The Accounting Onion

And Our IFRS Survey Says…

This is the first of a series to discuss the results of our IFRS opinion survey. The idea for a survey originated with yours truly, and I was moved to do so (more like propellled with outrage) by the ersatz pro-IFRS "research" coming out of the Big Four and the AICPA propaganda machines. I also decided to seek a collaborator from the ranks of academia through the AECM listserv, and I consider myself very fortunate that Pat Walters, herself an IFRS proponent, volunteered to work with me. Pat's association with this effort should lend, at the absolute minimum, a semblance of balance; which is, ironically, completely absent from published views of the Big Four and their shills.

But, thankfully, I can report that not all CPAs have behaved like pigs at the trough. We owe a huge debt of gratitude to Gaylen Hansen, who has provided us with a clear-eyed compilation of the response letters to the SEC's Roadmap proposal; and to Grant Thornton for their survey, which was published as we were conducting ours. GT asked a question of import ("Ideally, who should set U.S. accounting standards?") properly, and received proper responses from CFOs and senior comptrollers in return. GT reports that only 18% of more than 800 respondents from public companies are of the opinion that the IASB should be setting accounting standards for U.S. companies.

Full Disclosure and Caveats

We received a total of 289 responses. We can't beat GT on sheer number of responses, but we did ask a broader set of questions regarding the perceived relationships between IFRS and GAAP: (1) quality differences; (2) costs and benefits of IFRS adoption; and (3) how the SEC should act on its Roadmap proposal. You can view all of our response data in a spreadsheet format here, and the text of the online questionnaire here. Twenty-seven responses came from non-U.S. residents and 13 from students. Our analysis excludes these two groups, and the tabulation at the end of this post breaks down the respondents we analyzed by all of their occupations.

Before we proceed to the major takeaways from our survey, two further caveats are in order.

First, we sure were hoping to generate a larger number of responses. GT excepted though, our level of participation is well within the range of other "studies" conducted by the IFRS proponents, including the number of comment letters received by the SEC in response to the Cox-instigated Roadmap Proposal. We left our survey open for three weeks; the SEC's comment period extended for months.  

Second, one should always take with a grain of salt unsolicited responses, as opposed to a random sample. But, no study that we are aware of has employed a more open self-selection process than ours. For example, I was solicited for Deloitte's survey apparently because I subscribed to one of their IFRS information services; if that was Deloitte's only method for soliciting responses, the self-selection bias therefrom is self-evident.

The Major Takeaways from Our Survey

As with GT, we asked for opinions regarding IFRS adoption; and our results were very similar to theirs:

My initial interpretation was that 71% of respondents do not agree with the proposition that IFRS should replace U.S. GAAP. Pat pointed out that this may be somewhat of an overstatement—since we don't know why 16% of respondents "neither agree nor disagree." Those respondents, according to Pat, could very well be indifferent to the prospect of IFRS adoption. My own take on that is: if one took the trouble to take the survey and to answer the question, then indifference would not be the most likely sentiment being expressed. Nevertheless, Pat and I agree to this interpretation:  respondents who disagreed with the proposition outnumbered those who agreed by a margin of about 5:3. Anyway you look at it, especially in light of GT's results, it should give the SEC pause before proposing to supplant the FASB with the IASB.  That's as mildly as I can put it.

When I took a closer look at the answers to this question, I was not surprised to see that the frequency distribution of responses from Fortune 500 companies and the Big Four appeared to be negatively correlated with all of the other occupations. To evaluate their impact on the full results, I decided to disaggregate each question by three subgroups: (1) Fortune 500 + Big 4; (2) academics; and (3) everyone else. The chart below repeats the results from above and adds these subgroups:

 

See that tall blue bar on the left? That's Big 4 and Fortune 500 money talking. Notice also that academics (the ascetic purists J), are the least inclined to adopt IFRS (as indicated by the short green bar on the left).

Given these results, it should come as no surprise that a significant majority of respondents do not believe that the benefits to investors of IFRS adoption would exceed the costs of conversion:

77% of all US respondents do not believe that benefits to investors will exceed the cost of conversion. Indeed, although a majority of the Fortune 500 accountants and Big Four auditors believe that the SEC should adopt IFRS, only 44% believe that the benefits to investors would exceed the cost of adoption. Figure that one out.

The bottom-line question we asked pertain to how the US should approach adoption of, or convergence, to IFRS:

These results are, admittedly, somewhat difficult to interpret with precision, but they clearly indicate that few respondents would like to see IFRS adopted before 2014. Moreover, 54% of respondents (including the Fortune 500 and Big 4) would either prefer not to adopt IFRS, or to adopt it starting with 2020 at the earliest. Although an in-depth analysis of the "other" category of responses was not undertaken, my brief analysis strongly indicates that a comfortable majority of the "other" responses more closely resemble those who stated a specific preference to either delay in IFRS adoption beyond 2020, or to abandon IFRS altogether.  If you don't believe me, you can look at the data for yourself.

And, as one might expect, the Fortune 500 accountants and Big Four auditors were strongly in favor of relatively fast-paced IFRS adoption, although it must be said that less than 10% favored adoption by 2012-2013. But, take those folks out, and you have even less interest among respondents for adopting IFRS anytime soon … or ever.

Act II

Thus far, I have discussed the results of only three of the ten questions that we asked about IFRS vs. U.S. GAAP. I promise you, more drama is to come. Also, Pat has agreed to write a guest post with the working title, "How the Survey Result Informs an IFRS Proponent." I'm sincerely looking forward to that.

Announcing Our IFRS Survey!

This is a brief announcement of an online IFRS survey that I have prepared with Pat Walters of Fordham University. 

I invited Pat to collaborate with me because we have divergent views on the questions being asked.  Thus, I hope that together we have achieved a modicum of balance in the survey's design--particularly in the phrasing of the questions and response choices offered.  There are only 12 multiple-choice questions, and afterwards, I cordially invtie you to express your own opinions regarding its design by posting a comment to this blog post. 

We are also trying to reach many more stakeholders than any other survey has reached to-date on the IFRS adoption/convergence question.  To that end, we hope you will choose to email the link at the bottom of this post to anyone else whom you think might have an interest in taking it.

Pat and I thank you in advance for clicking here to take the survey, or by pasting this ugly link in your web browser:

http://www.surveymonkey.com/s.aspx?sm=pF0E3UgdSV_2bHMQvdAnXv8w_3d_3d

IFRS Adoption Critics: More Silent Majority than Vocal Minority

Given my public record of opposition to IFRS adoption, you might be surprised to know that I have taught courses on IFRS for over ten years, beginning in Switzerland and the UK. If anybody is interested, I will be presenting a two-day IFRS/GAAP comparison courses in Chicago and Vegas this November; and I gladly collaborate on the delivery of those courses with representatives of two Big Four firms.

I try to stay away from blatant self-promotion in the body of a blog post, but I wanted to make the point that I am not an IFRS newbie, and have thought about the problems of which I blog for years. I also strongly believe that certain aspects of IFRS are much stronger than U.S. GAAP.

The larger point, however, is that I actually do have a significant stake in IFRS adoption; yet, for reasons only a psychiatrist might be capable of explaining, I persist in my financially self-destructive rants.

Imagine you're my shrink. As I lie on your couch, I tell you that my attitudes toward IFRS adoption are rooted in my childhood. (Surprise!) Both my parents fled from Nazi Germany, but my Dad was involuntarily detoured in a Nuremberg prison and Dachau concentration camp before managing to finally extricate himself from miscreants' clutches.

After immigrating via the UK to the USA, Dad soon thereafter entered the military (he was drafted after first volunteering and being turned away). He was returned to Germany on D-Day +30 as a POW interrogator. It's a long and unique story, which late in life he wrote about in a book that I posted on line.

Obviously (I try not to use that word very much), my dad's perspectives on life were shaped by these experiences. As to their effect on me, his bitterness rarely came to the surface, except indirectly when he was motivated to speak out against some proximate injustice. Dad was non-violent in actions and manner, but his words were sharp and he didn't give a hoot what others thought of his pithiness and directness. He was only self-conscious about his thick German accent (think Henry Kissinger). Also, I'm sure that his "attitude" and accent did not help his career aspirations at AT&T. Anyway, I think that is the font of my self-destructive outspokenness.

I bring this up now, as I am about to present you with a quote from a kindred spirit, and former Big Four auditor, who shall remain nameless; his nom de email is SuperHeater, and I have no idea what that is supposed to mean, but I have a pretty good idea that his brief turn as a Big Four auditor shaped his perspectives. Here's an excerpt from one of his war stories:

"I knew I needed to leave [the Big Four firm I was working for] after about three months. I had questioned a client (politely) about how they arrived at a $90,000 bad debt reserve on an A/R balance of $10,000,000 for unsecured receivables where the aging detail showed items 500 days old. I was told by the assistant controller that the 'CFO knows our customers, and knows what invoices they'll pay.'

The in-charge senior associate told me, 'I don't care if it's adequate, I care that it's there'- so much for adequate audit evidence and professional skepticism.

The following day I was summoned to meet with the partner on the job (who happened to be the HR partner) in order to be told 'the client had a complaint,' but offered no details. As the client was a trucking company that financed their equipment and was surely trying not to violate the current asset requirement of their debt instruments I suppose that's not hard to figure out. I'd like to say that was my only eye-opening experience, but it wasn't. There were screaming 'seniors' and days when testing exceptions were explained away with 'this appears to be a one-off transaction, P/f/p' rather than expanding the test sample as indicated by the audit plan."

I don't receive many substantive comments on my posts, (roughly two per post), but they are about 95 percent supportive. (BTW, those who have chosen to express their disagreement with my points of view are invariably respectful.) Thus, I want to at least surmise that SuperHeater's sentiments (with certain colorful features omitted) are generally in the same direction as those of a large proportion of my readers. In addition, the comments about how the market for auditing staff will shift after IFRS adoption is a fresh perspective for me.

"Having spent an unpleasant year at KPMG as an older, nontraditional hire and observed their methods and now currently employed at an enterprise where Deloitte is an IT contractor, I remain convinced that the only people who think IFRS adoption (either wholesale, convergence or some other method) is desirable are the Big 4, major transnational corporations and the SEC.

