The Accounting Onion

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:

Shortly 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 APB Opinion No. 9 at the time), would be delayed for decades – until retirees were actually paid.

The CEO chose to disregard the economist's advice and 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 standards 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 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, it 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 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 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..

My view of the right way to set accounting standards is based on my experience and study of the myriad example that are just like the GM story (albeit few of them are as overtly laden with societal consequences). Determining 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 how the current state of accounting standards, 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 captured and 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, just because they were a political football for five years.

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*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?

Let the "Condorsement" Games Begin

The SEC has finally conceded that its efforts to adopt IFRS have failed. Damage control has begun in earnest, but the ship is still taking on water.

The SEC took a tentative poke at the problem last May with the publication of a Staff Paper, Exploring a Possible Method of Incorporation (with emphasis, supposedly, on "exploring"). Once upon a future time, the staff fantasized, it will be possible that financial statements prepared in accordance with U.S. GAAP will simultaneously comply with IFRS as issued by the IASB. Known informally as 'condorsement', the paper describes the staff's wishful thinking in the form of three "convergence" phases and a final "endorsement" phase.

Convergence Phase I — Would somehow complete the few surviving MoU convergence projects by the end of this year, but even those have since been shot full of enough holes to push the timeline out by at least another year. The SEC will not acknowledge this, but everyone pretty much agrees that the decade-long effort to converge U. S. GAAP and IFRS has been marked by many more failures than successes.

Convergence Phases II and III — Would take an additional 5 to 7 years and require the FASB to formulate plans for merging active IFRS projects into U. S. GAAP. If FASB-style "due process" can't get it all done, someone is supposed to be able to figure out a way to pick up all the pieces.

Endorsement — Simple math combined with the most obvious lessons learned from recent history leads to the inescapable conclusion that the "endorsement" phase can't even begin for at least another decade. At that point, the FASB is supposed to get hog tied; it will not be allowed to do anything except for figuring out how to fit new IFRSs into the GAAP codification.

The Staff Paper Fizzles instead of Sizzles

Except for the Big Four (I'll be getting to that later) and perhaps a few large companies, the Staff Paper has gone over like a lead balloon. To start, the handpicked investor panel at July's SEC Roundtable on IFRS provided only tepid encouragement, and the smaller public companies panel could barely be held back from strangling the SEC staff; all they saw in IFRS was a lot of incremental cost and zero incremental benefit. Other federal regulators exercised political restraint, but the representative of the state boards of accountancy condemned the SEC's for its foolhardy quest for a holy grail -- which not everyone believes is so holy -- in no uncertain terms.

It is quite possible that the failure of the Roundtable to drum up support for IFRS adoption may have also moved the IASB itself to go negative shortly thereafter. In an August 3 public conference call discussing the IASB's agenda, Ian Mackintosh, vice chairman of the IASB, was asked whether the IASB will continue to develop projects jointly with the FASB. With surprising frankness, he sent a strong signal that our favored nation status could be revoked:

"It depends on what decision is made in the United States on adoption, or convergence, or incorporation of IFRS. I would have thought … that we would continue to work jointly with FASB on those four major projects I mentioned before. But I wouldn't have thought … that we would work jointly with them on new projects. I think we are in a situation where we have a global constituency; every country has its right to a place in the process."

In some respects, all Mackintosh has done is echo the sentiments expressed some months ago by EU Commissioner Charlie McGreevy and the IASB's John Smith, as they attempted to ratchet up the pressure on the U.S. to abandon GAAP – lest it forfeit any future say on IFRS. But, whatever the motivation, Mackintosh is clearly not happy with the SEC's condorsement fantasy; and to add insult to injury, apparently, the SEC failed to consult with the IASB beforehand. Perhaps Mackintosh chose to inflict public humiliation on the SEC as payback for the slight.

The Big Four Tries to Pick up the Pieces

Given the Roundtable bashing and the Mackintosh lashing, the SEC may not have been at all surprised by E&Y's recent defection from the IFRS adoption bandwagon, as expressed in their belated comment letter on the Staff Paper:

"Ideally, we would like to see a single set of high-quality accounting standards used throughout the world, including the US, without modification. However, we unfortunately are not convinced this worthy goal can be practically achieved at this time. … Few nations are willing to sacrifice their accounting standard-setting sovereignty, particularly for issues they view as important to their local capital markets and economies. We doubt constituents in the US will be more willing to make this sacrifice. Therefore, some form of endorsement process seems necessary and the creation of a 'US flavor of IFRS' inevitable. [italics supplied]

There's that word "inevitable" again!

"Inevitable" means that something will undoubtedly come to pass, doesn't it? E&Y used to say that IFRS adoption is inevitable; and now they would have the SEC believe that a mutually exclusive proposition, namely a "US Flavor of IFRS", is the new "inevitable." I'm not surprised by the tactic, but I could certainly have wished for somewhat more inventive rhetoric to digest.

