The Accounting Onion

Is the IFRS Rhetoric Machine Running Out of Gas?

I haven't posted for a few weeks, because I broke my leg (road bicycling). I'm working on a few things having to do with leasing, but Floyd Norris's recent NYT column, "The Case for Global Accounting" has me back in the saddle again – though not on my bike L:

"For more than a decade, politicians and regulators around the world have claimed to want a common set of high-quality accounting standards that applied globally. The extent to which that rhetoric will become reality may soon become apparent."

"Rhetoric"? I would have chosen a stronger pejorative. But coming from the likes of Floyd, it clearly implies the absence of substance: that special interests are blithely spouting anything they can get away with just to keep the IFRS conversation alive. Everyone knows that GAAP/IFRS convergence has been a spectacular failure; yet the Big Four, the AICPA, maybe a few mega corporations, too-big-to-fail banks and the EU (albeit ambivalently) are continuing to prod the "politicians and regulators" to the point where many are wishing this whole IFRS thing would go away on its own.

But before I get to the main purpose of my post, let's not forget to give China – whose financial shenanigans could easily occupy the entire staff of the SEC's Division of Enforcement all by itself – its rhetorical due:

"'China and the United States support the objectives of a single set of high-quality global accounting standards,' the two countries said in a joint statement after a meeting in Beijing."

What a joke. China claims to be behind IFRS 100%, but its own standards are more like War and Peace condensed to ten pages instead of what one would normally regard to be a comprehensive basis of accounting. Chinese Accounting Standards (CAS) have less than one page of guidance on consolidation (CAS 33), and CAS 24 on hedge accounting is only seven pages. The Chinese representative to the IASB (Dr. Zhang Wei-Guo), I am told, seemingly has nothing to say for public consumption, and the Chinese contribution to the IASB's budget barely covers his $600,000 per year salary.

Bringing Back David Tweedie for an Encore

The undisputed king of IFRS rhetoric remains David Tweedie, even though he is no longer IASB chair. Mr. Tweedie's reconstructed version of history is that none other than Chair Arthur Levitt, promised back in the 1990s that the SEC would consider adopting international accounting standards, and "… the S.E.C. can complete [Levitt's vision] or not."

The problem is that Mr. Levitt never promised, or envisaged, any such thing. What he did promise was to consider allowing foreign private issuers only to file financial statements in accordance with international standards without reconciliation to U.S. GAAP – after the IASC's core standards project (1995 – 1999) was completed. It wasn't until ten years later, when Chair Christopher Cox (who has been pretty much relegated to the dustbin of SEC history) "surprised many" (Floyd's words) by permitting FPIs to file IFRS financial statements without reconciliation.

But, just to be sure that I had my facts straight, I checked with Lynn E. Turner, who served as Arthur Levitt's chief accountant at the time. This is what Lynn wrote me:

"Neither Arthur Levitt or I ever endorsed the International Accounting Standards while we were at the SEC. While IFRS is an improvement over statutory accounting principles used by some countries, it would seriously impede the competitiveness of the US capital markets by impeding their ability to provide greater transparency than is available elsewhere. Accordingly, I strongly oppose their adoption by the SEC for use in the US." [italics supplied]

Oh well. Even my beloved New York Times makes mistakes.

Key Players Coming to Their Senses?

The best news coming out of Floyd's article is the sense that the FASB and SEC are finally acknowledging the problems that have always been present, and have never gone away. From the FASB chair:

"'I am in favor of some form of incorporation of international standards, but we do not have a compelling urgent need to adopt I.F.R.S.,' said Leslie F. Seidman, the chairwoman of the [FASB] in an interview. 'We believe in the goal of minimizing differences and ultimately having a common set of standards.'" [italics supplied]

That's starting to approach passable, but I would like to ask Ms. Seidman why she still thinks that formal endorsement of IFRS standards is appropriate or necessary; and especially why the goal of common standards is worth limiting the FASB's flexibility to set its own agenda in any way.

Seidman's remarks are also consistent with speculation that Mary Schapiro, SEC chair, "… will step down after the election and would be happy to leave [the IFRS status] decision to her successor." If that wishful thinking becomes reality, then her successor's choice for chief accountant should foretell right away whether the IFRS question will be subject to reason, or just more rhetoric – just as Ms. Schapiro's choice of James Kroeker reliably indicated that she was greasing the skids for IFRS adoption.

And, speaking of Mr. Kroeker, I would have to say that I was most pleased to read this:

"At the Baruch conference last week, [Mr. Kroeker] asked the audience of accountants, 'Does anybody know of an entity that will provide global enforcement' of international standards? No hands were raised." [Italics supplied]

Mary Schapiro has failed to demonstrate any appreciation for the accounting nuances her staff deals with on a daily basis, or the implications of the complex differences between IFRS and U.S. GAAP. Now, however, her own chief accountant must be thinking, "No SEC means no hope of enforcing consistent application of IFRS."

To which I would add that the SEC's influence will be universally unwelcome outside of its narrow jurisdiction.

Is there anything else the SEC chair needs to know in order to make her decision?

Securitization Accounting and Grand Theft Auto

Many books and articles have been written to describe the mishaps that led to the Great Recession of 2008, but few have done so while putting the role of accounting standards and auditing in context. I reported back in January 2010 that Paul Krugman at least was cognizant enough of accounting to acknowledge that we do not presently have honest financial reporting standards that let investors make good decisions and that "… forces management to behave responsibly." But, other than changing the name on the sausage packaging from GAAP to IFRS, detailed suggestions for achieving fundamental change have been exceeding rare.

NC State accounting professor Paul Williams also drew inspiration from Krugman's column and the financial crisis for a brief paper entitled The Wrong Metaphor, which I recently heard him present to the Public Interest Section of the American Accounting Association. Much as I have (but certainly with some important differences that you should read for yourself), Williams has come to the conclusion that a paradigm shift is needed for accounting to re-assume its proper role in society. I wish we could have much more from Williams reagrding what he thinks should be changed and how to make change happen.

A recent paper by S.P. Kothari and Rebecca Lester of MIT, The Role of Accounting in the Financial Crisis: Lessons for the Future, is very strong in its description of flawed accounting and its potential role in the past crisis. These are some of the basic messages:

• The accounting rules provided originators of subprime mortgages (SFAS 140) the opportunity to record economically specious gains on securitization transactions.
• The accounting rules also permitted regulated financial institutions that invested in financial instruments created out of subprime mortgages (MBOs and CDOs) to delay recognition of likely losses; which, in turn, distorted measures of capital adequacy.
• Estimation errors, most significantly estimates of fair value, committed by issuers of financial statements and their auditors exacerbated the accounting misstatements inherent in the accounting rules.

Although, like Williams, the Kothari/Lester did not provide much in the way of "lessons for the future," I would still highly recommend it. Accounting students could, and should, read it if only for its lucid examples and explanations of the arcane and flawed accounting rules that are applicable to securitizations.

The purpose of this post is to distill the analysis of Kothari/Lester so as to further discuss "lessons for the future." Before I do that, however, I want to tell you about an email correspondence I had with S.P. Kothari after I read their paper. Since I was preparing my own remarks for academics on the topic of IFRS adoption and the future of U.S. accounting, I asked him whether he thought it more or less likely that promulgation of more appropriate fair value or securitization standards would occur if the SEC continues to pursue convergence with IFRS. This was the response:

"…I think convergence will harm promulgation of more appropriate standards because a converged standard setting body would become a monopoly that would be pulled in all different directions by its constituencies."

Clearly, whatever the "lessons for the future" may be, adoption of IFRS is not one that he had in mind.

 

Securitization Accounting as Grand Theft Auto (not the video game)?

The process of securitization reminds me of large-scale car theft ring.* To obscure the link to the illegal 'acquisition' of cars, much like subprime mortgage loans, the cars are almost immediately chopped up into parts and re-sold. As a business model, stealing cars works only because the cost of obtaining a car is low; but let's ignore that for the moment and assume that someone actually establishes a legit buy/chop auto parts business – in other words, cars are bought for full price and chopped up for the sale of parts. Here is a representative sent of journal entries:

Day One – buy a car:

Dr. Car (at cost)                               30,000
      Cr. Cash                                                   30,000

Days Subsequent – chop up the car and sell its parts:

Dr. Cash (from sale of parts)            25,000
Dr. Engine (at estimated fair value)   7,000
     Cr. Gain on sale of parts                            2,000
     Cr. Car**                                                    30,000

I readily acknowledge that second entry does not comport with current GAAP.  I am using to illustrate securitization accounting in the context of a highly simplified example.  Having stated that, however, I don't see any reason (although others might) that the accounting for a chopped car should be different than the accounting for a chopped subprime mortgage.  I can't abide mixed-attribute accounting systems, and believe that college-educated professionals should not be adding apples and oranges, much less elevating the error with misleading names like "statement of financial position."

If you can set aside any cavils you might have with respect to my violation of current GAAP, please answer this question for me:  Would you invest in a business whose financial statements were based on journal entries like these? They sure do look legitimate, but common economic sense would dictate that the second journal entry must overstate the real profit on the resale transactions. First, as Kothari and Lester observe in the securitization context, "how is it possible that the sale of an asset originally recorded at one value could generate income and higher asset balances upon merely transferring this asset to another entity?" I suppose one could say that butchering a chicken should add value such that the sum of the parts is greater than the whole chicken. But that's because there's only one way to one way to obtain chicken parts – first, you gotta grow a chicken. However, one doesn't have to manufacture a car just to obtain a spark plug; or to originate a subprime mortgage loan just to create contracts containing a particular pattern of future cash flows.

The second reason indicating that the second journal entry is misleading is that the flawed business model would not be able to earn an economic profit over a full cash-out-cash-in cycle (i.e., buy car Þ chop Þ sell Þ reimburse for defects under warranty). If the engine could actually be sold for $7,000 (and generating an overall profit of at least $2,000), then I'll be a monkey's uncle!

The Lessons for the Future

In order to determine whether a better accounting is feasible, we need to be able to identify the sources of overstated income. With respect to both the car parts example and securitizations, overstated income could be the result of any of the following:

1. Kothari/Lester do not refer to this explicitly, but the most subtle and important aspect of the problem, in my view, is the unavoidable change in the 'unit of account' from the original asset (e.g., car, subprime loan) to the retained portions (e.g., engine; or in the case of securitizations, a servicing asset, and the right to residual cash flows). For example, erroneous accounting will occur because the values of the components of the car will not exactly sum to the pre-chopped value of the car itself; it doesn't matter how one chooses to measure value.
2. The appropriateness of the basis of measurement for the retained assets: such as historic cost, fair value or replacement cost.
3. Given a basis of measurement, biased measurement of the assets retained (which auditors fail to correct). Kothari/Lester surmise that this is the most significant source of overstated income.
4. Unrecognized or understated liabilities (e.g., a warranty obligation on the car parts, or a written put option for underperforming loans).

As to mitigating these sources, I have provided my two cents on #3, the biased estimate problem in a number of posts, the latest of which is here. Regulators have tried over and over again to make incremental improvements to auditing standards, with no perceived help in increasing the public's confidence that auditors can play a significant role in averting a large-scale financial crisis. It is time to abandon any notion that: management can provide unbiased estimates of value; and/or that auditors are intellectually capable or even inclined to provide a independent and knowledgeable assessments of management's estimates.

Therefore, when financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – i.e., neither management, nor the auditor. The auditor's role should be limited to:

• Verification of the components of financial statements that can be verified.
• Verification of the inputs to current valuations that can be objectively measured, and hence, verified.
• Verifying that third party experts charged with measuring current values and expectations of future events have performed the procedures they said they would perform.

As to #2, above, the conventional wisdom is that historic cost accounting is fact-based, objective, understandable, and even verifiable. We have learned the hard way that this is a fiction; however historic cost accounting has been practiced. To get to a point where financial reporting can be freed from perverse incentives for management to produce biased estimates, standard setters must dedicate themselves to the establishment of accounting standards that yield financial statements capable of being audited and understood by auditors, investors, credit rating agencies and the like. Securitization/loan accounting standards clearly indicate that historic cost "principles" when applied to financial instruments create nothing but a big mess.

