The Accounting Onion

Fiddling with Fair Value as Rome Burns

If you took a look at the House Bill that went down in flames today, you might have caught Congress fiddling with GAAP as Rome burned. See Section 132 of the bill proposed to empower the SEC to suspend application of FAS 157, Fair Value Measurements at any time, and for any company. Doesn't Congress know that the SEC already has the power to make and break GAAP?

See also Section 133, which directs the SEC to submit a study to Congress on FAS 157 as it applies to financial institutions, and preferably to make FAS 157 and the FASB a scapegoat for bank failures. If Congress were serious about studying accounting's role in how our economy's "fundamentals" have been heading due south, they shouldn't be looking at FAS 157, because it only addresses "how," and not "when" fair value is to be measured. "When" is, of course, the real question, which means that Congress should be questioning instead the accounting standards that the members' banker friends actually do favor: FAS 115 (marketable securities), FAS 140 (securitizations), and FAS 114 (loans). You know, the ones with the loopholes. Such is politics.

The Blog Must Go On

I feel somewhat abashed to be discussing the niceties of financial reporting in the wake of current events, but if Congress can do it, why can't I? My topic for today is to follow up my previous post on current value accounting, discussing whether the current values to be measured should be replacement costs or fair values. Specifically, I want to share with you my reactions to Federal Reserve Chairman Ben Bernanke's view of "hold-to-maturity" versus "market value." Two other comments on my advocating for replacement cost accounting (and a history lesson from Bob Jensen) also got me thinking a little bit more about what I wrote.

First, Bernanke gave congressional testimony arguing that two prices existed for troubled loans: a "hold-to-maturity" price and a current market price. At first blush, this sounds something like the difference between replacement cost and fair value, but it isn't. This is important to me, because I think that some people (for example, see the comment of George Weintraub on my previous post) may erroneously associate replacement cost measurements with 'value in use,' which I believe would be the FASB's nomenclature for what Bernanke has called "held-to-maturity." There can be no question that value in use invariably presents one with a reliability problem due to the subjectivity of estimating future cash flows and discount rates (i.e., 'mark-to-model'), but that is not necessarily the case with replacement costs.

Moreover, I'm not sure that Bernanke, whose intellectual capacity I respect and admire, is making much sense here (and I suspect he knows that). If we are talking exclusively about financial assets and a global marketplace, how could it be that the market price understates the present value of holding a loan until maturity? If the subject were changed to producing or consumption goods, one could expect a difference between value-in-use and value–in-sale. However in the case of financial assets, such a presumption is perhaps a step too far. Teaming up with Treasury Secretary Paulson to sell such a dubious notion to the public may in the long run affect Bernanke's reputation for independence, just as Greenspan's reputation was damaged by his flip-flop on Bush's tax cuts.

Moving on to replacement costs and financial assets, the 'bid-ask' spread captures the difference between replacement cost and fair value. The 'bid' price is fair value, because it is the amount that someone is willing to pay to purchase the asset from you. The "ask" price (a higher price) is the replacement cost, because it is the amount that a market participant who already has the asset is willing to sell it to people who want it. But, even if there is no formal market maker to provide both bid and ask prices, the concept still applies for the purpose of comparing replacement cost and fair value accounting. For example, and moving from financial to real assets (and I owe this one to Bob Jensen), bluebook prices for vehicles are the functional equivalent of average ask prices by used-car dealers.

Second, Jim Noel, my longtime friend and sounding board, expressed his doubts after reading my previous post that replacement costs were an appropriate basis of measurement for bank balance sheets. That's because the single most important question to ask about a bank, as the financial crisis painfully illustrates, is liquidity. Indeed, the strongest argument for fair value is that it is the gold standard for measuring liquidity.

My response to Jim is to revert to core principles (at least mine) of financial reporting: investors primarily seek information about wealth and changes in wealth. In normal circumstances, liquidity is of secondary importance. As a case in point, maximum liquidity leaves one with just cash and no wealth producing assets.

Granted, there are circumstances when liquidity is paramount, but that should not mean that principles-based accounting needs to be either replacement costs all the time, or fair value all the time. For example, when ARB 43 requires a departure from historic cost to measure inventory, the general basis of measurement is replacement cost. However, replacement cost valuations are capped by 'net realizable value' and floored by 'net realizable value less incremental costs to sell.' A second, and more general example, is the required switch to liquidation values when an entity's ability to continue as a going concern becomes doubtful to a sufficient degree.