Of course, that's not the only curious statement in the comment letter:

"Although we support the approach described in the Staff Paper, we believe it is unlikely that method would allow US issuers (following a transition period) to assert compliance with IFRS as issued by the IASB." [italics supplied]

On the one hand, it's a relief to finally see the day when even E&Y has conceded that IFRS adoption is a virtual impossibility; but on the other hand, E&Y is also saying that the SEC should proceed as if IFRS adoption were to actually take place!

Methinks the method to E&Y's madness lies in their latest policy recommendations. First, E&Y would still like to see the FASB hog tied:

"[W]e hope the FASB would make changes to its legacy standards only to converge with IFRS."

Second:

"We would support voluntary adoption of IFRS as issued by the IASB by US issuers."

Essentially, this latter recommendation, which quite predictably has now been echoed by the AICPA, repudiates the one and only rationale that has ever been proffered for adoption of IFRS: comparability of financial statements. Now, E&Y and the AICPA are saying 'pick a number.' If a free choice between IFRS and GAAP by foreign private issuers (FPIs) does not harm investor interests, they say, then it would also be appropriate to give domestic issuers the same freedom to choose.

Obviously, I think they're wrong. To begin with, the option given to FPIs to file financial statements in accordance with IFRS without a reconciliation to U.S. GAAP was highly controversial decision made during the Christopher Cox era. It cavalierly brushed aside the fact that it was strenuously opposed by investor interests. But even more important to evaluating E&Y's latest proposal, it has been established for decades that the criteria for FPI rulemaking are fundamentally different from those for domestic issuers.

Whereas disclosure adequacy is generally the paramount concern, the SEC has long recognized that FPIs are a special case. If the SEC were to impose the same disclosure requirements on FPIs, it could discourage many FPIs from offering their securities to U.S. issuers. That would harm investors, because they would be deprived of an opportunity to invest in foreign companies while enjoying the broad regulatory protections and lower costs afforded by U.S. markets.

Thus, if there was any rationale to allowing FPIs to choose between IFRS and U.S. GAAP, it was to accommodate the FPIs. And the fact remains that whatever the outcome, the decision to accomodate them ran the risk of lowering investor protections. Although E&Y and the AICPA would have us believe otherwise, none of this has anything to do with whether domestic issuers should be given a choice between IFRS and U.S. GAAP. 

I have, as you might have suspected, many other concerns with E&Y's recommendations:

• As Jack Cieselski pointed out in his early comment letter on the Staff Paper, the FASB will be prevented from adding items to its agenda that are of particular concern to U.S. investors. Is E&Y thinking that its voice counts for more at the IASB than at the FASB? The IASB independence problems are well known, and entirely consistent with that self-serving scenario.
• Getting back to the comments of the IASB vice chair, the 'condorsement' strategy that E&Y would like to see the SEC implement must be anethema to at least some IASB members. I imagine they are torn between taking our money, and telling us to take a hike. The EU wants to drive the bus, and China and India also want their say. But, are they ready to pay for the gas?
• How will accounting education (and the CPA exam) be affected if IFRS is merely optional? By the way things are headed, students eventually would have to master three sets of rules – public company U.S. GAAP, private company U.S. GAAP, and IFRS. I'm all for studying comparative accounting systems, but having to be tested on three systems will perforce crowd out real learning in favor of committing details to memory.
• The hundreds of FPIs, which include some of the largest banks in the world, are probably shaking in their boots, contemplating a condorsement plan where the U.S. would require of its domestic issuers compliance with IFRS plus additional disclosures. Instead of IFRS becoming the only game in town, it would once again look like the weaker of two regimes.  When will we finally get the message that the EU doesn't want us in their sand box?
• The courts have recently set the bar a lot higher for SEC-generated cost-benefit analysis in support of any new rulemaking. If the SEC had continued down the path of ultimately requiring adoption of IFRS, would they be capable of conjuring up a cost-benefit analysis that could actually survive a legal challenge? Methinks condorsement was cooked up in part to achieve de facto convergence without additional SEC rulemaking.

In summary, all I can say is, 'here we go again.'

I'm Not the Only One Dissing the SEC's IFRS Fixation

Every time I write a post, I might receive a couple of non-spam comments, and perhaps a few more private emails intended for my eyes only. Most of the feedback is positive, and even encouraging. Nonetheless, I am by nature particularly sensitive to negative feedback, even when delivered in a kindly and constructive manner.

For example, Edith Orenstein thinks I jumped the gun with my assertion that the "fix is in," on the forthcoming SEC Roundtable on IFRS; and Lane suggested that my arguments lack force when I predicted that some panelists would be shills. These comments came even prior to my most irrascible rant on the Roundtable after it took place. In some ways, this post is a response to Edith and Lane: I know that my comments are often unkind and liberally dosed with irreverence and sarcasm; but in my defense, I am not the only one out there letting their frustration with the SEC's IFRS fixation hang out.  Consequently, even in my most untethered moments, it feels kinda OK to know that I'm in pretty decent company:*

Lynn Turner, a former SEC chief accountant no less, circulated this email bearing the incendiary subject line "Stacked Deck":

"I find it interesting that so many credit rating agencies are given slots at the SEC IFRS roundtable when they were the very ones who so shafted investors. And Jonas who was at one of them, now at Morgan Stanley, and who was head of the AA national office is another one of the participants.

