The Accounting Onion

Is the IFRS Dance Over? Maybe… but Maybe Not

My grand plan was to write about political influences on GAAP and IFRS, which I did last week; and then to move on to the FASB's mark-to-market proposals. But having received a torrent of emails – well only four – I've decided to squeeze a little more juice out of the IFRS lemon (double entendre intended).

One of my e-mailers, a proud CPA from Illinois, wrote to claim that maybe it was ICPAS, the Illinois group, that was the first to speak out against IFRS.  ICPAS "responded over a year ago that this was not the best idea at this point in time"  although the NYSSCPA comment letter was more strongly worded.  Actually, I think he was being a bit too modest: the ICPAS letter is unequivocally non-supportive of IFRS adoption.  Moreover, they say that it should not even be considered until IFRS and U.S. GAAP are fully converged.

But the most trenchant email was from a senior audit partner, who has to remain anonymous. Just for jollies, I'll call him "Debit Throat":

"Although the NY Society letter was substantial, the writing was already on the wall with [Charles] Niemeier's stand back in September, the comment letters from the ITAC (FASB Investors Technical Advisory Committee), NASBA [National Association of State Boards of Accountancy] and last week even the FASB itself." [Links in the above are to the comment letters Debit Throat cites.]

I think we are going to continue to see a lot of lobbying and whining from the Big 4 and AICPA since they had invested so heavily in this – even the IIA [Institute of Internal Auditors] and CMA [Certified Management Accountant] groups saw IFRS as a bucket of fees. …[T]he big firms and IASB was absolutely furious with state regulators about the stand they took." However, from the very beginning the arrogance of them trying to ram IFRS down the U.S.' throat was a major strategic error on their part. For one thing, they totally ignored the … enormous costs involved. As I am sure you know – academia was never invited to the party either.

…IFRS is a solution looking for a problem. There are a lot more pressing things the profession should have its eye on like M2M [mark-to-market]. IFRS is a sort of déjà vu of the XYZ/Cognitor fiasco that was another solution to a non-existent problem. "

I may be wrong, but I believe that the IFRS dance in the U.S. is over. The whole structure of a standard-setting body without any real authority or oversight in my view is a very unstable platform that requires more than support from those that stand to benefit from it the most. Conspicuously and as usual, this has not included investors." [bold italics supplied]

Whew. I wish I could be as sanguine as Debit Throat about the dance being over. I'm still holding my breath until Mary Schapiro finally names her Chief Accountant. If it is anybody else other than Niemeier, then we'll have to take a hard look at just how much slack Schapiro has been given by President Obama's advisers to follow her own mind, and to part the special interests from their "fee buckets."

IFRS v. U.S. GAAP: Which is More Corrupted by Politics?

The New York State Society of Certified Public Accountants (Society) seems to have become the first group of professional accountants to break with the AICPA's big push to get the SEC to throw out U.S. GAAP and adopt IFRS. The Society's comment letter responding to the IFRS roadmap proposal expressed numerous concerns, including the following:

• The SEC's plan for adoption lacked sufficient detail as to "... the methodology and criteria expected to be applied to the milestones in assessing the adequacy of IFRS in meeting the needs of preparers, users, and auditors."

• The proposal did not recognize any tilting in the cost-benefit calculus that must surely have occurred as a result of the current economic environment: "…companies, investors and other participants in the U. S. capital markets have to face the continued dearth of capital at an economically feasible price. It would be reasonable to conclude that the monetary and human capital costs of the transition to IFRS could be burdensome to entities with limited resources and prohibitive for smaller entities, even over a period of many years." [italics supplied]

• For a variety of technical, legal and practical reasons, IFRS will not enhance comparability of financial statements across companies. As this is one of the purported benefits of IFRS adoption, if not the primary benefit being touted, a positive net benefit from adoption is somewhat illusory. Moreover, another benefit of IFRS adoption put forth in the proposing release is the added flexibility afforded to issuers to account for transactions and events by applying their own judgment; the Society is concerned that opportunities for management judgment will actually result in less comparability.

• Recent events indicate that the IASB is inappropriately influenced by various national regulators and others "... who promote the interests of their specific constituencies, as opposed to the needs of the worldwide community." The Society cites as an example the recent changes to IFRS (IAS 39 and IFRS 7) that have allowed companies to "... 'cherry pick' [financial] assets with significant losses and reverse those losses out of net income."

Regarding that last bullet point, Steve Zeff, the eminent accounting historian, recently replied on the Society's blog page asking why just "one or two" instances of political interference in IASB standard setting should cause concern. After all, according to Steve, given the extensive history of political influence and lobbying on GAAP, which he lays out elegantly yet succinctly, those instances cited by the Society's comment letter pale in comparison.