The Fair Value Debate Needs Some Rules

My general sense is that some order is needed to make sense of the challenge to fair value. Whatever your position is on the issues, I would like to suggest that you think about providing answers to the following three questions—in the order listed:

1. Which assets and liabilities should be measured at current value?
2. Which 'attribute' of an asset or liability should be measured—i.e., replacement cost, fair value, historic cost, present value of future cash flows?
3. What rules would be needed to assure that the attribute chosen is reliably measured?

Which assets and liabilities should be measured at current value -- So much of the balance sheet and earnings volatility that the fair value naysayers are complaining about is brought on by our 'multi-attribute model', where some assets and liabilities are measured in terms of actual past cash outflows and others are measured in terms of estimated future cash inflows. The status quo is simply not stable, so we have to decide whether to move backwards to historic cost or forward to a single set of current values.

Of course, I believe that means we have to finally bring ourselves to measure liabilities as well as assets at their current values. This shouldn't be so hard. A simple economic principle that I pointed out in a previous post is that all of the liabilities of an entity are perforce assets of other entities. If we can measure these financial relationships when they are on the lender's balance sheet at current values, then why in the name of symmetry can't we use that valuation for borrowers? Oy, it makes me crazy.

Which attribute should be measured – Some say fair value, some say present value of future cash flows, some are sticking with historic cost, and I say replacement cost. Whatever your druthers, reported earnings will not pass a reasonableness test until we stop being content with adding apples and oranges on the balance sheet.

How to reliably measure the current value attribute chosen? -- I hope George W. (the Skeptical Texas CPA) and others may now see that the difference between replacement cost and fair value is really not a difference between market quotes and mark-to-model. Rather, it's how best to measure what it is you think ought to be measured. Maybe fair value and replacement cost measurements will require mark-to-model every now and then, but for reasons I pointed out in a previous post, replacement cost measurement will require less of it.

http://cryptome.org/bailout-2.pdf

The Anti-Fair Value Lobby Has a Point (Even if They Don't Know It)

In the current environment, I am an ardent supporter of those who would resist calls to suspend fair value accounting rules. But, when I was at the SEC, I had a front-row seat on what was perhaps one of the most brazen abuses of fair value accounting in history. I was reminded of it by Joseph Stiglitz's recent commentary on CNN.com, in which he characterized the mortgage securitization craze as just another pyramid scheme. Keep that in mind as I tell you the story of Stephen Hoffenberg's $400 million fraud.

Hoffenberg controlled Towers Financial Corporation whose business ostensibly was to purchase junk receivables for just a few cents on the dollar from hospitals, credit card companies, phone companies, etc. Claiming to be able to draw water from stones, Towers would blithely write up the value of the receivables (not strictly 'fair value,' but functionally the same) to create the illusion of collateral and earnings. Investors would be enticed by high interest rates, stellar financial results, apparently healthy cash flow, and a successful track record of paying off prior investors. But like all pyramid schemes, the returns to investors came from only one real source: new investors-cum-victims. The collection operations themselves were pretty much a sham.

All of this occurred in the late '80s and early '90s before business journalists could no longer allow themselves to remain ignorant of accounting matters—save, perhaps the occasional exposé in Barron's. The Justice Department was even worse, eschewing the drudge work of explaining complex financial fraud charges to juries in favor of prosecuting drug pushers. Hoffenberg also flew under the SEC's radar for years by avoiding (perhaps, evading) registration of its debt and equity offerings (think hedge funds).

Hoffenberg might have been able to actually get away with his scheme if he had only known when to quit. But, as is often the case, greed and ego knew no bounds for him. He eventually accumulated enough of other people's money to buy the New York Post from its bankrupt owner, and was practically knighted by the state's governor, Mario Cuomo (by coincidence, the father of the guy whom John McCain now says should be the next SEC chairman). Being on the verge of obtaining permanent financing of his acquisition of the Post by using his ill-gotten gains as collateral finally lit a fire under the regulators; if Hoffenberg were allowed to close the deal, the government's case could turn into an "investigation of a citizen above suspicion" in the eyes of the public.