Take a look at the panelists on the small-company panel. Bank of the West isn't a public company – it's owned by BNP Paribas. Cuisine Solutions has a subsidiary in France – sort of unusual for a small U.S. company. Viropharma has a European unit. Tandy Leather has operations in Canada and the UK. Are you seeing a pattern here? They specifically aren't having as panelists the kind of strictly domestic small public company that wouldn't benefit from IFRS."

And in a subsequent email:

"The SEC so stacked this deck it is beyond one's imagination as to why they would expect anyone outside their 4 walls would see this as anything short of the typical Washington DC contrived outcome."

Jack Ciesielski, former member of FASAC, AcSEC, EITF and author of one of the most highly respected publications for financial statement analysts, described the upcoming Roundtable as a "railroad job." And he also wrote a must-read comment letter on the SEC staff's paper, "Exploring a Possible Method of Incorporation." Like Gaylen Hansen's remarks from the Roundtable, all of Jack's criticisms are quite devastating, but the one from Jack that resonates with me for its originality and the vividness of the example is the following:

"If the FASB is barred from starting projects independently of the IASB, how are American investors best served? There could be financial reporting issues that are unique to our country, that would never be addressed by the IASB - simply because they are not a problem in the rest of the world.

An example may help make the point. In the United States, many … are troubled by what they consider to be excessive executive compensation. There is only a limited amount of information available annually regarding executive compensation. More comprehensive information about all of a firm's human capital costs (not just executives' compensation), directly displayed in financial statements on a quarterly basis, would be useful for investors to help them assess the value of pay packages on which they vote annually. … There's no cohesive model or set of disclosures for reporting pay information. What gets measured, gets managed - and since there's not much reporting of pay information to investors, it's likely not to be managed too well.

It's a uniquely American problem, not shared elsewhere in the world. The FASB should undertake a project for improving investor information in this area - but it would be barred from doing so under condorsement, unless the IASB deemed it necessary. That's not likely to happen unless it became a problem elsewhere in the world. Is it fair to ask American investors to wait until an American issue that may be resolved by better accounting and disclosure is a problem in the rest of the world? In a word: No." [ first line bold in original, bold italics supplied]

Professors Ed Ketz and Anthony Catanach (Grumpy Old Accountants blog) evidence even less restraint in venting their frustration than yours truly. The title of their latest blog post, "IFRS is for Criminals" is more than sufficient evidence for that.

Floyd Norris, NYT columnist, trenchantly observed that, if the SEC were to follow through on its "condorsement" idea, many "flavors" of accounting would be the result for many years – if not indefinitely. The drive for IFRS to eventually replace U.S. GAAP increasingly appears to be coming from large companies who would like the SEC to give them the option to report using IFRS, just like many of their counterparts overseas.

But, I enjoyed Floyd's column the most for his one-liner response to the latest lobbying by IASB chair Hans Hoogervorst for the EU to endorse its latest pronouncement on the accounting for loan losses. Hoogervorst said straight out that the rule should appeal to the European Commission because it gives banks the free option to ignore economic reality, e.g., Greek bonds trading at junk debt levels:

"But it may not appeal as much to those who rely on financial statements, and would prefer to know when a bank's loans go bad. As a sales pitch, 'Adopt our rules and you won't have any losses' does not sound like a promotion for a superior set of accounting standards." [emphasis supplied]

Gosh, I wish I had written that!

Some say that the same sorts of political machinations are at work on U.S. GAAP. Even granting that point today (which I don't), imagine how things will look if more countried created an EU-like infrastructure for the purpose of lobbying the IASB for just the right IFRS standard to incorporate into its own system. The EU, the US, China, Japan and a hundred other smaller economies would be 'on board' with IFRS, but the IASB chair's head would have to be on a swivel in order to fend off each and every attack from increasing numbers of 'incoporators', 'endorsers', 'advisory groups', etc. The IASB will, in effect, devolve to something awfully akin to its early beginnings when the IASC (the IASB's predecessor) worked as a 90-person committee.

The only "standards" or "principles" back then were that there were none. A new era of balkanized accounting jurisdictions could put the IASB right back to where it started.

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

*Some of the comments made were in private correspondence with me. In every case I received permission to reproduce them here.

SEC IFRS Roundtable Debrief: March of the Zombies

If IFRS incorporation is supposed to be some fantastic opportunity for achieving one set of accounting standards worldwide, then why was no one at the SEC's Roundtable on IFRS jumping for joy at the prospect? You would think that someone, anyone, would have projected at least a modicum of excitement and energy in anticipation of great things to come.  Instead, try as I might, I couldn't eradicate the image from my mind ofa bunch of zombie CPAs chasing after me for five hours.  

I also take no joy in reminding everyone that I predicted that the Roundtable would amount to nothing more than blatant pretense and deception. If I do say so myself, my prediction was very close to hitting the bullseye. Where I missed, it was because, as hard as SEC Chief Accountant Kroeker as putative moderator tried to stifle/ignore them, there were some telling blows to the SEC's cause.  Unfortunately, they were spaced too far apart to score the knockout the SEC deserves.