I don't believe the Society was at all implying in their comment letter that the "one or two instances" cited were the only ones that could have raised concerns. Moreover, the larger point is that IFRS and U.S. GAAP are both being raced to the bottom by special interests. For those of you scoring at home, here are a few other very recent examples that I have written about in past posts, and which reinforce this race-to-the-bottom notion:

• In its recent revision of IAS 23 on interest costs, IFRS abandoned its "benchmark" alternative of expensing interest to require capitalization, which heretofore was merely the "allowed alternative." The fact that no substantive basis for conclusions was given for abandoning long-established and well-reasoned basis for conclusions leaves no doubt that behind-the-scenes politicking by the IFRS issuers most addicted to interest capitalization threw their weight around.

• IFRS 3R on business combinations was not fully converged with SFAS 141R in respect to measuring non-controlling interests –- even though the FASB was led by representatives of the IASB to understand that if the FASB held their ground on this controversial issue, the IASB would follow suit. Here is a case where the FASB withstood political pressure and the IASB caved. I do concede that accounting for minority interests can be a more sensitive topic in Europe than the U.S.; but nevertheless, this one gets scored as yet another recent case of the IASB sacrificing its principles for politics.

• IFRIC 15 on construction contract accounting was finalized just a few months ago, and it is cleverly crafted to provide discretion to the construction industry for managing their earnings. The same loopholes were closed in U.S. GAAP decades ago. The IASB could have easily converged to GAAP instead, but political interests again won the day.

• The Chinese are putting pressure on the IASB to amend IAS 24 to suppress required information about related party transactions. All indications are that the Chinese government will get what they want from the IASB. 

Like Steve's examples, the ones I bring to bear clearly reveal an intent on the part of the standard setter to appease special interests. But, there are broad swaths in GAAP and IFRS where we can never really nail down the degree to which an accounting rule has been influenced inappropriately . For example, is IFRS less prescriptive than GAAP because the IASB believes as a matter of principle that such a policy maximizes the quality of financial reporting? Or, does the policy spring from a cynical calculation borne out of a desire to gain acceptance of IFRS by as many countries as possible?  Pardon my own cynicism, but I am inclined toward the latter hypothesis.

It is both obvious and unfortunate that politics has and will continue to play too large a role in both U.S. GAAP and IFRS. Aside from the academic question as to who is guiltier of yielding to politics in the past, the relevant question when considering the SEC's Roadmap proposal is whether IFRS adoption will expand or limit the potential for politics to influence accounting standards. Even if you are somewhat biased toward IFRS, the answer to that question must be self-evident 'yes.' 

And even if you still hold on to the notion that IFRS has been relatively free of political meddling, it is more than a little disingenuous to presume that U.S. adoption won't be a game changer--for the worse. All the stakeholders in eventual IFRS hegemony must surely know that the IASB needs to be on its best behavior until the U.S. ventures so far down the road(map) toward adoption that it can't turn back. But even knowing that, the examples I have provided evidence a broad array of political interests are still having lots of trouble keeping their hands out of the cookie jar.

I am quite sure that Steve's comments were motivated purely by a desire to ensure that whatever decisions come out of the Roadmap proposal, they should be well-reasoned. But, few will share Steve's purity of motive.  I expect that the responses by the IFRS lobby in the U.S. to the concerns about political influence will disingenously ignore the hopelessness of a cure for the inevitable Pandora's box of political meddling on a global scale. Instead, they will propose oversight mechanisms that can amount to nothing more than symbolic gestures. Power corrupts, and monopoly power over accounting standards will corrupt absolutely. 

Call me a chauvinist, but I would prefer to consume information that tastes like American-style corned beef hash instead of European blood sausage mixed with Chinese chop suey. 

Mark-to-Market Accounting: Scapegoat for the Failure to Properly Regulate Banks

The congressional hearings on "market-to-market accounting" are scheduled to begin in a few hours. I shudder at the prospect of financially-illiterate congressmen becoming putty in the hands of savvy lobbyists bearing gifts.

My concern was piqued by Steve Forbes' latest error-filled epistle sans data, which the Wall Street Journal rashly deigned to publish last Friday. I fear that it is a microcosm of what will unfold in the hearings: that mark-to-market accounting will become the scapegoat for practically the entire financial crisis.

"Mark-to-market accounting is the principal reason why our financial system is in a meltdown," writes Forbes. But unlike Congress, who will welcome the suggestion of a convenient scapegoat to keep its constituents at bay, I give Forbes credit for being sufficiently informed to know the real reason; and which lately seems to be fading to the background: DERIVATIVES!

