The Accounting Onion

Can Auditors Help Save Spain's Banks? Nuts!

Less than a day after posting my critique of the FASB and IASB loan loss allowance proposal, I happily learned that the FASB may be backtracking. According to a PwC In Brief:

"After considering the results of outreach efforts and constituent feedback, the board unanimously agreed with concerns that aspects of the "three bucket" impairment model are complex and difficult to understand. As a result, the FASB will not move forward with an exposure draft on the "three bucket" impairment model …

The FASB's decision to explore a revised approach could result in an impairment model that differs from the IASB's model. During today's discussion, certain IASB members indicated that they have heard much less concern about the "three bucket" impairment model and therefore, plan to move forward with that approach. ….

It is unclear at this time whether the IASB will move forward with an exposure draft in the near term, or whether the IASB will first consider any revised proposals from the FASB." [bold italics supplied]

Dare I now hope that the FASB will ultimately rediscover the wisdom of measuring loans at market-based values? I would be more optimistic that reason might prevail if the newest three board members hadn't been specially chosen by the powers that be at the Financial Accounting Foundation to be dependable opponents of market values for loans.

In an unrelated event, but telling nonetheless, the Wall Street Journal published a few days later a very perceptive and perspicuous article, by Gabriele Steinhauser, discussing the approaches the EU might take for bailing out Spanish banks. The gist of the article is that "a team of private auditors is rummaging through the books of the 14 largest Spanish banks to determine…" the amount of the loan losses. Nuts.

I recommend that you read the full article, but for the points about the auditors' role that I want to make, it is sufficient to know the following, which in any case is somewhat oversimplified:*

• The European Financial Stability Facility (the bailout fund that is backed by guarantees from the Eurozone member states) will lend €100 billion to Spain for a bank bailout.
• An uncertain amount of the investment, perhaps €25 billion, will be used to capitalize a 100%-owned "bad bank," which will purchase the junkiest of junk loans from the banks.
• The amount not invested in the bad bank will be contributed to those pretty-awful Spanish banks, probably in exchange for some form of TARP-like equity.
• "Each lender's needs will depend on how much it is likely to lose on its part of some €200 billion in loans the banks made to property developers and other boom-time real-estate investors." Presumably, the audits are supposed to help determine these amounts.

I Said "Nuts"

First, whether new capital comes from private or public sources, the valuation question pertaining to an investment should be the same. An investor should want to know how much one could pay for identical or similar assets if they were acquired some other way. Yet, the auditors it seems are not being asked to provide an answer to that question. Instead, they are tasked with estimating: (1) how much cash could be scavenged when (or if) the Spanish economy rebounds within a reasonable time period; and/or (2) the current sales value of the banks' portfolios of loans and abandoned development projects.

Some months ago, I was amused to watch Angela Merkel and Nicolas Sarkozy debating on TV an accounting question: the size of the balance sheet haircut that EU banks should take on their holdings of Greek bonds. Such discussions of paper losses or sale values for asset positions that won't be sold can make for interesting political theater, a play which seems to have been remounted in Spain.

Unfortunately, the real economics of the situation facing Spain and its fellow EU members is much less like theater and much more like surgery without anesthetic. Time marches on and risk is high; hence a simplistic cash-in-cash-out view of gains and losses is far from the transparency that taxpayers, or any other investor, need and deserve before committing one's money to a risky venture that is perilously close to a hopeless cause.

Second, whatever the measurement objective, auditors have no demonstrated competence to produce estimates that policymakers/investors can rely on. If you want a valuation, ask a valuation expert. If you want to understand future cash payment scenarios, then ask an economist. Very simply, and with absolutely no disrespect intended, auditors don't possess the depth of training in asset pricing methodologies or econometrics to do this critical job right – which if not done right could spell the end for the euro.

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I see a pattern here. Both the ECB's bailout plan of Spanish banks and the IASB's three-bucket approach to measuring loan carrying values are misguided and inappropriately dependent on the competencies of auditors -- who even with the best of intentions lack the requisite training to evaluate a market value much less an ineffable reserve estimate.

Maybe this is the case study that can convince the FASB that it should leave the IASB and the EU to its own devices when it comes to loan accounting.

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

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

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

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

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

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

 

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

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

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

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

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

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

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

 

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

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

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

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

 

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

   "The Board further noted that both IAS 23 and SFAS 34 Capitalization of Interest Cost were developed some years ago. Consequently, neither set of specific provisions may be regarded as being of a clearly higher quality than the other. [Nonsensical] Therefore, the Board concluded that it should not spend time and resources considering aspects of IAS 23 beyond the choice between capitalisation and immediate recognition as an expense." [bold italics supplied]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

False Claim #4: IFRS is already widely adopted elsewhere

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

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

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

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

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

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

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

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

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

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

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

 CLICK HERE FOR PART THREE OF THIS ESSAY.

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

Dear Reader,

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

Best,
Tom

* * * * *

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

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

How We Got Here

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

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

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

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

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

The Ten False Claims for IFRS Adoption

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

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

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

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

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

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

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

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

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

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

CLICK HERE FOR PART TWO OF THIS ESSAY.

It's Nice to Win Something, Even if it’s the "Losing Cause Man of the Year"

No one likes to be told they are irrelevant, but that was my first reaction to Bob Jensen's AECM post, in which he dubbed me the "Losing Cause Man of the Year." I am certain that Bob meant it as a compliment, and I've gotten over the unintentional slight. Now, I am ready to reflect on how I came to merit such a dubious distinction.