 The "Investor" Panel

There were a number of panelists whom I think shouldn't have been there: present and former employees of rating agencies and Big Four partners. So, I found it supremely ironic that the most apt panelist, Gerry White as representative of the CFA Institute, made an early grab of the overall gold medal for shilling. It's an open secret that the Institute is pushing IFRS adoption in the U.S., because that's what its leadership perceives the non-US membership wants. The percentage of non-U.S. CFAs could be as high as 70%.

Gerry might could have stated that 'x% of U.S.-based CFAs in analyst positions strongly support convergence with IFRS'; but since he didn't, I expect that 'x' must be an embarrassingly low number. What he stated (according to my notes) was that the Institute's membership surveys showed "overwhelming" support for a single set of global accounting standards.

Of course, as any great shill is wont to do, White omitted some important qualifications to his statement that the SEC might at least pretend to be interested in knowing. Most critically, he didn't mention which accounting standards were supported by U.S.-based analysts. Although a majority of U.S. respondents to one of the Institute's surveys said that the global standard setter should be the IASB, it wasn't "overwhelming" – and the data is about 2 ½ years old. And, when you consider that only about one-half of CFAs actually work as research analysts or portfolio managers, the other CFAs (auditors, corporate accountants and corporate financial analysts) in the sample could have been the reason that the total responses tilted towards the IASB.

Another curious moment occurred when this panel appeared to have expressed a consensus view that the basis on which the financial statements are prepared matter very little, ostensibly because investment analysis is cash-flow focused. I find that to be a gross oversimplification, which might be explained by a ratings agency mindset of at least three of the panelists. My concern with such notions is that the SEC is on a scavenger hunt for any shred of evidence that will justify incorporation of IFRS into U.S. GAAP. In this case, the panelists are telling the SEC that accounting is only the starting point of an exercise in reverse engineering with the goal of producing estimates of future cash flows. Of course, any text on financial statement analysis, including Gerry White's co-authored book, will tell you that financial statement analysis is much more than that.

But, if those who take the cash flow view really believe it, then the solution to the IFRS v. GAAP problem is actually quite straightforward: require that financial statements are accompanied by detailed roll forwards of every balance sheet account. If this actually were to be a requirement, then all of my concerns regarding IFRS incorporation would dissolve. But, it won't, of course, simply because the proponents of IFRS incorporation are more interested in hiding the ball. I.e., not revealing to much about the way that earnings were manipulated through contrived 'principles.'

Finally, no investor expressed any concern whatsoever for the effect that conversion to IFRS could have on management decision making – and consequently shareholder value. The SEC has yet to express the slightest concern for the effect that changing the basis of accounting will have on decision making.

Why is that? Of all the potential costs of conversion to consider, skewed decision making relative to shareholder value creation may be the most significant by far. It is also the most difficult concern to minimize, for there is no doubt that fewer accounting rules will mean fewer restraints on managers to steal from the cookie jar. I fear not only those managers who would act with financial malice aforethought, but also about those in regulated industries or are simply fixated on earnings. Would European banks still be holding on to their Greek bonds, now worth something like 30 cents on the dollar, if they had been forced to mark their investments to market? No way. Even more fundamentally, would banks have been willing to expose themselves to the degree that they have to a Greek default if they knew those bonds would have to be marked to market? Same answer, and the same again for thousands of similar questions one could ask about the nexus between managerial decision making and financial reporting.

 

The "Smaller Public Companies" Panel

The first ray of sunshine (being the best disinfectant, of course) came from the smaller public companies panel when its members were asked whether incorporation of IFRS into U.S. GAAP would be a good idea. The consensus was virtually unanimous that it would cost them far too much money; and not only would the costs exceed any conceivable benefit, there wouldn't be any.

That took only about 10 minutes, and the rest of the time was spent on: 'OK, even if you don't think we should incorporate IFRS into U.S. GAAP, how should we do it?'

This, for me, was the nadir of the proceedings. A reasonable inference from the feedback from its handpicked panelists should have been something like this: at least half (very conservatively) of the public companies registered with the SEC must really want any and all talk of IFRS to go away ASAP. It was a full stop moment, but instead, the intrepid chief accountant forged on down his prepared list of questions as if he were utterly oblivious to the near universal condemnation of what he clearly hopes will be his legacy at the SEC.

 

The Regulators

The SEC was very lucky that Gaylen Hansen, the NASBA representative, was given the floor only as the zombie march was winding down. For, if the "investor" and "smaller public companies" panels were given the chance to digest and respond to his prepared remarks, a full zombie assault on civilization might have begun in earnest.