Saving the worst for last, the unit of account issue (#1, above) may defy a principles-based solution, but I still want to take a stab at it. Referring to the sample journal entries, the higher the values assigned to the assets retained, the higher will be the reported gain. This suggests, once again, replacement cost is the most appropriate basis of accounting, for it would require measurement based on the least costly way to replace the asset subject to being measured. For the car example, the business model indicates that the most economical way for the entity to acquire an engine would be to buy a car, chop it up, and sell all of its parts except for the engine. Thus, the marginal cost of an engine might be essentially zero – and the result would essentially eliminate the gain recognized in the second journal entry. Indeed, the loss recognized in the second journal entry by this logic would be the telltale sign of a flawed business model.

The same logic used to measure the replacement cost of the engine could easily apply to securitization assets such as servicing rights and residual interests, and leads to an analogous question: Did the subprime loan origination/securitization business model only work, or appear to work, because of favorable accounting treatment? These are questions worthy of further research, but if the accounting for securitizations had been more reasonable, we would already have reasonable answers.

---------------------------------  

*Kothar/Lester address both the accounting for securitizations by the originators of subprime loans and the subsequent accounting by investors in the financial instruments created by securitization. I am only looking at the former in this post.

**I am assuming that costs of chopping the car are negligible or are expensed in a journal entry not displayed. Capitalization of these destruction costs would affect the form of the journal entries, but it would not affect my conclusions.

Ten Claims in Support of IFRS Adoption by the SEC – and Why They are False (Part Three of Three)

Click here for Part One of this Three-Part Series.

* * * * *

False Claim # 6:    Costs of conversion to IFRS can be spread out over a long transition period.

All I can do here is to point out the obvious: merely spreading out the costs doesn't lessen them, nor lessen opportunity costs. What cost spreading does, however, is unduly prolong the time until financial reporting will reach a stable environment. If proponents of IFRS adoption are still playing that misleading comparability card as a primary benefit of IFRS adoption, then they should also explain why prolonging the transition, and the resulting lack of comparability, benefits investors.

Especially in light of the feedback the SEC has already received and the current economic climate, what is the benefit for a small public company of incurring the transition costs to IFRS? These companies could care less about how they stack up against the financial statements of a foreign company, and neither could their banker or venture capitalist.

We know from the European and Canadian experiences that transition costs were not trivial – to say the least – and it put a lot of shareholders' money into the pockets of auditors. If any member of Congress that voted for the Jumpstart our Business Startups (JOBS) Act believes that companies with $1 billion in sales or less have been unduly burdened in their capital raising by SEC rules, then they should act now to prohibit the SEC and FASB from changing accounting standards primarily for the sake of convergence with IFRS.

 

False Claim #7:    The U.S. will not experience any loss of sovereignty over its ability to set accounting standards.

There could be mechanisms to assure that the U.S. will always be heard, but the absolute very best the U.S. can expect is to have a significant influence over IASB decision making. That's a far cry from sovereignty; and frankly, any efforts to minimize this issue are disingenuous.

Added to the fact that the EU will continue to do its level best to control all aspects of the IASB, there are other formidable forces that may be working to mitigate the U.S. voice in IFRS. Let's take one case that has recently been in the news – India. From reading an interview with India's Chairman of its National Advisory Committee on Accounting Standards, the mindset of India's accounting establishment reminds me more of the reserve-oriented income statement smoothing approach developed by the Germans. The interview mentions four (of a total of 65) major carve-outs from IFRS; but one in particular, on deferral of gains and losses on foreign currency-denominated debt, best reflects the great divide that still exists after years of negotiations with the IASB. Indian issuers, who rely on foreign debt more heavily than their U.S. or European counterparts, are unwilling to tolerate the income statement volatility of FX gains and losses on that debt. Hence, an exception to IFRS in India permits an issuer to spread any foreign exchange gain or loss over the life of the loan.

This is just one of many examples of an irreconcilable difference in financial reporting mindsets. It is inconceivable that such differences can be bridged by a single set of global accounting standards. It's just not realistic to expect that the U.S. will be the winner in every case when there is a difference in mindset, regulatory, political or legal circumstance; or not even in the majority of cases.

Indeed, history suggests that the U.S. will lose most of these battles. The numerous failed convergence projects alone attest to how many battles the U.S. stands to lose if it incorporates IFRS into U.S. GAAP. None of these issues – R&D, inventories, pensions, borrowing costs, business combinations, impairment of long-lived assets, financial instruments, hedge accounting, to name the ones that quickly come to mind – are trivial. For, if any of these, or any of the other differences between U.S. GAAP and IFRS were small differences, surely they would have been converged by now.

It is not unreasonable to expect, even, that a country like India might form a coalition with other countries against the U.S. Here's just one scenario: India makes a deal with the EU, and together they push a new standard that permits the deferral of unhedged foreign exchange gains and losses on foreign currency denominated debt. How will condorsement work? Will we carve out that particular deferral option? If so, the goal of comparability would be irretrievably lost.

I should add that what we are seeing now in the United Nations is not all that different from my hypothetical. It seems that numerous smaller nations have learned to use the United Nations to advance agendas that are making citizens of wealthier nations question their own willingness to continue belonging to and funding these efforts. Thus far we do not have a similar problem arising with the uniting of smaller nations to dominate standard setting in the IASB. However, once the U.S., Japan, India, and China become committed to IFRS, smaller nations could begin to rise up in the IASB. Their incentives would come from the fact that international accounting standards are not necessarily neutral when it comes to global capital flows and economic development.

 

False Claim #8: Bad things will happen to the rest of the world if the U.S. does not adopt IFRS

Harvey Goldschmid speculates that, without IFRS adoption, the so-called coalition of IFRS members would break apart. However, history strongly suggests otherwise. As I have already mentioned, much of IASB's growth was driven by the desire to insulate Europe and other jurisdictions with less developed standards, like China, from the influence of U.S. GAAP. So, maybe the only thing that could possibly break up the IASB would be for the U.S. to join it.

The IASB was created in 1973. It was reconstituted in 2001. In all those years, it has not been the sole creator of accounting standards. Yet it has grown and done well. Without the U.S. in the coalition, the IASB will continue to have the degrees of freedom events have shown that it needs to do what it takes to bring everyone currently in the coalition even closer together. That will mean giving the EU the financial instruments and hedge accounting standards it wants, giving India the foreign exchange standards it wants, and giving China the watered down related party disclosure standards that it wants – and so on and so forth, and all in the form of free choices that are in opposition to the goal of comparability and the mindset of U.S. GAAP. None of that would be possible if the U.S were to adopt IFRS.

I find it difficult to imagine that the U.S. could ultimately justify subsequent endorsement of the IASB's standards from the numerous failed convergence projects without significant modification – and what if the EU likes those standards just the way they are now? Just recently, for example, the Financial Times reported that there was a "real risk" that the European Commission would reject the IASB's new consolidation and joint venture accounting rules, developed jointly with the FASB, and which were due to become effective for 2013. Indeed, it is entirely possible that, as the EU has threatened before, they could cut their support for the IASB, establish aggressive new carve-outs, or even promulgate its own standards.

 

False Claim # 9: Bad things will happen in the U.S. if the U.S. does not adopt IFRS

Mr. Goldschmid also predicts that if the coalition does not break apart, it will leave the U.S. to fend for itself when it comes to accounting standards. According to Mr. Goldschmid, this is would be the worst of all possible worlds.

Again, history would suggest otherwise; and moreover, if it did occur, many believe that it would be a good thing, not a bad thing. As the AAA's Financial Accounting Standards Committee concluded, standards competition is desirable, and monopolies can have dire consequences. I find it extremely ironic that individuals and organizations such as the AICPA that normally speak out for free markets for goods and services somehow think that granting a monopoly on accounting standards is preferable to accounting standards produced in a competitive environment. Even if, and this is certainly not true at present, IFRS could be regarded as higher quality at some point, granting IFRS a monopoly would risk stagnancy – and in place of innovation toward higher quality accounting standards, we could be racing to the bottom. It is a great understatement to say that there is still plenty of room for improvement in both IFRS and U.S. GAAP, and a monopoly would virtually assure that not enough of that improvement would happen.

And, perhaps the monopoly effect explains the many failures to progress on convergence in the past ten years. If one were to accept that execution of the convergence projects and the results of that work to-date are the most important factors for the SEC to consider when deciding the future status of IFRS in the U.S., one would have no choice but to conclude that continuation by whatever means – condorsement or anything else – will be a monumental waste of time. That should also make it apparent that the FASB's time would have been much better spent on efforts to improve the quality of U.S. GAAP, instead of on convergence with IFRS.

It's hard not to be amazed at how much time has been devoted since 2002 to debating accounting issues and to see how so little of the convergence objectives have actually been accomplished.

Going back just two years to the time of the SEC's February 24, 2010 Statement on IFRS, the FASB and IASB had nearly a dozen joint projects planned for completion by both boards by mid-2011. The Commission was hopeful that at least some of those projects would be completed by now; but even IFRS adoption skeptics (like me!) could not have imagined that we would actually be further from convergence today than we were back in February 2010. Progress has been made toward partial convergence of some trivial matters – like the way that the components of dirty surplus (so-called "other comprehensive income") are presented, and the IASB has finally agreed to adopt the FASB's fair value measurement standards for the few items that are measured at fair value. But, almost everything else seems to be heading in reverse.

The US could lose its seat at the IFRS table, as Harvey Goldschmid warns, but this doesn't mean it will lose its voice. Even before convergence projects began, it was obvious that IFRS owed its form, and a great deal of its substance, to U.S. GAAP. It is very clear that IFRS wouldn't be what it is today without U.S. GAAP to serve at least as a point of reference, and whatever U.S. accounting standards will become in the future, they will always make the rest of the world at least stop and think – if not do.

 

False Claim #10: All nations have the same goals for financial statements.

I suppose that one could take the position that although there may be differences in objectives for financial statements, they are not enough to abandon efforts to establish a single set of accounting standards suitable for use by companies worldwide. Yet, who could in all seriousness state that the financial reporting objectives of the SEC and Chinese regulators are anywhere near the same?

Even more significant at the present time, the history of the EU's efforts to monitor and steer the IASB clearly indicate its regulators believe that a legitimate role for accounting standards is to support the agendas of politicians and key industrial powers. It is undeniable that when it comes to bank accounting, EU regulators clearly see nothing wrong with investor protection taking a back seat. I know the Greek bond problem remains extremely serious, but I have to admit that it amused me last fall to see heads of state Angela Merkel and Nicolas Sarkozy arguing on television, for all to see, over an accounting issue: the size of the balance sheet haircut that banks should take on their Greek bonds. Surely, their constituencies must have been asking themselves, 'what are they talking about'?

If IFRS were high quality, as Messrs. Hoogervorst and Goldschmid claim, then politicians wouldn't have to get involved in accounting debates, and could instead turn their attention to the real problems. The EU could continue to muddle along using the same approach to financial problem solving long after the Greek bond crisis is behind it. But, that doesn't mean the SEC has to muddle along with them. By adopting IFRS, the SEC will essentially be telling U.S. investors that it is willing to tolerate insurmountable barriers – such as the EU's obdurateness – to high-quality, investor-purposed accounting standards.

* * * * *

So, here today we sit with the awareness that IFRS adoption is still laden with many problems and issues. There is seemingly overwhelming opposition to IFRS adoption, but many fear that the decision to proceed with some form of condorsement is soon at hand.

I would like to thank the following people who have provided comments on drafts of my speeches, and on which this series of posts is based: former SEC Chief Accountants Walter Schuetze and Lynn Turner; Gaylen Hansen; my colleagues, Jim Noel and Ray Stephens; and Bob Jensen, retired professor and current lifeblood of the AECM listserv.

I can only speak for myself, but I am confident that everyone whom I have just named all agree with me on this: for the sake of investor protection and the public interest, the SEC should have long ago made a U-turn on its Roadmap to IFRS adoption.