I'll begin by restating Bob's remarks. I am using much of his own words, but without quotation marks (the full text of his remarks are here).

Losing Cause 1 — Fending Off the Takeover (Convergence) of US GAAP by the International Accounting Standards Board

Tom has never accepted that international standards will replace domestic accounting standards in the United States. But, the takeover of US GAAP by the IASB is a fait accompli because all the people that count applaud such a takeover. Domestic corporations like the idea of softer principles-based international standards replacing the thousands of bright line hard rules in present U.S. GAAP. Multinational corporations really like the idea of only having one set of accounting standards to deal with year after year. Large auditing firms and the AICPA are salivating over being able to bill companies for IFRS training programs and materials and software.

The only serious, albeit ineffectual, resistance to IASB takeover of U.S. GAAP has been perpetrated by a few powerless academics like Tom Selling, Shyam Sunder, Ray Ball, David Albrecht, and Bob Jensen. Among these protesters, Tom Selling is our persistent champion.

Losing Cause 2 — Mandatory Rotation (Term Limits) of Audit Firms

In 2011 the PCAOB put mandatory audit firm rotation out for discussion. The response from the business community and auditing firms has been overwhelmingly negative to the idea.

The academic community remains largely silent on the issue, but when push comes to shove I suspect that most accounting professors, like me, see more costs than benefits of audit firm rotation even though rotation of the auditor partners themselves on audits is a current practice supported by almost all academics.

Tom Selling remains the lone voice in favor of mandatory audit firm rotation – click here. He proposes something like seven-year term limits before a corporation has to change its audit firm.

Losing Cause 3 — Financial Statements Entirely Based on Replacement Costs

For nearly 100 years leading academics have advocated some type of current cost or value replacement of the historical cost basis of accounting. Historical cost never pretended, as repeatedly noted by AC Littleton, to be valuation accounting. In 1929, John Canning started the ball rolling for current (replacement) cost accounting, which is sometimes called "entry value" accounting. In 1939, Kenneth McNeal commenced the ball rolling for exit value accounting where buildings, vehicles, and factory machinery are valued at what they can sell for, rather than amortized historical costs.

From an academic standpoint the literature on value accounting has probably been more focused upon the bad features (e.g., goodwill accounting) of historical cost accounting rather than on convincing research that some type of "value" accounting justifies the costs of preparation. The sermons on the evils of historical cost accounting became less convincing as research emerged in the 1990s showing that historical cost accounting really did have value for both earnings and stock price forecasting.

John Canning's current (replacement) cost baton has now been passed to Tom Selling. Like John Canning, Tom advocates that business firms spend tens of billions of dollars annually shifting from traditional historical cost reporting of operating assets to replacement costs. The problem is that replacement cost advocates can point to zero research convincing us that the benefits of such drastic changes in financial statements justify the costs.

My Response to Bob

Bob, I appreciate the compliment, especially coming from you. I covet your erudition, and you are the lifeblood of the AECM listserv. We both have strong opinions, and we disagree on some pretty important matters. But, I am proud to say that we both willingly wear our hearts on our sleeves.

I wish I could say the same about most other academics – You state that the academic community remains largely silent on the issue of mandatory audit firm rotation, but I say that the academic community has largely remained silent on all of these issues – IFRS, auditor rotation and independence, and crappy accounting standards (despite the boat loads of narrowly-focused research produced by academics on the information value of GAAP-based financial statements). I believe I am your Losing Cause Many of the Year because academics as a group have proven themselves milquetoasts at this critical juncture for the accounting profession, on which we claim to have a unique and valuable perspective.

I can't know what I would have been writing and saying if I were still a faculty member somewhere, but I would like to think that my training and upbringing would not have permitted me to stifle strongly-held points of view that directly affect my teaching and/or research activities. The accounting professor who denies having strong opinions on at least one of these "lost cause" topics should be asking themselves: what the heck do they spend their time thinking about; whether what they actually are thinking about matters very much to society; and whether they have an ethical obligation to participate in the conversation.

Costs and benefits of change — Bob, you seem to focus on incremental costs (like amounts paid for experts to make various estimations); and I focus on avoidable costs, because I believe they are many times larger:

• The vast amounts spent on auditors and accountants need only be a small fraction of what they are today. Auditors do perform many valuable services; but, some of the services performed require highly subjective judgments and consequently have little value. Those low-value services seem to cost the most, and they challenge the ability of an auditor to be objective.

   

• The amounts of shareholder value destroyed because of "earnings management" and similar games that executives are permitted to play can be stupefying just by recalling the role that financial reporting played in Enron, Worldcom, GM, Lehman, S&Ls in the 1990s, financial institutions over the last few years, just to name a few. If auditor rotation could have prevented just one of these debacles, then your own cost-benefit calculus would be flipped on its head.

   

• There is plenty more value waiting to be destroyed because the system of accounting rules actually encourages it. Bob, you may not agree that replacement cost accounting is the answer, but surely you recognize that financial reporting has many more and far more unsightly warts than simply goodwill accounting! The patchwork of rules we call US GAAP or IFRS is not analogous to the result of some Darwinian evolutionary process of natural selection, as you once said. It is — in spite of (or perhaps even because of) all of the research confirming its predictive value to which you allude — a "garbage truck." (That's not my term; it belongs to David Mosso, a former FASB member no less.)

The end of a tumultuous 2011 may be an appropriate time to recognize a champion of lost causes. But looking ahead to 2012, I see all of these issues in play. Audit rotation may fizzle in the U.S., but it is more alive in Europe; the voices against IFRS adoption are getting louder (even though academics are still sitting on their hands); and once the U.S. escapes from the clutches of the IASB, perhaps we can have a real discussion of value accounting.