Basically, in about ten minutes, Gaylen shot down every stated reason and unsupported assertion for incorporating IFRS into GAAP into oblivion:

"International standards may be likened to the Holy Grail, worth searching for but only if you think there is a reasonable chance of finding it. In the meantime, there is a real risk of obsessing in the quest at the expense of more pressing and worthy goals. There are extremely high risks in the "condorsement" approach suggested by the Staff. We may not know for several decades whether it was a very bad idea and, if so, in time to recover." [emphasis supplied]

If you are interested enough in this topic to have read all the way to this point, then PLEASE click here to read Gaylen's remarks in their entirety. Here are just a few of his remarks (accompanied by parenthetical observations from yours truly):

• The SEC owes it to the national interest to establish that IFRS itself is at least better than U.S. GAAP, if not far superior, to justify such a radical change with so many unknown (and uninvestigated) variables. (Of course, it can't be done. Moreover, the SEC's IFRS fixation has helped to improve IFRS, but it has done more to harm the quality of U.S. GAAP than to help it.)
• The notion that one version of IFRS (i.e., the Holy Grail) has been gaining currency in the rest of the world is a myth. "It has been hyped that over 120 countries worldwide have adopted IFRS issued by the IASB. That is simply not true – carve-outs resulting in jurisdictional versions are legion … I have spoken to Canadians who have indicated some of their companies are not doing anything other than wrapping the IFRS name around Canadian GAAP. The same has been reported about France." (And, I have heard presentations from large Canadian companies reporting that conversion to IFRS was extremely costly, and without benefit.)
• Let's face it, this is not about accounting, it's about politics. "[T]he original dream of comparability seems to have taken a back seat to the real agenda of some promoters…. I have read the 200 plus comment letters sent to the SEC on the 2007 Roadmap. Despite the spin of overwhelming support for global standards, there is actually substantial concern and much outright opposition."
• "I have never had a lender or investor request international standards. I have never even heard of such pleas. On the contrary, the call for IFRS always seems to be from the suppliers [of financial statements], primarily large multinationals and international accounting firms."

* * * * *

I'm sure any negative reaction to the SEC's current thinking on IFRS was to the chief accountant and his staff like water off a duck's back.

Accordingly, and on this basis only, I am issuing my first stock tip to readers of this blog: buy Accenture. Or for that matter, any publicly traded consulting company that is surely gearing up to help U.S. companies make the costly "transition" to IFRS.

As for the companies that will be converting, buy puts.

 

SEC IFRS Roundtable Agenda and Panelists are Announced: Even Worse News than I Expected

This is a short follow-up to yesterday's post on the upcoming SEC Roundtable on International Financial Reporting Standards.

As I feared, the agenda is not even on the same planet as the core questions, indicating ever more strongly that the fix is in. Of the panelists, I know two of them (good things), and know a little something about one other (a bad thing).

Of the two panelists I know, the more outspoken is Gaylen Hansen, director at large of the National Association of State Boards of Accountancy (NASBA) and partner at accounting firm EKS&H. Gaylen was the first, even before the SEC, to go public with an analysis of the constituent feedback from the SEC's Roadmap proposal. He did it at a NASBA convention, and I wrote about it here:

"The problem for … IFRS supporters is that the data is so darn unequivocal against the IFRS Roadmap proposal that any errors due to small sample size would have to be tsunami-sized in order to reverse the results. Public companies disfavor the Roadmap by a margin of exactly 2:1; and the public companies that express "strong" opposition to the Roadmap proposal outnumber all supporters, however strong, by exactly 1.5:1. Perhaps even more damning to the Roadmap proposal is that not a single investor group expresses "strong" support, and the overwhelming majority want to tear it up." [Just to be clear, I am quoting myself.]

I'm guessing that the SEC felt they had no choice but to ask NASBA to provide a panelist, and bless NASBA's little hearts, they picked Gaylen. I know he has a lot to say about IFRS, and for me, the only drama remaining is whether he will actually be given a chance to say it.

I Don't Know this Guy, But I Think I Know What He's Going to Say…

The panelist I know of by reputation only is Bill Yeates, partner at Hein & Associates. The SEC's brief description of him doesn't mention that he is a past member of both the SEC Regulations and Professional Prace Executive Committees for the Center for Audit Quality (CAQ). For that reason alone, I suspect that he was handpicked by the AICPA, and will as a matter of course shill for them.

Mr. Yeates is on the "smaller public companies" panel, and I find it amazing that the SEC refuses to recognize that CPAs have a built-in conflict of interest on any IFRS policy question. Moreover, regardless of the size of the issuer, the SEC should be focusing on the financial statement user, and not the financial statement supplier. How are these panelists supposed to tell us about "…financial statement users and their needs," as listed in the agenda, if not one is actually a financial statement user?

The Token Investor Issues

Here are the issues that the first panel, entitled "Investor Understanding and Knowledge of IFRS" are supposed to address:

• U.S. investors' current knowledge of IFRS and preparedness for potential incorporation
• How and when U.S. investors educate themselves on changes in accounting standards
• Extent, logistics, and timing necessary to undertake changes to improve investor understanding of IFRS
• Potential methods of incorporation

These topics aren't even on the same planet with the core questions that the SEC has been avoiding for years (I know, I'm repeating myself):

• Do investors perceive that IFRS gives them higher quality information than U.S. GAAP?
• Is there any hope that financial statements will become more comparable across issuers over time by continuing to work with IFRS?

And, please tell me how this handpicked panel, which purportedly can represent investors' interests in the IFRS policy decision, is competent to evaluate the "potential methods of incorporation"?