Additionally, the cheerleaders' affection for IFRS has absolutely nothing to do with any intrinsic superior quality, simplicity, brevity or any other (supposed but immeasurable) attribute of IFRS; it's about the ease and profitability of the cheerleaders' enterprises. The transnationals have a similar perspective; the SEC is a study in "regulatory capture", with its bureaucrats giving speeches and missing the likes of Enron, Worldcom, Adelphia & Madoff.

However, the leader of the pack is the Big Four. Like most modern propagandists, they furiously release marketing information disguised as objective technical analysis. I personally think the IFRS' "ordained clergy" are easily identified by the use of the word "robust." We are supposed defer to the presumed expertise of Big 4 partners and senior managers about the arcana of accountancy-especially when they use nebulous language and speak with the authority of historicity with constant references to IFRS as "inevitable."

For years the Big 4 have envied their clients who outsource their production to places like India, China, and other lands, where there's plenty of high intellects looking for opportunity. As the birthrate has fallen in America, it has been harder to represent the typical associate's position as something more glamorous than the fraternity hazing it resembles. The Big 4 have copied the outsourcing on their IT side, where there's no credentialing impediments; but on the attest side – well, that's different. Sure, you can staff an office full of staff and senior associates from other countries; language barriers don't matter that much when you don't speak to the client that much. Also, we know they'll work like the dickens because they're working for permanent US residency and having family half a world away creates less desire for time off.

However, when you get to be a manager, you need to have that CPA-and the exam is hard. Harder still, when you don't speak English, let alone when you have to learn a new book of rules. Do away with GAAP, you do away with the need to comb among potential US born associates with their tender egos, high debt loads and social and esteem needs. Once we're on IFRS, the Big Four becomes a truly global enterprise; picking off bright minds from lands of less opportunity-obtaining a deep inventory of intellectual capital at distress sale prices. Perhaps at the Big Four, the "A" in CPA stands for arbitrageur. I suppose it's a losing battle, because in the end, some very deep and mercenary pockets are driving this surrender of US commercial sovereignty. Now we know why Mr. Niemeier was passed over for the CA job."

The supporters of IFRS adoption have long-dismissed detractors like myself, Charles Niemeier and SuperHeater as comprising nothing more than a "vocal minority." The tepid-to-hostile feedback on the Roadmap should have put that libel to bed, but the recent remarks of chief accountant Kroeker and SEC chair Schapiro indicate that they are willing and able to follow Christopher Cox's oft-repeated example of plowing straight through reasoning critics behind nothing more than a blast of hot air.

I'll soon be posting a link to an online survey of attitudes towards IFRS adoption. Whatever the truth is, I want it to be more clearly evident.

First Missive from the New Chief Accountant: Get Ready to Roll with IFRS

It came as no surprise that SEC Chief Accountant James Kroeker's first public foray, since Mary Schapiro deigned to remove "Acting" from his title, was to announce that the IFRS Roadmap has once again become a priority at the SEC. That should please his former employer, Deloitte, one of the Big Four IFRS Cheerleaders. To give you some indication of the goal-oriented culture from whence Kroeker came, here's a couple of examples from recent "surveys" Deloitte has been peddling.

In 2008, Deloitte asked financial professional what they thought were the benefits and costs of IFRS adoption. That sounds reasonable, but the next logical question appears to have been intentionally left off: which was whether respondents perceived that the benefits of IFRS adoption might not exceed the costs.

And, here's a sample question from a survey I received in my email this month:

In your view, what should the IASB's and FASB's approach be to convergence?

• Extend a comprehensive convergence plan over the next 5-10 years
• Achieve as much convergence as possible between now and 2011, and then focus on IFRS conversion at that point
• Wind down convergence efforts at this time, and support IFRS conversion
• Not sure

"Not sure"? What if you're "sure" or just pretty "sure"; but your answer is not one of the three that Deloitte is willing to tabulate? What if, heaven forefend, you are really "sure" that further convergence efforts would be a waste of time and money?

Answer to my questions: Should you dare opine that IFRS adoption is of no benefit, Deloitte doesn't want to have to acknowledge that gazillions of other like you perchance exist amongst the public, whose interests Deloitte has an ethical obligation to serve. These were not surveys; they were charades. They were put together to serve special interests – at the expense of the investors that Mr. Kroeker now is supposed to be working to protect.

Thus far, the text of Kroeker's remarks have yet to appear, as is customarily the case, on the SEC's website. Consequently, my comments will be based on press coverage from the following sources: CFO.com, Reuters and WebCPA.

Be Very Afraid … of a "Race to the Bottom"

Some people took IFRS adoption for dead, but Kroeker came to say that it has returned to becoming a priority at the SEC, in part because the financial crisis may have underscored its importance. It appears, for example, that without a single authority over standards, the U.S. and Europe may get caught up in a "race to the bottom" to set accounting standards most favorable to banks and to the detriment of investors.

While it is true that the EU has made its fears that lower-quality accounting standards in the U.S. will cause its banks competitive harm, more recent events don't comport with a race-to-the-bottom scenario. The FASB (as I have written here) is proposing that all loans should be fair valued. The FASB is clearing saying to the IASB, 'You can take the low road if you want, but we'll take the high road.' (By the way, there's no way that the IASB will follow the FASB's lead on this. If Sir David Tweedy so much as dreamed of requiring fair value for loans, he'd call up Charlie McCreevy the very next morning to apologize.)

Nonetheless, I do concede that, in the absence of SEC intervention, a race to the bottom is at least theoretically possible. But, for at least two pretty obvious reasons, that possibility is remote, if not downright silly to contemplate.

First, as a general matter, it is not clear that competition among jurisdictions inevitably results in a race to the bottom. As one of many possible counterexamples, consider the development of the state laws governing corporations. The Delaware laws are regarded by many to be least restrictive; however, many corporations choose to register elsewhere. There are two lessons from this that I can think of: (1) there is not necessarily one set of rules to suit all tastes; and (2) the stability and longevity of our system of corporate laws indicates that multiple law givers are preferable to giving the federal government a monopoly on that role. Thus, notwithstanding the 99 other reasons (okay, 10) I can think of, it is far from clear that granting a worldwide monopoly to the IASB is the most efficient thing to do.

Second, and this is the biggie, whatever Kroeker might fear about incentives of standard setters to debase their own coinage, his job, whether he likes it or not, is fundamentally to prevent a race to the bottom from even getting past the starting line. Various securities laws clearly state the authority of the SEC to set accounting standards for public companies. It must be said, however, that the SEC has published its policy that, for the most part, has left standard setting to the FASB. (For the rule wonks amongst you, that would be Section 101 of the codified Financial Reporting Releases.) Kroeker weakly assures us that the SEC will always be active in interpreting accounting standards adopted by SEC registrants, but the SEC historically has done much more than that – by judiciously picking its moments to pre-empt or outright reject FASB pronouncements.

Given Kroeker's own stated preference for uniformity in bank accounting and his own view of its significance in the global financial order, no opportunity could be more ripe than for the SEC to take the initiative on loan accounting. All Kroeker need simply do is to endorse the FASB's proposal to measure all loans at fair value, and counsel the IASB that they should get with the program. That oughta eliminate any fears of an accounting standards race-to-the-bottom.

But, alas, world peace is a more likely scenario; fair value for loans doesn't fly in the EU, so it surely cannot fly with Kroeker's former colleagues at Deloitte. Who wouldn't prefer to know what Kroeker's thinks about loan accounting than the Roadmap? But it's a steady diet of Roadmap that we will surely be force fed in the months to come.

Saying So Doesn't Make it So

As was sadly the case when Christopher Cox was SEC chair, I found nothing in Kroeker's remarks to indicate that he cares much about citing evidence in support of his ideology. Take these accounts:

• Reuters – "Kroeker … said … that in the more than 200 comment letters the SEC has received on the proposal, it was 'resoundingly clear' that people agree there should be a single set of global high-quality accounting standards…"
  
• WebCPA – A single set of global accounting standards is "…like motherhood and apple pie."

Given, as I reported here, that the overwhelming majority of investor responses to the Roadmap proposal want to tear it up, I don't know where he comes up with this stuff. And, don't forget about Deloitte's paranoia about even broaching the question in its "surveys." (By the way, Wayne Carnall, former PwC partner, and chief accountant of the Division of Corporation Finance had characterized the response rate as a pittance, and now Kroeker is spinning 180 degrees away from that.)

Ironically, Kroeker delivered his remarks before a meeting convened by the New York State Society of CPAs. It was there that another candidate for chief accountant, Charles Niemeier, trashed the whole notion of IFRS adoption for what it was: a full-employment act for the current chief accountants' former colleagues.

Not only were Kroeker's and Niemeier's positions as different as black and white, but the quality of their inputs and reasoning couldn't be more starkly contrasted. Niemeier's inspiration clearly sprang from a foundation of cited broad-based analyses produced by published rigorous, peer-reviewed, independent research. The source of Kroeker's remarks apparently came from nothing more than his own wishful thinking.

Emergency Post: Chief Accountant Candidates Could be Down to Just Two

My practice has been to post about once per week, and I had completed my latest less than a day ago. I'm coming back at you so quickly, because Bloomberg News has just come out with this:

"Securities and Exchange Commission Chairman Mary Schapiro settled on two finalists to be chief accountant, acting director James Kroeker and Baltimore money manager Jack Ciesielski, people familiar with the matter said.

Kroeker, a former Deloitte & Touche LLP partner and acting chief since January, and Ciesielski, who has defended mark-to- market accounting, met with commissioners this month to discuss their interest in the job, said the people who declined to be identified before an announcement …" Continued in article.

With the passage of time, it seems increasingly less likely that the next Chief Accountant will come from the Big Four; it would break a string of the last six in a row (more or less, I think). Especially given the records of the most recent guys in charge, I think that most would agree that it's time for a change in emphasis.   