2012 is just getting started, and so am I.

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.

The Hans Hoogervorst IFRS Sales Pitch Hits the Road

For a standards setter, Hans Hoogervorst, the new IASB chairman, doesn't know much about accounting. By his own frank admission, he wasn't even very interested in the subject until after the financial crisis hit in 2008, and he seems almost proud to disavow a command of the details of IFRS.

Consequently, his role on the IASB is obvious: to sell IFRS to as many countries as possible. Why anyone should expect someone with his background to do that with any sort of credibility is beyond me, but his selection seems to reflect a conscious strategy on the part of the IFRS Foundation: to promote the sizzle instead of the steak.

The Wooing of China

Hoogervorst's first major sales pitch was delivered in China last month. Predictably, there were two parts: a standard litany of the general benefits of IFRS, plus some special words like these to the good folks in China:

"[W]hile Chinese GAAP is not word-for-word IFRSs, I understand that analysis by the Chinese regulator shows that for companies with dual listings in Shanghai (using Chinese GAAP) and Hong Kong (using IFRSs) the average difference in reported profit is 0.6%. The difference in term [sic] of net assets is even as smaller [sic] as around 0.2%."

The impetus for this post was an email from one of my readers, Steve Chai, who made this telling observation:

"If [Hogervoorst] truly believes that the financial results are similar under both IFRS and Chinese GAAP, he should instead recommend switching to Chinese Standards, which are 100 times shorter and simpler than IFRS!!! … For example, Chinese Accounting Standards (CAS) have less than ONE page of guidance on how to consolidate companies (CAS 33), and CAS 24 on hedge accounting is only 7 pages."

To Steve's point I would add that if CAS can generally be expected to come close to IFRS on major financial metrics, then maybe the rest of the world should adopt CAS. Moreover, Hoogervorst doesn't even seem to be aware that the point of that simplistic statistical exercise would more likely have been to support the proposition that convergence to full IFRS was not a necessary condition for achieving "high quality" financial reporting in China. If the actual income and balance sheet numbers are similar, then there would seem to be no point to burdening Chinese companies with more detailed accounting standards.

Steve wrote to me because he is incensed that, right from the start, Hoogervorst is not telling the truth while promoting the adoption of IFRS. I am more than inclined to agree with him. Throughout his speech, Hoogervorst figuratively bows and scrapes to the Chinese for their "work," "support," and "herculean effort" to bring CAS closer to IFRS. The reality appears to be quite different.

For example, the Chinese representative to the IASB (Dr. Zhang Wei-Guo), I am told, says little if anything at Board meetings. The ostensible purpose of holding public meetings is for stakeholders to receive at least some indication of each board member's thinking, and that independent reasoning forms the bases for votes. Therefore, one might reasonably conclude that Dr. Zhang has nothing to add to the conversation.  If his accounting background is indeed rooted solely in working with the bare-bones regime of CAS, then in that respect he is much like Hoogervorst: which means that at least two voting board members are lacking technical knowledge to participate in any effective way in the Board's deliberations.

I suppose one could argue that at least Hoogervorst has a real job to do: hawking IFRS with the zeal of a snake oil salesman. But, for merely showing up and voting with the party line when required, Dr. Zhang is paid around $600,000 per year plus benefits. I wonder how that compares with what he was paid while working in China.  Did I hear anyone say "regulatory capture"?

And the other thing is that China's "herculean" contribution to the budget of the IASB is, I understand, only slightly more than Dr. Zhang's salary. The message there is also loud and clear: China will pay for made-to-order standards only. Won't it be interesting to see how that plays out once the IASB moves its sights from the U.S. towards other big fish!

The Double-Edged Butter Knife

Hoogervorst is probably a pretty sharp guy, and he may have a deep technical knowledge of something, but it isn't accounting. The China-centric aspects of his speech are sufficient by themselves to demonstrate that he will operate as a blunt instrument; a double-edged butter knife, if you will. One edge will blithely spew forth misleading statistics or generalizations, and the other will plead ignorance of the critical details.

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 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.

Hedge Accounting: Convergence Crunch Time

If you want to appreciate the political circus masquerading as "due process" in accounting standards setting, I recommend that you read two recent documents. The first one is the CFA Institute's stinging 39-page comment letter* on the IASB's hedge accounting exposure draft:

"We do not find investors calling for a standard which allows broader and more liberal application of hedge accounting and which permits its use to alter the IASB's classification and measurement of financial instruments. Rather, our research indicates that users find hedge accounting and disclosures to be confusing, difficult to understand and low in quality. We would be interested to hear how the IASB's outreach to users allows them to conclude that this proposal will benefit users." [Emphasis supplied.]*

And second, this equally-detailed publication from Ernst & Young, which hit the internet at about the same time:

"Among the proposals issued by the … [Boards] … to amend financial instruments accounting, the hedge accounting sections were the most favorably received. Both Boards heard support from constituents for attempting to make hedge accounting easier to accomplish with changes that constituents found substantial and helpful."

That much is all you need to get the sense that preparers, as represented by EY's clients, are clearly talking past investors, as represented by the CFA Institute. If you need more evidence, search for the word "users" or "investors" in EY's 26-page document. You'll find "users" once, but not in any relevant context to the point I am making. What you will find is a lot of support for the IASB from EY, buttressed by this kind of client cheerleading: "hedgers like", "valuable to many industries", "entities typically want to match", "many banks and financial institutions have long wanted", "entities … would benefit", etc.