* * * * * * *

And, tell me again why, two years after the Roadmap proposal's comment letters were tabulated and analyzed we are still wasting time on this? It should be said that a couple of commenters to my blog post on Gaylen's analysis found fault because one form or another of non-response bias could have skewed the results. There is a lot of validity to that, but there are ways to investigate the degree to which non-response bias accounted for the findings. The SEC has had two years to follow up on the comments from the Roadmap proposal, but of course, they have done nothing – because, I'm thinking they were thinking that they couldn't control the results.

A "roundtable," on the other hand, can be controlled. Even though it may not be possible to handpick each panelist, a watered-down agenda with very little time for each panelist to say their peace is likely to do the trick.

An earlier version of this post incorrectly stated that Bill Yeates is a CAQ board member.  I regret the error and apologize to Mr. Yeates.

No News from the SEC on its IFRS Roundtable is Bad News

I'm looking forward to the SEC's July 7^th IFRS Roundtable like surgery without anesthetic. Perhaps the SEC feels much the same, as notification was only posted to its public calendar of upcoming events within the last day or two – absent an agenda and list of participants.

In an attempt to fill in the blanks before writing this post, I called Christopher White in the Office of the Chief Accountant for more information. His voicemail was extremely friendly, but equally unhelpful. It turns out that even though there are only three more working days between now and the Roundatable (announced 10 weeks ago), the agenda is still a work in progress and the panelist roster has yet to be finalized even.

The Fix Must Be In

All of the past SEC actions, spins, jumps and procrastinations are consistent with my expectation that the Roundtable is being carefully orchestrated to achieve one specific end: to yield a message that will justify the deals and commitments already consummated out of the public view. The only remaining question is whether the Roundtable can shroud these arrangements with some modicum of legitimacy; or at the very least a large dose of white noise.

The white noise outcome may be the best the SEC can hope for since, try as they have, not a shred of empirical support for further association with IFRS in any shape or form, has been marshaled. Most poignantly, the SEC staff's first (and last) progress report fully eight months ago said almost nothing, except for sheepishly admitting that glowing reports of hook-line-and-sinker IFRS adoption is not nearly so widespread as the IASB's propaganda would have us believe. Moreover, the subsequent departure of India and Japan from the IFRS Adoption Express only further confirm a more sobering reality on the ground.

Since the staff's progress report, the SEC staff has hardly uttered a peep, despite solemn pledges of in-depth investigation on an impossibly wide range of controversial topics. Perhaps the Commission is hoping that hyping the Roundtable will cover over the absence for public scrutiny of hard work and hard thinking from its staff.

Starting from the time when the SEC tried to be dismissive of the overwhelmingly negative feedback, from even large issuers, on the initial IFRS adoption proposal, it has become ever clearer with time that the one thing the SEC does not care to receive from the Roundtable event is real feedback on the core strategic propositions. Even if the panelists selected* turn out to be slightly more open-minded and honest than the shills I expect them to be, I am concerned that they won't have more than a glimmer of a chance to respond to strategic questions like, "Why should we do this?"

Count on, instead, a numbing series of tactical questions like, "How should we do this?" That's the only way that I can think of for the SEC to divert attention from the fact that benefits from adopting IFRS are mere speculation without empirical or theoretical foundation. If, for example, you think the debate is still about 'principles' versus 'rules' in accounting, you need to think again. For an effective debunking of this tired old nonsense, you should read George Washington law professor Lawrence Cunningham's 82-page paper, "A Prescription to Retire the Rhetoric of "Principles-Based Systems in Corporate Law, Securities Regulation, and Accounting." Please.

Trying my best not to gag as I write this, these are the types of questions of the panelists that I expect will dominate the as-yet-to-be-published agenda:

• How would IFRS adoption affect your organization?
• How is GAAP used in your industry?
• What is the impact that a change in accounting standards will have on your industry? (If you don't know, then make something up!)
• How should (i.e., not if) the transition to IFRS take place?

 

The Hard Questions that Won't be Asked

Sovereignty – If the IASB is allowed to set the agenda and take first crack at writing a standard under an "endorsement" strategy for continued association with IFRS, what are the risks? In particular does the U.S. risk a race to lowest-common-denominator accounting standards? Why wouldn't investors be better protected by a competitive standard-setting strategy instead of a merely cooperative strategy with the ultimate goal of producing a monopoly?

My favorite case study is India and its accounting for the foreign exchange effects on foreign-currency denominated debt. They are adamant that foreign exchange losses on freestanding debt denominated in a foreign currency should be eligible for deferral. For U.S. issuers, that approach harkens back to the stone ages of pre-FASB financial reporting. With that in mind, how could the U.S. take IASB rule-making seriously should it deign to make some sort of concession to India? This is not a hypothetical: India has every expectation that the IASB will take up that case once U.S. GAAP considerations are at long last moved off center stage.

What is there to converge with, anyway? – The hyperbole about IFRS adoption throughout the world has been intense and unrelenting. Yet, the SEC staff admits that very few countries have adopted IFRS as issued by IASB. Ironically, U.S. GAAP is probably closer to IFRS than the versions in use by the majority of those countries which have already adopted to some degree or another.