Appointing Jack Ciesielski, a wise and straight-shooting investor advocate, would send a strong signal from the SEC that the voices of special interests would be muted henceforth. But, if Kroeker is promoted to be the permanent big cheese as an appeasement to the Big Four, it will look to much like Chair Schapiro lacked the gumption to face down a special-interest juggernaut. After all, Kroeker's only bona fides as an investor advocate are his leadership of a recent fair value study that chafed the chops of the banking industry big time. Other than that, the public pretty much knows only of his Big Four acculturation (and the inevitable accompanying baggage), and that he was appointed to deputy chief by the best imitation of a paperweight ever to hold the title of chief accountant.

Bonus Coverage

This morning, I merely smiled to myself at the audacity of two missives (missiles?) from PwC that came across from two very different sources. Now, after the sobering news from Bloomberg, not so much. These guys are nothing, if not tenacious.

First, there was a letter to academics directing them in no uncertain terms to include appropriate IFRS-related materials in the courses—else, their students would be deemed insufficiently programmed to serve as audit highly paid drones according to PwC's new hiring hiring criteria:

"PwC believes it is important for our new hires to have sufficient knowledge and skills about IFRS to transition easily into our practice. Therefore, we will include IFRS in the basis for making decisions about an applicant's level of technical and professional skills and knowledge. Starting in Fall 2009, we will expect that applicants will have used our learning opportunities or other means…"  [italics supplied]

Bob Jensen, a retired academic and former American Accounting Association Educator of the Year called the letter in remarks on the AECM listserv an "insult to the academy of accounting educators." ... " and "I've always admired PwC.  But I can only hope that they lose some terrific accounting graduates because of this Orwellian Big Bully strategy." 

Ditto from me, and sad to say some faculty seem all too willingly to line up and salute the flag.  About a year ago, I asked a first-year assistant professor at a smaller university, that was extremely proud of its record of placing students with the Big Four, why they were looking to add an entire course on IFRS to their curriculum.  Her answer was simple, yet devoid of any trace of irony or regret: "It's our job to give the Big Four what it wants."

Second, revisionist history continues in PwC's latest IFRS First newsletter: 

"Due to a new administration, ongoing economic issues, and responses to the proposed roadmap, there is some uncertainty around the final timetable for adoption of IFRS in the US. However, the responses to the Proposed Roadmap indicate that there still is strong support for a single set of global accounting standards. [LOL] We remain confident that:

The SEC is interested in moving forward with IFRS
The SEC will continue to approach the change with a thoughtful, measured process
The SEC will ultimately propose a revised roadmap
Adoption of IFRS in the US is inevitable " [italics supplied]

Has anybody else noticed that the mantra of "single set of high-quality global accounting standards" has been truncated to exclude that pesky 'high-quality' part?  The marching orders to all who have been captured by the Big Four's largesse is becoming more and more pointed:  'Forget quality. Forget convergence. Get with the IFRS program … or no more soup for you!'

If Mary Schapiro doesn't take a strong stand for investors on the chief accountant appointment, then  "inevitable" will become sooner than you can say PricewaterhouseCoopers.'

Which SEC Roadmap Comments Matter, and What They are Saying

A couple of commenters on the last post found fault with my assertion that the "low" response from issuers on the SEC's IFRS Roadmap proposal is pretty much a non-issue. For example, commenter Andy argues that self-selection bias may well exist because only "... those who feel strongly against or for, will make their views known."

I do agree with Andy in general, and there is strong empirical evidence to support that sort of tendency in some circumstances.* But, I don't agree that it is the phenomena that operates on issuer response rates to an SEC proposal such as the Roadmap.  I consider only the following four factors to affect the decision of an issuer's CEO to submit a comment letter: (1) one's stake in each potential outcome; (2) the subjective probabilities of each potential outcome; (3) the costs of commenting; and (4) the subjective probability that a comment letter can favorably influence the SEC's decision.

Thus, strong opinions are not enough – and perhaps irrelevant – to move a CEO to speak out on the Roadmap. The issuers who determined that investing in a comment letter was worthwhile did so.  For whatever reasons a lot didn't, but it is unlikely that it was systematically related to the 'strength' or substance of their opinion.

Moreover, the third and fourth factors, above, indicate that if the comment submission rate is judged insufficient, the Cox-lead SEC should bear some of the responsibility for that. For example, the cost of commenting is influenced by the ease of doing so. I, for one, wasted a full day out of my life to draft one, and then abandoned the project out of frustration. It took just too much effort to respond to all of the niggling questions, and I felt that anything that didn't fit the particular and numerous questions the SEC was asking would not even be classified, much less read.

With regard to the fourth factor, above, it certainly didn't help that the Cox SEC all but threw in the dust bin the strident and numerous criticisms of their proposal to eliminate the IFRS-to-GAAP reconciliation requirement. The saber rattling by the EU, and the relentless lobbying and PR by the Big Four doesn't help either, as they only lend credence to the proposition that bigger fish will have the ultimate say.

Moreover, issuer comments are in my view, a sideshow compared to investors.  If the SEC largely ignores them, that's how it should be. For example, let's take a look at an excerpt from Wal-Mart's response:

"For a global company like ours, [the benefits of IFRS adoption] include standardized reporting systems, efficiency in accounting training, and efficiency of financial statement review. However, these benefits are limited to the extent that various government and regulatory bodies in countries we operate in adopt IFRS as issued by the IASB for all oftheir reporting requirements. Failure to achieve this consistency in reporting standards minimizes or eliminatesany benefits. At the present time, we do not see any other significant benefits to offset the expected costs in adopting IFRS." [italics supplied]

Is Wal-Mart providing an honest assessment of the costs and benefits of IFRS, or do they have a hidden agenda? I haven't looked at Wal-Mart's financials in a few years, but in the years I did, I was amazed at how steady was their growth rate, and their profit margins were like a steady drum beat year after year. Wal-Mart, being in a very straightforward business with short cash cycles and tending to grow without a lot of M&A activity, probably doesn't face a lot of thorny accounting issues where GAAP and IFRS are significantly different. Except for one: asset impairment, where (as I have written here) IFRS can create more earnings volatility than GAAP. I suspect that avoiding the IFRS long-lived asset impairment standard could be their real agenda.

So, the long and short of it is that we can argue about whether the issuer response rate is low, but the SEC shouldn't be paying much attention to issuer comments anyway – except, perhaps, to help them divine what the costs of IFRS conversion to issuers might be. Evaluating the potential for IFRS to improve the quality of information provided to investors should be the purview of investors and others with financial reporting expertise, and who have no obvious axe to grind (academics, for instance).

And what of the auditors' strongly pro-IFRS comments?  I believe they actually have a role in the process, but not the one they have chosen.  I am reminded of a comment made by the irascible college basketball coach, Bob Knight. When asked about his position on a proposal to reduce the time on the 'shot clock' from 45 to 35 seconds, he said something like, "I don't care if you make it 5 seconds! We're good enough to play that game, too; and if somebody is dumb enough to thnk that the best basketball team will win that way, that's their problem."

What I mean to say is that the only thing I want to know from the auditors is akin to Bob Knight's shot clock response.  In switching from IFRS to GAAP will auditing practices and the reliability of an auditor's report be affected?   The Big Four never features (or perhaps even deigns to answer) those kinds of questions, because they are self-evident and non-self-serving: auditing procedures should not change very much, but the reliability of the auditor's report will decline due to greater reliance on management's judgment.

I'll readily admit that everyone is supposed to have a hidden agenda (except me), but with that caveat, I'll close with a selection of what I believe are some of the more revealing comments on the Roadmap proposal by a few of the organizations which, one might say, should hold 'super votes.'**

In summary, while the FAF and the FASB continue to support strongly the ultimate goal of a single set of high‐quality global accounting standards as part of a global financial reporting system, in our view, additional study is needed to better identify, understand, and evaluate the strengths, weaknesses, costs, and benefits of possible approaches the U.S. should take in moving toward that goal. – FASB

Until a single set of standards that produce such a result [high quality standards] exists, with a demonstrated record of compliance andenforcement, we believe it is premature and unwise to move away from U.S. GAAP… [W]e have seriousdoubts as to whether the proposed roadmap, as currently envisioned, will tangibly benefit investors' interests…In our view, the proposal fails to provide sufficient support as to why it presents a better course of action than the current on‐going convergence efforts… – Investors Technical Advisory Committee, FASB

[L]ittle existing research directly addresses whether U.S. investors, issuers, and markets would benefit fromimplementation of IFRS in the U.S. … We recommend further analysis of the costs and benefits of a mandated transition to IFRS for U.S.issuers, investors, and markets. – American Accounting Association, International Accounting Section

In our opinion, converting to IFRS is a solution without an underlying problem. In fact, we have never heard aninvestor in our company, any stock analyst covering Marriott, or any lender with which we do business in theUnited States or abroad suggest to us that they would prefer we report our results in IFRS. – Marriott

We believe that the costs to convert to IFRS will be extraordinary. The total cost to convert to IFRS is extremelychallenging to capture since it involves both quantifiable cash costs, as well as the cost that the distraction andreallocation of resources will cause to businesses. – McDonald's

Amen.

_________________________________

*See, for example, Richard J. Cebula, "Strong Presidential Approval or Disapproval Influencing the Expected Benefits of Voting and the Voter Participation Rate," Atlantic Economic Journal, (2005)33:159-167.

**Extracted from a document of excerpts presented to members of NASBA

The Comments on the SEC Roadmap are Clear: Make a U-Turn

There are some definite signs that Mary Schapiro is getting closer to naming her Chief Accountant. For example, I received an email from Denny Beresford, former FASB chair, who was left with the impression from a reporter that an announcement would be coming this week. Indeed, because of recent events I'll be discussing in this post, I'm inclined to believe that it will indeed come to pass.

The Chief Accountant appointment will clearly be setting the tone for the debate on the IFRS Roadmap proposal. But I am also getting strong vibes that, this time around, the many negative comment letters in response to the proposal will be a significant factor in the SEC's deliberations —as opposed to Christopher Cox's tone deaf handling of the elimination of the IFRS-to-GAAP reconciliation requirement. Because of that, the IFRS supporters are spinning the comment letters like crazy.