Less known about the case, but adding to my own deep sense of injustice was that Hoffenberg was able to successfully parry the SEC for a time by trotting out all manner of exorbitantly paid 'expert witnesses' to bless his accounting and business model. Exhibit A was Sidney Davidson, an emeritus professor of the University of Chicago's business school and former member of the Accounting Principles Board. Was Davidson also taken in by Hoffenberg? I think not; Davidson was also allegedly (my information is second hand here) on the payroll of Charles Keating's Lincoln Savings and Loan, one of the great implosions of the S&L era. One of Davidson's 'consulting assignments' was to convince Ernst & Young that the partner who smelled a rat should be taken off the engagement.

Back to the Present

The point of dragging Davidson into this is to show how big money can talk; and it is doing a lot of talk about fair value accounting lately. Invariably, it seems, a very ugly side of human nature seems to come out as a pyramid scheme inevitably starts to lose steam. Those whose investment may be hung out to dry curse the doubters for 'ruining it for everyone else.' That's how I see the proponents of suspending, or even doing away with, the current set of rules we have in place for recognizing certain financial assets at fair value, and taking the gains losses to income.

But, how could fair value accounting be the device by which one scheme was kept alive, yet could have prevented another? Like the Hoffenberg case, there is no question that the two main ingredients of the current fraud were lack of transparency into what was going on, and accounting tricks to give the illusion that all was well. The difference is that in the case of our present extreme unction, it was the ability to hide actual losses (as opposed to create fictitious gains) by not using fair value accounting for junk assets. The answer for the apparent paradox lies in a significant flaw in 'fair value' accounting.

Fair Value is Not Perfect, But It Replacement Cost Would Have Been a Lot Better

First, the limitation of fair value. As I have long argued, I believe in comprehensive application of some form of 'current value,' but 'fair value' ain't it. Fair value is based on exit prices – the highest amount something could be sold for in some market, and there may well be more than one, or even no market to choose from. But 'current replacement cost' is based on the lowest amount that you would have to pay to replace the thing you already have. If the standard for measuring bad loans were current replacement cost, there would have been no way that even Sidney Davidson could have defended a higher replacement cost than the price Hoffenberg had just paid, no matter how much he, the putative master collector, thought he could extract.

The logic of replacement cost also, I believe, takes out the critics of current values at the knees, and also gives them a little something--a higher valuation than fair value. In illiquid financial markets, the question of how much it would cost you to replace a stream of risky cash flows with another contract(s) that provide the same flows with the same risk could be a lot greater than what you could sell them for. Replacement cost relies on the proposition that there will always be a seller if you offer enough money. Stated another way, replacement cost accounting would say that the point on the bid-ask spread to value a security would be the lowest accepted 'ask' price from among all sellers, which in illiquid markets could be significantly higher than the 'bid' price.

Even the proponents of fair value measurements would have to admit that FAS 157 equivocates on where fair value lies on the bid-ask spread. Under replacement cost accounting, the answer is unequivocal. If you want more information on the logical superiority of replacement cost, see here and here for two earlier posts in which I explain the correspondence between replacement cost measures and economic concepts of wealth.

But setting aside the differences between fair value and replacement cost, there are other important observations to make about the mess we are in, and who is proposing what to get us out. First, those who would argue that fair value rules should be suspended during this economic crisis are no different to me than the first potential investors in the pyramid scheme who express concern that there might not be a seat for them when the music stops.

Second, if fair value accounting had been more comprehensively applied, and not less as some would like to see, than at least the bubble would have burst before it became as large as it did; financial institutions would have been forced to take more losses earlier for fair valuing loans and held to maturity investments. For this, the FASB has to take much of the blame for the loopholes they permitted when crafting FAS 115.

Third, it appears that the fair value debate, no matter how cynically one may regard the critics, is finally making it clear that we have to de-link regulatory capital measurement from reporting to investors. If regulators want to rely on a fair value balance sheet, fine. If not, they should make their own, thank you very much.

And another big difference between Towers and the current crisis is that Hoffenberg got 20 years. Today's CEOs are smart enough to take their money and run.

Top Ten Reasons Why U.S. Adoption of IFRS is a Terrible Idea

Now that the SEC has proposed its "roadmap" for jettisoning US GAAP in favor of IFRS, critics are finally starting to build momentum. Charles Niemeier, outgoing PCAOB board member, delivered a brilliant critique of the SEC's plans to the New York State Society of CPAs. As he faces the SEC Chair Christopher Cox's guillotine for daring to disagree, Niemeier might be thinking that speaking the truth as the end approaches can set him free. On SEC-related matters, Niemeier is among the most experienced, qualified and thoughtful persons in the federal government. Only greater opportunity must await him in a private sector position for which personal integrity counts for something. Not all bureaucrats are so lucky; rumor has it that Cox resorted to arm-twisting on at least one occasion to make his staff toe the party line.

