Many investors are not accountants. Many accountants are not investors. And, yet, the latter produces what the former reads, and the former relies upon what the later produces to make investment decisions.
What if they are no longer speaking the same language?
If we look at the changes to the International Financial Reporting Standards (“IFRS”) over the last two to two-and-a-half decades, the accounting standard changes implement have steadily marched towards “fair value” driven accounting and less “historical cost” based accounting. In other words, these changes have steadily sacrificed the income statement in favour of the balance sheet.
I got Google Gemini to go back into the old IFRS standards and, count how many and which IFRS standards have introduced fair value into financial statements. It might have missed one or two, but the below table is the results:
| Period | IFRS Standard(s) / Amendment(s) | Effective Date | Nature of Shift | Count for Period |
| 2005-2009 | IAS 40 Investment Property | 01-Jan-05 | New fair value option for investment property | 1 |
| IFRS 3 Business Combinations (Revised 2008) | 01-Jul-09 | Mandatory fair value for acquired assets and liabilities, contingent consideration, and remeasurement of previously held equity interest | 1 | |
| Subtotal | 2 | |||
| 2010-2014 | IFRS 10 Consolidated Financial Statements | 01-Jan-13 | Investment entities measure subsidiaries at FVTPL | 1 |
| IFRS 11 Joint Arrangements | 01-Jan-13 | FVTPL option for certain entities (e.g., venture capital) to measure associates and joint ventures | 1 | |
| Subtotal | 2 | |||
| 2015-2019 | IFRS 9 Financial Instruments | 01-Jan-18 | Fundamental reclassification and measurement of financial assets and liabilities, mandatory FVTPL/FVTOCI for many, and FVTPL option for accounting mismatch elimination | 1 |
| IFRS 15 Revenue from Contracts with Customers | 01-Jan-18 | Fair value measurement for noncash consideration | 1 | |
| IFRS 16 Leases | 01-Jan-19 | On-balance sheet recognition of right-of-use assets and lease liabilities initially at present value | 1 | |
| Subtotal | 3 | |||
| 2020-2024 | IFRS 17 Insurance Contracts | 01-Jan-23 | Current measurement of future cash flows for insurance liabilities | 1 |
| Subtotal | 1 | |||
| 2025 | No new shifts identified meeting criteria | N/A | N/A | 0 |
| Subtotal | 0 | |||
| Total Shifts (2005-2025) | 8 |
Source: Gemini
Sources: Gemini, writer’s charting
It is quite clear that this trend of dropping historical cost in favour of fairly valuing accounting items has been compounding quietly through IFRS for decades. In fact, from mid-2000’s till about 2019, the number of IFRS standards requiring “fair valuing” exercises doubled about every five years.
Why is any of this relevant?
Well, value conscious investing traditionally views picking stocks with low Price-to-Book ratios (share price divided by the share’s net asset value) and/or low Price Earnings ratios (share price divided by earnings per share) as prudent investing.
But what if “book” is inflated by being fairly valued? What if earnings are distorted from real earnings by the contra-entries of these balance sheet fair valuations being pushed through profits and losses? What if an accountants view of value “fair value” is differs from the market’s?
A written-up book (i.e. NAV) could trade at a discount in the market (because, well, it’s actually just a journal entry and not backed by cash flows), offering a low Price-to-Book ratio but no actual relevance for investing decision-making.
Same with earnings-based measures. Oh, and returns on capital (e.g. Return on Equity) could also be distorted from this process…
But that’s alright because we have cash flow statements!
No, actually (and quite subtly), IFRS 16 distorts these statements too where it considers a lease payment to have an interest portion and a capital portion and these get split in the cash flow statement (“fair valuing” the lease)… Thus, this would change the structure of “free cash flow” in assessing a company, which is pretty darn fundamental to investing.
And so it has quietly and steadily gone for IFRS, eroding the decision-worth of traditional financial ratios over the last decade and a bit…
I don’t think this is anyone’s fault, but it is perhaps worth pointing out as many investors are not accountants and many accountants are not investors.
Now, can someone let whomever decides IFRS know what is happening…?
ORIGINALLY APPEARED ON MONEYWEB.