Most recently, CFO.com reported on remarks emanating from Wayne Carnall, Chief Accountant of the SEC's Division of Corporation Finance. He is generally seen to be an IFRS adoption proponent, and rumored to be a candidate for the Chief Accountant in the Office of the Chief Accountant -- yes, I know it's confusing, because he is already a 'chief accountant.' There are, to the best of my knowledge at least four positions at the SEC bearing the title of Chief Accountant. There's one each in the functional divisions of enforcement, corporation finance, investment management; plus the"Chief Accountant to the Commission" with one's own staff to serve the Commission as its principal advisor on accounting and auditing matters. That's the seat of power that everyone covets, and it's the one that has lacked a permanent possessor since Mary Schapiro took over from Cox's gang.

Anyways, Wayne is reported to have expressed his disappointment that so few public companies have even bothered to express their views on the Roadmap proposal:

"A total of 240 letters were received, about half of them from registrants. Cornall [sic] called that level of response 'disappointing.'

'Only about 1% of the companies in the United States that would be impacted by this change, if we were to adopt it, decided to comment. I thought that was a surprisingly low number,' he said.

He noted that a pair of FASB staff positions issued in March on what he called a 'relatively small, narrow item' — valuing assets in illiquid markets — got 700 comments in a 15-day comment period. 'Yet on a proposal to change the reporting framework in the United States we got 120 comments" from public companies during a 120-day comment period."

Wayne seems to be implying that nothing of significance can be inferred from such a low (in his judgment) response rate. He might have a point if the responses were equivocal, but that's simply not the case.

I read only a few of the comment letters, but I know of at least one person who read them all. That would be Gaylen Hansen, a partner in a Colorado CPA firm, and self-described detractor of IFRS adoption in the U.S. Among other high profile national service positions that Gaylen holds, he is chair of the Strategic Initiatives Committee of the National Association of State Boards of Accountancy (NASBA). The data on roadmap proposal comments displayed here is straight from his presentation at recent NASBA regional meetings (video, here):*

The problem for Wayne and other 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.

Not even the AICPA, an IFRS adoption cheerleader for years, can spin a very positive message out of the comment letters, but eschewing all references to actual data, spin fast and furiously they did with something they call an "analysis":

"While many expressed support for the goal of high-quality globally accepted accounting standards, the request for comments produced numerous critics of the SEC's proposed roadmap.  Commentators had serious concerns about the cost of adoption, the benefits of adoption compared to convergence, and whether IFRS were in fact as good as or better than U.S. GAAP. ….

While in the minority, some U.S. registrants generally supported the roadmap and mandatory adoption in the near term. [i.e., the majority voted "nay"] These organizations noted the benefits of global comparability, increased transparency, decreased cost of global financial reporting and the belief that converged standards would fall short of the benefits accruing from use of one global set of accounting standards. …

Responses from investor groups were mixed." [emphasis supplied]---

"Mixed"? While they were relatively few in number, it's safe to say that the major U.S. investor groups one normally expects to weigh in on accounting standards did so here. I suppose one would be technically accurate to state that investors were not unanimous in their strong opposition to the Roadmap proposal, but saying that 'most were strongly opposed' could only be an understatement. (Sometimes, I wonder if the AICPA outsources its communications department to the National Rifle Association.)

Even so, the AICPA's spin is not nearly as blatantly disingenuous as PwC's recent press release:

"Despite uncertainty about timing of the move to International Financial Reporting Standards (IFRS) in the United States, PricewaterhouseCoopers (PwC) maintains that the adoption of IFRS in the U.S. is inevitable [emphasis supplied], and that there is still overwhelming support for a single set of global accounting standards.

We expect steadily increasing convergence activity followed by eventual conversion to IFRS. …

Additionally, all U.S. businesses will face an unprecedented wave of U.S. GAAP changes, influenced by - and, in many instances, conforming to IFRS - over the next several years."

Having to make an explicit choice between the Big Four, and now, practically everyone else, is a scenario that a new SEC chair would certainly like to avoid so fresh out of the box. But, so far, Mary Schapiro appears to be handling it brilliantly: by waiting for IFRS to self-destruct.

"Inevitable"?  Not even close to that anymore.  'Implosion' more aptly describes what is now occuring, with almost shocking rapidity. On the overseas front, Charlie McGreevy of the EU and the European Federation of Accountants (FEE) have been applying countervailing pressure on the IASB to de-link itself from U.S. GAAP -- else the EU is threatening to part company with the IASB. It's a highly credible threat, and it would leave the IASB with little more than the Asian powers, Australia and a gaggle of third worlders no capital markets of their own to speak of.

On the embattled U.S. front, the FASB, without a breath of mention of convergence, has announced its intention to require that all financial assets, including loans, would have to be presented at fair value on the balance sheet. To abandon McCreevy's beloved 'amortized cost' accounting for loans investments in debt instruments would certainly be a bridge too far for EU regulators; and most encouraging to moí, the FASB by this action may finally be tacitly admitting that convergence is holding them back from making urgently needed changes to accounting standards that have contributed to the recent bout of financial havoc.

So, at this rate, the long-awaited appointment of a Chief Accountant may turn out to be an anti-climax -- which is just the way Mary Schapiro would like it.

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

* Gaylen's tabulation of the Roadmap comment letters excludes the Big Four, AICPA and others with an obvious pecuniary interest, foreign companies, foreign accountancy groups, foreign companies currently using IFRS, students and responses that defied classification.

Spinning "Convergence"

"Converge" from Merriam-Webster's Online Dictionary:

1. to tend or move toward one point or another: come together: meet

2. to come together and unite in a common interest or focus

3. to approach a limit as the number of terms increases without limit

Now that it has become abundantly clear that convergence of IFRS and U.S. GAAP is not likely to happen, the proponents of IFRS adoption in the U.S. are trying to downplay its importance, and spinning what convergence is supposed to mean. That stratagem should come as no surprise to those who have observed the numerous instances where immutable plain English words have been misappropriated by accounting standards to serve as terms of art no more artful than Dickens' Artful Dodger.* (For some examples I have posted, see here, here and here.)

I have been meaning to write about the notion of convergence and its implications for some time now, but I was having trouble organizing my thoughts until I read D.J. Gannon's article, The IFRS Convergence Quandary.  Gannon is a Deloitte & Touche partner and as far as I can tell, he is his firm's point person on issues related to the SEC Roadmap.  (As Gannon seems to be singing in unison with the Big Four chorus, I hope that my criticisms are not taken to be a personal attack, but simply as a convenient point of reference.)

"Let's start with what convergence is. Convergence is designed to bring U.S. GAAP and IFRS closer together. The focus is on having similar general principles. Many have misinterpreted convergence as meaning the development of the same or "identical" standards. The reality is that convergence never really contemplated "identical" standards.

In fact, the FASB and IASB have acknowledged that doing so is too difficult to accomplish. This is evident in the boards' recently issued business combinations standards that contain differences in certain requirements. And, based on the boards' current thinking on topics such as consolidations and leasing, differences likely will exist in future converged standards."

I would like to suggest that a reading of very plain language in the Boards' 2008 joint progress reporton the Memorandum of Understanding between the FASB and the IASB indicates a very different view of "convergence":

"Convergence of accounting standards can best be achieved through the development of high quality, common standards over time." [italics supplied]

In other words, both Boards have stated that convergence was intended for GAAP and IFRS to actually meet, and not merely come "closer together." The distinction is crucial, because, by claiming that "convergence" has a meaning that is not in the ordinary-folks dictionary, proponents of IFRS adoption now seem to be trying to find excuses for a lack of progress on convergence—and more important, the increasingly dysfunctional relationships between prime movers at the IASB.  I also can't resist pointing out that the phrase "differences likely will exist in future converged standards" makes no sense without some special meaning for convergence, which neither appears to have been contemplated by the MOU nor accomodated by the dictionary definition of "converge."

As to what the FASB and IASB have "acknowledged" regarding their convergence efforts, the alleged facts are that IASB representatives sat in Norwalk as the FASB determined to finalize their new business combination standards (FAS 141(R) and FAS 160). Those envoys reportedly gave assurances that the areas in which the FASB was sticking its neck out would be adopted by the IASB as well. In essence, the IASB reneged on its assurances; and that's as close to an 'acknowledgement' that I am aware of.

Convergence Has Reached the End of the Road -- Now What?

Actually, D. J. Gannon and I do agree on one thing. We both believe that convergence has probably gone as far as it can go. Our differences concern the question of what to do next. Gannon thinks that the U.S. should be ready for IFRS adoption:

"…[Y]ou only have to look at the recent events surrounding the current financial crisis. What historically have been seemingly harmless differences between U.S. GAAP and IFRS now are the source of much politicization.

Take, for example, the issue of when companies can change the classification of financial assets, which in turn impacts the measurement of these items. Prior to last year, the "technical differences" on classification between U.S. GAAP and IFRS were never considered a significant issue in practice. However, the financial crisis put the IASB under tremendous pressure to conform IFRS to arguably a "lesser-quality" answer under U.S. GAAP. This is only one example of literally hundreds of differences between U.S. GAAP and IFRS that likely will never be addressed by convergence."

Actually, it was the EU (not the "financial crisis") that put the IASB under "tremendous pressure," and just as the FASB responded to the U.S. Congress, the IASB caved. I see nothing compelling about this particular case, but that's not my main point. I find it curious that of the "literally hundreds of differences" that could have been picked, Gannon happened to pick one whose lessons are obscured by anomalous constraints imposed by inefficient banking regulations. Just because Congress and the EU want to shoot the messengers, that doesn't mean the U.S. should appoint a new messenger who will no doubt be harder to shoot the next time Congress wants to engage in that distasteful exercise.  

Also, my wandering mind wants to liken the relationship between the FASB and the IASB, as set out in the 2002 MOU, to a crumbling marriage. Both spouses have made some very poor choices in the past and it's as if one spouse is desperately imploring the other to stay together despite a tumultuous past together. "Everything could be just like it was when we first fell in love if we started a family—just like we were planning when we got engaged!" (sob, sob)

Whoa. I say divorce now rather than take a crazy risk like having kids. And, don't think further counseling is the answer either. As Gannon points out, there are "literally hundreds" of irreconcilable differences. Maybe none of those little tics and peeves matter by themselves, but collectively they're sure to drive the whole family nuts.