On the overseas front, CFO.com reports that the UK-based Association of Investment Companies has expressed concern that investor needs are not being placed front and center in the deliberations of the IASB. And what's more, newly proposed changes to the IASB's makeup may be little more than going through the motions.

So, with inspiration from Charles Niemeier, and apologies to David Letterman, here are my "Top Ten Reasons Why US Adoption of IFRS Is a Terrible Idea."

#10: Another S-OX 404 Waiting to Happen

It is a certainty that direct costs of conversion to IFRS will be in the billions of dollars, and much of it will go to auditors for new "services" like training, systems rejiggering and whatever else companies can be induced to pay for. If the continuing saga of the S-OX 404 debacle is any guide, it is also a safe bet that initial estimates, bearing the imprimatur of the audit firms and/or the SEC, will understate the actual costs by orders of magnitude.

What will be the benefits? The politically correct answer is that conversion to IFRS will reduce the cost of capital by achieving comparability through principles-based standards. LOL. There is simply no evidence that IFRS will reduce the cost of capital, much less be able to cover the humongous costs of conversion.

In fact, we have nothing except wishful thinking to prevent an increase in the cost of capital. Generations have bought into the notion that our capital markets are preeminent because of the distinctiveness of our system of financial reporting. Now that the current administration has decided to foist IFRS on the public, we are supposed to believe that we had better adopt the conventional wisdom about IFRS, or globalization will pass us by.   

IFRS conversion is also eerily similar to S-OX 404, in that we not only have a problem of uncertain cost and unquantifiable benefits, but we also have even more acute problems in justifying the costs for smaller companies. In the case of S-OX 404, costs were not incurred by stakeholders in any sense proportionate to the benefits they could have expected to realize. That's why it is taking the SEC far too long to figure out how to reasonably implement S-OX among smaller reporting companies. As many are coming to realize, there is no good solution to that problem; far too many companies are going to be spending far too much money on their internal controls over financial reporting and receiving far too little benefit. Likewise, there is no good solution to the IFRS conversion problem for smaller companies, and that's probably why nobody at the SEC is talking about it.

#9: "The Lady [actually, the AICPA] Doth Protest Too Much, Methinks"

Far too many of the people promoting a change to IFRS can't stop salivating over the effect it will have on their bank accounts. Who can't see that auditors push IFRS out of their own self-interests: a new revenue source that could exceed S-OX, plus the prospect of reduced exposure to litigation? Who can't see that the top executives of public companies push IFRS because it will be easier to make their numbers, and they won't be second-guessed by auditors, disgruntled investors or the SEC?

Of course, none of these are good reasons, and except for the shills at the SEC, we hear no one else promoting IFRS. If there is to be a legitimate evaluation of IFRS, we have to get auditors and issuers to shut up; especially, the auditors. Just for jollies, read the AICPA Code of Conduct, mindful of what the "P" in "CPA" is supposed to stand for: "Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism." Then, ask yourself whether the AICPA's one-sided promotion of IFRS constitutes an attempt to serve or to fleece the public. (See especially the incessant and unrepentant cheerleading of its CEO, Barry Melancon, and the misleading white papers put out by the AICPA's Center for Audit Quality.)

For legitimate acceptance of IFRS to occur, we need to hear from informed investors, and not just their putative surrogates, i.e., SEC and FASB, who receive far too much support from special interest groups to be legitimately perceived as being all for the investor all of the time. Rather than blowing their own smoke, the SEC should be discussing ways to obtain large quantities of investor input – not just from carefully selected attendees at carefully orchestrated roundtable events. Relative silence from investors should not be interpreted as approval of convergence, because a classic free rider problem is at work: What small investor would incur the opportunity cost to give the SEC their two cents on IFRS for practically nothing in return? Perhaps a very few good samartans might, but the problem becomes even more acute when you consider the SEC's recent history of ignoring the investor feedback it does receive.

