Income Statement Dominant Cost - PDF

							PORTER HETU INTERNATIONAL
Standards Committee
July 26, 2004

                          ACCOUNTING STANDARDS IN CANADA:
                                FUTURE DIRECTIONS

                                         COMMENTS
                            In Response to the Invitation to Comment


Introduction:

Porter Hetu International (PHI) is an association of independent firms established in 1988. In 34
offices from Halifax to Victoria we provide accounting, assurance, tax and management consulting
services primarily to private (small) businesses and not-for-profit (NFP) organizations. Although
we have 2 offices qualified by the Canadian Public Accountability Board (CPAB) and we provide
assurance services for a small number of listed venture corporations, this is not yet a significant area
with respect to revenue or resource allocation at this stage of our development.

Our primary experience is with the 97% of small businesses with fewer than 50 employees, and
with the 175,000 or so not for profit organizations in Canada.

In this context, financial statements, to be useful for user decision making should be understandable
(not unnecessarily complex), and not misleading (complete and straightforward).

It is in this framework that we set forth these comments.


    1.       We believe that the Accounting Standards Board should maintain its own
             standard setting capability, and its own GAAP. Harmonizing with US GAAP or
             increasing convergence with International Financial Reporting Standards (IFRS) are
             not matters, in our view, that weigh on the minds of NFP management or contributors,
             nor on the minds of small business operators or their bankers and leasing brokers.


             As discussed later, it is our view that IFRS and US GAAP are, quite naturally, under
             the heavy influence of global enterprises and their investors and creditors who are also,
             for the most part, global or large national financial institutions. These players are under
             pressure from regulators and institutional investors, especially after Enron but even
             before, to provide fair value based position statements. The advent and evolution of
             complex financial instruments and the calamity resulting from off balance sheet
             “special purpose entities” push forward this trend.



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     The consequence is that the global financial reporting community seems bent on
     emphasizing the position statement over the income statement (the opposite of the over
     emphasis on the income statement through the eighties and early nineties) and fair
     value over historical cost.


     Previously, the position statement resembled a repository of debits and credits on hold,
     waiting to be moved to the more dominant income statement. Currently, the income
     statement appears increasingly like a spill tank to clear fair value adjustments on the
     increasingly dominant position statement.


     This seems to us to result in standards which are expensive to implement and add little
     value to users of financial statements of the private business and NFP communities we
     serve. Moreover, the increasing use of fair value, with its alternative methods and
     highly sensitive assumptions in many cases, is clearly open to manipulation by those
     willing to do it.


     A balanced effort to report both position and income in understandable ways for
     the often less sophisticated users we serve is far more useful. The usefulness of
     financial statements – to each of the types of reporting entities and their users -
     should be their dominant quality.


     These brief comments are to indicate why we believe that the Board must
     continue its standard setting capabilities, whatever theoretical winds are sweeping
     through the international standard setting community in any given decade.


     Modified historical cost basis accounting has served the needs of small business for
     6000 years. Practical GAAP for smaller users must be maintained in a sovereign
     Canada, and not subordinated to outside standard setters with their own often
     irrelevant, sometimes conflicting interests, and needs to serve.


2.   Our committee does not have a common view on harmonization with US GAAP and
     international convergence. Some of us think that the inter-listed Canadian companies
     will use US GAAP in any case, and therefore we should probably harmonize for large


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     public enterprises and then support convergence with IFRS. Others hold the view that
     convergence with IFRS should be the main line of march.


     We note, with some curiosity, that a number of contributors to this discussion from
     larger public companies have taken the time to oppose Differential Reporting. We
     wonder why, given that they are unaffected. Because our clients are largely private
     businesses and NFPs we have largely left the discussion of standard setting for public
     companies out of this submission. We suggest that public company participants might
     wish do the same with respect to Differential Reporting.


3.   We support the modification of GAAP to provide better information to NFPs
     (Section 4400 etc.) and “non-publicly accountable enterprises” (Section 1300). In
     our experience, such modified GAAP rules should be maintained and extended.


     However, the requirement for unanimous shareholder approval to use differential
     reporting (DR) is difficult to understand. The concern for minority or non voting
     shareholders must be weighed against these facts. A majority of voting shareholders
     can make most major decisions and 2/3 of voting shareholders can decide almost
     everything else including issuing shares, assuming heavy debt loads and selling the
     enterprise. In this context, the DR requirements are excessive. It is also difficult and
     expensive, for purely logistical reasons, to obtain. Similarly, the rule that any
     shareholder change requires repeating the whole process is excessive.


     We have other comments on these matters but such comments are better reserved for
     Exposure Drafts (EDs). Here, our only purpose is to support the direction of
     modifying GAAP to meet the needs of users of financials of different types of
     entities.


     The use of DR is not merely a cost benefit issue. In many cases, the use of DR is better
     understood, and therefore more useful to our clients, their shareholders, creditors etc.
     But the implied burden on public accountants (*to ensure that all are adequately
     informed, advised to seek counsel etc.) is frequently not worth the effort and costs more
     than the savings offered as a reason for DR.


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4.   In the Board’s Invitation to Comment a chart of scenarios is presented with comments
     on the effects on standards, timing and implications. Larger public enterprises should
     comment on the harmonization with US GAAP and convergence with IFRS.


     We believe that the cost of maintaining Canadian participation in the
     international discussions is worthwhile. Not only does the work of the Board assist
     in these global deliberations, but the international process, we are sure, informs the
     process of formulating Canadian GAAP. As we outlined in point 3, however, we
     believe GAAP has to allow for the needs of users (including management) of smaller
     business and NFP entities. We do not see that any of your scenarios quite fits this
     view.


