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November 14, 2007

The dangers of complexity

The dangers of complexity

As standard setters and regulators pave the way towards the future of financial reporting, Carolyn Canham speaks with Gerard Ruizendaal of Dutch electronics manufacturer Philips Electronics about the dangers of complexity and how it can affect the fortunes of public companies.

Complexity in financial reporting was one of the causes behind the near-bankruptcy of Dutch electronics giant Philips Electronics (Philips) in the 1990s, according to Gerard Ruizendaal, a member of the company’s group management committee. Ruizendaal, a certified public accountant, addressed the issue of complexity in financial reporting at the PricewaterhouseCoopers’ Meet the Experts event in London recently.

At the conference, he explained how Philips, which has a multinational workforce of 125,000 employees, manufacturing sites in 28 countries and sales outlets in 150 countries, was founded in 1891 and therefore had to invent much of its financial reporting itself, while making sure reporting was consistent in dozens of countries.

Following up on the presentation, Ruizendaal tells TA that the first comprehensive law on financial reporting in Europe was introduced in about 1984. “Before 1984, there was only one sentence in Dutch law and that said you have to report ‘in a good way’, that’s all,” he says.

As the reporting requirements grew, so did the complexity. Philips’ management reporting was different from its external reporting and the company used various combinations of its own GAAP, Dutch GAAP and US GAAP.

On the brink

Ruizendaal explains that during the early 1990s, Philips skimmed close to bankruptcy and during one year was forced to fire about 50,000 people.

“We analysed, of course, what had happened to make sure it never happened again and one of the many conclusions was that all our sophisticated [internal] reporting was too sophisticated and not really understood. That was one of the factors – that the company was not financially managed in the best way,” Ruizendaal explains.

He says Philips’ operational managers, who had to use the internal reporting systems, did not really understand them and there were challenges using different systems for internal and external reporting. Ruizendaal adds: “The other thing which did not help was, of course, that properly communicating with financial markets is difficult when you only use external reporting standards for your external reporting.”

Move to IFRS

From 2009, Philips expects to use IFRS for both internal and external reporting. However, Ruizendaal warns that “we’re not out the woods yet” because he believes there is still the possibility the company, which has a shareholder base that is about one-half European and one-half US and other international investors, will be forced to report under IFRS as adopted by the EU and interpreted by the Netherlands’s Auhtority for the Financial Markets, as well as IFRS as adopted by the International Accounting Standards Board (IASB) and interpreted by the US Securities and Exchange Commission (SEC).

Ruizendaal says this issue has become more apparent with the SEC’s recent announcement that it will drop reconciliation requirements only for companies that report under IFRS as adopted by the IASB. “So if the European politicians create more changes than the current IAS 39 carves out, then it would really have [a significant impact],” Ruizendaal says.

He adds that the options would then be to either report under the various standards or to “delist and deregister so that you don’t have to file the statements anymore”.

Ruizendaal says Philips is not currently looking at delisting. “But if things really get worse in terms of all we’re currently seeing, it could come on the table like it has for many other European companies that are dual-listed,” he says.

Ruizendaal has a number of suggestions on how to apply simplicity for financial reporting. “I think it is up to the European Union to make sure that they keep aligned with the IASB to avoid [the situation whereby we] will get to at least two different versions of IFRS,” he says, adding that he would also like to see standard setters talking more with users of financial statements to understand their requirements.

He also says he would like to see IFRS kept as simple as possible. “If they make IFRS too complex, then I cannot use it for my operating unit. I cannot expect the sales manager, the factory manager and the mid-level controllers to be accounting specialists, so I see a danger that before we know, I’m back in the situation we were in the 1990s,” he says.

“I think it needs to be as simple as possible so that it can be used by operational people in smaller units. I think sometimes it has to be complex, maybe like pension accounting – I don’t know how to make that one simpler, but luckily that is something you can handle centrally. But [IFRS] should be much more driven by the users.

“A secondary test for me would be is it also usable by the people who have to live day by day with the accounting information, because if companies don’t use it and investors don’t use it, then I don’t know what the purpose of the whole circus is.”

Ruizendaal says financial reporting is moving towards being too much about compliance and not enough about adding value. “Companies will spend tens of millions, in the case of a company our size, to produce the information to comply with the regulators, but there is no economic benefit,” he maintains.

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