Ten Claims in Support of IFRS Adoption by the SEC – and Why They are False (Part Two of Three)

Click here for Part One of this Three-Part Series.

* * * * *

False Claim #2: A move to IFRS would restore the public trust in accounting standards.

I'm going to present three examples – one from 2007 and two from 2011 – that directly challenge this claim.

The 2007 case is one of my pet peeves. It has to do with the revisions to IAS 23, Borrowing Costs, ostensibly to further convergence of US GAAP and IFRS. I say "ostensibly" because there are still significant differences between IFRS and its U.S. GAAP counterpart. The bottom line is that IFRS rules still give management more latitude to manage earnings than the corresponding U.S. guidance.

Be that as it may, I'm am very confident that if you were trained in accounting or finance, one of the basic principles you were taught is that asset acquisition decisions are separate from the decision of how to finance them. And, prior to the 2007 revisions to IAS 23, that was the IASB's principled position as well.

Under IAS 23, prior to the 2007 amendments, two accounting treatments were permitted for self-constructed assets: the treatment designated as the "benchmark" treatment was to expense borrowing costs; but the "allowed alternative" permitted rules-based capitalization: a senseless alternative, unless one values opportunities to manipulate earnings.

Incredibly, the IASB in 2007, the supposed principles-based system of accounting, blithely rejected the sound and long-ago-established principles it had embraced earlier, by requiring the capitalization of interest on self-constructed assets. In other words, it threw out the principles-based benchmark and now permits only the management-friendly erstwhile allowed alternative. There can be no basis, other than politics, for this change, but that did not seem to bother all but two of the IASB's members. This is what was stated in the basis for conclusions of the revised standard:

1. Eliminating a difference between IFRS and GAAP is always progress. (In other words, two wrongs can make a right.)
2. Allowing only one method will enhance comparability. (This is not true, because companies with different financing policies will generate non-comparable results from business operations. It is more accurate to state the irony that the IASB's rules-based standard actually defeats comparability since initial asset values and subsequent depreciation charges will depend on the timing and type of financing employed.)
3. It will improve financial reporting (for reasons unstated).
4. This reason is so ludicrous and outrageous that I have to quote it verbatim:

   "The Board further noted that both IAS 23 and SFAS 34 Capitalization of Interest Cost were developed some years ago. Consequently, neither set of specific provisions may be regarded as being of a clearly higher quality than the other. [Nonsensical] 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." [bold italics supplied]

I chose this example because it demonstrates that the IASB cannot be trusted to adhere to its own due process policies, or to provide a legitimate basis for conclusions. Yes, the FASB is also susceptible to pressure, but the way that the IASB went about revision to IAS 23 was untrustworthy and made a mockery of its own "due process" policies.

There can be little question that big-issuer interests drove the revisions to IAS 23; both investors and smaller issuers were cast aside without so much as a nod to the real reasons for the adoption of a rules-based accounting standard. Any issuers that formerly elected the benchmark treatment were forced to change their accounting to a lower quality and costlier-to-implement alternative. The unavoidable conclusion is that the IASB caused significant wealth destruction, and it continues today under the guise of "convergence" of accounting for borrowing costs, even though it has no hope of enhancing comparability.

The second example is the IASB's revisions to its pension accounting standards, which incidentally were not undertaken as part of any convergence project – and I shudder to think that the FASB might actually be called upon to incorporate these changes into U.S. GAAP. I wrote a rather lengthy description of the revisions to IAS 19, Employee Benefits, in my blog this past October, and the bottom line is the same as for the first example: the revisions foster more income smoothing and earnings management; they indicate that the IASB cannot be trusted to tell the truth or to put investors' priorities first. Again, and just a few months ago, to accommodate special interests, the IASB shows its willingness to promulgate accounting standards that surely result in shareholder value destruction.

My third example is the secret letter sent by Mr. Hoogervorst to the European Securities and Markets Authority this past August, in which he expressed concern at the inappropriately high valuations produced by specific EU banks on their holdings of Greek sovereign bonds classified as 'available for sale.' Setting aside the accounting implications of that letter, and there are many, the subsequent revelation that the letter was kept secret – until the IASB was forced to make it public once news of its existence was leaked to the Financial Times – raises trust issues that can be directly traced to the current head of the IASB.

Hans Hoogervorst, as a former regulator, surely knew that sunlight would have been the best disinfectant, yet he chose secrecy. The numbers in financial statements are cyphers, and pronouncements of accounting standards are the principal means by which they are de-encrypted. If one is not concerned that investors fully understand the basis under which the financial statements were prepared, then one might have no qualms about withholding part of the de-encryption key. Evidently, the IASB wanted to be certain that European regulators fully understood the financial statements, and for the regulators to have that knowledge without letting investors in on the secret. It leaves a strong impression, to say the least, that EU regulators are currently the IASB's primary constituency.

False Claim #3:    U.S. GAAP is not superior to IFRS

Mr. Hoogervorst stated that quality of the actual accounting standards should be the most important consideration for the SEC as it formulates its IFRS policies, but he is "not convinced by the arguments that one set of standards is clearly superior to the other."

Moreover, he stated that "academic studies have concluded that both IFRSs and US GAAP are high quality standards." A vaguely-worded footnote to that statement reads as follows:

American Accounting Association Financial Accounting Standards Committee, 2008 ‐ Karim Jamal

That footnote leads me to believe that Mr. Hoogervorst was referring to a paper published in Accounting Horizons [Vol. 22, No. 2, 2008, pp. 241-248] by the AAA's Financial Accounting Standards Committee.

Let's take a closer look at that paper. That committee did indeed cite evidence from academic research that IFRS and U.S. GAAP were substantially similar; but, crucially, it added that it had no basis to state that either set of standards were "high quality." Furthermore, that same committee stated in a subsequent comment letter to the SEC that high quality depends on a number of factors that are specific to each environment: legal systems, securities enforcement, taxation and incentives of preparers, for example.

Taken as a whole, the paper from which Mr. Hoogervorst took one supportive nugget out of context clearly would not provide academic support for IFRS adoption in the U.S. Rather, I took the committee's remarks as an endorsement of a standard setting system that supported where standard setters were in competition with each other. And indeed, in the comment letter I mentioned, the Committee stated:

[A]cademic research indicates that using a single set of uniform accounting standards will not lead to the production of comparable and consistent financial reports that are desirable to regulators [citation omitted]. The promise that adoption of IFRS will deliver comparability and consistency in accounting reports is false and misleading. [bolding and italics supplied]

There are two more quick points I want to make about what academic research has to say about the relative merits of IFRS versus GAAP. In the same issue of Accounting Horizons, another AAA committee of academics, the Financial Accounting and Reporting Section of the Financial Reporting Policy Committee, took the opposite position on the relative attributes of the IFRS versus U.S. GAAP: empirical evidence suggested that analysts actually preferred working with GAAP financial statements instead of IFRS. Consequently, the elimination of the SEC requirement to provide reconciliations of differences between IFRS and U.S. GAAP was premature.

But, whatever these papers stated at the time they were published, time has elapsed, and both IFRS and GAAP have changed. Has IFRS been improved? The SEC needs to acknowledge that IFRS has taken a number of steps in the wrong direction: to name just a few, there are the borrowing costs and pension accounting issues that I already mentioned; there is also the free choice in accounting for non-controlling interests, and most recently, there is the proposed hedge accounting revisions that would broaden and liberalize the application of hedge accounting. I wonder if a single investor has called for any of these changes that will permit preparers to further manipulate earnings?

False Claim #4: IFRS is already widely adopted elsewhere

The IASB has been successful in achieving various degrees of acceptance of IFRS in many jurisdictions, and notwithstanding one significant carve-out, the EU should be regarded as the IASB's greatest success. But, if proponents of IFRS adoption are claiming that the U.S. should be following the EU to IFRS, the reasons why the EU adopted IFRS must be examined – for they are as different from legitimate regulatory goals for the U.S. as north is from south.

The impetus for IFRS adoption in the EU has its roots in events that were triggered by the NYSE listing of Daimler-Benz in 1993. At that time, German GAAP was known for the availability of so-called "hidden reserves," which permitted a high degree of non-transparent income smoothing. The SEC was under significant pressure to waive the reconciliation to GAAP requirement, but the SEC held firm; and the financial results reported by Daimler backed them up. For its latest reporting period disclosed in its initial registration statement, Daimler showed a small profit under German GAAP, but a significant loss under US GAAP. The difference was due to Daimler releasing reserves that were accrued in prior periods under German GAAP.

For similar reasons, the Daimler-Benz listing incited a debate in Germany about whether its own accounting standards were adequate. In 1998, German law was changed to allow listed companies a choice between German GAAP, IFRS or US GAAP. The end result was that many companies switched away from German GAAP, and about half of those switchers picked US GAAP.

Just as today, where the EU fears that the US could end up with too much influence on the IASB, the US GAAP switchers seem to have caused great concern throughout Europe; both governments and large banks feared the loss of their power to establish accounting standards, and especially feared inflexible standards that were rigorously interpreted and zealously enforced by the SEC. Stated bluntly, there was great concern that US GAAP could take over Europe; so, in 2002, the European Commission acted swiftly and decisively to mandate IFRS for all listed companies in the EU.

My point is that the SEC is now being urged to give up its prerogative to set accounting standards for U.S. issuers – not for the greater good as is generally thought, but solely because members of the EU feared their own loss of sovereignty. Without adoption of IFRS by the EU, we wouldn't be discussing whether the US should be adopting IFRS in any manner, shape or form; and anybody who doesn't think that the EU won't push back hard if it finds that the U.S. is limiting the EU's ability to influence, if not control, the IASB is kidding herself.

If the shoe were on the other foot – in other words, if the U.S. were part of the IFRS coalition along with the rest of the world – would the EU be inclined to join the coalition if it couldn't control the outcomes? Of course not.

False Claim #5: Even though IFRS may not be consistently applied elsewhere, the SEC can enforce compliance with IFRS as it sees fit.

It's hard to imagine that SEC enforcement of IFRS can take place without SEC-quality enforcement in the EU at a minimum. More likely, one of two scenarios will come to pass: SEC enforcement will raise the quality of IFRS worldwide, or the SEC will be pressured to join in a race to the bottom. I fear, and would expect, the race to the bottom scenario.

Here's an example of how the race to the bottom could take place: a questionable interpretation of IFRS is the basis of a loan loss allowance methodology adopted by, say, a French bank; and that treatment is approved by its French auditors and regulators. The race to the bottom begins when SEC registrants facing similar facts and circumstances argue to the SEC that if they were forced to comply with the SEC's stricter interpretation of IFRS, then they would be placed at an economic disadvantage – it could create competitive pressures, or perhaps affect compliance with banking regulations.

Consequently, even though the SEC may find no merit in the registrant's position, it might have to yield to pressure from registrants and sacrifice investor protections. The pressure could also come from an outside source: Congress, lobbyists for special interest groups, other foreign governments, and maybe even the United Nations. Even if the SEC manages to keep the high ground, the scenario is not pleasant to contemplate, and arises from the fundamental problem of a single set of global accounting standards: the present and likely future reality is that one size doesn't fit all. The relatively low degree of detail in IFRS also creates opportunities for this type of race to the bottom scenario to occur, and the higher detail present in U.S. GAAP may explain why it rarely occurs in the U.S.

I think there is also a technical problem that has not yet been the subject of much discussion and could easily start that race to the bottom rolling. If the SEC were to implement the so-called 'condorsement' approach, U.S. GAAP would continue to survive with IFRS rules incorporated into it. Ignoring whether such an approach is actually practicable or even feasible, U.S. GAAP provides that when an authoritative source does not specify an accounting treatment, an issuer would eventually be allowed to adopt a "practice that is widely recognized and prevalent either generally or in the industry." U.S. registrants could validly claim that they are permitted to adopt industry practices that developed globally among any critical mass of IFRS issuers, and not just in the U.S.

 CLICK HERE FOR PART THREE OF THIS ESSAY.