In case you don't get it from my cutsey troubled marriage analogy, let me spell it out for you.  Adopting IFRS any time soon will require a giant leap of faith that is not at all warranted by past actions. 

What Exactly is the Problem that IFRS Adoption Will Solve?

I learned from a colleague some years ago that the way to resolve a turf battle is to ask the power grabber to describe precisely what the problem is they are trying to solve, and how their solution solves that problem. 

Gannon's opening statement lays out that problem, insofar as IFRS adoption proponents would have the rest of us see it:  

"One thing most everyone in the financial reporting community can agree on is the need for a single set of high-quality globally accepted accounting standards."

Let's start with the presumption that IFRS is "high-quality." I see that as the biggest reason why the arguments of IFRS adoption proponents are not persuasive to skeptics such as myself. To my way of thinking, the one thing that most everyone in the financial reporting community really should finally admit is that IFRS is deeply flawed, and U.S. GAAP is no better.

In far too many respects that belie any pretense of quality, IFRS merely apes GAAP. The GAAP standards that have wrought the savings and loan crisis, the pension crisis, the thousands of pages of hedge accounting rules, hidden executive compensation costs, and now the worldwide financial crisis are converged all right. They're converged at a point barely above lousy.  In short, we will certainly be no closer to high quality accounting standards by adopting IFRS.

As to the advantages of having a "single set" of standards, it would certainly be desirable for all financial statements to spring from a single set of high-quality accounting standards, but we are worlds away from that utopia.   Indeed, dysfunction is beginning to take over the IASB's most prized relationship, the EU.  Charley McGreevy is grumbling that the IASB may not be able to be satisfy the financial reporting needs of the EU, so it remains a distinct worst-case scenario that the U.S. could adopt IFRS just as the EU is trashing it.

But let's ignore that, and assume that we do end up with a single set of accounting standards, albeit badly in need of improvement.  In that case, I predict that, with the U.S. voice muted, the chances will only increase that broken financial reporting standards will stay broken. I still have high hopes that better financial reporting standards can be obtained, but getting them is much more likely to spring from competition between standard setters than cooperation. In all things capitalistic, competition breeds excellence; and cooperation is the fuel for a race to the bottom.

In summary, failure to converge may be a "quandary" for IFRS adoption proponents.  Should we stop convergence efforts and set the stage for adoption?  "Absolutely," they say.  "Damn the risks and costs... full speed ahead (towards higher consulting fees)!"  But for me, the whole notion of convergence is, and always has been, nothing more than propaganda.

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*"He was a snub-nosed, flat-browed, common-faced boy enough; and as dirty a juvenile as one would wish to see; but he had about him all the airs and manners of a man." (Oliver Twist)

High Time to Abandon the Accounting for Contingent Liabilities

What the FASB calls "contingent liabilities" in FAS 5, the IASB terms "provisions" in IAS 37. I prefer the IASB's language, because of its pejorative ring to my American ears: it more clearly connotes the virtually unchecked discretion issuers have abused to obfuscate liabilities and trends in earnings.

In a previous post, I described how the IASB has been working on giving issuers even more discretion to manage their provisions.At the same time, the FASB has been fighting the good fight, but getting its butt kicked in the process. Their latest defeat was the issuance of FSP FAS 141(R)-1, to back off of their requirement to measure at fair value contingent liabilities assumed in a business combination.

Part of the FASB's problem is that they still haven't fully come to grips with measuring the fair value of any liability, much less a contingent liability. It seems reasonable enough to aim for consistent measurement of all assets acquired and liabilities assumed; but, how does one measure the fair value of a matter under litigation? Even if it were legal to pay a third party to assume the consequences of a matter in litigation, a 'moral hazard' is likely an unwanted by-product. Specifically, the transferor's incentives to act in ways that could lessen the ultimate consequences of the obligation could diminish significantly. The bottom line: score one for the issuers who fought the offending provisions in FAS 141(R) and made the FASB retreat.

But, as the FASB has retreated in one area, it is retrenching in another with the issuance of Proposed FSP No. FAS 157-f, Measuring Liabilities under FASB Statement No. 157. The FSP, among other things, addresses fair value measurement of a liability when contractual restrictions may prevent it from being transferred. The proposed FSP provides that if a quoted price in an active market for the identical liability is available, that price must be used to measure fair value. In all other circumstances, fair value would be measured by selecting the one approach, of four allowable approaches, that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The four allowable approaches are as follows:

• The quoted price of the identical liability when traded as an asset in an active market;

• The quoted price of the identical liability, or the identical liability when traded as an asset in markets that are not active;

• The quoted price for similar liabilities, or similar liabilities when traded as assets in markets that are active;

• Another valuation technique that is consistent with the principles of SFAS 157.

 

So, as best as I can tell, the issue of measuring contingent liabilities is still not resolved. Since FAS 157 defines the fair value of a liability as the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date (para. 5), it seems that the FSP is providing no help for contingent liabilities. The first three approaches permitted by the proposed FSP are clearly inapplicable, and there is nothing new in the fourth approach that would permit the evaluation of a contingent liability from the perspective of the asset holder.

 

A Solution: Assume There is No Problem

As I mentioned earlier, both the FASB and the IASB have been working on the contingent liability problem in their own separate ways. The FASB has been getting lambasted for their proposals to enhance disclosures and fair value measurement, while the IASB is going on its merry way to see how they can make a new and improved version of chicken salad for issuers. They have been mulling over an approach that would recognize all 'present obligations' (whatever that means), regardless of likelihood of payment, if they can be measured 'reliably' (whatever that means).  Since likelihood of payment is being taken out of the equation, whatever 'present obligation' means is the crux of the matter. And, as it turns out, a hypothetical case scenario that the IASB discussed during its deliberations is a convenient vehicle for me to express how I think contingent liabilities ought to be handled.

Here's the case:

A vendor sells hamburgers in a jurisdiction where the law stipulates that the vendor must pay compensation of C100,000 to each customer who receives a contaminated hamburger. Past experience indicates that one in every one million hamburgers is contaminated. On the last day of the reporting period, the vendor sold one hamburger.

And, here are some questions, along with my responses:

Question #1: Does the vendor have a present obligation at the balance sheet date?

My response: No.

Businesses have many responsibilities under various laws: reasonably ensuring that no physical harm will come to their customers as a result of their actions, truth in advertising, not polluting, and so on and so forth. Although investors would care to know about these exposures and their potential affect on future cash flows it is simply not practical to convey this information through recognition of contingent liabilities on the balance sheet.  It has been vividly demonstrated over the past 35 years that FAS 5 has been in existence that it is a pipe dream to think that reliable estimates can be expected from issuers when doing so conflicts with the interests of executives. (Note as well, that the ability to precisely state an amount for the contingency does not affect my response to this question.)

Question #2: Does the answer change if the probability of contamination is more likely than not instead of one in a million?

My response: No.

This gets at the key issue as to whether the probability of an outcome should determine whether a contingent liability is recognized. I agree with the IASB in so far that the probability of an outcome should not affect recognition. Whatever their reasoning, however, mine is that FAS 5 and IAS 37, which depend on probability estimates, have failed. Moreover, from my point of view, which is different from theirs, it is undesirable to let preparers continue to abuse the opportunities to exercise "judgment" in FAS 5 to manage earnings. The only solution is to restrict liability recognition to legally certain obligations.

Question #3: Should the answer change if the customer who purchased the hamburger claimed it was contaminated?

My response: No, unless it is established with virtual certainty that the vendor has a legal obligation.

I admit that judgment would be required to determine whether a legal obligation exists, but it is significantly less consequential than estimating probabilities and expected outcomes of contingent liabilities.

Question #4: Reverting to the original scenario, should the answer change if the vendor warranted the safety of their hamburgers, and stood ready to pay C100,000 to anyone with a valid claim?

My response: Yes.

The vendor clearly has a present obligation to stand ready to compensate customers who have been served contaminated hamburgers. That obligation is strongly analogous to an insurer's obligation, and should be accounted for the same way. Amazingly, neither GAAP nor IFRS currently require recognition of liabilities arising from a product warranty unless the warranty is separately priced.

Question #5: Reverting to the original scenario, should the answer change if there was a "constructive obligation" to compensate customers who were served with contaminated hamburgers?

My response: No.

Basically, a constructive obligation is defined in both GAAP and IFRS as a non-legal obligation inferred from business conditions indicating that if a payment would not be made, then the impairment of future business prospects would be greater than the payment saved. While there is some justification to be made on economic grounds, the practical problems of inviting preparers to exercise "judgment" once again trump.

In summary, after years of thinking about ways to improve the accounting for contingent liabilities, I am now throwing in the towel on what I have come to see as a futile exercise. By limiting liability recognition to present legal obligations, standard setters can kill two birds with one stone: first, financial statements will become more reliable and auditable; second, some of the difficult issues in measuring the fair value of liabilities that have not yet been satisfactorily addressed would become moot.

EU and IASB Ratchet Up Pressure on the U.S. to Abandon GAAP

The European Commission sponsored a two-day conference last week entitled "Financial Reporting in a Changing World." I was not invited to speak (J), but if I had been, this is what I would have said: Let's not use this 'changing world' stuff as an excuse to make more silly rules! Financial reporting is much less than it could be, and will remain so unless we recognize that it can only serve one master, investors. If we cannot come to agreement on that simple proposition, then we are doomed to more decades of posturing and squabbling, and with little to show for our efforts.

But it was Charlie McCreevy (EU Internal Markets Commissioner), and not I, who was tasked with giving the "keynote" address.

"We have important lessons to learn for the future role of accounting. … The crisis has thrown up certain issues which need to be addressed. Did the accounting rules accelerate the crisis or aggravate it? Moving forward, there are also medium- to long-term reflections, such as to what extent buffers should be in place and what model we should use for this. Another broader issue is whether the current corporate reporting model serves the information needs of investors and those that run the businesses."