The SEC went ahead and eliminated the IFRS-to-US GAAP reconciliation despite significant and strident criticism from investor groups and academics. In order for democracy to work, one has to believe that one's vote has the potential to count for something, but this SEC has already sent too many signals that the fix is in.

#8: IFRS Is No More "Principles-Based" Than US GAAP

I have already written a number of posts exposing this myth: fuzzy-lined rules are not principles, and holding up the notion of "true and fair view" as the core principle underlying IFRS is undocumented, amorphous and vacuous. The IASB's track record is anything but principles-based, and there is plenty of recent evidence, which I've written about here and here, to support that statement.

#7: Research Strongly Indicates That GAAP Is At Least As Good, If Not Superior to IFRS, so Why Switch?

In her testimony to Congress, Teri Yohn of Indiana University, brought to bear about 25 high-quality academic research studies comparing IFRS to U.S. GAAP. Highlights of her testimony are that the studies indicate that investors appear to prefer U.S. GAAP over IFRS, and that IFRS has provided greater opportunities for earnings management. Duh.

The depressing part of all this is that the SEC gave her and the academics whose research she presented short shrift when deciding to permit foreign filers to provide IFRS financial statements without reconciliation to US GAAP. The unmistakable message from the Cox-administered SEC is "damn the evidence -- full speed ahead to IFRS!" One can only hope that the Democratic commissioners will insist this time around that faith-based rulemaking will be supplanted by attention to the evidence. Who knows whether the new Republican commissioner, Troy Paredese, also an academic, can rise above partisan politics to do the right thing for investors?

#6: GAAP Is Better Than the IFRS

In 1999, the FASB concluded, in its extensive report on the similarities and differences between IFRS (technically IAS at the time) and US GAAP, that IFRS was lower quality than GAAP. Very little has happened in the ensuing eight years, except for some shuffling of the deck chairs, to change that conclusion. I am certainly not aware that anyone is claiming that significant progress in closing the gap between the GAAPs has been made. In fact, PwC is now questioning whether convergence efforts should continue, since they have produced so little over the years.

Chairman Cox, ever the salesman, is fond of pointing out that the IFRS SPE rules seem to have worked better during the current subprime mortgage crisis than US GAAP's FAS 140; but, that's something of a red herring. Here is what retired professor Bob Jensen (Trinity University) wrote on the AECM listserv:

"The main problem in the subprime crisis was not the accounting standards. It was the fraud that went on in real estate appraisals and self-serving loans way beyond what many buyers could ever be expected to pay off. This is fraud at a totally different level. It was in fact a Ponzi scheme.

Also, the auditors failed to properly audit bad debt reserves in the subprime crisis. This signals an independence problem between big banks and their auditors. It's not a problem with the FASB or the IASB standards themselves. It is more of a problem with auditing standards and professionalism. Where were the auditors in the options backdating scandals? Where were the auditors in correcting absurd bad debt allowances."

The most important event affecting the IFRS versus US GAAP debate was not any single substantive change in either IFRS or US GAAP, but actions taken by the European Union to stamp out the nascent trend of adoption of US GAAP in Europe before it could be given any real chance to take hold. The political forces that control the European Union were scared to death by changes in the German law in 1998 that allowed public companies a free choice between outmoded German GAAP, US GAAP and IFRS. Indeed, the hundreds of public corporations that did switch from German GAAP split more or less evenly among IFRS and US GAAP. Panicked, the EU abruptly issued Regulation 1606/2002, mandating adoption of IFRS for all public companies by 2005.

I admit to not having an in-depth grasp of this history as to why US GAAP came to be declared contraband in Europe. One thing that is clear, however, is that any notion that acceptance of IFRS grew organically in Europe is a myth. More likely, IFRS was seized upon as a defensive measure against US GAAP, which probably made the powers that be in countries like France fearful for their reserves. The rise of IFRS in Europe was simply a political power play, and the current US administration is using Europe's fervent desire to murder US GAAP as a bargaining chip, with the Republican faithful of the SEC playing the tune.

#5: There Must Be a Better Way to Improve US Financial Reporting Than This!

Just because accounting standard setting in the United States has become a political process dominated by non-investor "stakeholders," it doesn't mean that the only path to reform is to ship the process overseas! Instead of cutting the size of the FASB, the Financial Accounting Foundation, its governing body, should have been looking for ways to increase investor influence on standard-setting. Raising awareness of this issue was one of the many positive legacies of Arthur Levitt's tenure as the SEC chair, but except for token compliance, it went largely unheeded.