Ten Claims in Support of IFRS Adoption by the SEC – and Why They are False (Part One of Three)

Dear Reader,

This essay is far too long for one blog post. For that reason, I have chopped it into three pieces, with links at the end of each one to take you to the next. I apologize for any inconvenience.

Best,
Tom

* * * * *

I am a terrible 'blog administrator.' I don't obsess about my blog statistics, and I don't even know how to track the number of hits to each of my posts. Still, I am 100% certain that Top Ten Reasons Why IFRS Adoption is a Terrible Idea, written 3 1/2 years ago has been my most popular posting. Time sure has flown by; and so, lately, has the rhetoric as the SEC girds itself for a giant leap of faith toward IFRS.

This past Saturday I had the honor of addressing the Public Interest Section of the American Accounting Association on the topic of IFRS adoption. In that speech and a similar one that I gave in October, my remarks were largely structured around ten claims being made in support of IFRS adoption, and why they are false. This series of posts is based on my latest speech, and regular readers of my blog should be aware that there is some repetition from earlier posts. However, I do believe that many visitors to The Accounting Onion can benefit from the re-organization and having everything in one place.

How We Got Here

The IFRS adoption question has been so long in the works that many readers may not be fully aware of how this whole thing got started. So, before we get to the new Top Ten, let's begin with some background.

Convergence with IFRS became a topic because Congress believed that inadequate accounting standards were at least partly responsible for the wave of frauds exemplified by Enron and Worldcom. (I disagree – see the end of this post.) Consequently, Section 108 of the Sarbanes-Oxley Act of 2002 directed the SEC to consider, when adopting accounting standards, whether "…international convergence on high quality accounting standards is necessary or appropriate in the public interest and for the protection of investors." The SEC, FASB and IASB have been working together towards adoption of IFRS since the passage of Sarbanes-Oxley.

One of the first formal actions was the so-called Norwalk Agreement, whereby the FASB and IASB entered into their initial Memorandum of Understanding to make their best efforts to converge U.S. GAAP and IFRS. After six years, little substantive progress had been made on convergence; yet, just as SEC Chair Christopher Cox was preparing to step down, the SEC published its proposed Roadmap toward final rulemaking that, if finalized, would have required SEC registrants to begin complying with IFRS sometime about now. To be sure, the Roadmap has hit numerous snags, and timelines have been stretched. Nevertheless, a follow-on policy statement from the SEC should be coming by the end of this year.

The SEC staff provided a strong indication of what may come from the Commission in a May 2011 staff paper informally referred to as the "condorsement" proposal. In that paper, the Staff has finally conceded that a complete abrogation of U.S. GAAP in favor of IFRS as set forth in the Roadmap would not be feasible, and now proposes a restructuring of the standard setting regime: the FASB would retain its status with the SEC as the standard setter for U.S. GAAP; but it would not add any new projects to its agenda, unless to endorse an existing IASB standard, or to work with the IASB on a project the IASB chooses to undertake.

At this point in time, the FASB and IASB are focusing their efforts on achieving closure on just a couple of pivotal projects: revenue recognition and leases. These projects have, as one would predict, been extremely controversial, but some sort of final standard is clearly a prerequisite to a continuation of the SEC's efforts to adopt IFRS.

The Ten False Claims for IFRS Adoption

Time is of the essence on IFRS adoption; in large part because the IASB has made it clear it will not continue to wait for the U.S. to come up with a firm IFRS adoption policy for much longer. Its own final public relations push began this past October when Hans Hoogervorst and Harvey Goldschmid, IASB chair and CAQ board member, respectively, delivered keynote speeches (both available here) at the IFRS Foundation/AICPA Conference in Boston. While I understand that speeches in that kind of setting leave little time to deal with the details, I do believe that the devil of IFRS adoption is in those details.

Richard Breeden, a former SEC chairperson and now the head of a $2 billion international investment fund, stated that if the SEC were to adopt IFRS, "it would be the darkest day in the history of the SEC." My goal for this second "Top Ten" list is to convince you that he was not exaggerating, and that the SEC should have long ago made a U-turn on its IFRS adoption proposals.

False Claim #1: There are some large U.S. corporations that want to switch to IFRS.

Indeed, there are, but there are many more that adamantly oppose a switch to IFRS. As summarized by Gaylen Hansen, Vice-Chair of NASBA, large public companies responding to the SEC's original Roadmap proposal opposed IFRS adoption by 47 to 28; and of the 47 that opposed IFRS adoption, 35 – about three-quarters of them– strongly opposed IFRS adoption.

Those invested in IFRS adoption would like to dismiss any analysis of the comment letters on the grounds that only 240 letters were received in total. However, based on historic response rates to SEC requests for comments and widely accepted statistical norms, a sample size of 75 large companies is considerable, and I have not seen anyone try to claim that the sample was not representative of the population from which it came. If anything, the weight of the comments received would seem to be biased for IFRS adoption, because economic incentives to write a comment letter in support should be high; and there seems to be little incentive to be critical of IFRS adoption.

For example, if a company's management actually perceived that IFRS adoption would be profitable, then it would seem that the marginal cost to write a comment letter in support of IFRS adoption would be low relative to being able to nudge the SEC in the direction it obviously wanted to go. The presence of economies of scale would further suggest that the cost-benefit tradeoff could be most attractive to the management of large public companies.

Cavils about sample size notwithstanding, the results of the comment process were strongly negative, and that negativity has been confirmed by subsequent feedback. During the first panel of the July 2011 Roundtable convened by the SEC to discuss the Staff's condorsement proposal, the representatives from the credit rating agencies conceded that they do not rank either accounting framework, U.S. GAAP or IFRS, above the other in rating financial statements. Most tellingly, the smaller public companies panel unanimously and emphatically turned their thumbs down; all anyone saw in IFRS was a lot of incremental cost and zero benefit.

As to the few large companies that still support IFRS adoption, my own consultations with U.S.-based global companies makes me skeptical of the claim that adoption of IFRS would save money.

For example, foreign operations often have local statutory reporting obligations that may conflict with, or may even be completely independent of IFRS, and these statutory reporting requirements will remain even if U.S. GAAP is replaced with IFRS. Moreover, in the significant majority of the companies I have interacted with, the accountants physically located at the foreign operations are in charge of producing U.S. GAAP financial statements; and the managers at the foreign subsidiary are evaluated on their U.S. GAAP results as stated in the foreign currency. In these cases, whether IFRS is currently in the mix or not, everybody already speaks the same language; and that language is U.S. GAAP.

IFRS adoption would mean that all U.S. accountants would have to learn a new language, and so would many of the accountants at the foreign subsidiaries. As for accounting educators, there will come the day when you will have four bases of financial reporting to know and to teach – and your students will have four sets of rules to learn and to be tested on: U.S. GAAP, U.S. GAAP for non-public companies, IFRS, and IFRS for SMEs; and that doesn't include all of the tax rules that must be taught, learned and tested.

CLICK HERE FOR PART TWO OF THIS ESSAY.

Where is the Center for Audit Quality When We Actually Could Use It?

Below is an email I received from Lynn Turner. My several comments are in brackets, and the italics/bolding are all supplied by yours truly (I also took the liberty of fixing a couple of minor typos):

"One of the interesting side stories during the Congressional Debate on the IPO legislation [Jumpstart our Business (JOBS) Act, which I wrote about in my previous post] is the remarkable deafening silence of the Center for Audit Quality (CAQ) [which tries to brand itself as "nonpartisan" and "dedicated to enhancing investor confidence and public trust in the global capital markets" -- but behaves more like a joint venture of the Big Four and the AICPA] as the debate had moved to the Senate. While in the past they have been very vocal opposing legislation that would step on the independence of the FASB, and that would roll back the SOX requirement for companies to have their internal controls examined, there are no such letters forthcoming to the Senate this time.

I suspect it is because in the legislation, there are provisions that would limit the ability of the PCOAB to impose auditor rotation. In addition, the legislation would impose a new requirement on the SEC to conduct a cost benefit test of any new rule the PCAOB itself adopts, prior to the SEC approving the rule. This would apply to new rules the PCAOB has under consideration such as to expand what the auditor reports to investors, and efforts to enhance auditors' objectivity and independence through such means as auditor rotation. And the laws would require the SEC to do the analysis within 60 days of when the PCAOB adopts a new rule. This is an impossible task given court rulings in the last year on how the SEC must perform such analysis.

As such, this proposed law would likely make it most difficult for the PCAOB to adopt new rules, if the large[st seven] auditing firms [all of which are represented on the CAQ's governing board] opposed them. Already, I understand the CAQ has told reporters litigation would be forthcoming if the PCAOB adopted a standard for auditor rotation.

It appears as if the CAQ has finally shown its true colors. One must wonder if its independent board members agree with this approach as we have heard nothing publicly from them on this.

As to those (only three) "public" board members, let me get this part out of the way first: I am told by an anonymous source, who is plugged in enough to know about such things, that public board members receive around $100,000 in compensation for serving. Not that this arrangement explicitly buys silence in public on matters inimical to the interests of international auditing firms, but at least it is something that the CAQ should be more upfront about. I haven't found anything on the CAQ website to indicate how board members are recruited or compensated.

At a minimum, these "public" board members should be questioning the CAQ administration as to whether a lack of comment is a breach of commitment to CAQ'ss stated mission.  But, I'm going to take this one step further for one particular public board member, Harvey Goldschmid. He is a former SEC Commissioner and a long-time member of the law faculty at Columbia. I am unable to bring any direct evidence to bear on the question, but I do find it (more than) curious that, at the behest of CAQ, he has insinuated himself into the IFRS adoption discussion, yet he has kept his own counsel on the JOBS Act.   

As to IFRS, Mr. Goldschmid has chosen to be a strong proponent of IFRS adoption by the SEC in conferences sponsored by CAQ-allied entities. His message has been that the U.S. must adopt IFRS forthwith – or else face dire consequences. In doing so, he makes no apology or allowance for the fact that he is speaking outside of his field of expertise; he is not an acknowledged expert on accounting and auditing matters. I have also stated that I believe his rhetoric, made in tandem with the IASB chairperson (also not an auditing and accounting expert), were synthesized from an admixture of vague generalities, selective use of the facts, cherry picking of academic research, and biased speculations of a doomsday to come if the SEC does not act to adopt IFRS.

I'm not saying that every securities law professor has a civic or moral duty to make their views known on every proposed piece of capital markets regulation, but I do find it remarkable and ironic that Mr. Goldschmid chooses to speak freely about IFRS adoption, while choosing to keep his own counsel on topics that are right square in his wheelhouse: SEC registration requirements and exemptions.

Stated another way, I know of no other securities law professor who is advocating publicly for IFRS adoption except for Mr. Goldschmid; however, I do know that many prominent professors are highly circumspect or critical of the JOBS Act. Here's just three:

• John Coffee, Mr. Goldschmid's colleague at Columbia no less, has derisively nick-named the bill's crowd-funding provision the "boiler room legalization act." As to other provisions of the bill, he is not so impressed by those either.
  
• Harvard law professor John Coates finds it "odd" that "amid an economic downturn caused in part by financial deregulation … Congress should be actively considering (and indeed have passed in the House) a raft of proposal [sic] for more financial deregulation.
• If the views of other prominent academics in his field are not persuasive enough, then perhaps Mr. Goldschmid should consider the views of MIT Economist Simon Johnson, who has called the JOBS bill, "a colossal mistake of historic proportions" that won't create jobs and will raise the cost of capital instead.

Surely, for such a significant piece of capital markets regulation, an active and lauded former Commissioner would not want to miss an opportunity to weigh in along with his academic colleagues, wouldn't he?

Lynn is absolutely correct: if the CAQ were truly nonpartisan, as opposed to the equivalent of the National Rifle Association for international auditing firms, it would have issued a public comment on the JOBS Act – at least to the extent that it affects auditors and financial reporting. And, as Lynn strongly implies, the CAQ board should be called to account.  Moreover, if Harvey Goldschmid cares to be perceived as an independent thinker, as opposed to a hired gun, we should be hearing what he has to say about the JOBS Act as well.

