With Such Double Standards in Accounting, Is Any Company Safe from the Samsung Biologics Ruler?

A “Second Samsung Bio” in the Making: Cosmetic Accounting Disputes Driven by Principles-Based, Not Rules-Based, Standards

A binary “right or wrong” logic makes application difficult; supervisory authorities need to clarify matters.

As someone who studies accounting, I have always found the subject of cosmetic accounting fascinating. The accounting we currently learn and use was systematized beginning with double-entry bookkeeping in Chapter 9, Section 11 of Summa de Arithmetica by the famous Italian mathematician Luca Pacioli. Later, after the Great Depression in the United States in the early 1900s, it became more sophisticated in an effort to avoid repeating the mistakes of the cosmetic accounting that had been widespread before the Depression. Looking back on that history of accounting’s development, even accounting—which seems extraordinarily sophisticated—has not changed that much over the centuries in terms of the accounts used in financial statements, and the methods of cosmetic accounting are not all that different either. That is why cosmetic accounting is so interesting: I have always been curious about what supposedly groundbreaking method was used to manufacture the numbers.

Samsung Biologics’ cosmetic accounting controversy was one of the hottest issues of 2018, and whether it constituted cosmetic accounting was a matter of intense public interest. Since the question is still under legal review, I will leave the final conclusion to the courts. The starting point and core of the controversy was Samsung Biologics’ decision in 2015 to change the accounting treatment for Samsung Bioepis, an investee company, after having recorded continuous losses since its establishment in 2011. By changing its accounting treatment, Samsung Biologics reported net income of 1.9 trillion won for the period despite an operating loss of 200 billion won. It is only natural that this drew public attention: a company in the red had instantly turned into one posting enormous profits through a single accounting change. And because the company was “Samsung,” the attention was all the greater.

In Korea, large companies like Samsung Biologics apply Korean International Financial Reporting Standards (K-IFRS). The biggest difference between these standards, adopted in full beginning in 2011, and the accounting standards used before 2010 is that the earlier standards were “rules-based,” whereas K-IFRS is “principles-based.” In other words, the previous standards were like the rules in an encyclopedia: for a particular situation, one simply looked up the accounting treatment in the standards book and applied it. But there are too many economic realities that no encyclopedia can fully address. “Principles-based” accounting standards—namely K-IFRS—therefore recognize managerial discretion so that management can choose the accounting treatment that best reflects the substance of the company. When K-IFRS was introduced, there was significant opposition and concern from practitioners over matters such as implementation costs, but the authorities pushed ahead, presenting a vision of increased corporate value and relief from the Korea discount. However, because “principles-based” accounting inherently involves discretion, conflicts have often arisen between corporate judgment and regulatory oversight.

In 2015, Samsung Biologics changed its accounting treatment for Samsung Bioepis. The reason was that, until 2015, it had regarded Samsung Bioepis as a company it could effectively control, but from 2015 onward it changed its judgment to view it as a company over which it could no longer exercise effective control, though it could still exert significant influence. Management’s rationale was that Biogen, a U.S. biotech company that had jointly invested in Samsung Bioepis with Samsung Biologics, would exercise a previously agreed call option and increase its shareholding in Samsung Bioepis, meaning Samsung Biologics could no longer exercise the same level of control as before. Samsung Biologics then commissioned an external professional institution to value Samsung Bioepis, and based on that valuation, it reported a gain of 4.5 trillion won under non-operating profit and loss as gain on investment in a subsidiary.

This is where the cosmetic accounting controversy begins. First: “Why did Samsung Biologics change its judgment on Samsung Bioepis shares at that particular time?” From the perspective of K-IFRS’s principles-based approach, the answer would be that management believed changing its judgment at that point was the best way to reflect the company’s economic substance. In other words, viewed purely as an accounting treatment, it may not have been something entirely impermissible under the current accounting standards. In particular, even before the cosmetic accounting controversy emerged, Samsung Biologics had already undergone an external audit and regulatory review and had received the opinion that there was no problem.

Second: “Did Samsung Biologics overvalue Samsung Bioepis?” On this point, given the future growth potential of the pharmaceutical and biotech sector, it could have been overvalued—or undervalued. The key yardstick for deciding between overvaluation and undervaluation is the perspective from which one views the issue. What matters is whether the valuation institutions conducted their assessments fairly using professional standards; if they met that standard, that should be enough.

As of the closing price on the 7th, Samsung Biologics had a market capitalization of 49.6 trillion won, hovering around 50 trillion won. Its stock, which was priced at 160,000 won at the time of its November 2016 listing, was trading at 767,000 won that day—an increase of no less than 4.8 times.

The Samsung Biologics cosmetic accounting controversy will eventually be resolved one way or the other, but a second Samsung Bio incident could happen again at any time. In a survey of 116 accounting scholars conducted by the Korean Academic Society of Accounting, 109 respondents (94%) predicted that another major accounting scandal like the Samsung Bio incident would occur. The reason is that under K-IFRS, a single issue can allow for multiple accounting treatments, and if a binary standard of “right” versus “wrong” is applied, as in the Samsung Biologics case, an accounting treatment made in accordance with the standards could later be deemed cosmetic accounting. To prevent a second Samsung Bio incident, supervisory authorities need to specify the scope of application and interpretation of the current K-IFRS so that companies can predict how the standards will be applied. K-IFRS, introduced to enhance accounting transparency and strengthen national competitiveness, must not instead become a source of greater interpretive uncertainty that allows compliant accounting to be labeled cosmetic accounting and thereby ends up undermining the country’s competitiveness.

Sung Ho Bae

Professor, School of Business Administration (Accounting), Kyungpook National University

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Original title: 삼바 잣대 이분법적 회계 기준 안걸릴 기업 있나

Author: Seong-ho Bae

Date: 2020-07-08

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&pn=20&idx=22908