You can forget about any pretense of investor influence at the IASB once US GAAP is out of the picture. China, a world leader in opacity, is now beginning to hold more sway over deliberations, while simultaneously the IASB comes increasingly under the spell of the many parliamentary approval processes it has to negotiate. Effective "board membership" will swell as every major economic power will insist on having its say.

#4: IFRS Is Not Compatible with US-Style Corporate Governance

As I wrote in a previous post, John Coffee of the Columbia Law School sees the corporate scandals taking place in Europe as fundamentally different from those in the U.S., due to significant differences in ownership structure. The scandals in Europe generally involve majority-owned corporations and do not feature an accounting manipulation. There are two reasons for this. First, financial reporting is less important to the majority owners because they rarely sell shares.  Second, fraud is more easily accomplished by authorization of related-party transactions at advantageous prices, below-market tender offers, and other forms of misappropriation.  Any trading that takes place between minority owners has less to do with recent earnings reports, and more to do with an assessment of how minority shareholders will be treated by controlling interests. 

In dispersed-ownership corporations that are prevalent in the U.S., stock price can have a significant effect on a manager's compensation, providing them with strong incentives to manipulate accounting earnings. Thus, it stands to reason that accounting should be difficult to manipulate if it can be used to rip off shareholders.  The evolution of U.S. GAAP can be seen as a response to the need for specific rules that minimized the role of management judgment because of management's a strong self-interest in the reported earnings and financial position.  Lacking empowered gatekeepers to prevent accounting fraud, we have had to place our hopes on very inflexible accounting rules, the SEC and private attorneys to catch the cases where management has attempted to surreptitiously cross the bright line.

Thus, it should be self-evident that IFRS-style accounting, replete with fuzzy lines, "judgment" and "reliable measurement" tests, would be a gift to U.S. managers.  Outright fraud would be replaced by more subtle means of "earnings management," rendering the SEC and private attorneys much less potent.

Even accepting the assertions that IFRS works well in the 100 or so countries in which it is used, we have no way to tell whether it can work well in our environment. Anyone who says that IFRS properly applied in the US would have prevented Enron, or WorldCom, or Adelphia should have their head examined. No basis of accounting can stop fraud, but rules-based accounting will help put the fraud feasors in the clinker.

The libel against U.S. GAAP that found its way into S-OX was that Andrew Fastow was a mad genius, capable of walking an accounting tightrope by creating complex special-purpose entities (SPEs).  Not true. Frustrated Fastow was only able to get the accounting treatment he needed past the auditors by hiding from them side agreements that unwound critical provisions requiring the new investors to have a sufficient amount of capital at risk in the SPEs.  More likely, if IFRS had been the basis of accounting for Enron instead of GAAP, it might have taken longer to discover the fraud, or to pin the blame for the fraud where it belonged.

#3: Would You Have the United Nations Rewrite the US Uniform Commercial Code?

Such was the way that Bob Jensen expressed the problem of lack of sovereignty over IFRS. No matter what motions the SEC will go through, or resolutions Congress may enact, the risk of near total loss of US influence over accounting standards is a real possibility. Rising economic powers like China will have their own agendas, virtually assuring that any place at the table we would be given in exchange for abdicating our sovereignty over accounting standards used by US companies would be temporary.

And, I seriously wonder how IFRS can flourish if US GAAP is dead. Without having US GAAP for a benchmark, the race to a lowest common denominator version of financial reporting would begin in earnest. In addition to the obvious harm to investors, the US could lose one of its comparative advantages as a financial center; listings on our markets would shrink instead of grow.

#2: There Is No #2 -- Can't Have a Top 10 List with Just Nine Reasons!

#1: If It Ain't Broke, Don't Fix It!

One of my colleagues at the Tuck School was Brian Quinn, who championed the approach to business policy known as "logical incrementalism." The premise is that business processes in large corporations are so complex that it is usually too risky to undertake radical change. A more effective approach would be to make smaller course adjustments over time.

Granted, sometimes things are so bad, radical change is unavoidable, but no one can say that US GAAP has put us between the proverbial rock and a hard place. US GAAP is plenty complex and has plenty of its own problems, but it is far from broken, if not still the best system of its kind that has ever been produced.  While it is true that some accounting standards have done more to harm investors than to help them, the majority have resulted in incremental improvements. In other words, the process, though far from perfect, works.