If McCreevy's thinking is any indication of changes to come for IFRS, then I hope the U.S. has the good sense to say 'thanks, but no thanks.' The most "important lesson" we should finally have learned, but apparently have not, is that financial reporting cannot serve more than one master (I know, I already said that). It has been almost 90 years since a University of Chicago economist/accountant, J. Maurice Clark, coined the maxim, "different costs for different purposes."* Obviously, it applies to more than costs; in fact, it applies to all manner of decision making. If government regulators want to measure the capital adequacy of financial institutions, they must develop their own rules; if corporate boards want to measure the performance of management, they must develop and implement their own systems; if accounting standard setters are to respond to the needs of investors, then they must tell all other 'stakeholders' to take a hike.

If we can maintain separate systems for taxation and financial reporting, why can't we do the same for investors? What McCreevy won't confess is that institutions (financial and otherwise), by dint of their magnanimous contributions to the coffers of the politicians that tolerate his presence, insist on being able to massage their financial statements.

So, to McCreevy, how accounting serves the information needs of investors is just "another" issue; and not THE ISSUE. According to his speech, the "lessons" we are supposed to have learned are that: accounting does not allow for sufficient "flexibility" in the application of accounting standards; fair value accounting has been applied too widely; and believe it or not, accounting rules should "broaden" the use of loan loss provisioning because it "…has served many banks well in the past."

Perhaps, loan loss provisioning has worked better in Europe, although I seriously doubt it, but Americans and Japanese investors may have more vivid recollections of their own banking crises of the '80s and '90s. Those debacles were inarguably caused to a great extent by a financial reporting system that permitted managers to delay their day of reckoning until the trumpets of hell had sputtered silent. Moreover, in the years after the crisis, standard setters sat idly by as banks once again abused the provisioning rules: this time to create those "rainy day reserves" that former SEC Commissioner Arthur Levitt so eloquently decried.

McCreevy evidently has no qualms with going back in time to those chicken salad days when German-style reserves and "judgment" infected European financial reporting – and unintentionally helped fuel the boom of foreign listings on U.S. stock exchanges. When U.S. GAAP threatened to take over Germany, the EU hit the panic button and adopted (or should I say, 'acquired') IFRS.

 

Message to the U.S.: "Don't Make Us Angry!"

On the role of the U.S., McCreevy had this to say:

"It is very important that all major jurisdictions sign up to the international system. For us, it is crucial that the US come on board." [emphasis supplied]

If McCreevy is so confident that IFRS can be the standards he wants them to be, why must the U.S. play along? The answer is to be found in the peculiarly institution-friendly approach to financial reporting he so stridently promotes: since companies compete globally to show the highest reported earnings, no one jurisdiction should be able to create an 'unfair' advantage for its constituent companies.

On the other hand, an investor-friendly approach to financial reporting reasonably assumes that investors will seek to lower their risk of buying overpriced securities by tending toward investments listed in jurisdictions known for promulgating and enforcing full and fair disclosure rules. Such is the nature of the competition that the Europeans fear, because the U.S. can, and should, easily win. Like German GAAP before it, IFRS would shrivel up and die.

Even more strident in calling for the U.S. to play nice was John Smith, IASB member. While still smarting from McCreevy's bullying comments that the IASB wasn't jumping high and fast enough to suit the European financial institutions, he thought he would see how it feels to play the bully himself:

"If it [the United States] doesn't adopt, it will be the outlier and those countries already adopting and committing themselves to IFRSs will not accept a situation where the United States remains outside the system indefinitely, yet has a seat at the table."

I really am sorry to have to say this, but I channeled good ole George W. Bush as I read Smith's ultimatum. I hear Smith saying, "If you are not with us, you are against us." I hear myself saying to Smith and McCreevy, "Bring it on!"

The only way that McCreevy's institution-friendly vision for financial reporting can be realized is to wipe out any real competition among capital markets—by brilliantly and completely executing a grand plan to corner the market on accounting standards. But, the stridency of Smith's remarks is the first indication that a certain smugness on the part of the EU and IASB is rapidly devolving into a panicked fear that the U.S. has finally come to its senses.  

While we don't yet know much about President Obama's ultimate position, it is undeniable that the SEC seems to be getting its groove back under Mary Schapiro. Her delay in appointing a chief accountant notwithstanding, I am pretty sure the fears on the other side of the pond are justified.

______________

*J. Maurice Clark, Studies in the Economics of Overhead, University of Chicago Press, 1923.

Lease Accounting: Replacement Cost is the Only Hope for a Principles-Based Solution

A couple of weeks ago, the FASB and IASB jointly published a discussion paper (DP) entitled Leases: Preliminary Views. I take no pleasure in saying that SFAS 13 is the oldest worst accounting standard currently living and breathing; and the DP is a wet blanket on my hopes that it (along with its politically tweaked clone, IAS 17) would ever be replaced with a principles-based standard.

SFAS 13 was issued almost 35 years ago, irreparably broken right out of the box. For decades, it has been Exhibit A for critics of bright line rules, while IAS 17 has been similarly excoriated from the outset for its fuzzy rules. There has been no better example than these two standards of the proposition that rules without principles cannot result in high quality financial reporting—unless you're a big fan of off-balance sheet financing and earnings management. The rules are so bad, that a flurry of articles and textbook chapters appeared almost immediately after SFAS 13 was issued to guide users in their restatements of 'operating lease' accounting.

Financial reporting lived with SFAS 13 for 20 years until some quasi authority, the G4+1 group of standard setters, finally published a discussion paper advocating the capitalization of all leases. Duh.  Ten more years had to pass for the FASB and IASB to commence its joint project on lease accounting. It has taken almost another three years for these accounting whizzes to come out with this watery "preliminary views" document.

Why so long? First, issuers are in no hurry to give up the chicken salad they ordered, and were served on a silver platter in FAS 13; and second, as we are finally coming to recognize, investors have not pushed hard enough on their own for the changes in accounting they are entitled to. If there is any good that might come out of the mark-to-market debate following the financial meltdown, it is the realization that investors can't count on any other 'stakeholder' group to help them unless they themselves become a much stronger voice.

The Good News First

By far, the best thing to come out of the PV document is the proposal to treat all leases as giving rise to an asset (termed the "right to use the leased item" in the PV), and a liability for the obligation to pay rentals. In other words, 'operating lease accounting' and the gift of off-balance sheet accounting that went with it, may finally be out the window! Unfortunately, the rest of the PV follows a long-practiced FASB gambit of doing just enough, and no more, to cross the project off the list -- and to keep those pesky investors at bay for another 15 – 30 years.

Now for the bad news. Actually, there's lots of it, but I don't have time to write a book. So, in this post I'm just going to focus on the one issue that relates to some of my previous posts on 'fair value' versus 'replacement cost' measurements.

Let's Pretend These Numbers Actually Mean Something

To illustrate the point I want to make, let's take a relatively straightforward variation of a plain vanilla 8-year lease on retail store space: the lease term is divided into an initial 5-year period with an option to renew after 3 years at an inflation-adjusted price. Monthly rents contain a fixed component plus a variable component depending on store sales.

The FASB and IASB have slightly different preferences at this point, but let's start with the IASB's only because it's easier to explain: they propose that initial measurement take place as follows:

Estimate the expected lease term, and the expected (i.e., probability weighted) cash payments to be made by the lessee; and discount the expected cash payments at the lessee's incremental borrowing rate.

That's rules-based accounting for you. The DP does not state what the objective of this calculation is, because there isn't one, other than to come up with some number, any number, which they think enough people will say that 'it looks about right.' Stated plainly, the calculation results produces a hash—a number that can only be described by the chicken salad recipe used to cook it up.

There actually is a better way to measure a lease based on discounted cash flows, but it only applies in very restrictive circumstances. Let's set aside the choice of discount rate for the moment, which is a big problem in and of itself, and focus on measuring the numerators, if you will, of the terms in an expected net present value calculation. Finance 101 would say that there should be one term for each possible year (i.e., the maximum lease term), and the amounts for each year should be their expected cash flows.

Too see why that's the only rational approach to present value, think about how you would calculate the present value of an annuity for the rest of your life. Choice 'a' is to calculate your life expectancy (say, 80 years) and to discount the cash payments you would receive only up to the year in which you attain the age of 80. Choice 'b' would be to discount the expected cash flows for each year you could possibly live, where the expected cash flow is the contractual amount multiplied by the probability you should live so long. Choice 'b' is obviously the correct one, and should also be the approach for measuring the present value of a lease obligation of an uncertain term.

For some reason I fail to grasp, the flawed choice 'a' is essentially what the IASB is advocating. The DP describes some other, even more obtuse approaches they purportedly considered, but Choice 'b' is not even given lip service; probably because they knew of no way to put it back in the bag once they let it out. In this, and other aspects, the DP's reasoning is disingenuous at best, but more likely, intentionally deceptive.

Now, let's talk about the discount rate. Using the lessee's incremental borrowing rate for a fixed term lease could make sense, because the result of the calculation would yield the 'settlement amount': i.e., the amount that should discharge the liability in a single payment at the inception of the lease. But, in the presence of the renewal option, or any other type of option, the incremental borrowing rate is just a number pulled out of the air; kind of like adding red food coloring to artificially flavored jell-o. Where the FASB and IASB differ is only with respect to the shade of red: in place of expected cash flows, the FASB would use "most likely" cash flows. Big Hairy Deal. Nothing about either calculation method will produce historic cost, fair value, replacement cost, settlement amount, or any other attribute of assets and liabilities. Neither calculation will result in a "fair presentation" or a "true and fair presentation," or any other paliative weasel phrase the boards want to associate with the financial reporting solutions they are pushing.

A Principles-Based Approach to Lease Accounting

There are two basic principles of lease accounting that should guide the project. First, I agree with the FASB that lease contracts give rise to assets and liabilities; operating leases should be history. Second, and this is the payoff from reading this overly long post, the only relevant measurement attribute of rights and obligations arising from lease contracts is replacement cost. In fact, if you believe that non-transferable rights should be recognized as assets, I can think of no better example to show why replacement cost is preferable to fair value as a comprehensive basis of measurement.

Both boards take the position that contractual rights meet the conceptual definition of an 'asset,' including non-transferable contractual rights. But, if you are contractually prohibited from selling something, the only logical answer to the fair value question is 'zero'! Imagine the fair value balance sheet of an airline that finances its entire fleet of planes with non-transferable leases. It's not just ugly, it's of absolutely no use investors.