Also, the SEC's staff ad lib proposal from just a few weeks ago would provide for US carve-outs with an "endorsement" approach. They are saying that the differences would be few and far-between, sort of like the SEC's involvement with the FASB. However, in reality the SEC really meddles a great deal with the FASB. It has issued hundreds of Staff Accounting Bulletins and Financial Reporting Releases, and a huge Financial Reporting Manual (351 pages); and importantly, it retains veto authority over private sector standards setters. Will the FASB have that same power with IFRS? The only that happens is if we adopt a US version of IFRS and not as issued by IASB. Linking agendas in this manner could further bog down improvement agendas and will do more to constrain, rather than advance, development of timely and high quality financial reporting developments

Will Comparability and Cost Savings Really Occur? – The attraction of IFRS adoption for investors was supposed to be worldwide comparability; and to that end the SEC originally stuck to its guns and demanded pure IFRS in accordance with IASB in exchange for removing the reconciliation requirement a few years ago for foreign private issuers. Yet, hypocritically, the SEC now purports to prefer a US-flavor of IFRS for domestic filers (while foreign private issuers will continue to file pure IFRS financial statements. This is because the SEC cannot transfer the authority to set accounting standards to anyone else. In effect then, we have come full circle back to a lack of comparability due to multiple versions of standards. Heretofore, it had been possible to state that all U.S. listed companies were 'comparable' at least insofar that all of them reported income as per U.S. GAAP. That is no longer happening, and will never happen again if any of the paths currently being contemplated is taken.

Public Confidence in IFRS – I received a request just this morning from a reporter, from one of the premier business publications, who is trying to investigate how IFRS adoption would affect smaller public companies. He asked me for names of sources he could contact, because he couldn't come up with any himself. The problem has been that the issue he wants to report on has barely been considered:

"[Sources are] nearly impossible to find. There's been almost no public opposition to IFRS from small companies that I've been able to find. The groups that might be representing small businesses' interests here, like the US Chamber of Commerce and the National Federation of Independent Businesses, haven't done anything. … And there have been virtually no comment letters from small companies on convergence and IFRS.

The sentiment I'm getting is that this issue just isn't on small companies' radar screens as yet – they've got enough to do just to keep their heads above water financially, deal with the impact of Dodd-Frank, etc. I suspect, though, that this is very much going to be an issue for small companies – we just haven't seen it yet." [italics supplied]

Here we are on the cusp of a momentus decision, and the impact on smaller reporting companies remains a mystery. Isn't that one of the things the SEC has supposed to have been looking at this year? (Where is that darn progress report from the SEC staff!?)

There is also a huge issue with trust because, of the most strident voices, the public doesn't know whom to believe. The problem is that the loudest IFRS cheerleaders are doing their best to cash in as they speak. The AICPA is already selling IFRS certifications, and Big 4 partners have vested themselves in accumulating expertise in something that now has to be "sold." To my view, the credibility of virtually everyone hawking IFRS adoption has been auctioned off for big bucks.

Any notion of receiving a balanced view from veteran regulators is also laughable. The most prominent, including Paul Volcker, Harvey Goldschmidt and Ray Glauber have long been captured through their status as IASB Foundation Chairs or Trustees at one time or another.

Other – I could go on, but I'm running out of time and space, so I'll just leave you with these additional thoughts:

• The issues of IASB independence and lack of uniform (or practically non-existent) enforceability throughout the world.
• What about the cost? When is the SEC going to do a realistic study?
• How is the U.S. going to fund the IASB, and is that a political reality?
• Is there any substance over form to the IASB's Monitoring Board? It was supposed to solve the governance issues but I can't see that the U.S. will have any more influence than just one vote of many. Conclusion: it's just there for appearances sake.

* * * * * * *

I'll be dragging myself to the computer next week to watch the Roundtable on the web (three hours earlier in AZ!), but like I said, I sure ain't lookin' forward to it. Here's hoping that there are at least a couple of panelists who haven't either been bought or brainwashed.

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

*I responded to the SEC's request for panelist nominations. The SEC has not responded to my email.

A Brief Exchange with an IASB Member on Hedge Accounting

A reader of my post on the CFA Institute's critique of the IASB's hedge accounting exposure draft suggested that I write to the two members of the IASB, Patrick Finnegan and Patricia McConnell, who had a close association with the Institute prior to joining the IASB. So, I did, and Pat Finnegan was kind enough to respond. This post is based on our very brief correspondence.

Why Would I Do Such a Thing?