5.   In our view, many smaller public (venture) companies can ill afford the cost of an
     increasing number of GAAP standards (e.g. standards requiring valuation where
     market prices are not available).Extension of Differential Reporting to such
     companies is a possible solution. Perhaps a criterion such as market value of total
     shares and public debt outstanding not to exceed $X million. Such an approach could
     NOT be justified for inter-listed companies.


6.   In our view the Board should proceed on a “principles based” approach to
     standard setting. Such standards should generally be guided by an up to date
     conceptual framework. However, we do not hold the view that consistency with
     such a framework should stand above usefulness and the cost-benefit calculation.


     Standards should set out clearly the objectives intended by the Board. We welcome the
     recent trend towards increased implementation assistance for accounting standards. We
     encourage the Board (and the Institute) to do more to provide implementation
     assistance for different types of entities, including smaller private businesses and NFPs.


7.   Like many of our colleagues who serve our markets, we welcome the recognition in the
     Board’s discussion paper of “standards overload” (exhaustion) and the problems of
     coping with change. We are not convinced that all of the changes are necessary for
     private businesses and NFPs. We are very concerned with the increasing cost to public
     accountants, and the increasing resistance of our client markets to paying higher fees to

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     apply standards for which they see no purpose. The result for us is a reduction in
     margins.


     Quite frankly we are working longer and harder, incurring higher staff costs and
     making less money at the end of the day. The accounting profession, for all its skill,
     cannot continue on such a course. Why should anyone enter such a profession? For the
     past 16 years we have striven to maintain high quality work by becoming associates of
     a Canada wide entity, establishing common standards, using a division of labour to
     make more feasible compliance with GAAP and GAAS. Even so, the effort at our
     individual offices is very taxing.

8.   The costs of standards are not easy for us to calculate. We spend more time reading
     exposure drafts, attending standards update seminars both within Porter Hetu and
     outside, more time considering how they affect our working paper templates and how
     they apply to individual clients. We spend more time training students because the
     standards have changed, often significantly, since they graduated from university. We
     spend more time explaining such standards to clients, including what benefit, if any,
     there may be for such clients.


     We recommend that a part of each request for comments on each ED be an
     estimate by respondents of the costs associated with the implementation of the
     change(s) for companies and public accountants. In addition, comments should
     be sought on the expected benefits to user decision making of the proposed
     change(s)


     We further recommend that the Board continue and extend its recent trend
     towards reducing the impact of standards changes through management of
     implementation times for smaller entities to establish a more survivable pace of
     change.


     We suggest that such implementation management not only consider time
     required to adapt to a particular change, but that the total volume of changes be a
     factor and that this too be managed.



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9.    We support the development of Differential Reporting. In these comments we have
      recommended simplified qualification rules with respect to shareholder approval;
      consideration of the extension of the rules to single listed public venture firms below a
      set level of value of public securities. (see point 3 above)


      We further recommend that non market based (more subjective and more
      expensive)) fair valuations (including goodwill) be avoided for qualifying
      enterprises in future extensions of DR.


10.   We welcome the establishment of the Differential Reporting Advisory Committee and
      the Not for Profit Advisory Committee.


      However, we recommend that the Accounting Standards Board itself increase
      representation from public accountants in the small business and not for profit
      areas of practice. Their financial reporting needs and their resource limitations
      can best be presented by a stronger voice at the big table.


      We further recommend that the terms of reference, activities and summaries of
      advice from the DR Advisory Committee be made available on the web.


11.   We wish to take this opportunity to comment briefly on some of the ways GAAP
      changes can have an impact – often negative - on smaller private businesses. Small
      companies – especially growth companies – often face cash flow problems. For tax
      reporting purposes, CRA looks generally to GAAP where the Income Tax Act (ITA)
      does not explicitly modify reporting requirements. Thus, when accounting policy was
      changed to recognize retractable preferred shares issued under certain tax arrangements
      as debt instruments, CRA began considering the treatment of dividends on such shares
      as interest. Differential reporting options for such shares solved the problem.


      Similarly, callable debt obligations (CDOs), reported as current liabilities, has created
      some problems. In our view, these problems do not arise so much from the correct
      view of the Board that such debt should be current, but the bureaucracy in some banks.
      Most banks key certain numbers from customer financials into bank-wide software.
      Even though the bank itself is often the lender under CDOs, most appear to accept their

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             presentation as term debt for the purposes of ratio calculation. Such a presentation
             produces a better working capital ratio.


             Presenting CDOs as strictly current debt is being mechanically applied by some
             bankers resulting in current ratios being out of covenant. Some small business lending
             managers at the banks have made an issue of this – even though nothing has changed
             but the presentation, and the loan payments are up to date.


             A third area of concern is the trend towards fair valuation and the recognition of
             unrealized gains and losses. Taxation has always been based on realized gains and
             losses with certain exceptions (e.g. death of a taxpayer). This tax policy matches tax to
             cash flow from sale proceeds. Some at CRA see the trend in GAAP towards
             recognizing unrealized gains as an opportunity to press their long held view that tax
             should be based on the same principle. The mismatch between tax and cash flow can
             be very difficult for small businesses. It would certainly impair their ability to finance
             growth and jobs.


             In these and other ways, the law of unintended consequences seems to include negative
             economic and tax consequences as part of the cost benefit calculation with respect to
             changes in GAAP for smaller private businesses and to a lesser extent for NFPs. We
             believe these wider costs must be included in such calculations.




Conclusion

         We appreciate the opportunity to provide comments on the future direction of the Board’s
activities.




Gary Porter, FCGA CA
For the Committee




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