The collective failure to speak out on the JOBS Act undermines CAQ and Mr. Goldschmid's credibility on every other issue for which he has supported CAQ; and most especially, IFRS adoption.

An Accounting Parable for Our Time

As told to me by a faculty member at Ohio State, who heard it in a presentation by Eugene Flegm, former general auditor for General Motors:

Some years after the end of World War II, GM was negotiating a new contract with the United Auto Workers. The labor union proposed that GM should pay an additional amount per hour to its unionized employees, which the UAW would take and invest in a pension fund. Pension payments to retirees would eventually become the full responsibility of the UAW.

The CEO of GM consulted with his economist, who advised that the proposal was a good deal for GM: the expected cost of funding the pensions would remain the same, but the risk of funding unanticipated losses would be borne entirely by the union.

The CEO next consulted with his accountant, who informed him that current profits would suffer if the union's offer were accepted: the additional wages called for would be reflected in expense immediately. On the other hand, if GM were to keep the responsibility (and risk) of paying the pensions, recognition of the associated expense under extant GAAP would be delayed for decades – until retirees were actually paid.

The CEO chose to disregard the economist's advice and to decline the UAW's offer.

Postscript: Following similar decisions of subsequent CEOs and questionable funding decisions, GM's underfunded liability for retirement benefits grew to $50 billion as of December 31, 2008. In December 2008, under President Bush, GM received $13 billion of TARP funding, and another $39 billion under the Obama administration.

 

The 'Moral of the Story'

This tale of GM wealth destruction is just one of many that can be told that begins with a bad accounting rule. It's a relatively dated story, but if the first twelve years of this millennium are any indication, the problem of perverse accounting incentives has been getting much worse – despite the putative best efforts of standard setters to enhance financial reporting "quality."

Either the problem is seen by accounting standard setters to be in the "not my job" category, or if they are sensitive to it at all, then history suggests they are going about it the wrong way. That's just one reason why convergence hasn't been worth a hill of beans, and any forthcoming statement from the SEC about continuing on with IFRS adoption in one form or another is dross. I'll have more to say about that at the end of this post.

The wrong way that the Boards have been pursuing is predicated on the explicit assumption in their respective conceptual frameworks that the fundamental purpose for financial statements is to provide information to help interested parties value an entity. But, a major problem with this approach is that it doesn't provide any consistent answer as to how the recorded assets and liabilities of the entity should be valued. Instead, the approach is used as a justification for the kinds of accounting that managers can manage.

To illustrate, one of the most recent contributions to the valuation perspective for accounting standards is a new book by Columbia professor Stephen Penman, Accounting for Value. In many respects it is an excellent book and I highly recommend it; however, I take exception with his line of reasoning that rejects current values as the basis for asset and liability measurement.

Without wishing to oversimplify, there are two sources of equity value from Penman's perspective: things that we know; and things we can only speculate about. If accounting restricts itself to measuring things we know (such as the historic cost of land), then the amount of speculative value in the current stock price can be deduced from the difference between it and the book value per share. Penman argues that speculation should be left to investors, for if accountants were to engage in too much speculation, then it will be difficult to avoid paying a market price that could over value a company.

I do have questions about Penman's analytics that lead to a conclusion that historic cost accounting is to be preferred to current value accounting; but, if valuation is not the primary objective for financial statements, then it doesn't matter whether he is right or not. My intent is solely to point out that a rigorous defense of historic cost accounting depends on whether one maintains that it is appropriate to prepare financial statements under the presumption that valuation analysts are the primary user group. My position is that to determine that this assumption is inappropriate, it should be sufficient to have enough stories like GM, where transaction-based financial statements clearly caused massive value destruction. Based on my own experience and study, I would estimate that there are thousands of examples out there just like it – albeit few that are as overtly laden with societal consequences.

The right way to select a basis of measurement should begin with the assumption that financial statements exist to guard the interests of investors in an entity. Indeed, I would think that this "stewardship" function was the original intent of double-entry accounting in the first place. It entails a high level of accountability from managers to owners for the manner in which business was conducted. Normally, this should mean that managers have an obligation to utilize the (net) assets of a business in a manner that appropriately balances risk with return on the owners' investment.

Of course, neither stewardship nor any other financial reporting system is foolproof. But, if accounting has any hope of bringing perverse incentives to manipulate financial statements down to a tolerable level, the implication of a stewardship perspective is that accounting must focus, to the extent practicable, on measuring the effect of managerial decisions on wealth and changes in wealth.

While some argue that estimating current values injects too much subjective judgment into accounting, I suggest that no matter what system of accounting is proposed, judgment is an unavoidable reality; and therefore, quibbling about which approach to valuation requires larger doses of judgment is largely irrelevant. A stewardship role for accounting also implies that it is not "management's view" that should count, for that would be circular logic indeed. The only view that should matter is the view of a disinterested economist, taking into consideration current business conditions.

Getting back to that annoying IFRS question, which most of us wish would just go away, the SEC's Chief Accountant, James Kroeker, spread the word last week that he will be preparing a proposal to the Commission for moving forward on IFRS. I don't know what will happen here, particularly since not a single Commissioner has delivered a major speech on accounting standard setting – despite the fact that it is one of the most critical regulatory functions within the SEC's purview. If any of the five sitting Commissioners has a reasonably complete understanding of accounting standards and policy, I haven't seen it demonstrated.

Obviously, I'm not going to go into all of the reasons why the SEC should finally move away from IFRS in this blog post, but I do hope the Commissioners will ask themselves this one question:

If accounting standards can either create or eliminate perverse incentives for the managers of public companies – with potentially profound consequences for the U.S. economy – how can we set a goal of convergence with standards that cater to "management's view" instead of a goal of reflecting economic reality?

The SEC's "90% Convergence" Fantasy

"…[W]e know there are going to be challenging issues to resolve under any [IFRS] incorporation decision. The issues of LIFO and contingencies immediately come to mind. But even with all of this, I would offer up one final thought for your consideration: Would it better to be 90% converged and understand the differences, or should the objective be abandoned? [bold italics supplied]

Paul Bestwick, SEC deputy chief accountant, asked this question at the end of his remarks on IFRS at the AICPA conference last December. As I'll explain further, it's an inappropriate question; and I thought as much when I read it around the time it was asked. But, I had decided to live and let live, considering that I had already issued a pretty brutal send up of Beswick's boss, James Kroeker, for his own IFRS comments at that conference.

All that changed a few days ago upon reading a report in the Financial Times that the European Commission is still balking at endorsing reasonable and U.S. GAAP-like standards for consolidating special purpose entities:

"The [European Financial Reporting Advisory Group] said some companies felt that [2013] was not enough time to meet the deadline [for adoption], citing additional opposition from financial services groups, including insurers." …

However, European reservations go deeper than timing. France is questioning the substance of the new consolidation rules, which say a company can have a de facto control of an entity while holding less than half of voting rights." [italics supplied]

Basically, the EC is thumbing its nose at GAAP/IFRS convergence. The EC is the elephant in the room, and it will never leave, so anything the IASB wants to do to address its governance processes and independence is mere window dressing. It seems to me that there will always be (a) France standing in the way of investor-purposed financial reporting. (To their specific gripe, I say meh. An entity can be structured so that nothing of substance may be subject to a vote of the common shareholders.)

Not only are we not getting enough convergence out of the joint projects, but there will always be forces standing on guard to break apart what has been converged and is not paltable to the EC -- or India, or China. That's why the FT article made me realize that this ludicrous notion of a "90% solution" has to get it with both barrels.

Let's start with Beswick's implication that IFRS and GAAP will be 90% converged after completion of the current joint projects. What does "90% converged" even mean? On its face, it may have been a slick rhetorical device (recall that Beswick also takes credit for coining "condorsement") to get the audience's heads nodding up and down, but it's far too slick. In fact, it's highly misleading.

First, there's the pretense that convergence will beget comparability, the putative object of the exercise. How could a single set of standards without a single, consistent and rigorous enforcement mechanism deliver on the promise of comparability? But, even more important, IFRS is so loosey-goosey that comparability is not a practical possibility even with the requisite enforcement mechanism.

Second, even if revenue recognition, leasing and financial instruments are converged, even the study (as bad as it is) coming from Beswick's bailiwick shows that differences between U.S. GAAP and IFRS exist for practically every topic – even the ones that have been declared "converged" by the powers that be. Are these differences between GAAP and IFRS significant? Of course they are; for if they weren't significant, they would have been converged already!

Third, there is the problem of costs and benefits. Even Beswick acknowledges (albeit somewhat as an afterthought) that "strong voices" are "concerned" that the cost of IFRS incorporation could be "significant with no commensurate benefit, either to an individual company and or the U.S. markets"; and that IFRS is not high quality. To these naysayers, Beswick coos, "I think these will be important issues the staff will need to consider." The staff has never once stated that it would conduct a study to evaluate the benefits of IFRS incorporation.

* * * * *

Obviously, my answer to Beswick's question is YES, PLEASE ABANDON CONVERGENCE WITH IFRS.

And, I'd like to ask him one: Thus far, what benefits have U.S. investors realized from the ten-year effort to converge IFRS and U.S. GAAP?

IFRS Convergence: Let's Play 'Chief Accountant for a Day'!

When I was at the SEC (1992 – 93), one of the senior staff members whom I admired greatly for his competence and integrity was Robert Bayless, the Chief Accountant for the Division of Corporation Finance. ("Corp Fin" is the branch of the SEC that reviews and comments on financial statement filings.) Sometime after I had left the Commission and the position of "Chief Accountant to the Commission" had opened up, it was rumored that Bayless would be in line for the promotion. But, the chatter quickly died down after Bayless was supposed to have responded, "Why would I want to drink battery acid?"

The point of my story is that the Accounting Establishment can always make life miserable for the Chief Accountant to the Commission – especially one who, like Bayless, would have made investor protection his sole priority. I thought of him recently as I read James Kroeker's (the current Chief Accountant to the Commission) remarks at the AICPA's annual conference on SEC and PCAOB developments. Mr. Kroeker did concede that the planned imminent policy statement from the SEC on International Financial Reporting Standards could not possibly happen for at least several months. But, in all other respects, he once again demonstrated his abilities and willingness to be the implacable Chief Spinmeister for the Accounting Establishment. If nothing else, it's a way to keep battery acid out of one's diet.

Rather than criticize Kroeker point by point, I'd like to imagine that I could take his place as Chief Accountant for one day – the day of that speech. This is what I would have said:

Good morning. It's an honor and a privilege to be the Chief Accountant to the Commission for a day.

Let me begin with a discussion of the current state of the IASB/FASB convergence agenda. If I were to start with the premise that execution of the convergence projects and the results of that work are important as the staff considers the issue of incorporation of IFRS, I would have no choice but to conclude that further efforts at convergence will be a monumental waste of time. Moreover, it is clear to me that the time and efforts of this office and the FASB over the past 10 years could have been much better spent on efforts to improve the quality of U.S. GAAP, instead of on convergence with IFRS.

As all of you certainly are well aware, the work of the two Boards on convergence has been at the top of their respective agendas since 2002. It's hard not to be amazed at how many hours have been spent debating accounting issues over those ten years while so little has actually been accomplished. I am stunned that the SEC staff has not given more direction and constructive criticism to both Boards. But, as my kids would say, "I'm not gonna lie. It is what it is." (I hate both of those expressions!)

Let's go back just a little bit to see how bad things have become. At the time of the February 24, 2010 Commission Statement on IFRS, the FASB and IASB had nearly a dozen joint projects planned for completion by both boards by mid-2011. The SEC was hopeful that at least some of those projects would be completed by now, and even IFRS adoption skeptics, like me, could not have imagined that we would actually be further from convergence today than we were back in February 2010. Progress has been made toward partial convergence of some trivial matters – like the way that components of dirty surplus (so-called "other comprehensive income") are formatted, and the IASB has finally agreed to adopt the FASB's fair value measurement standards for the few items that are measured at fair value. But, everything else seems to be heading in reverse.

