Peeling away financial reporting issues one layer at a time

IAS 23 and FAS 34: Political Interests Trump Accounting for Interest

In Finance 101 it is taught that the decision to acquire assets involves two steps.  First, you figure out which assets you want to acquire (capital budgeting), and second, you figure out how to pay for them (capital structure).  If accounting should represent this process in a faithful manner, interest must be seen as a financing cost, separate from the cost of acquiring the asset.  If you need further convincing, think about this example:
  • Two debt-free oil companies undertake to build refineries, with construction costs of $1,000.
  • One company pays for its refinery by issuing stock and the other by issuing debt.  Accrued interest on the debt to the date of refinery completion is $100.
  • Common sense dictates both assets would be measured at $1,000.
  • FAS 34 defies common sense: one company reports assets of $1,000, and the other $1,100.

As you can already tell, I have no problem finding things to criticize about GAAP, but no pronouncement offends me more than FAS 34.  To require interest capitalization is not merely senseless, it was nefariously designed to smooth the earnings of the largest industrial companies and to defeat the efforts of analysts to measure operating expenses separate from financing costs.

Now comes the IASB, newly reconstituted just a few years ago (albeit still dependent on funds from corporate interests), and purportedly to increase the quality of financial reporting by faithful adherence to its conceptual framework.  Mary Barth, an IASB member from the U.S., and her Canadian colleague informed the members of a seminar I attended that they were asked to affirm their faithful adherence to the conceptual framework upon joining the well-compensated board.  It warmed the cockles of my heart to learn that international accounting standards were principles-based and could no longer be corrupted.

Under IAS 23,  prior to the reconstituted IASB getting its hands on it, two accounting treatments were permitted: (1) the benchmark treatment was to apply common sense–non-capitalization of interest costs; (2) the allowable alternative permitted senseless capitalization.  Yet, a few months ago, the IASB amended IAS 23 to be 100% senseless by requiring capitalization of interest.  There can be no reasonable basis for their position, and I report herein what was written as their basis for revising IAS 23 for your amusement:

  1. Eliminating a difference between IFRS and GAAP is real progress (i.e., two wrongs can make a right).
  2. Allowing only one method will enhance comparability (not true–see above example).
  3. It will improve financial reporting (for reasons unstated).

and the best was saved for last:

"The Board further noted that both IAS 23 and SFAS 34 Capitalization of Interest Cost were developed some years ago. [FAS 34 is 20 years older than IAS 23.  IAS 23 is only 9 years old.] Consequently, neither set of specific provisions may be regarded as being of a clearly higher quality than the other. [Huh??] Therefore, the Board concluded that it should not spend time and resources considering aspects of IAS 23 beyond the choice between capitalisation and immediate recognition as an expense." [comments added by yours truly}

In short, the most baseless basis for conclusions I have ever read.  If the new IASB were a virgin, it is now despoiled. 


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