Ask yourself whose views should carry more weight at the IASB (or FASB): the prestigious CFA Institute, which represents more than 100,000 investment professionals worldwide, and whose stated purpose is to advocate for investor protections; or EY – and its clients? Next, ask yourself whose views are actually weighted more by the IASB (or FASB)?

Case closed.

Whither Hedge Accounting – and Convergence?

The FASB has also issued its own discussion paper, Selected Issues about Hedge Accounting, but they are substantially different. While the FASB has proposed incremental liberalizations of their existing approach to hedge accounting, the IASB took a clean sheet of paper – and has drawn a picture of what accounting standards would look like if the U.S. would kindly step aside.

I want to be clear at the outset that if I had my way, there would be no such thing as hedge accounting, and I believe many investors share my preferences. If the probability is 1/x that reasoning life forms reside on another planet, the probability of their adopting more complex hedge accounting standards than ours is 1/x². Hedge accounting is already ridiculous enough; and with that introduction, I present but a taste of the Institute's many concerns with the IASB's further plumbing of the depths:

• Absence of investor primacy – The Institute believes that most investors would prefer broader application of fair value and increased rigor around the permissibility of hedge accounting, not the opposite which is being proposed. The IASB has done nothing to demonstrate how their proposal would benefit investors. If investor primacy no longer exists at the IASB, then it should say so. Moreover, increased use of fair value accounting, which the CFA Institute has consistently recommended, would reduce any "need" for hedging accounting, yet the IASB is proposing to expand hedge accounting, a dubious and anomalous concept. (My strong sense is that, consistent with my own views, the Institute would eschew hedge accounting altogether if it could get the Boards to agree.)

   

• Lack of conceptual basis – The foundation of the ED is a new concept of risk management strategy that is only vaguely specified, and has no foundation in either economics or the conceptual framework definitions of assets and liabilities. Moreover, the ED has been so broadly written and so removed from any conceptual framework that there seems to be no way it can be adequately policed for abuses. Investors would benefit more from the disclosures of the risks that are not hedged, than the (inadequate and vaguely-specified) disclosures of risks that are purportedly being managed.

   

• More ways to management earnings – Especially because of the failure of the financial statement presentation project, the notion of accounting treatments being driven by management intent has become discredited, so now we are being sold other amorphous concepts like "risk management strategy" which really means 'more choices for management.' Global accounting standards are being promoted under the premise that enhanced comparability will be the result. But, no one can seriously argue that the IASB's ED will move comparability anywhere but on a serious jag in the wrong direction.

   

• Hedge effectiveness threshold lowered – Like the FASB, the IASB is eliminating the requirement to assess hedge effectiveness quantitatively. But, the IASB's new criteria is much more amorphous: to minimize ineffectiveness, and to be "unbiased and other than accidental offsetting" – whatever that means. Relatedly, retrospective assessment of ineffectiveness would no longer be required.

   

• Increased use of "other comprehensive income" – OCI has yet to be defined for any other purpose, yet this "principles-based" hedge accounting proposal would run all hedging gains and losses through OCI.

   

• Held to maturity positions can be hedged – Although these will be re-named when IFRS 9 becomes effective, measurement based on amortized costs only makes sense if management is indifferent to changes in the fair value of their investments. Permitting hedge accounting of these investments means exactly the opposite – that management is not indifferent to price changes, which was what had been asserted to allow amortized cost accounting. What a farce!

   

• Derivatives can hedge other derivatives – Don't like the bet you made on a commodities future contract anymore – and don't want to recognize a loss when you sell it? Under the proposal, you can construct a hedged item out of your anticipated purchase of the commodity and your under-water forward contract (which had been designated as a hedge in order to put the gains and losses in OCI). All you would have to do is to find an offsetting derivative that better suits your new view of price movements, and now the gains and losses on both derivatives can be thrown into OCI.

   

• The ability to hedge a portion of an item – This is where the games start to get really interesting.  There is no restriction that requires that the identified hedge portion be unrelated to the unhedged portion.  So, management could identify a portion (such as the copper component of insulated wire) and describe the hedged portion as a perfect offset of the derivative. Even though the "risk management strategy" may be questionable, who is going to question it? And, there need never be any ineffectiveness to report in net income.

 

• The new concept of "net nil positions" – Which in effect says that when assets and liabilities (which may include derivatives) net to zero, both sides are hedged items – and voila all restrictions on what qualifies as a hedging instrument are swept away, because the asset and liability positions qualify as hedged items.   The fair value option and its restrictions (elected only at inception, irrevocable, gains and losses through net income) are circumvented.  Even better (or worse, depending on your point of view), it could be that all aspects of IFRS 9 classifications can be "managed" with the right financial engineering.

   

• Cash instruments to be used as hedging instruments — Currently under US GAAP, cash instruments (such as debt instruments) may be used to hedge the net investment in a foreign subsidiary whose functional currency is the local currency (an utterly stupid concept to begin with) or a firm commitment denominated in foreign currency. Under the proposal, cash instruments that are measured at fair value through net income could be designated in various kinds of hedging relationships. That means, of course, that the gains and losses on those cash instruments would flow through OCI instead of net income.

The Institute has many other gripes, and a lot of it has to do with process; i.e., timeframe, risks, etc. But, I think I have given you enough to convey the impression that the most prestigious association of investment professionals in the world is trying to tell you that the IASB's ED is a HORRIBLE HORRIBLE document. Yet, politics being what they are, there will doubtless be a lot of pressure put upon the FASB to come as close as they can to the IASB's madness as it re-deliberates its own more modest discussion paper.