We have come to the point where the SEC is placing all of its hopes for any indication of significant progress toward convergence on the revenue recognition and leasing projects. However, the best that can be said of these projects is that two watered-down standards could become finalized by the end of 2012. I do not consider this to be progress, as I believe that the FASB would have been capable of creating higher quality standards without being forced to collaborate with the IASB. We do have our politics here in the U.S., but recent years have shown that it is nothing compared to the political pressures exerted on the IASB by its many "stakeholders."

The major project that seems most likely to be finalized in 2012 is revenue recognition. In the revised exposure draft issued just last month, the Boards have abandoned any semblance of a principled position on the asset/liability view – supposedly one of the prime reasons the project was begun almost 10 years ago. If finalized as currently proposed, all sorts of deferred costs will populate the balance sheet. 

Overall, I think it is fair to say that this project has devolved into a desperate quest to somehow quell criticisms by preserving current practice while at the same time replacing the rules from 200 separate pronouncements and interpretations with one cohesive document. The unsurprising result is a draft standard that is so vague and lacking in robust illustrative examples, I wouldn't be surprised that we will soon have 200 new interpretations to deal with before an effective date finally comes to pass – which I expect to be no earlier than January 2017.

I should also mention that the prospects for a high-quality lease accounting standard are even more dismal. The Boards are being pushed to whittle down recognition of lease obligations to some crudely calculated minimum amount that lessees might grudgingly accept. Lessor accounting, after years of vacillation and improvisation, is still in flux.

Ironically, if my predecessors had been completely honest with the public, they would have admitted long ago that the greatest progress made on convergence has been to point out where convergence has no chance of succeeding in our lifetimes.

Take financial instruments. Please. Given the 2008 financial crisis, the impending implosion of bank balance sheets in Europe and the recent embarrassment in the U.S. of MF Global, this is the one area where the Boards could provide an immediate service to investors. Yet, the SEC stood idly by as one FASB Chairman was fired by the Financial Accounting Foundation for daring to insist that convergence result in high quality financial instrument standards, and while the FAF stacked the Board with three more reliable IFRS shills. But, it seems that nothing less than a return to post-WWI hidden-reserve accounting will satisfy the German and French bureaucrats. (At least we can thank the current members of the FASB for resisting at least that much.)

Even as the SEC's arguments for continuing with convergence have been pounded to dust by the vast majority of SEC registrants and independent-thinking investors, the staff has been blithely proceeding (albeit at a snail's pace) with its work program – exploring whether and, if so, how the Commission could or should proceed with a decision to incorporate IFRS for U.S. issuers. In truth, the scope of that work plan is woefully inadequate. I have absolutely no idea how the staff will produce a rigorous analysis of the costs and benefits of incorporating IFRS into U.S. GAAP that meets the standards set by a recent court ruling against the SEC.

My skepticism in this regard is further reinforced by the two progress reports that the staff has recently issued in the form of Staff Papers. The first is a comparison of the differences between U.S. GAAP and IFRS. Although revenue recognition, leasing, and financial instruments were excluded, it's amazing how many significant differences still exist! First, there are all of those convergence projects that have been abandoned or indefinitely postponed; second, there are the significant differences that remain from projects that the staff is counting as converged; and third, there are the differences that are so fundamental, the boards didn't even bother to put them on any convergence agenda.

Yet, it appears that the staff has attempted to downplay the sheer impossibility of bridging these differences, mainly by providing a document that no Commissioner would find any reason to actually read, except perhaps as a natural and highly effective cure for insomnia. The bulk of the report is a turgid regurgitation of differences between IFRS and U.S. GAAP that could have easily been lifted from a pamphlet written by any one of the Big Four. The staff also made sure to leave out any summary, takeaways, or any indication whatsoever of the dim prospects for, and herculean efforts that convergence will continue to entail. If the authors' intention was to provide no new information or guidance, then they succeeded admirably – and they should also be quite ashamed of themselves for the dismal quality of their work.

The second Staff Paper is an analysis of the use of IFRS in practice by the subset of Global Fortune 500 companies that claimed to comply with IFRS in their financial statements. This paper was actually well done (and it should be noted that it was not written under the direct supervision of the Chief Accountant to the Commission). The number of apparent departures from IFRS noted, and the inconsistent ways that IFRS has been interpreted by the largest companies, should explode the myth that worldwide adoption of IFRS will result in more comparable financial statements. The unavoidable conclusion is that even if a single set of global accounting standards were possible, the paper leaves no reason to believe that effective global enforcement would occur. A single set of standards without a single, consistent and rigorous enforcement mechanism will fail to deliver on the promise of comparability.

In summary, as I reflect on the negative feedback from the July Roundtable and these two staff papers, I see absolutely no reason to continue consideration of IFRS adoption in any manner shape or form. But, I'm only the Chief Accountant for today, and James Kroeker returns tomorrow. You should expect that he will continue to display his singular talents to spin convergence whilst the SEC's project spins ever more rapidly out of control (or down the toilet, if you will).

Thank you for listening. If only the Commission would do the same for once.

 

 

More SEC Reports on IFRS Coming: Will they be Genuine Analysis or Just More Dithering?

The minutes of the latest meeting of the SEC Staff with the CAQ SEC Regulations Committee provide an indication of what may be coming soon on the IFRS adoption front:

"Jill Davis [Associate Chief Accountant in the Division of Corporation Finance] noted that the comment letters provided to the SEC staff on the Staff ["Condorsement"] Paper have expressed overall support for the longer-term objective of moving toward a single, high quality set of standards that are applied consistently on a global basis.

Ms. Davis also noted that the SEC staff plans to issue two additional Staff Papers during 2011 on (1) a principles level analysis of US GAAP as compared to IFRS and (2) an analysis of the application of IFRS in practice. The SEC staff also is considering issuing a report by the end of the year that would summarize observations and information gained through its IFRS Work Plan. [italics supplied]

If you are a regular reader of my blog, you would know that I think that the Staff is either just spinning its wheels, or it has decided that it has come time to spin out yet more propaganda to support IFRS adoption. I italicized those portions of Ms. Davis's remarks that are my particularly hot buttons.

Single set of standards – There isn't even a single set of IFRS, and there still won't be, even if the U.S. swallows IFRS hook, line and sinker. This is due in part because of the multiple carve-outs that could live as long as IFRS lives. But it is also true because even within 'pure' IFRS, the notion of a single set of standards is a fiction: there are far too many free choice and built-in opportunities to manage earnings. Stated another way, there may be a single system accepted by a few countries called IFRS, but it surely is not a single set of standards.

High quality standards –I'm sure that Indian regulators, with its 65 carve-outs utilized by thousands of companies, believe that the Indian version of IFRS is high quality, because it accomplishes policy objectives set for India; and the same goes for China, which regards it abridged version of IFRS to be just as good as the real thing. The EU is pretty close to genuine IFRS, but is it much different from India or China? It has only one carve out utilized by only about twenty companies, but some of these companies are the GIANT banks whose failure could bring the global economy to its knees, yet once again.

I'll have more to say about "high quality" in my next post, when I discuss the concept of "investor protection." But for now, I'll just observe that high quality is context-dependent; and it behooves the SEC to give us at least some hint, finally, as to what "high quality" means forthe SEC's mission to protect U.S. investors.

(Accounting) Principles – This would be a good time to mention the online availability of the text of my remarks at least week's American Accounting Association 2011 Northeast Region meeting (Whither IFRS Adoption: the Answer is in the Details).

During the Q & A afterwards, one professor in the audience asked what advice I had for his doctoral student, who was seeking to write a dissertation on a similar topic to my remarks. I won't go into my response, but it got me to thinking why the SEC has not commissioned academics to undertake some of their research projects – like the two reports Ms. Davis said the Staff is planning to deliver by the end of this year. Or how about commissioning a comprehensive and independent analysis of the comment letters?

For one thing, the SEC Staff has little or no collective background in conducting accounting research, and for another it is known to be extremely shorthanded. Cynical me suspects that the SEC is unwilling to risk losing control of the outcome of their "analysis."

In any case, these reports are going to be too little, and too late. The SEC should have made a U-turn on its IFRS adoption roadmap years ago. But, let's play along, and hark back to the Staff's 2003 report to Congress on a "Principles-Based Accounting System." In many respects, it is a horrible document, but two clear outcomes were: it endorsed a more consistent asset/liability view to standard setting; and it called for a revamped and strengthened conceptual framework. It is undeniable that neither Board has made adequate, or even significant, progress on either front.

The Staff knows US GAAP and IFRS well enough to anticipate the only legitimate conclusion that can come from of an exercise in which IFRS and U.S. GAAP is compared and contrasted – either at a "principles level" or any other level. Both sets of standards contain so many internal inconsistencies and differences between them to dash any realistic hope that convergence to "high quality" (however defined) can occur within a reasonable timeframe. How much of those real differences will the Staff gloss over by some sort of "principles level analysis"? Answer: as much as the Staff wants.

The public interest and investors would be better served if the Staff were to finally acknowledge that IFRS is not clearly superior to U.S. GAAP; and, eight years after its report to Congress, the necessary conditions for principles-based standard setting to occur (especially at the IASB) are still not in place.

I haven't read more than a few of the comment letters to which Ms. Davis is referring, but from the ones I have read, the sense of their references to "a single, highly quality set of standards that are applied consistently on a global basis" is as something distant and desirable, yet for all practical purposes, unattainable. Given the recent track record on convergence, the current state of the economy, the problems with IASB governance and many other factors convincingly argue that it should be put on the back burner for at least a few years.

No future SEC Staff report can controvert the reality on the ground that IASB accounting standard setting and convergence are in a state of chaos, with nothing like "principles" or consistent "objectives" to orient them. The prospects for anything approaching a "single, high quality set of standards that are applied consistently on a global basis" in any of our lifetimes are dim to nonexistent.

Will the SEC Sneak IFRS in Through the Back Door?

I have been hearing rumors that the SEC is getting ready to come out with its IFRS adoption plan any time now. Richard Breeden, a distinguished former SEC chair, and now the head of a $2 billion international investment fund, stated that if the SEC were to adopt IFRS, "it would be the darkest day in the history of the SEC."*  Like it nor not, though, there is no denying that it will be the most radical and riskiest change to accounting standards since the establishment of the federal securities laws in 1933.

The latest indication of what could be in store for us is set forth in the May 26, 2011 SEC Staff paper, Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers: Exploring a Possible Method of Incorporation, informally referred to as the "condorsement" proposal. To the staff's credit, it finally conceded that a complete abrogation of U.S. GAAP in favor of IFRS as established by the IASB has absolutely no chance of succeeding.

 But, seemingly out of thin air, it now proposes a very curious restructuring: the FASB would retain its title as the standard setter for U.S. GAAP, but it would be emasculated. It would be prohibited from adding any new project to its agenda, unless it would be to endorse an existing IASB standard, or to work with the IASB on one of a project of the IASB's own making. In this way, the FASB's activities would be limited to only incorporating IFRS standards into the FASB's Accounting Standards Codification over just a few years' time. Hardly anyone feels that this is realistic, or shall I say, "justifiable."

 The Back Door Gambit

 "Justifiable" is a key word, because I believe that the SEC is planning to proceed with a condorsement policy without adequate evaluation of the costs and benefits. This is because the new proposal is deviously structured such that it could be implemented without any rulemaking by the Commission itself. This is especially alarming in light of a recent court ruling which makes clear that the Commission must accompany all rulemaking with a rigorous, reasonably complete and unbiased evaluation of costs and benefits.

 If IFRS adoption were to take effect, by a process that circumvents rulemaking, then that by itself would make for "the darkest day in the history of the SEC." And, indeed, it now seems that IFRS could only be possible without rulemaking; because the Staff has absolutely no idea how it will be able to conjure a justification with more than a snowball's chance in hell of passing muster in a court of law.