Can we say the same for IFRS?  Will it work as well, if at all, in the US? One answer is being brought to you by the people who said our troops would be greeted as heroes by the citizens of Iraq. I give you 10 -- okay, only 9 -- reasons to have a different answer.

IAS 24: Related Party Disclosures Are Too Transparent to Suit China

Earlier this month, Compliance Week published an article entitled, "Related-Party Transactions Bane of China's IFRS." I had been generally aware that China's eagerness to fully embrace IFRS had been tempered by its reluctance to furnish the required related party disclosures per IAS 24, and that it was working with the IASB to relax the related party rules in IFRS, and the article does a very nice job of fleshing out the details and describing the dynamics. The IASB has published an exposure draft of amendments to IAS 24 to reduce the related party disclosure requirements, with perhaps more still to come.

China's economic reforms may have started almost 30 years ago, but it will continue to remain distinctly different from other large economies for years to come in that a significant amount of their GDP is produced by state-owned enterprises. Approximately 150 corporations report directly to the central government, thousands of others (including subsidiaries of these 150 corporations) are owned by provincial and municipal governments, and many companies that were partially privatized retain the state as a majority or influential shareholder. (source: Forbes.com)

The Compliance Week article reports that China's stated motivation to change IFRS is costs/benefits based. Their position is that since so many companies are state-owned, and therefore related, disclosing them all would cost too much and provide little information of value to users of the financial statements. Alain Texeira, a director of technical activities states, "We had a genuine concern that if you disclose so many parties as related parties, you'll get hundreds of pages of disclosure and the real related parties will be masked…"

"Hundreds of Pages"?

Just for jollies, I pulled up the latest annual reports filed with the SEC for the eleven Chinese companies listed on the New York Stock Exchange. Although I would have to go back and verify this, I have a high degree of confidence that each company stated that it was in compliance with IFRS; therefore, IAS 24 would be the operative standard for the related party disclosures in the notes. IAS 24 is broadly similar to SFAS 57, but IAS 24 also requires disclosure of compensation information to executives – which incidentally, are to found elsewhere in SEC filings.

All of these companies disclosed that either a government entity was either a majority owner, or owned a large enough percentage to be able to exercise significant influence. As relatively large companies, the volume of transactions with other government-owned entities could be expected to be on the high side, along with the number of pages in the notes to their financial statements dedicated to related party disclosures. As SEC registrants, the adequacy of their related party disclosures would have been subject to review at least once every three years; and related party disclosures are almost always the focus of an SEC staff review.

In contrast to hundreds or tens of pages, I found that the average number of pages devoted to the related party transaction note accompanying the financial statements was merely five. The individual disclosures ranged from a low of three to a high of seven pages, so there weren't even outliers. Not to beat a dead standard setter, don't forget some of these pages would have been utilized in every case to provide executive compensation information.

A More Clear-Eyed Cost/Benefit Analysis

Let's set aside the hyperbole and take a principles-based look at the role related party disclosures serve in financial reporting.

Shareholders and potential investors use financial statements to help them assess "stewardship" and "value." Stewardship refers to management's responsibility to use assets efficiently and in the interests of shareholders; value refers to the future profitability of the enterprise. One of the fundamental presumptions underlying the value of financial statement information is that the transactions on which they are based take place between disinterested parties. If this were not the case, there is less assurance that transactions were negotiated to the maximum advantage of the shareholders of the enterprise, or that historic transactions can be validly extrapolated to predict the future.

There is really no good solution to deal with oft-encountered situation where this unrelated-party presumption is seriously challenged. The best that can be expected is for liberal and extensive disclosures to alert the reader of the financial statements of material related party transactions. Not only should the disclosures help an investor assess the information value of the financial statements provided, but the sunlight provided by related party disclosures deter those who may be able to negotiate transactions with a company on a basis that is something less than arm's length from doing so.

Will China Lead a Race to the Bottom?

Related party disclosures are just one more example of where IFRS tends to be diverging from the quality of financial reporting that results in the relatively low cost of capital we currently enjoy in the United States. China is a highly distinct economy and any attempt to craft disclosure rules that respond to the peculiar needs of its economy and society are likely to clash with what is best for U.S. investors. (So much for the idea that one single set of accounting standards can work well the world over!) As the second-largest economy in the world, China is already demonstrating its willingness to use its economic clout to shape IFRS to his own needs, which as I have stated, would not just deprive investors of relevant and reliable information, but could further increase the risk of loss due to fraud.

