, there were many good reasons why our predecessors on the Board decided to get rid of it in 2004. The information value of amortisation is very low as it is impossible to determine objectively the timeline over which amortisation should occur. Goodwill is an asset with indefinite life and in some cases its value might not decrease over time. We also know that many investors will ignore amortisation and will immediately add it back in their projections. Given our efforts to push back on non-GAAP measurements, this would not be a great development. Finally, any major accounting change needs to pass a clear cost-benefit analysis. It is not immediately clear that re-introduction of amortisation would clear that hurdle.

However, whatever the outcome of this exercise will be, the discussion paper should serve to make our stakeholders better aware of the shortcomings of the impairment-only approach. It may be that there is no better alternative, but in that case we should accept the current shortcomings of IFRS 3 with our eyes wide open. Should the discussion paper lead to better awareness of the possible pitfalls of current accounting for goodwill, this would in itself be a positive development.

Better Communication

Finally, let me say a few words about our Better Communication project.

We are conscious that we have created a lot of work for companies around the world with the implementation of IFRS 9 Financial Instruments, IFRS 15 Revenue from Contracts with Customers and IFRS 16 Leases. These Standards brought much-needed improvements, but in the short term they led to considerable implementation costs.

The good news is that, after these big changes, we do not anticipate introducing wide-ranging, cross-cutting changes in IFRS Standards. Instead, we decided to focus more on improving the way in which financial information is presented. We will improve what we have, rather than create big, new Standards. This will bring improvements to financial reporting, but at much less cost, because it will be mainly about presenting better information that is already being collected. We called this work ‘Better Communication in Financial Reporting’ and it consists of several strands of work.

Primary Financial Statements

The first workstream under the umbrella of Better Communication is the Primary Financial Statements project.

The objective of the Primary Financial Statements project is to provide better formatting and structure in IFRS financial statements, especially in the income statement. Currently the IFRS income statement is relatively form-free. We define Revenue and Profit or Loss but not all that much in between. In practice, both preparers and investors like to use subtotals to better explain and understand performance. Our lack of guidance in this respect has had the unintended consequence of stimulating the use of self-defined subtotals, also known as non-GAAP measures. Non-GAAP measures can be useful to explain in more detail the performance of a company and we do not intend to root them out. However, non-GAAP measures are often non-comparable and they tend to be on the rosy side. So we decided it was important the IFRS Standards themselves provide more detail and structure.

We may end up introducing around four or five additional subtotals, including subtotals which come close to Operating Profit and Earnings Before Interest and Tax, or EBIT. We are also thinking about defining some new line items, especially regarding financing and investing activities. This is important work, because nearly everyone reports operating profit and EBIT, but they are not always covering the same things.

By introducing more standard definitions of some subtotals, investors will have greater comparability among income statements. Such definitions will also help creating more discipline around non-GAAP measures by providing more anchors in the financial statements to reconcile to.

Providing more structure to the financial statements is also important as more financial information is produced and consumed digitally. There is more and more automated investing going on and increasingly artificial intelligence is used to digest information from vast numbers of financial statements from companies around the world. The greater the amount of data consumed by investors, the more important that data is properly structured, consistently defined and tagged.

The increasing trend of digital consumption of financial information is also an important reason why the IASB puts a lot of effort into building and maintaining a high quality IFRS Taxonomy. The IFRS Taxonomy enables machine reading of the financial statements using XBRL. I know that in Japan, the use of XBRL to disseminate Japanese GAAP-based financial information quickly and reliably is already very common and we hope to achieve the same for IFRS Standards. Our Taxonomy is now required for use by foreign companies listed in the US by the American SEC and the European Union is also working on making it a requirement.

Management Commentary

Another work stream under the Better Communication umbrella is what we call our Management Commentary project. There is a lot going on in the world of wider corporate reporting. There is increasing interest in trends like sustainability reporting, integrated reporting and reporting for public policy interests. I am aware that in Japan wider corporate reporting is being promoted as a means of improving corporate governance.

Any organisation needs to remain focused on its core competencies, and for us that is financial reporting for capital market actors. So we do not plan to get into, for example, environmental and sustainability reporting. That is not our area of expertise.

Having said that, the IASB knows that financial reporting in the narrow sense has its limitations. There are many elements of value creation which are important to the investor, but which are not adequately captured in the financial statements. Investors need to understand a company’s business model and its strategy for long-term value creation. They need to understand the intangibles that are vital to their business model. And, yes, sustainability issues can also be important for long-term value creation in certain industries, just think of mining and car manufacturing.

As it is very difficult to measure intangibles reliably, such topics are often best covered in the management commentary section of the financial report.

Our awareness of the limitations of financial reporting in the narrow sense is one of the reasons that the IASB issued its non-mandatory Management Commentary Practice Statement in 2010. This Practice Statement encourages management to provide context to the financial statements. It encourages management to report on the nature of the business, on its objectives and strategies, critical financial and non-financial resources, principal strategic, commercial, operational and financial risks, performance indicators and information about the company’s prospects.

However, there has been a lot of development in this area since 2010. I have already mentioned the increasing interest in integrated reporting with its focus on long-term value creation and the increased awareness about how the environmental and societal restrictions have an impact on long-term value creation. The establishment by the Financial Stability Board of the Task Force on Climate-related Financial Disclosures is a notable example of this trend. Our Management Commentary Practice Statement is silent on these issues. Because of all the changes in recent years, we have decided to update our Practice Statement to capture the developments.

Close

Ladies and gentlemen, I very much appreciate your attention. As I mentioned at the outset, Japan is an important and highly influential member of the IFRS community. The Japanese ethos is to always think long-term, so your long-term support is very much appreciated.

Together, we have made excellent progress in these last few years. We will continue to listen carefully to your feedback. There is a lot we can learn from each other.