•  The CFA Institute, representing over 100,000 investment professionals worldwide has expressed similar concerns regarding the SEC's obligation to reasonably consider all of the pros and cons of IFRS adoption. In a recent comment letter, the Institute reminds the SEC Staff that it hasn't done much homework at all. In fact, as we sit here going on two years after the announcement of that work plan, little has yet to be been done to:
• Define what "high quality standards" means, and whether IFRS standards measure up;
• Address whether the IASB has made needed improvements to its infrastructure and governance;
• Specify an enforcement mechanism for IFRS; and
• Specify how endorsement of IFRSs would actually take place (and by implication lead to the ambitious goal of generating financial statements that simultaneously comply with US GAAP and IFRS).

 "I should add to the Institute's concerns that the staff work plan provides no indication whatsoever as to how the SEC will assess the economic benefits of IFRS adoption – either quantitatively or qualitatively. The DC District Court's decision explains in no uncertain terms that rulemaking must be accompanied by a clear-eyed assessment of benefits, yet nothing in the Staff's planning documents indicate that such an analysis is in process, or will ever be produced.

Send in the Shills

Yet, despite the fact that the SEC clearly has no intention of honoring its word, and there is overwhelming opposition to IFRS adoption, many fear that the decision to pre-empt real answers to these threshold questions is soon at hand. Earlier this month, Hans Hoogervorst and Harvey Goldschmid, IASB chair and CAQ board member, respectively, attempted to provide momentum to the Staff's condorsement proposal with keynote speeches at the IFRS Foundation/AICPA Conference in Boston. Their unqualified exhortations to the SEC to move ahead on IFRS adoption is exactly what one would have expected from the most visible paid promoters of IFRS at a conference jointly produced and staged by the two most active and powerful IFRS lobbying groups. The biased conclusions of Messrs Hoogervorst and Goldschmid were synthesized from an admixture of vague generalities, selective use of the facts, cherry picking of academic research, and biased speculations. (These are not empty accusations; I'll be discussing these in detail in posts to follow.)

* * * * *

The real answers to IFRS adoption questions are in the details. I am certain that we are never going to get those details that the public is entitled to from the SEC or the special interests that only want to line their pockets at more expense to shareholders and investors.

If IFRS gets shoved down the throats – without formal rulemaking – of the thousands of corporations that want this whole thing to go away, and the millions of investors who deserve better, then the next thing to do is to call for Mary Schapiro's resignation.

-------------------------

*As reported to me by Lynn E. Turner, former SEC Chief Accountant, who two years ago attended the semiannual meeting of the Council for Institutional Investors in Los Angeles where Mr. Breeden spoke and made this statement. Among other reasons, Mr. Breeden believes US GAAP provides him and his portfolio managers with better data.

The IASB's Revisions to Pension Accounting Rules are Based on a Preposterous Premise

Last June, the IASB issued revisions to IAS 19, Employee Benefits. The accompanying press release would have us believe that the five-year project resulting in incremental changes to the accounting for pension costs are a significant improvement; unfortunately, they are just one small step forward followed by a giant step backward.*

The small step forward is the elimination of the alternative approaches for dealing with actuarial gains and losses – i.e., differences between the expected change to the net pension liability (after taking into account contributions and payouts) and the actual changes. The older version of IAS 19 permits a free choice among no less than three treatments:

1. Similar to U.S. GAAP (which is also highly deficient in this regard), amortization of 'excess' cumulative gains/losses;
2. Immediate recognition of the excess cumulative gains/losses; or
3. As per UK accounting standards, immediate recognition of the total gains/losses for each period in other comprehensive income (OCI), without recycling.

The giant step backward is, of course, the new treatment, which gifts issuers with a new set of tools for managing earnings. Under the new accounting, only management's (biased) forecast of the change to the net pension liability is included in net income, and the actuarial gains and losses go to OCI – without recycling.

It's easy to see what is going to happen after companies adopt IAS 19. First, a manager can rest comfortably in the knowledge that, even if the sky falls on the company's pension plan, it won't affect hitting any of their earnings targets – and their earnings-based bonuses – ever. All variability will be forever sequestered in accumulated OCI (AOCI).

Second, and relatedly, management will be much less concerned with actual pension cash flows, especially those cash flows that won't take place until long after current management has departed. A limitation on the amount of income from pension plan assets** could mean that management will care less how those assets are invested; and the plans themselves will become more liberal in ways that wouldn't exist if the total change in the present value of cash flows were fully reflected in net income.

Third, estimates of the future costs that actually find their way into net income will be inappropriately low. Will 'independent' auditors feel any compunction to correct management's naturally occurring bias? I'm not betting on it, and especially not without mandatory audit firm rotation.

OCI Has Become the IASB's Kitchen Sink

The new pension accounting treatment is apparently based on a preposterous premise: that net income for a period is supposed to reflect "the underlying financial performance of the core business" or "an entity's day-to-day operations."

I say preposterous because, although it is certainly an appealing thought, it is perforce not possible for net income to reflect "underlying financial performance" or "an entity's day-to-day operations." To take just a few examples:

• Gains/losses from dispositions of PP&E, as well as impairment charges, largely reflect events that occurred in prior periods. Would the IASB suggest that these items, too, be thrown into the kitchen sink of OCI? Of course not.
• Some events are recognized in net income only after their cash flow effect meets a measurement threshold, like "probable" or "capable of reliable measurement." These terms make me gag, but again, this means that much of the amount recognized in the current period is due to events that occurred in prior periods.
• Some items in accumulated OCI, such as translation adjustments from prior periods, are recycled from AOCI to net income in the current period when certain criteria are met. Yet again, this is a conflation of current and prior period events.

For each of these, and more, IFRS would permit additional line items; and additional subtotals may also be added to the income statement, in order to assist the user in assessing performance for the period. The same could apply to pension costs: if actuarial gain/loss components merit separate disclosure, nothing should prevent a company from separately captioning them within the income statement; and quantitative disclosures as notes accompanied by explanatory paragraphs would also do the trick.

But, none of these treatments would have accomplished the political objective of the IASB, which was to gift managers a new tool for managing their reported net income.

Another Standard for No Good (Stated) Reason

I say apparently based on a preposterous premise because my source for the above quotations is from that little press release I mentioned earlier. The official standard is devoid of any remotely similar language or any other reasonably detailed discourse answering the 'why' questions that must be integral to the "basis for conclusions" of any new standard. This is not new, by the way. See my post on the revisions made to IAS 23, Borrowing Costs.

If you want to see the problem for yourself, go to paragraphs BC3 – BC11 of the revised standard. While actual words are there to be read and understood, they amount to little more than boilerplate, addressing 'what' and 'when' types of questions.**

The unavoidable conclusion is that there is no defensible logic to the new accounting treatment for pension costs. More generally, OCI has become the kitchen sink in which to toss anything that management feels would despoil its precious 'bottom line.'

SEC, Are You Paying Attention?

Whether or not one supports the actual revisions, there can be no denying that a section of an accounting standard labeled "Basis for Conclusions" creates an expectation that the IASB will explain why the accounting treatment chosen is the best among a reasonable set of alternatives. To be as generous as possible, the IASB's explanations are vague and misleading. But, to be brutally honest, the IASB has made a mockery of due process on this and any other occasion where it suits its political agenda.

If the SEC is still thinking about looking to the IASB as its principle accounting standards setter, with the FASB following in lockstep in a so-called "condorsement" role, this is just one more indication of the folly of that strategy. As much as it has tried, the SEC cannot blithely presume that IASB-promulgated standards are high quality, but only that a final standard ultimately emerged out of a five-year political football match. 

-------------------

*On September 9, 2011, Patricia Walters started a discussion of the revisions to IAS 19 on the AECM listserv. Some of the comments to that thread have influenced my own views.

**The new standard also creates a new approach for measuring the expected return on plan assets, which I completely disagree with (see paragraph 125). I may discuss this in a later post.

***To be fair, there is this statement further down in the document (paragraph BC88):

"The Board noted that although changes included in the remeasurements component [i.e., the actuarial gains/losses] may [italics supplied] provide more information about the uncertainty and risk of future cash flows, they provide less information about the likely amount and timing of those cash flows."

I think this is inadequate for reasons that are self evident. Substitute "does not" for the weasel word, "may", in the above quote, and you have a much more realistic assessment.

IASB Tried to Keep its Greek Bond Letter a Secret – But it Leaked!

Two of my favorite columnists, Floyd Norris and Jonathan Weil have put in their two cents worth on the implications of the Greek bond accounting issues brought to the fore by the IASB's letter to the European Securities and Markets Authority (ESMA). I have already written two posts on the issue, and I certainly don't want to beat it to death, but Floyd and Jon have turned up the heat that cooks the IASB's goose to a crisp.

AccountiLeaks

The biggest surprise came from Floyd's column, in which he revealed that the IASB letter was kept secret, until it was subsequently leaked to the Financial Times. Only after it was leaked, presumably, did the IASB post the letter to its website. Here are just a few reasons why this is so outrageous:

Tipping the scales at the SEC – The IASB simply could not bring itself to publicly acknowledge that consistent application of IFRS takes a backseat to politics in the EU. If the SEC were to adopt IFRS in the wake of this debacle, either it or its registrants will be the chumps. The best case scenario is that SEC registrants and their auditors would be forced to behave themselves, while varying degrees of equivocation would be the norm practically everywhere else.

The CYA imperative – My guess is that the IASB feared political reprisals if it were to publicly humiliate EU regulators for their tacit and/or explicit support of bogus accounting maneuvers. Yet, it couldn't completely ignore the accounting misstatements; for if Greek bonds investors actually do get left holding the bag, the IASB would be blamed for promulgating rules that allowed important information to be hidden until it was too late to do anything about it. At a very minimum, the IASB had to create some sort of paper trail that it could pull out of its archives in a doomsday scenario. Its story would be that it wasn't the accounting standards that were faulty; it was the fault of auditors and regulators for not compelling the banks to adhere to those standards.

Busting the myth of investor primacy – Floyd's article documented the fact that the accounting issues being raised are not merely a question of form, but that, in some cases, there is not enough disclosure to permit an accurate restatement. If the IASB were genuinely committed to investor primacy, secrecy would be entirely out of the question. On this side of the pond, for example, it has been my experience that the SEC will require restatements when they could have an immediate impact on investors' decisions.

When evaluating the propriety of a secret communication amongst regulators, it is simply not relevant that the SEC has enforcement power and the IASB does not. Hans Hoogervorst, as a former regulator, surely knew what the right thing to do was, yet he chose secrecy. Going public with the accounting misstatements – including the specifics of each one – might not have induced the needed restatements, but it was the only principled alternative. Shame.

The Tip of the Iceberg

It was obvious that the IASB's letter only addressed the tip of the iceberg – the Greek bonds classified by investors as "available for sale," but Jonathan Weil makes two important observations in that regard. First, a mere 10 percent of the Greek Bonds were not sheltered from fair value measurements through re-classification as "held-to-maturity." Second, the reason why this percentage is so low harkens back to the politics of 2008, when the IASB amended IAS 39, without justification, to permit reclassifications out of the trading and available-for-sale (i.e., fair value measurement) categories.

On that last point, I'll simply conclude with Lynn Turner's (former SEC Chief Accountant) reaction to Jon's column, which I received via email:

"[Jon's article] highlights what fools the European regulators and accounting standard setters now look like. The article rehashes how the Banks and Politicians ganged up together on both the FASB and IASB to immensely water down their rules three years ago, so that banks could prepare misleading financial statements that omitted losses on their investments. At the time, the SEC also failed to defend the FASB and in fact, when questioned, told a congressman they would see to it the FASB got the rule changes done in just 30 days.

Now, … this change has allowed: (1) banks to avoid reporting the losses they have suffered on Greek debt, (2) banks are slowing "dripping" their losses into their financials over a number of years including years to come, much like Chinese water torture, (3) resulting in banks failing to actively manage their problems, [my emphasis] and (4) extending the problem and probably the magnitude of losses incurred.

Back at the beginning of the 1990's, a report from the GAO noted the US government had engaged in similar financial shenanigans until Richard Breeden became chair of the SEC and forced the S&Ls and banks to report their true losses. Unfortunately, the politicians undid his work and the result is noted [in Jon's article], with a very negative outcome for investors."

Ask yourself this: if issuers of financial statements were required to mark all of their investments and loans to market through net income, would the too-big-to fail banks in the EU be in the mess that they are now in?