However, the replacement cost of a leased asset, regardless of transferability, can be substantial. And, unlike the FASB or IASB's improvised approaches to measurement, any rules that the boards would deign to impose with regard to how one should go about estimating replacement cost can be based on sound principles.

For stating that operating lease accounting should go away, I give the boards a 10. But for the rest of their preliminary views, even though I haven't told you about everything that bothers me, I give them a big fat zero. When I ponder the measurement rules they are proposing, I can't help thinking of the game we used to play as little tykes: "Let's Pretend."

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Interesting Exchanges on FASB and IASB Governance

Since my previous post on the FASB's 3 - 2 vote to finalize the investor-indifferent FSP EITF 99-20-1, I have received a number of comments regarding the extent to which board size and composition have affected financial reporting standards.

Alpha Opens

A seasoned investor professional, who chooses to remain anonymous (I will call her "Alpha"), initially wrote to suggest that I recommend a return to a seven-member board. Contrary to to the views of "Beta," who I will bring to you later in the post, she writes: "It was a swipe of a pen in a short FAF meeting that brought it [FASB size] down to 5. The same should happen to reverse it."

In response to Alpha, I suggested that in addition to reverting to seven members, I would also support a requirement that at least 5 members would have to approve a change in GAAP. But Alpha took an even harder line in responding to me, stating that a majority of board members should be those with a strong record of advocating for investors and/or having been power users of financial statements while making investment decisions. She also threw in a few lovely barbs, which I paraphrase below, at the IASB's own gerrymandering:

• Going to 16 board members from 14 (as proposed in the constitution review document and likely to be pushed ahead) is ridiculous as is the geopolitical representation requirement – even if the IASB is setting accounting standards for the world. Instead of taking on new members who know accounting and are from certain regions, the IASB also needs a majority of strong users/investors on the board and should be selecting from the best available at all times. Geopolitical considerations could be researched by IASB staff and brought out in due process and comment letters.

• The IASB's board of trustees should have substantial investor representation.

• The monitoring group process being proposed would bring politics even more into the process, as opposed to providing insulation from politics.

• In order to have global standards, we in the U.S. would have to live with huge loopholes to accommodate deeply national, cultural, legal and regulatory divergences.

Obviously, Alpha and I are members of the same choir.

Beta Bespeaks

I subscribe to a listserv for professors of accounting, AECM (http://pacioli.loyola.edu/aecm/), to discuss emerging technologies, pedagogy, and pretty much anything else. As I was having my correspondence with Alpha, Bob Jensen (retired professor from Trinity University) brought my blog post to the attention of the AECM:

"What recent 3-2 FASB vote riles the feathers of Tom Selling with innuendos that the banking industry and large accounting firms had too much influence on a vote that was not in the best interests of accounting transparency for investors? … What must our students think?"

Bob seems to have riled the feathers of another listserv member I will call "Beta", who at one time or another was an audit partner and partook in accounting standard setting. He also wrote a comment letter to the FASB in support of finalizing FSP EITF 99-20-1. The gist of Beta's comments concerning board composition and decision processes is as follows:

• The FAF Trustees reduced the board size after due process and there were arguments for and against. It allows the Board to be more efficient and reach conclusions more quickly rather than the past practice of working on some issues "forever." In addition, with only five members, the present members from the user and academic community have more influence (2 of 5 votes) than they did under the old system (2 of 7 votes).

• The voting requirement has changed several times - majority vs. super majority, and it does not make much difference. In almost all cases the Board would have acted on a final standard regardless of the voting requirement. The bare majority rule just allowed one more member to get on his/her soapbox and express a personal view that often didn't affect the overall conclusion but rather one or more of the technical details.

• The question of whose opinions should prevail has already been thoroughly considered and agreed to by those with interest in the process. In other words, once interested parties have bought into the idea that having standards is likely to improve the quality of financial reporting and that the system for developing those standards is reasonable, then those parties should be willing to accept the results of the system. The financial markets are better served by having some accounting standards even if those standards aren't perfect (and who can judge that?).

I responded to Beta in an email to the listserv membership as follows:

• So far, it does not appear that the Board has become more efficient after having been pared down from seven to five members.  Perhaps the most egregious case is the financial statement presentation project which I wrote about recently on my blog.  The Board could have resolved matters quickly but instead chose to combine forces with a 14-member IASB with the result being, among other things, that we still don't have a direct method statement of cash flows.  We should also be asking why the amendments to FAS 140 and FIN 46R are taking so long. And, how come a five-member board has not fixed the blatantly bad effects of pension and OPEB accounting on the income statement?

• While it may appear that the two members from the user and academic communities have more influence, I don't believe it to be the reality.  Greater proportionate representation does not mean more influence.  The chair now exclusively controls the agenda. FSP EITF 99-20-1 provides a strong indication that he or she who controls the agenda now has a much greater influence on outcomes. I highly doubt that Bob Herz would have put this project on the agenda, and indeed on a fast track, unless he already had two other board members in his pocket.  Notwithstanding any arguments as to the quality and appropriateness of the FSP, resistance from the other board members and dissenting commenters was futile; the FSP was a done deal after that.

• Considering the views of "those with interests in the process" is not an appropriate or necessary role of the FASB.  While there may be many stakeholders in the FASB's decisions, the only voices that should count in the FASB's deliberations are those advocating the interests of investors.  I believe the SEC has finally acknowledged this unequivocally in its recent report to Congress.  So, why do we have former auditors and preparers on the FASB?  It would seem that some believe they are there to represent the interests of auditors and preparers, but I believe they are there only to provide technical and practical perspectives. Other-than-temporary impairment accounting does not benefit investors, and the changes made to OTTI accounting by the FSP also did not benefit investors.

Gamma Ganders

Finally comes another comment from a reader of the AECM listserv, who distributed the back-and-forth emails between Bob Jensen, Beta and me among his own circle of readers. That person would be Lynn Turner, former SEC Chief Accountant, who along with Bob Jensen, makes a point of airing his views publicly, so I am happy to identify him here – and to give him the final word on the subject:

"From my vantage point as a member of ITAC, I see no change in the influence of the one investor representative on the board.  The recent 3-2 vote on the EITF 99-20 issue is a prime example where Bob Herz publicly discounted investors views.  I strongly believe, as pointed out in the recent policy of the Council for Institutional Investors, that investors are underrepresented and under served.  My sense on ITAC [Investor Technical Advisory Committee to the FASB] is that Herz and the Board give us lip service, little more.  I know a number of my fellow members feel the same." [italics supplied]

Making Financial Statement Presentation Simple: Mandate Account Reconciliations

Following my most recent post on financial statement presentation, Eddie Thomas, a frequent commenter of this blog, wrote: "Wouldn't investors be better off pushing for a more robust XBRL so that they can make their own decisions about what is relevant information and what is not? It seems like an effective end run around the politics of the FASB and the IASB."

I agree with Eddie to a point, but I am afraid he may be discounting the "garbage in, garbage out" rule of data processing. The information value of "robust XBRL" heavily depends on the granularity, uniformity and quality of inputs. As to whether GAAP or IFRS has attained a quality level even approaching 'satisfactory' is, as Eddie implies, highly debatable. With respect to granularity and uniformity, it's not even a close call -- hence the financial statement presentation project in the first place.

But, what I am about to suggest can make Eddie's wish to "end run" politically motivated accounting standards come true: balance sheet account reconciliations. In that last post, I suggested that one of three important things that the Boards could do would be to provide reconciliations of the beginning and ending balances of all balance sheet accounts. The other two were to mandate a direct-method statement of cash flows and to maintain a strict separation between financial and operating items. Upon further reflection, the reconciliations would be the single most important thing the Boards could do. It would also be the simplest and most logical way to do raise the level of financial reporting on all dimensions. Here are just three examples.

Example #1: PP&E

A reconciliation of PP&E can provide a separation of depreciation charges by function, and highlight the effect of discrete events hitting the income statement that are widely regarded to be of interest to investors: e.g., business combinations, restructurings, discontinued operations and impairments.

Perhaps some of this information can be teased out by the FASB/IASB proposal, but certainly not all of it. But, the FASB/IASB proposal would subject much too much to management's whim; and without detailed mandates it would be difficult to develop consistent XBRL tags.

The last two items in the reconciliation example clearly go beyond the FASB/IASB proposal: the effect of capitalized interest, and changes in the balance due to "translation" of accounts on the books of foreign subsidiaries at current exchange rates. The transparency of capitalized interest is essential to investors whose first analytical objective is the isolation of the effect of financial decisions on "operating" profits. The effect of foreign currency translation allows the investor to unwind the purely random effect on comprehensive income from multiplying a historic cost by a current foreign currency exchange rate.

Example #2: Inventories

The inventory example has a couple of extra twists. First, methinks it is not well-known that U.S. GAAP permits the capitalization of interest costs in inventory (IFRS does not). Also, "fair value hedge accounting" under both FAS 133 and IAS 39 permit the historic cost of certain inventories to be adjusted by gains and losses due to certain "hedged risks." The result of fair value hedge accounting on the carrying amount of inventories (and other assets/liabilities) is a process that I heard Tom Linsmeier refer to (prior to his being appointed to the FASB, of course) as "mutt" accounting – i.e., neither historic cost nor fair value. If comparability is truly the key reason for U.S. adoption of IFRS, then the Boards should be seeking to enhance comparability generally, and not merely through IFRS adoption. This should mean that investors are entitled to data for unwinding the effect of hedge accounting, a free choice creating lack of comparability, whenever it is applied.

The IASB/FASB proposal calls for disclosure of expenses by "nature" if management deems it to be significant information. Instead, I would require, where applicable, a statement of cost of products manufactured (i.e., a reconciliation of production costs and changes in inventory balances to cost of sales). The components of cost of sales could be highly informative, and, like reconciliations of balance sheet accounts, they are already being prepared for internal control purposes. Besides, undergraduate accounting students learn how to prepare a statement of costs of goods manufactured in their second semester!