The Forbes critique of mark-to-market accounting for banks and other financial institutions goes something like this:

• Writing down investments will reduce a bank's "regulatory capital," which will in turn cause to reduce lending.

• Reduced lending by banks triggers a vicious cycle: lack of investment begets higher unemployment, which in turn begets higher loan default rates, which causes the fair value of bank investments to decline even further.

• The current accounting rules implementing fair value exacerbate the situation by applying an illiquidity discount to "subprime securities and other suspect assets" even if there has been no direct evidence of impairment.

Forbes believes that President Obama should end "the most destructive policy of the Bush administration" (though I find it curious that he's waited until after Bush has left office to say it) by mandating historic cost for bank assets unless and until there is direct evidence of impairment. I am quite sure that FASB Chair Bob Herz, when he testifies at the hearings, will eloquently and fully describe the many shortcomings of this approach as they bear upon the quality of financial reporting, investor interests and public confidence in the capital markets.

But, Bob's testimony on mark-to-market v. historic cost should be no more than a side show compared to the real problem: derivative financial instruments have rendered the current approach to banking regulation obsolete. Capitalization ratios based on U.S. GAAP, if they ever were reliable, were reduced to white noise when derivatives hit bank balance sheets in a big way. Neither Steve Forbes nor anyone else can provide a solution framed as a change in accounting policy to change that critical fact. And, channeling democrat FDR's banking policies during the depression, which Forbes is wont to do even as he holds his nose, doesn't get us anywhere today; FDR didn't have the DERIVATIVES problem.

Take as a simple example, a financial institution (it could be a bank or an insurance company) that holds only one "investment." Let's say that investment is an interest rate swap with a notional amount of $50 billion dollars; the historic cost of entering into the swap was nil, and its current fair value is $1 billion dollars. Further assume that the bank has liabilities of $0.5 billion dollars. With a debt/asset ratio of 50%, is this bank well capitalized? Technically, yes, but effectively, not on your life. If interest rates were to move slightly in the wrong direction, a $1 billion asset could become a $10 billion liability; and the probability of that occurring could be 50% or more.

Forbes also contends that

"…although banks have twice the amount of cash on hand that they did a year ago, they lend only under duress, or apply onerous conditions…. This is because they know that every time they make a loan or an investment there is a risk of a book write-down, even if the loan is unimpaired."

The existence of derivatives suggests a much more plausible reason: the bankers know that they are going to need every penny of their cash if their derivatives positions go south as a result of, say, a slight increase to mortgage loan default rates. Stated another way, even though their cash position has doubled, they are still way short of capital.

The problem that we really want to resolve is how to restore the banks to a sound financial footing. Even granting that financial reporting to investors could play a role (and I don't), tweaking accounting rules that cover a surprisingly small percentage of assets that banks mark-to-market is hardly the job of Congress. Any solution must radically restructure bank regulation. Throw away any notion of capital adequacy based on capitalization ratios. Stress testing of future cash inflows and outflows is where it's at, and that has nothing to do with financial reporting. For a bank without derivatives, a strong correlation between a static capitalization ratio (based on some set of accounting rules) and the probability of future insolvency might be obtainable; but for banks holding loads of derivatives, we have learned through hard experience that Congress should acknowledge, that any correlation must be spurious.

Finally, although I consider this to be out of my area of expertise, I would like to offer one more suggestion. I believe that federal deposit insurance played a significant role in creating a sense of confidence in the soundness of our financial system. Like prudential regulation, however, it needs to be radically restructured.

Financial soundness of our economy is about whether the failure of one financial institution will damage the entire system. Getting back to deposit insurance, the government should not just limit its exposure to an account (e.g., $100,000 per account), but also to a financial institution. Following the example of Japan in its heyday, a conventional wisdom emerged in the U.S. that our banks would not be able to achieve the economies of scale and scope that would allow them to compete with their international rivals unless they, too, morphed into behemoths. Not only has that strategy failed from taking on too much risk, but U.S. banks along with their Japanese counterparts became "too big to fail," which has now become synonymous for "too big to exist."

I do not advocate that we issue a mandate to banks to break themselves up into smaller pieces, but we should reign in the perverse incentives that encouraged them to become too big in the first place.  One way to do that would be to limit the amount of deposit insurance per bank. Any bank that is too large by the new standard will break itself up without any further prompting, and one would hope the result will be more efficient than what would occur via government fiat.

Basically, I think it's a good idea for Congress to hold hearings related to financial reform.  I just hope that they come to an understanding that regulatory modernization that adequately addresses the singular risks to the financial system posed by derivatives must be an integral part of any legislative response to the economic crisis. 