Who Are These Guys Anyway?

In understanding where the notions in the IASB's ED come from, it is important to remember that circumstances essentially forced the IASC (IASB's predecessor) to swallow US-style hedging accounting with one big bite. Basically, the IASB was thrust from relative obscurity into international prominence when, in 1995, the International Organization of Securities Commissions (IOSCO) tasked the IASC with establishing a set of high-quality accounting standards, within five years, covering all of the core topics IOSCO specified.

Of these core topics, financial instruments proved to be the gnarliest; plus everyone knew that the final arbiter of high quality was to be the US, where FAS 133 was published in 1998. By then, time was running out on the IASC, and an international consensus on hedge accounting was nowhere at hand. In desperation, the IASC essentially made a carbon copy of U.S. financial instruments accounting and dubbed it IAS 39.

I can't say for sure why the IASB has so sharply tacked away from the FASB on hedge accounting at the eleventh hour of the current convergence project. But, it is clear that the Europeans hated IAS 39 from its inception during that eleventh hour of the IOSCO "core standards" project 12 years ago. With the hedge accounting ED, either the EU is trying to tell the US to take a hike, or they realize that the promise of a "stable platform" for accounting standards would effectively wed them to US-style hedge accounting rules forevermore — unless they make a bold move within the convergence timeframe.

In bringing the EY document to my attention, Bob Jensen wrote:

"There's an old saying when cable companies are bringing fiber to households: 'The last mile costs more than all the other miles.'"

To which I will add a sports adage: Crunch time is when you learn the most about your teammates.

Hedge accounting is crunch time for the SEC.

Speaking of IFRS

You may have noticed the advertisement on my website for the Core Concerns Conference in Chicago this June, sponsored by CFO.com. I will be attending all three days of the conference, and I would welcome the chance to meet and share ideas with any Accounting Onion readers in attendance.

You might also be interested in two other things about that conference. First, if you click on the ad on my website to register, you will receive a $300 discount off the standard registration fee.

Second, and apropos to this post, the conference will feature a panel discussion entitled "One Global Accounting Standard — IFRS in America." The panelists are:

• Paul Cherry, Chairman, Standards Advisory Council, IASB; Former Chairman, Canadian Accounting Standards Board
• Brian Fiedler, VP Finance, Canadian Tire
• Christian Leuz, University of Chicago's Booth School of Business
• William Hildebrand, Financial Accounting Standards Board (FASB) Practice Fellow
• Jack Klingler, Director of Accounting Research and IFRS Implementation, Alcoa, Inc.

You can count on me to use the opportunity to ask questions, and I hope to see you there!

__________

* This document was provided to me via email from a member of the CFA Institute. Since neither the IASB nor the Institute has posted it on the internet as of the time of this writing, I am taking the liberty of posting it to my own website. I just wanted you to know that this is where the link will take you.

India's IFRS Carve-Outs and the Pipedream of Global Accounting Standards

It seems that I was not the first to report that IFRS adoption in India could be on the rocks. Compliance Week editor Matt Kelly posted a link to their short blurb headlined "India Could Abandon Mandatory IFRS" from February 18^th. India's parliament was reportedly stalled on needed legislation, and that its Ministry of Company Affairs was considering delaying IFRS adoption, and even making it optional.

As to the sources of differences between IFRS and Indian accounting standards (Ind AS), Deloitte's website has an article that tabulates the many differences, large and small. And, another Deloitte article from last month states that IFRS adoption may never have been in the cards for India:

[T]he Ind AS are based on IFRSs, but include some changes which are noted in the appendix to each standard. Some of the modifications may prevent an entity following Ind AS from making an explicit and unreserved statement of compliance with IFRSs (Ind AS 1 … requires a statement of compliance with Ind AS, not IFRSs). [bolded italics added]

It appears from a quick review of all of this – the numerous differences, and the requirement to comply with Ind AS instead of IFRS – is that India is more focused on trying to converge their own standards where possible with IFRS rather than an outright adoption of IFRS. But, why India would want to do this, I don't know. Perhaps, the strategy is for issuers in India to continue to have the standards they desire, while doing everything they can to avoid being seen as an outlier by the rest of the world – at least on the big issues.

But, if that has been the strategy, India may have just come to the realization that it would fail.  From reading an interview with India's Chairman of its legally constituted National Advisory Committee on Accounting Standards, the mindset of India's accounting establishment reminds me more of the defunct reserve-oriented income statement smoothing approach once practiced and perfected by the Germans. The interview mentions four major carve-outs from IFRS; but one in particular, on foreign currency debt, best reflects the great divide that still exists after years of dickering back and forth with the IASB.

Ever since the mid-1970s, the U.S. has required that foreign currency-denominated debt instruments be measured at the balance sheet spot rate, with changes due to remeasurement recognized in income for the period. International standards eventually followed suit; but, Indian issuers, who obviously rely on foreign debt more heavily than their U.S. or European counterparts are unwilling to tolerate the income statement volatility. Hence, an IFRS carve-out permits the issuer to spread anyforeign exchange gain or loss over the life of the loan. The evident result: balance sheet, wrong; income statement, wrong; issuers, happy.

Also, it seems, that India would never be able to abide revenue recognition rules that would measure agricultural commodities at fair value -- too much income statement volatility. Nor are they willing to deprive their booming construction industry of percentage-of-completion accounting.

These are all clearly fundamental differences, but the most important thing to contemplate is not whether the Indian accounting establishment's views have merit. Think instead about the difference in financial reporting mindsets, which could not possibly be bridged by a single set of global accounting standards.