Writing to the board members was a departure from my modus operandi, which is to limit my sources to what I happen to read as I pursue my nerdy interests, plus other items brought to my attention by readers and others. I simply don't have time to do much more than that. But, in this case, I couldn't resist reaching out to IASB members. Here's why:

• Pat Finnegan was associated with the CFA Institute until relatively recently, and presumably he helped determine, and advocated for, the Institute's positions on financial reporting issues. (Pat McConnell's direct association with the Institute was longer ago.) Hence, I was looking for an explanation of the inconsistency between Finnegan's present endorsement of the hedging ED and the present disagreements on practically all aspects of the ED expressed by his previous employer. Moreover, these disagreements involve core conceptual issues that go beyond hedge accounting (e.g., fair value, comprehensive income, management intent, etc.) 
• The ED also contains a dissenting view, which the CFA Institute supports, and which IASB members could have joined. It happens to have been written by another U.S. member, John Smith, who is reputedly the most informed and technically capable board member when it comes to financial instruments accounting.
• The utter passivity of the SEC with respect to the actual substance of "convergence" of financial reporting standards suggests that it may be using the votes of the IASB "investor" members as justification for remaining on the sidelines.  Finnegan and McConnell must be aware of the significant influence they have, especially as the SEC approaches closure on its own IFRS policy questions; and for this reason alone, providing greater transparency of their views is the right thing for them to do.*

I Got Criticized, but I Didn't Get an Answer to My Question

In my email, I asked only one question: "Given your former intimate connection with CFA Institute, I would like to ask you whether you agree with their comment letter; and if you disagree, kindly explain why."

And, here is Pat Finnegan's response in its entirety:

 

Dear Tom,

Many thanks for your email, and for sharing your recent posting on our work to reform hedge accounting. I am on your distribution list and read your posting last week.

 You will not be surprised to learn that I do not agree with your assessment of our extensive due process as a 'political circus'. I suspect that most of the 250 or so respondents to the Hedge Accounting consultation would also disagree with your assessment. 

It also seems odd to substantiate your arguments based on just two comment letters. If you are interested in investor views, why ignore, for example, the Investment Management Association (whose members manage over £3 trillion of assets) that broadly supports our proposals? There are a range of views expressed in the comment letters received – some supportive, others offering constructive criticism, which is the whole point of having such an extensive due process.

I understand from my colleague Pat McConnell that you have sent her a similar request for opinion. I am copying her on this reply.

The board is planning to discuss the staff's analysis of comment letters and outreach visits during the next several weeks.  Those discussions will inform the Board's decision making (including my own) before determining how to proceed. I believe the key questions and observations raised in the CFA Institute's letter will be addressed during those discussions. I invite you to listen and if you would like to discuss our tentative decisions as we proceed, please do not hesitate to contact us.

Best,
Pat

I am flattered that Pat reads my blog, and I hope he understands why I singled him out. I am going to respond to his concerns, below. But first, I must note that he has declined to respond to my request: to have an explanation for the inconsistency of his vote with the positions of his previous employer.

As to my inferences from only one comment letter and an analysis by E&Y, I should first point out that I have been following the IASB's "due process" for some time. I invite Pat to read my post on the revisions made to IAS 23 (interest costs), and tell me that "political circus" is not a better descriptor than "due process" for the way in which those revisions were made. But, more directly to his point, if that IMA comment letter is the best that Pat could come up with for investor input that I overlooked, then I clearly did not miss very much.

The CFA Institute's letter that I discussed contains almost 40 pages of solid analysis, including numerous reasoned and detailed responses to specific questions that the IASB asked commenters to address. In stark contrast, the IMA's letter is two pages in total, with barely more than one page of substantive comments. The IMA letter contains no responses to the specific questions in the ED, and it provides no explanations for why investors should be supportive of the IASB's proposals. The CFA Institute's letter, on the other hand, is thorough not just for its depth and breadth, but for its lucid explanation as to why the ED is inimical to investor interests.

Hedge accounting is the poster child for rules-based accounting.  It owes its existence to a highly-politicized process in the first place that made an explicit exception to principles-based accounting. But, even if the ED were actually principles-based, how should one weigh the IMA's two-page letter from an organization representing members that manage over £3 trillion of assets with the Institute's letter and its 100,000 members? Evidently, Pat Finnegan thinks the IMA letter is significant in comparison to the Institute's, but I disagree. A staff analysis of comment letters that could consider the IMA's contribution to be in the same ballpark as the CFA Institute's is precisely the kind of "political circus" I had in mind when writing my post that Pat disagrees with.

As to what the receipt of 250 comment letters actually says about "constituents'" perceptions of due process, unlike Pat, I don't see that it says much of anything. For example, commenters could be just as cynical as I am, and still find it in their interests to register their views. And, I wouldn't be surprised if that's the way the signers and drafters of the CFA Institute's letter regard the process – they have no real choice except to participate in a charade.

The IASB would do well to commission an independent survey of "constituents" (most especially, investors, academics and journalists) for their perceptions of the efficacy of the Board's "due process." That such a survey has not already been conducted is, in and of itself, telling. 

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Unfortunately, accounting reform is turning out just like banking reform: politics and influence, as opposed to economics and principles, are the deciding factors. I see only political reasons for Pat Finnegan and Pat McConnell to decline to explain their votes on the hedging ED. And, the IASB's analysis of comment letters on their hedge accounting ED, under the name of "due process," can be nothing more than pretense.

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*In a previous version of this post I incorrectly stated that hedge accounting was not discussed at the IASB's most recent meeting.  I apologize for the error.