Bella Italia!

My family likes to celebrate everything Italian, so in this article, I am excited to honour Luca Pacioli, often referred to as the Father of Accounting. Over 500 years ago, Pacioli, introduced double-entry accounting.

Double-entry accounting is still the basic structure that everything we do in financial accounting is built upon. And like all Italian designs, it is “molto bello”. The beauty of double-entry accounting is that it is self-balancing - every debit needs an offsetting credit. This is why I still use, and will never stop using, T-accounts to navigate complex accounting challenges.

In a previous article, I compared accounting standard setting to playing Jenga, and said a single wrong move can throw everything out of balance and send everything toppling down. How can this apply if double-entry accounting is inherently self balancing? Today, I will explore the relationship between the balance sheet and the income statement, illustrating how double-entry accounting creates challenges for us by looking at a few International Accounting Standards Board (IASB) projects.

Lease Accounting

Many years ago, a former partner at BDO Canada eloquently said to me, “Anyone who doesn’t think a lease is a liability, has never tried to get out of a car lease”. This perspective underscores the importance of reflecting leases on balance sheet for a clearer picture of an entity’s financial position. ?As the IASB begins its Post Implementation Review (PIR) of IFRS 16, a critical question arises: Does this approach provide better information on the income statement?

With almost all leases on the balance sheet, the income statement now reflects their impact as depreciation and interest expenses. This makes a lot of sense for many leases, however, we have heard from investors that they do not find this useful for leases such as office or retail space, as they would rather see the amount paid straight-lined as a rent expense. This is what they would see under US GAAP, which requires all leases on the balance sheet and differentiates operating and finance leases by how they are reflected on the income statement. As we know double-entry accounting requires every debit to have an offsetting credit, therefore the operating lease income statement accounting will impact subsequent measurement of leases on the balance sheet.

Many investors we have spoken with think the US GAAP approach provides better income statement information for operating leases. However, this must be balanced against the impact on the balance sheet measurement and the complexity of having to determine if a lease is operating or finance. I look forward to engaging further with investors as the Accounting Standards Board (AcSB) prepares to respond to the IFRS 16 PIR.

Intangible Assets

The IASB recently started a research project on Intangible Assets. I think we can agree that IAS 38 needs updating and that this is an important project. It is one of the older standards and was written at a time when intangible assets were less critical to value creation.

A paper discussed at the July ASAF Meeting highlighted a range of concerns about accounting for intangibles. Specifically, it noted that financial statements lack sufficient information about unrecognized internally generated intangible assets, which prevents them from reflecting the key drivers of how an entity creates value.

The IASB is in the early stages of this project and is considering various topics to take on. This includes exploring whether more intangible assets should make it on balance sheet. Some of the potential approaches to bring more on the balance sheet include updating the recognition criteria; eliminating the current recognition prohibitions; and eliminating the recognition differences between acquired intangibles assets, including those acquired in a business combination, and internally generated intangible assets.

We have heard from some that bringing more on the balance sheet would provide more relevant information, however we can’t forget that double-entry accounting requires every debit to have an offsetting credit. For example, if internally generated customer relationships were to be reflected at cost on the balance sheet, assuming we could reliably measure cost, that would likely result in a reduction of advertising and marketing expenses on the income statement. Will not reflecting these amounts as expenses provide more relevant information on income statement? I don’t know have answer to that question yet. I have started to dive into academic research on this topic and I am looking forward to future discussions on this topic as the IASB continues its research.

?Power Purchase Agreements

The IASB is very close to finalizing its project to address issues related to accounting for Power Purchase Arrangements (PPAs). As explained in Accountants Love Acronyms, this project addresses the fact that due to the long-term nature of these contracts and the fact that both price and volumes can fluctuate, derivative accounting results in significant fair value movements through profit and loss. The final amendments will result in less Physical PPAs being accounted for as derivatives, and allow hedge accounting to be used for Virtual PPAs resulting in less volatility in the P&L. Unlike, Intangible Assets, I have formed an opinion on this project as shared in Vulcan Logic. The AcSB did not agree with everything the IASB decided on in this project.?

In the case of PPAs, I believe fair value information and the changes in fair value, even if volatile, provides financial statement users with information on the risks of these long-term contracts.

In our AcSB response letter, we suggested hedge accounting be the approach for both Physical and Virtual PPAs, which would provide the fair value information, and we would see the changes in fair value, however through Other Comprehensive Income (OCI) and not the P&L.

I will admit, I don’t think Luca Pacioli, ever envisioned OCI when writing about double-entry accounting 500 years ago, and its use is not liked by all, but it is a tool that we have as standard setters to address when balance sheet measurement does not align with the information needs of the income statement. The IASB is not going this way for Physical PPAs, however they will add disclosure requirements to provide users with information to understand the risks.

I hope you found this article interesting and have a better understanding of how setting accounting standards is like playing Jenga even when our basic tool, double-entry accounting, is self balancing.

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