Example #3: Trade Receivables

I include this example in part to illustrate that some legitimate foreign exchange losses are hidden in other comprehensive income (i.e., the translation adjustment). These gains and losses, which are derived from assets and liabilities held on the books of foreign subsidiaries (whose functional currency is not the dollar), are no different in their economic substance from other foreign-currency-denominated accounts receivables on a domestic subsidiary's books. Yet, by a 4 – 3 vote, the FASB decided that they should be presented differently.

Reconciliations are a No-Brainer: That's why Investors Can't Have Them

Imagine having those reconciliations along with programs that can read XBRL data! Service providers would be competing with each other to create the very best 'out of the box' analytics, and just as Eddie predicts, users won't even bother glancing at the financial statements as presented by management and the sleep-inducing narrative disclosures written to obfuscate rather than enlighten. The oil and gas industry could stuff their cherished interest capitalization where the sun don't shine, and multinationals could do the same with their foreign exchange translation gyrations.

But, the reasons why we don't currently have reconciliations are the reasons we won't get them. Managers must continue to make value-destroying choices for the sake of the accounting results that, with reconciliations, could be easily unraveled and even prevent fraud. Even though S-OX essentially requires that these reconciliations must exist somwhere in the bowels of each issuers' accounting system, auditors could not abide the prospect of providing each and every investor with the opportunity to perform its own 'analytical review' from which its own could be second-guessed. 

So, there you have it: the result of a couple of days of talking to myself, as opposed to millions of dollars spent by the FASB and IASB to solemnly deliberate for seven years such weighty issues such as whether the direct method for the statement of cash flows should be required, and a bunch of ad hoc ideas like separate identification of recurring and non-recurring revaluations.

If there is hope for improved financial statment presentation, it may be with new leadership of the SEC.  Historically, disaggregation has been under the purview of the FASB or the SEC. For example, SEC Regulation S-X is the main repository of presentation guidance for public companies. About a dozen years ago, the SEC, as a favor to issuers, eliminated supplemental schedules set forth in Reg. S-X that required details on the movements in long-lived assets. But about eight years ago, it also proposed to augment disclosures of the movements in so-called "valuation and qualifying accounts." The proposal was never acted upon, with the advent of S-OX serving as the official excuse. But, intense lobbying against the proposal by the usual suspects is the only plausible scenario.

I am not necessarily saying that the SEC should be taking over this project, but presentation has long been the purview of the SEC, and the FASB is falling way short. The purpose of S-OX in providing an independent funding source for the FASB is to free the FASB from undue influence, so as to carry out its mission in an unbiased and timely fashion. How could something as straightforward as financial statement presentation take seven years (and counting), if it were not for the meddling of special interests? Intentionally, or not, the FASB has neutered itself, and harmed the interests of U.S. investors by agreeing to join forces on the project with the IASB – which is not independently funded, and more than ever appears to be under the thumb of the European Union.

Financial Statement Presentation: The Sequel

Two readers, including Robert Bloomfield, Cornell accounting professor (my alma mater!) and Director of the Financial Accounting Standards Research Initiative (FASRI) of the FASB, were kind enough to point out an error in my previous post. Here is the gist of what Prof. Bloomfield had to say (his full comment is here):

"… you link readers to the 7-page summary document, but there is a lot more than that. …The discussion paper is quite long and detailed, including elaborate examples of a manufacturing and a banking company.

Also, one very interesting aspect of the proposal is a reconciliation footnote that would reconcile, line by line, the cash flow statement to the income statement. The differences are broken into various categories including accruals, fair value remeasurements, other remeasurements, etc.

So if you are opposed to capitalized interest, you are likely to be able to undo a fair bit of that through the footnotes."

Indeed, I mistook the summary of the DP, which was separately posted on a different page on www.fasb.org, for the entire document. My bad. I guess the page numbering in the summary should have tipped me off that there was more to come. But as a feeble defense, the FASB could have made the project page more user-friendly by posting a link to the complete DP right on the project page itself.

Much more important, is that I am happy to have discovered that the Boards may be proposing some significant changes that can result in incremental information for financial statement users. But, in all of the extra data, what may be some of the most sensitive items are still artfully concealed. Notwithstanding Prof. Bloomfield's statement that I should be able to discover more about interest capitalization, "more" is not enough when "all" is easily achievable and principles-based.

Along the same lines, there is nary a scintilla of disaggregated information regarding the effects of foreign currency translation on earnings, assets and liabilities. As I have pointed out in previous posts, FAS 52 creates some pretty crazy effects: translating the fixed assets on the books of foreign subsidiaries at current exchange rates is nothing more than random number generation; gains and losses on foreign-currency-denominated monetary items held by foreign subsidiaries are not presented in a manner consistent with identical exposures that happen to be on the books of domestic subsidiaries.

Making Financial Statement Presentation Simpler – and Much Better

Even though the Boards hide behind a self-imposed constraint to excuse themselves from consideirng recognition and measurement issues, they can still make the effects of some of their most ridiculous rules much more transparent than they are currently proposing. Here's three frustratingly simple things, which if implemented would far exceed the benefits of their current proposal:

1. Along the lines of the logic I presented by the name Largest Possible Entity, maintain a strict and principled separation between financial and non-financial elements in the balance sheet and income statement. Call me cynical, but I simply can no longer accept that giving management any discretion whatsoever over financial statement presentation will result in higher quality or especially more comparable information (the putative goal of IFRS and U.S. GAAP convergence). Every student of finance is apprised at some point that Modigliani and Miller received their Nobel Prizes in large part for seeding the conversation that financial decisions are fundamentally different than whatever one cares to call the rest of the things that management does. The LPE concept is merely an accounting child of their enduring insights.
   
2. Mandate the direct method for the statement of cash flows. The format for the statement of cash flows proposed in the DP is pretty cool, and so is the reconciliation of cash flows to comprehensive income. I also like the new definition of operating cash flows that would comprehend expenditures on assets. But, all of that is icing on the cake compared to simply eliminating the indirect method alternative that was provided at the eleventh hour by the FASB in SFAS 95. Waiting for this simple change seven years after Enron has conditioned me to not ask for too much in this regard.
   
3. Require a reconciliation of the beginning and ending balances of each account on the balance sheet (I still can't bring myself to 'statement of financial position' for an accounting that suspends rules of arithmetic I learned in first grade). If reconciliations are done properly, users can unwind all sorts of silly things – of which the aforementioned interest capitalization, random number generation through foreign currency 'translation' and inconsistent treatment of foreign exchange gains/losses are but three examples.

   The proposed reconciliation information is much too vague, and again is subject to obfuscation by management. Get ready for the naysayers to dismiss this suggestion as impracticable. But, if Worldcom's auditors had actually reconciled the beginning and ending PP&E balances, they would have been heroes instead of goats – and Cynthia Cooper, the Worldcom employee who blew the whistle on Bernie Ebbers et. al. would be memoirless. Especially in these days post S-OX 404, shouldn't each and every consolidated balance sheet account be reconciled? If not, what's the point of "internal controls over financial reporting"?

   In my next post, I'll provide a couple examples of the simple form of reconciliation I have in mind.

Some Additional Tidbits

First, the first paragraph of the DP states that Phase A of the project addressed "statements that constitute a complete set of financial statements… and … Phase B would address more fundamental issues relating to presentation and display of information … including … reconsidering the use of a direct or an indirect method of presenting operating cash flows." [para. 1.1, italics supplied]

Fundamental? More like "highly controversial"! Maybe I'm missing the boat here, but Phase A is the "fundamental" issue, and Phase B is detail—albeit important detail. The DP process could be much more constructive if the Boards would simply set forth the reasons why investors would benefit from a direct method cash flow statement; and more important, why issuers stubbornly resist the wishes of investors. The absence of a willingness to openly acknowledge the actual controversies does not bode well for a satisfactory outcome.

Second, the third paragraph of the DP states that FARSI, Prof. Bloomfield's group, "…will study investor use of financial statements prepared using the proposed presentation model by conducting a series of controlled tests." [para 1.3] To test what? What parts of the DP are even amenable to controlled experiments?

Notwithstanding the unnecessary vagaries, I have to say that I'm not sure that any testing will provide actionable results. Controlled experiments in accounting overwhelmingly tend to address very narrow research questions whose results are difficult, if not impossible, to validly generalize. My fear is that results that merely weakly support the preliminary views expressed in the DP will be over-generalized by vocal proponents of an anti-investor agenda.

But, setting that cavil aside, my greater concern is that investors will provide some "statistically significant" indication that the new presentation format represents an "improvement" over the mishmash of statement and disclosures currently being fed to them – a pretty low hurdle given the current sad state of financial reporting. That "empirical evidence" will be seen as supporting the proposed changes, tepid as they are, and thereby rendering really needed changes to the bottom of the priority pile for another twenty years. If you need evidence, see FAS 115 and that ugly "other than temporary impairment" standard that currently plagues us in the midst of our economic crisis; or SFAS 95, allowing the indirect method. GAAP is littered with disastrous standards that were passed by narrow margins with at least some board members expressing disappointment, but justifying their "yea" votes as compromises in the name of some modicum of progress. Will the Boards be playing the same sorry tune one more time?

Third, the absence of any discussion of XBRL in the DP indicates that both Boards might prefer that XBRL's significant implications for disaggregation of financial information – the more the better – be swept under the rug for a while. Soon may come the day, perhaps even before a final standard becomes effective, that the value of static presentations will fade to dust compared to simple software programs that generate financial statements in accordance with each user's very own preferences. Thus, the real reporting issue of the near future is not presentation, but rather disaggregation.

Having said all that, I'll conclude by stating that I fundamentally object to a management approach. I also have little confidence that the detailed disclosures regarding cash flows, much less the direct method, will be accepted by the IASB. Financial statement presentation was not designated as a convergence topic in the fabled Norwich Agreement, and I believe that the FASB erred in agreeing to conduct the project jointly with them. I believe they chose to form a cartel on this one, because not to have done so would have once again spotlighted the IASB's record of reluctance to push back against their funding sources.

Evidently, the FASB feels that it is a far better outcome to end up with a watered-down presentation standard that won't be revisited for another twenty years than it is to jeopardize IFRS adoption in the U.S.