If IFRS adoption was ever a goal worth pursuing, it has long since vanished, and the political motivations of its remaining supporters are now deprived of any pretense of legitimacy. It's time to let the rest of the world "countdown to IFRS" if they want to, but If the SEC were really serious about protecting investors, it would scrap the IFRS roadmap.  In its place, there should be a new plan for making U.S. GAAP unquestionably the pre-eminent financial reporting system in the world.

Could the U.S. create the best financial reporting system in the world while at the same time caring about IFRS convergence? No way. Let's stop the charade.

Is Revenue Recognition the Death Knell for IFRS Adoption?

It is said that big surprises come in small packages. Last week's "small package" was a brief article in the AICPA's online edition of its Journal of Accountancy, reporting that its own Financial Reporting Executive Committee (formerly the Accounting Standards Executive Committee) submitted a comment letter to the FASB.  FinREC expressed "extensive concerns" with the revenue recognition exposure draft for converging FASB and IASB standards:

"We believe that based on the outcome of [what clearly must be extensive] re-deliberation by the boards, re-exposure of the proposed standard should be strongly considered to ensure sufficient and appropriate due process has been provided to those impacted by the exposure draft."

The "big surprise," however, is the last sentence of the article – which could well be the accounting understatement of the year:

"The suggestion that the proposal should be re-deliberated and re-exposed comes as FASB and the IASB are under pressure to complete the project [and numerous other major projects] by their self-imposed June 2011 deadline."

If I were an editor at JofA, this would have been the headline of that article:

IFRS ADOPTION PRONOUNCED DEAD BY FinREC!

How, with over 1,000 other comment letters having been submitted (mainly, I presume, from issuers trying to figure out how to be able to manage their earnings with impunity under a new standard) will the FASB be able to comprehensively re-deliberate, revise, re-expose, digest the next tidal wave of feedback, and then finalize? And, I didn't even mention the possibility of field testing.  The proposed rules (they are not principles, as the boards' propaganda would have us believe) are very broadly specified, with little more than a few simplistic examples to serve as implementation guidance.  This is a standard that is practically begging to be field tested.

Especially given the importance of revenue recognition, the next due process iteration would normally take at a minimum two to three more years; but the FASB and IASB have given no indication that they're giving up on getting something, anything, finalized so as not to miss their date with destiny. Give the AICPA credit at least for acknowledging the problem, albeit sotto voce, lest they be too blunt and give the SEC no option except for throwing in the towel on IFRS adoption – and losing face in the process.

The sorry state of the revenue recognition project, already eight years in the making, is also a prime opportunity to express my concerns with a statement in the staff's progress report: in evaluating the quality of the IFRS that the U.S. would adopt, the staff will consider without further evaluation converged standards to be good enough for U.S. consumption. [page 5] I'll be providing my own analysis of the revenue recognition exposure draft in my next post, but if the SEC would simply read FinREC's comment letter, they would see that what is going on here severely challenges the staff's presumption that convergence per se means high quality accounting standards. If a converged revenue recognition standard of the same scope as the exposure draft somehow is finalized in the next six months, we will have a convergence, but we could also have a standard akin to the collision of two garbage trucks at high speed. And that doesn't even take into consideration the accidents waiting to happen with the leasing and financial instruments projects.

The only way for the SEC to save face at this point is to do the right thing, right now; which is to stop this Keystone Cops approach to accounting standard setting before investors get hurt.

Even the AICPA, the captain of the IFRS adoption cheerleading squad, appears to be on the verge of openly admitting that IFRS adoption possibilities may have receded from "inevitable" to dead duck.

 

A Loan Accounting Problem to Make "Amortized Cost" Proponents Squirm

Some folks can see fine art in a soup can label, or poetry in a user's manual. I don't mean to brag when I state that I have a similar talent.  I seem to have a knack for stumbling upon interesting accounting issues.

Most recently, I tripped over a New York Times article entitled, "Investors Put Money on Lawsuits to Get Payouts," which describes a new and rapidly growing financing trend: lending to plaintiffs to fund the costs of their lawsuits. Interest rates are astronomical, which explains why everybody seems to be getting into the act, from boutique venture capital firms to behemoths like Citigroup and Deutsche Bank. I wouldn't be surprised if bankers see this innovation in lending like a new drug for repeating the intoxicating highs they got from subprime mortgages.

The article doesn't mention this, but it's important to my analysis.  I have learned through experience as an expert witness that neither lawyers nor their clients may convey a contingent interest in the outcome of a lawsuit to anyone except another lawyer. Thus, as the article states, "Law firms are generally obligated to repay loans even if they lose. In reality, however, firms that make less than expected often struggle to make the required payments, and a number of firms … have filed for bankruptcy protection."

 The Accounting Issues

I'm not going to comment on the social issues of placing bets on lawsuits. Those are the focus of the article itself, and you can find a whole bunch of eloquent readers' comments on all sides of the issues here.  You can read an interesting article written from a legal perspective here.