Accounting rules, no matter how you regard the current batch, are purportedly established to benefit investors.  These rules have have nothing to do with what everyone agrees is much needed reform of the rules that regulate the activities of financial institutions.  Fixating on the accounting rules is not unlike choosing to buffing the scratches out of a car that won't start, instead of opening up the hood to diagnose the real problem.

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Note:  I am indebted, as is often the case, to Jim Noel for comments he made when discussing the idea for this post with him.

EITF 96-15: Godzilla and Frankenstein's Love Child

As I was researching a question for a client a couple of weeks ago, I happened upon a love child of two of my pet peeve accounting standards:

• FAS 115 (marketable securities) – especially the part permitting available-for-sale (AFS) classification;

• FAS 52 (foreign currency translation) – practically every word of it makes my blood boil.

I have written a number of posts on FAS 52, and this one here hits the basics, should you feel the need to get canned up on the topic before reading further.

The love child I speak of is EITF 96-15, Accounting for the Effects of Changes in Foreign Currency Exchange Rates on Foreign-Currency-Denominated Available-for-Sale Debt Securities. Based on the title, it obviously deals with an interaction between FAS 52 and FAS 115. But, as to why it was issued three years after FAS 115 is an interesting question. For every crime committed with accounting standards against investors there is some other special interest being served. In this case, I can only guess at what it was, because the EITF issue summaries gave no hint as to how this bee got under their bonnets.

U.S. companies with foreign subsidiaries are generally reluctant to repatriate excess cash from their subsidiaries if negative tax effects attach to the decision. While waiting for a more opportune time to bring the cash back to the mother ship, they have to figure out where to park it; and one strategy is to invest it in marketable securities issued by other companies based in the U.S. From a risk management perspective, at least the money is invested in dollars. However, as I'm about to explain, earnings-obsessed managers might shy away from that choice, even if it is clearly the right thing to do from an economic standpoint.

FAS 52 has many generous elements, but it is relatively demanding in the area of "foreign currency transactions," which, simply stated, are receivables and payables denominated in a currency other than the entity's functional (foreign) currency. Normally, the effect of translating from the subsidiary's functional currency to dollars gets carried into the translation adjustment without affecting income. However, (with certain limited exceptions) the translation of "foreign currency transactions" must be reflected in income. (I have written about this in a previous post, here.)

The question addressed in EITF 96-15 is whether a marketable debt security designated as available-for-sale is a foreign currency transaction. That sounds like a serious question, but it's actually quite ridiculous. Notice that the EITF is not questioning whether marketable debt securities designated as "trading," or designated as "held-to-maturity" are foreign currency transactions – but only those debt securities that are arbitrarily and capriciously designated by management to be AFS. Knowing only that ought to tell you that the fix was in before the first word of debate had been uttered.

The way I thought about the issue before I did my research was, if I must say so myself, perfectly straightforward. First, an AFS marketable debt security is still at bottom a receivable; some arbitrary AFS designation doesn't change that.  Second, FAS 52 is crystal clear as to the treatment of a receivable: it's a foreign currency transaction.

Notwithstanding the obvious, the EITF arrived at the opposite conclusion. By quasi-Talmudic logic that can only be fully appreciated by those ordained to be accounting policy makers, the EITF established a new record for the figurative hop, skip and jump that lead them to conclude that a marketable debt security designated as available-for-sale would not be a "monetary item" – whatever that has to do with the price of tea in China. Anyway, since only monetary items like receivables and payables qualify to be foreign currency transactions, an AFS marketable debt security cannot be one of them.

Eureka! Gold made from copper! In other words, make a loan marketable, arbitrarily and capriciously designate it as AFS to unmake its monetary item characteristics, and presto change-o, you no longer have to worry about income statement exposure. Do you remember the running gag on Late Nite with Conan O'Brien called "if they mated"?  That's EITF 96-15: two wierdos, FAS 52 and FAS 115, matched by a funny guy to beget horrible looking thing that only a CPA could love.

Prior to EITF 96-15, an earnings-obsessed manager might have chosen to invest excess cash in marketable equity securities despite the additional economic risks relative to investing in debt, because the accounting risks happened to be low. That's because marketable equity securities are not receivables; by the perversity of the way FAS 52 converts foreign currencies to dollars, marketable securities might as well be equipment or inventory. Paradoxically, investing in debt would have created income statement volatility, even though economic risks would be lower than by investing in equities.

The clearly evident purpose of the EITF was to create a discretionary safe haven for excess foreign currency. Whether you think that is a good thing or not, it is not my point. What should be clear is that it is for reasons like this the accounting oligarchs deigned to create the grand ole EITF in the first place: to do whatever it takes to spice the sausage we call GAAP to managers' tastes.