Repeat the question for the S&L crisis of the 1990s and the financial crisis of 2008.

Mandatory Audit Firm Rotation and Greek Bond Accounting: What Might Have Happened?

In my previous post, I provided my reactions to Hans Hoogervorst's recent letter to the European Securities and Markets Authority (ESMA), in which he expressed concern for the pie-in-the-sky numbers produced by some EU banks on their Greek bonds classified as 'available for sale' (AFS). Now, I would like to pose a hypothetical: what if mandatory auditor rotation had been in effect? Would Mr. Hoogervorst's letter have been unnecessary?

As a preliminary matter, I am not asking these questions with French banks in mind. The banks in France are known to report anything they want, whenever they want. The regulators are powerless to stop them; ergo, there is no incentive for the auditors to do anything that would jeopardize relationships with clients. Vive le Société Générale!

So, setting France aside, let's start with a very simple fact pattern:

Mandatory audit firm rotation is required after seven years, and Bank One's current auditor (Auditor A) is in Year 7 of its term. Despite the fact that market prices for Greek bonds have declined by 51%, the management of Bank One maintains that a 21% haircut on its Greek bond investments is all that IFRS requires.

Auditor A knows that Auditor B is engaged for next year's audit of Bank One. Coincidentally, Auditor A will take over the audit next year of Bank Two, Auditor B's current client.

Of the possible actions/outcomes of the Bank One audit engagement, here are four to ponder:

1. Eat or be eaten – Auditor A will insist on a 51% haircut; either because Auditor A actually disagrees with Bank One's management, or it has some ulterior motive. For example, Auditor A's overriding fear could be that the successor auditor (Auditor B) is motivated to clear the decks of all 'gray areas' when it takes over. If such were the case, Auditor B could come in next year and require Bank One to restate Year 7. So, Auditor A could be thinking that it is s a far better thing to administer grief to the soon-to-be-former client than to be grief's recipient – by none less than by another member of the fraternal order of auditors.
2. One hand washes the other – Auditor A and Auditor B collude. They both have promises to trade: Auditor B won't mess with Bank One's Year 7 financial statements if Auditor A promises not to mess with Bank Two's Year 7 financial statements.
3. Safety in numbers – Auditor A will caucus with its peer group, Auditors B, C, D and E – either informally, or through a mechanism akin to the Center for Audit Quality. Since auditors are happy to advocate for their clients as a group, the quality of the accounting alternatives (from an investor standpoint) will not matter to the caucus as much as it should.
4. What goes around, comes around – Auditor A will accede to the client and have confidence that Auditor B won't try to call it to account. Auditor B is likely concerned with being disciplined by the fraternal order of auditors. This is what oligopoly theory would suggest.

You may provide your own subjective probability distribution over these (and perhaps other) outcomes; and draw your own conclusions as to whether mandatory audit firm rotation is worth the costs. But, the analysis shouldn't stop there; my larger point is that mandatory audit firm rotation has to be considered within the context of improving the entire financial reporting regulatory structure.

First, it goes without saying that criminal acts of collusion and fraud must be punished. However, this is not a panacea. If the death penalty doesn't deter murderers, then why should we trust the vows of politicians to enforce the existing securities laws and professional standards with renewed vigor, or to mete out more severe penalties for violations? In the best of circumstances, vigilant bureaucracies eventually fall asleep at the switch; and on the other side of the equation greed is boundless, inventive and infectious.

Second, mandatory audit firm rotation must complement robust audit inspection programs. To see this, simply change the date of my hypothetical from Year 7 to Year 1 of Auditor A's term. Audit firm rotation is so far in the distance in Year 1 that it couldn't possibly have much effect on the auditor's decision making.

The PCAOB's audit inspection programs, while seemingly effective in uncovering irregularities, don't seem to have enough of a deterrent effect. When the PCAOB uncovers deficiencies in an audit, it must publicly identify the auditor, the issuer, the deficiency and the remediation efforts – all in a timely manner. As a matter of principle, the investing public has a right to know which public company (could have) fudged its numbers, and which audit firm is responsible for letting it slip through their fingers. The PCAOB's has an inspection track record of being right far more often than wrong; this record should be used as the justification for undoing the secrecy and procrastination that is inimical to investor protection.

Third, an auditor has a right to be secure in the knowledge that it cannot be dismissed when it takes a stand against management. Mandatory auditor rotation should be accompanied by minimum audit terms, which cannot be lengthened. Once an auditor is engaged, it cannot be dismissed without performance-related cause, and the auditor may not resign simply due to a disagreement.

Finally, it is sad, but true, to state that the only reason why mandatory auditor rotation is being considered is because auditing has drifted too far afield from its original role as envisaged by Congress when it created the first federal securities laws. That role is verification. Today, the auditor's exposure to pressure from clients comes from their role as assessors of the 'reasonableness' of management's judgments. As I have stated repeatedly, and most recently here, it doesn't have to be this way, and I will have more to say on that in a future post.

Peeling the Onion on the Accounting for Greek Bonds

Yesterday, Han Hoogervorst, the IASB chair, sent a letter to the European Securities and Markets Authority (ESMA), in which he expressed concern for the pie-in-the-sky numbers produced by EU banks on their Greek bonds classified as 'available for sale' (AFS). Although I share Mr. Hoogervorst's concerns, they should be much broader than indicated by the scope of his letter. The IASB should be just as concerned with Greek bonds reported in its artificial held to maturity (HTM) category; and it should be profoundly disturbed by the auditor's role in this debacle.

Echoes of Soc Gen

The Greek bond accounting situation is not an isolated event, but merely a flash mob version of the incredible case of Société Générale. To refresh your memory, Soc Gen, a French bank, chose to dump rogue trader Jérôme Kerviel's 2008 trading losses (about $10 billion) into fiscal 2007. The effect of the 2007 makeover was to partially offset his gains of the previous year, and to give 2008 a clean slate so, I presume, management could get its earnings-based bonuses. There is no disputing that the losses occurred in 2008, yet the bank took the outlandish position that application of straightforward and sensible IFRS rules (marking derivatives to market through net income) would, for reasons unstated, result in a failure of the 2008 financial statements to present a "true and fair view."

You might also be interested to know that Soc Gen's financial statements, as is apparently the norm in France, were opined upon by not just one, but two (yes, two!) auditors. Could Soc Gen have been wrong to invoke the "true and fair" exception if both of its venerable Big Four auditors – Ernst & Young and Deloitte & Touche – gave the financial statements a clean opinion? C'est imposible!

Then, as now, the IASB cried foul, and if history is a guide, its sound and fury will again come to naught. In Europe, just as in the U.S. (I am compelled to add), the banks play the tune.

If You Don't Like Market Prices, Just Make Something Up

Getting back to the present, Mr. Hoogervorst's beef with European banks is that trading markets were discounting Greek bonds by over 50%, yet many banks were only giving the bonds in their "available for sale" portfolio a 21% haircut, the amount that the desperate Greek government averred their own bonds should be worth after all is said and done. Hoogervorst did not identify any offending institutions by either example or name, but the Associated Press has helped out with a few: BNP Paribas and CNP Assurances (a French insurance company) took only a 21% writedown on their AFS Greek bonds, but Commerzbank of Germany wrote the exact same bonds down by 51%.

Also sprach Hoogervorst:

"It appears that some companies are not following IAS 39 when determining whether the Greek government bonds that they classify as AFS are impaired. They are using the assessed impact on the present value of future cash flows arising from the proposed restructure of those bonds, rather than using the amount reflected by current market prices as required in IAS 39.

In addition, some companies holding Greek government bonds classified as AFS have stated that they are relying on internal valuation methodologies, rather than on market prices, to measure the fair value of the assets as at 30 June 2011. The reason generally given for using models rather than market prices is that the market for Greek government bonds is currently inactive (and therefore, in their view, does not provide reliable pricing information).

….[However, a ] … company cannot ignore observable transaction prices when it is clear that market participants are regularly entering into transactions for the same or similar financial assets, even if they are doing so less frequently than they have in the past." [emphasis supplied]

Lack of consistent enforcement is just one of the many reasons that the notion of a single set of, high quality global accounting standards is, in this blogger's opinion, a practical impossibility. If the Société Générale debacle has faded to a distant memory for some, then this case should be an additional reminder to the SEC that genuine comparability cannot possibly exist absent rigorous enforcement. In Europe, it seems, even token enforcement is absent.

And, speaking of the SEC, I wouldn't be surprised if some of the financial institutions taking insufficient writedowns also maintain U.S. listings. It will be interesting to see if the SEC tries to put the heat on them. And, if anybody reading this post knows of any such companies, I would appreciate knowing about them.

Other Problems Hoogervorst Might Prefer Not to Discuss

There are at least three other troubling aspects of IFRS that the Greek bond accounting debacle has exposed.

Accounting for bonds that are classified as held-to-maturity — While Hoogervorst's letter only addresses inconsistencies in measurements of AFS portfolios, the Greek bond crisis also makes it clear that HTM accounting exists for the convenience of issuers. This is for two reasons.

First, management has extremely broad discretion in measuring the amount of impairment. This is because the carrying amount of the HTM investments is based on a totally arbitrary calculation: management's subjective estimate of the future cash flows it will receive, discounted by the original yield to maturity. Unlike the AFS portfolio, there is no requirement to refer to current market prices, and so long as an auditor does not object, management can pick pretty much any number it wants.

For example, AP also reported that although Commerzbank took a 51% charge to their AFS Greek bonds, they also have Greek bonds that are classified as HTM; and for these, they only took a 21% charge. There is simply no way that the IASB can justify these internally inconsistent measurements for identical assets, even assuming that both numbers were produced in compliance with the extant accounting rules.

Second, even if management were to actually make a loan impairment assessment in good faith, the result is a completely arbitrary calculation that defies explanation in economic terms. The resulting number can only be described by the calculation that spit it out. There is nothing more that investors can glean from it, other than an acknowledgement from management that it doesn't expect to receive all of the payments the bank is contractually entitled to receive.  In respect to the Greek bonds, that's not much of a revelation.

And, by the way, I wonder how Commerzbank got that arbitrary calculation to come out to exactly that 21% figure the Greeks want everyone to accept – and don't? As I am about to explain, this case (just like Soc Gen) reveals that at least in Europe, getting one's auditor to agree that management's assessment is 'reasonable' may be the least of management's problems when faced with the consequences of an unfortunate investment decision.

The Vast Inconsistency of Audit Judgments — It just so happened that PwC was engaged to audit all three of the companies mentioned in the AP article. It seems impossible to get around the conclusion that PwC found a 51% haircut on Commerzbank's AFS Greek bonds was 'reasonable', and that a haircut of less than half that amount was also 'reasonable' for BNP Paribas's holding of the same bonds. It seems as if the credibility of the numbers reported by some of these European financial institutions are not worth the paper they are printed on; and by extension, the same conclusion would apply to the reports of their 'independent' auditors.

I wonder if Hoogervorst had considered writing to the Big Four instead of, or in addition to, ESMA. To me, anyway, it is more important to have the Big Four justify its acceptance of vastly different amounts of write downs on the same debt held by two or more different banks. At least the auditors are supposed to be gatekeepers; but ESMA, ironically, has absolutely no enforcement authority on any company.

If the IASB will not be asking the Big Four, the hand that feeds them, for answers, who will? What does this say about IASB independence?

Lastly, the the HTM problem is bigger than the AFS problem – And, don't expect it to get fixed any time soon. The IASB's financial instruments project is a bust on many levels. But with respect to HTM loans, the Board's good book/bad book approach to loan loss allowances is being scrapped, albeit not for any accounting that makes more sense. Instead, the IASB is getting ready to propose a three bucket approach whose only apparent purpose is to allow lenders and bond investors even more discretion to manipulate loan loss allowances and earnings.

. . . . . . . .

Hans Hoogervorst's letter has also reminded us that a single set of global accounting standards has no traction without consistent application and enforcement of the rules. The SEC didn't get the message after Soc Gen, but how about now?