For accounting purposes, these arrangements fall squarely under the definition of "loan" to be found in the FASB's Accounting Standards Codification: "A contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor's statement of financial position." The lender accounting issues can be illustrated by a simple example, inspired by one of the cases cited in the NYT article:

• One year ago, a small law firm recruited four hundred residents of one-factory town in Texas to be the plaintiffs for a series of planned lawsuits against the factory owner. A majority of the plaintiffs are being treated for skin cancer, and others for stomach cancer. Scientific research has established a strong link between a chemical used in the manufacturing process (creosote) and skin cancer; the links to stomach cancer are not as strong. All of the lawsuits allege that the cancers are the result of unsafe working conditions. The law firm's litigation strategy is to bring the cases with the lowest probability of success first.
• To date, the law firm has drawn $3 million from its line of credit provided by single investor at a rate of 20% per annum. Interest is payable annually, the principal amount is due in ten years and early retirement of principal is permitted at no additional cost.
• The average amount of the loan outstanding at the end of the first year was $1 million, and the law firm made its first interest payment, $200,000.
• Court filings and other documents made available to the lender indicate that the prospects for awards in the cases have improved since the inception of the line of credit.

Let's consider three accounting alternatives for the lender: (1) current GAAP or IFRS, both of which entail an 'incurred loss' model for measuring loan impairment; (2) proposed IFRS, which is an 'expected loss' model; and (3) proposed GAAP, which would require measurement of outstanding loans at fair value.

Even before we get into loan impairment issues, the first accounting question is the treatment of the $200,000 'interest payment.' As sure as the sun will come up tomorrow, that small law firm must have round-tripped a portion of its drawdown on their line of credit to pay the 'interest,' for it would have had no other source of funds. Yet, current GAAP/IFRS would blithely recognize $200,000 of interest revenue; and it would make no adjustment to the loan balance, since there are no indicators of an incurred loss. If a lender needs short-term earnings -- or a swift kick in the pants to its interest rate spread, litigation lending would be a sure fire way to get it done.  And, as crazy as this accounting is, I wouldn't count on any audit firm or issuer to ask the EITF to fix the problem anytime soon.

Obviously, the 'interest revenue' is pure fiction, but explaining why in logical terms could be a challenge. So, here's my attempt at an explanation that will also prove useful as we march forward through the example. The $200,000 is inappropriately based on the "yield to maturity" of 20%, which is in turn based on the contractual payments. In contrast, the economic return (i.e., internal rate of return) is based on the expected payments. One of the reasons why the NYT article inspired me to write this post is that the capital asset pricing model (CAPM) can be used to estimate the economic rate of return of litigation loans pretty well without any complex calculations: since the future returns from the loan are essentially uncorrelated to returns on the "market portfolio," the "beta" of this investment is zero. Therefore, in order to derive the economic value of the loan at any point in time, the capital asset pricing model would suggest that the expected cash flows on the loan should be discounted at the risk-free rate (say, 4%). (Stated another way, the risks of putting money down on a lawsuit are more like the risks of a casino bet with a positive expected value -- yes, these do exist, but that's another story -- than a corporate investment, because it is fully diversifiable.)

Proposed IFRS would also recognize $200,000 in interest revenue, but then it would give the loan a haircut for the lender's estimate of "expected losses" – despite the known fact that prospects for loan repayment in full had improved during the year. As I have explained in an earlier post, this approach makes no attempt to portray a sensible carrying amount for the loan itself.  Moreover, its ancestors are the secretive income smoothing techniques devised by German bankers that were financially slobberknockered by hyperinflation post WW I. Ich wünsche Ihnen viel Glück, if you are an investor trying to figure out how much the shares of the lender are actually worth from the IFRS financial statements. Good luck, as well, to the auditor risking money and reputation on a lender's biased and unverifiable estimates of the economic effects of unspecified uncertainties.

Proposed GAAP, which has been emphatically rejected by the EU, and consequently the IASB, would require fair value measurement of the loan. There are obvious accuracy issues to be concerned with, but "it is better to be vaguely right than precisely wrong."

At this point, I hope it is already apparent that the only relevant measure of value and earnings under this utterly simple scenario is fair value. And, we haven't even touched on impairment yet. To do that, let's fast forward one more year:

• The law firm makes the second interest payment on schedule (and from the same source of funds); but two of the weakest cases (involving stomach cancer) went to trial with no damages being awarded to the plaintiffs.

The accounting under current GAAP/IFRS for the second year could be even more ludicrous. First, there is the highly subjective issue of whether or not to recognize an impairment. If yes, then take the lender's latest estimates of expected cash flows and discount them at the original meaningless "yield to maturity" of 20%. More than precisely wrong, it's egregiously wrong – yet, the American Banker's Association has stated that this is the method of loan accounting they like the best. Proposed IFRS is no better. Trust me.

 
Defenders of amortized cost approaches to loan accounting will say that these litigation loans are not relevant, because they are risky equity investments masquerading as loans. But, if that's true, then junk bonds are also equity. If you can find it within yourself to agree with anything I have written in this post, I want it to be that it is futile for accounting standards to attempt to distinguish between loans and other financial instruments – except for basic ownership interests like common shares or partnership interests in a law firm. The history of financial reporting appears to have persuaded the FASB, but not the IASB, that rules for creating categories of financial instruments beyond this basic dichotomy are utterly ineffective.  Yet, the political farces (pun intended) behind convergence are pushing the FASB away from their principles.  That's not convergence, it's dysfunction.

It didn't take me long after reading the NYT article to realize that litigation lending could be the best example for exposing the absurdity of any amortized cost approach to loan accounting. And, it's not as extreme a scenario as it might initially appear. Too many greed-is-good-style managers have demonstrated an ability and willingness to test the limits of an accounting rule, and there is no one to stop them from saying, "show me the rule that says I can't do this."  Therein lie the seeds of the next multi-trillion financial 'service.' 

And, finally, we shouldn't fall for the story that IFRS's incurred loss model is an incremental improvement over the current expected loss model of amortized cost accounting. It will do nothing to change loan accounting from rules to principles; and it will give lenders greater discretion to massage their numbers.