Is six or seven pages of disclosures too much to ask to guard against the risk of fraud -- and fraud perpetrated by a sovereign state against foreign investors no less? I find it ironic and telling that around the time when the IASB is considering relaxing its related party disclosure requirements to accommodate China, the SEC (albeit before the arrival of Chairman Cox) ratcheted up its MD&A disclosures (see Financial Reporting Release 61) to include information about transactions with any person or entity that may have the potential to exercise leverage in negotiations with the company, even if the formal definition of a "related party" under GAAP has not been met.

Maybe the day will come when transparency in financial reporting has the same currency in China as it has in the U.S., but there can be no doubt that day is still a long way off. In the meantime, do we converge our accounting with theirs, or do we hold to our principles until China rises to ours? In case you have any doubts, that's a rhetorical question.

IFRIC 15: Revenue Recognition Rules Hark Back to Not-So-Good Ole Days of U.S. Accounting

With the SEC's publication of their proposed roadmap for the U.S. adoption of IFRS, all of the press coverage I have been reading has focused on the big picture. (As usual, Floyd Norris's is among the best.) But in the background, the IASB has been conducting its business as usual: drawing squiggly lines in the sand, vaingloriously dubbed principles-based standards. IFRIC 15 is a perfect example, as I shall now commence to explain.

What is 2+2? Answer: Whatever You Want.

The International Financial Reporting Interpretations Committee (IFRIC) of the IASB issued IFRIC Interpretation 15, Agreements for the Construction of Real Estate, effectively to provide whatever excuse an issuer could need to accounting for a construction project under either IAS 18, Revenue, or IAS 11, Construction Contracts. Stated as simply as possible, it's an unrestricted license for condominium developers to manage earnings.

Setting aside the vinegar bottle for a moment, the Interpretation provides that an agreement for the construction of real estate is to be accounted for by the percentage of completion method (IAS 11) when the buyer is able to specify the major structural elements of the design of the real estate before construction begins and/or specify major structural changes once construction is in progress. Otherwise, earnings would normally be deferred under IAS 18 until completion of the project, when cash has normally been received or is receivable.

Now, back to the attitude. Just to make sure everybody gets the wink and nod to issuers, IFRIC 15 states that determining whether an arrangement is a construction contract or something else requires "judgment with respect to each agreement" (¶10), and "is not an accounting policy choice" (¶BC16). What is a "major structural element"? Answer: Whatever it is, it's not an accounting policy choice. Construction agreements are like snowflakes; no two are exactly alike.

In other words, an entity will evaluate each contract whenever and however it wants. Do you need to smooth your earnings? If yes, those new construction projects are going to be accounted for under IAS 11 (percentage of completion method). Or, are you going to need the earnings next year to make your bonus target? If so, those new projects you just started are going to be accounted for under IAS 18 (essentially, the completed contract method). Even if they could, no auditor would dare to risk its fee by calling your "judgment" into serious question.

The American Way

U.S. GAAP takes a different approach, borne out of lessons learned the hard way. Statement of Financial Accounting Standards (SFAS), No. 66, Accounting for Sales of Real Estate, requires use of the percentage of completion method for recognizing earnings from sales of units in condominium projects or time-sharing interests (¶37), irrespective of a buyer's ability to affect the construction. SFAS No. 66 was issued in 1982, and its provisions were clearly motivated by a desire to put a halt to premature and inappropriate revenue recognition practices taking place in the real estate industry. Broad principles of revenue recognition have a certain attraction, but managers quickly figured out how to comply with the letter of an accounting principle (making the auditor happy), while at the same time completely disregarding its spirit. All sorts of investors, be they unsophisticated individuals hoping for a quick killing or ambitious loan officers looking for a few extra basis points, were taken in by the financial shenanigans of real estate companies that rode roughshod over the principles-based accounting guidance that existed at the time.

If there is a principle in SFAS No. 66 it is that you don't get to pick and choose under U.S. GAAP. I can't speak of financial reporting elsewhere, but in the U.S. financial reporting environment, that's a good thing. It bespeaks volumes about the current leadership of the SEC that it thinks otherwise—as evidenced by its near monotonic support of an IFRS that marches ever forth toward chicken salad for issuers.