SEC Staff Report on IFRS Roadmap: The Public Deserves to Know More

Last February the SEC announced, that their IFRS Roadmap had morphed into a "staff work plan." The staff was supposed to publish its first progress report sometime in October, and wouldn't you know, it was posted to the SEC's website on the last workday of the month.

It's appalling how little the SEC staff has accomplished over the ensuing eight months. If I were the SEC's 'thesis adviser', I would be torn between two painful conclusions: this progress report was a rush job from a student with an attitude problem; and/or, she is just not capable of getting the job done.

As for the SEC, I'm betting on the rush job scenario. That fits with the gestalt of recent IFRS developments:

• The February announcement from the SEC, with barely a tip of the hat to the overwhelmingly negative feedback from virtually everyone except the Big Four and a few mega corporations.
• The putative resignation of FASB Chair Bob Herz, and the opportunity FAF created for itself to stack the FASB to its liking;
• The rush to judgment on 19 major projects by the FASB, and now the sudden deferral of four of them without any serious thought given as to the implications;
• The progress report itself, which contains very little information regarding actual progress on the key factors that the SEC should be considering.

Is This the Level of Disclosure the SEC would Accept from an Issuer?

Let's start with a critical question the staff is not asking: Why are we working on convergence with IFRS in the middle of the worst economy we will likely ever see? The scuttlebutt I heard while attending a financial reporting conference this week is that Canadians were not happy about the conversion costs they were forced to incur for little perceived benefit. First-time costs ran as high as $1,000,000 for even small companies. That's money that could have been better spent on marketing instead of accounting, don't ya think?

In the U.S., we also need to ask, and the SEC is not, whether contemplation of a fundamental change in financial reporting policies is the best use of scarce resources at the SEC, FASB, and especially by private enterprise. Even after the deferral of four projects, the FASB is asking preparers to provide their comments to the FASB on 15 major convergence proposals, which they aim to finalize by June 15, 2011 just to keep IFRS convergence on track. Separate and apart from the questionable assumption that high quality standards can come from accelerating projects that historically have taken 5 to 15 years to resolve, is this the best use of executive resources in these trying times? Absolutely not: too many companies need that money for R&D or marketing.

As to the questions that are being asked, there are about a zillion of them with vague indications as to how they will be addressed between now and June 2011. Here is a typical example:

"The Staff intends to explore the extent to which the IASB promotes the pre-eminence of investor views. For example, the Staff will review the IASB's practices, as compared to the requirements detailed in the Constitution, Handbook, and other relevant IFRS Foundation and IASB documents and constituent expectations, to assess the IASB's focus on the pre-eminence of investor views." [italics supplied]

Why, after eight months, has none of this work been done yet? Why does the SEC presume that mere examples of their plans and the factors they are considering constitute a sufficient description of its processes?

The public deserves reasonably complete descriptions of everything of which the staff is aware that is reasonably likely to affect future SEC policies on IFRS. To borrow a phrase from the SEC's own interpretive guidance to issuers (on MD&A), these progress reports are an opportunity for the public to see the IFRS project "through the eyes" of the SEC staff. But, instead of concise tables and bulleted lists – the stuff the SEC wants to see from issuers – we have only general narratives of peripheral issues, which skirt the two key issues: whether IFRS can be better than GAAP by June 2011; and whether the IASB is the most appropriate standard setter for serving the interests of U.S. investors.

As regards to the quality of IFRS, the staff reasonably sees a two-pronged approach to this question: (1) whether the current convergence projects will pass muster; and (2) whether the other differences between IFRS and GAAP are suitable for use by U.S. public companies. But, even though the staff acknowledges that IFRS quality is the most relevant consideration for any future determination as to the status of IFRS by the SEC, there is not a single indication as to where their answer might lie. Here's a quick list of items that are indisputably major, and that the staff must have been thinking about for years and years already:

• Impairment and recovery of PP&E, goodwill and inventory; for each of these, IFRS is substantially differ;
• Restructuring charge accruals;
• IFRS option to not recognize minority interest portion of goodwill in acquisitions;
• Differences in consolidation rules – both voting- and variable interest entities;
• Presentation of actuarial gains and losses on pension plans in other comprehensive income;
• Differences in accounting for graded vesting plans;
• Differences in definitions of "hedging" and "derivative";
• Capitalization of development costs in IFRS;
• No uncertain tax position disclosure in IFRS;
• Differences in accounting for loyalty programs;
• Provisions for obligations that are not legally required;
• Fair value option for classes of PP&E;

For each of these differences between GAAP and IFRS, not to mention all of the additional interpretive guidance in GAAP that is absent in IFRS, the public is entitled to know how the SEC staff sees their future disposition – or how their disposition will be determined. I don't think that is too much too expect after eight months – and years of thinking before that.

Notwithstanding my strong views against the SEC's policies towards IFRS adoption – or convergence, or even acceptance from foreign issuers without reconciliation – I tried my best to find a silver lining in the February announcement that the SEC, despite all the negative feedback, has continued to be committed to working hand-in-hand with the IASB. At least, I wrote, a statement with "convergence" as opposed to "adoption" in its title gave me hope that the SEC was no longer fixated on replacing the FASB with the IASB as the principal standards setter. I also wrote that I felt the SEC did a pretty thorough job of laying out the issues that will determine whether IFRS adoption is even feasible or can be accomplished at a reasonable and predictable cost.

Now, however, the poor quality of the staff's first report has me wondering, and worrying that thoroughness, rigor and reason will not be the determinants of the SEC's future policies on IFRS.