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After having just written a post on HP’s massive write-off of goodwill, I am reluctant to keep on banging the drum of how bad goodwill accounting can be.  But, I can’t resist following up on Bloomberg columnist Jonathan Weil’s coverage of yet another recent acquisition by a big-time company that went sour practically out of the box. 

Mr. Weil’s main motivation was to express annoyance at companies that are wont to characterize asset impairment charges as being “non-cash” in nature -- as if it could mute the impact of the largest single accounting entry by the company in recent memory. ‘If mistakes were made, they’re history. So just fuggedaboutit.’ 

But, in Caterpillar's case, I think it goes deeper than merely choosing the words for best (or least bad) effect: it's misleading.

The sad story began last June, when Caterpillar Inc. acquired ERA Mining Machinery Limited (ERA), including its wholly owned Chinese subsidiary Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd., commonly known as “Siwei.”  According to Caterpillar’s 10-Q for its second quarter, tangible assets acquired and recorded at fair value totaled $671 million, customer relationships and trade names were valued at $105 million, liabilities assumed were $592 million and goodwill in the amount of $461 million was recognized. 

"Goodwill … represents the estimated future economic benefits arising from other assets acquired that could not be individually identified and separately recognized. … Factors that contributed to a purchase price resulting in the recognition of goodwill include expected cost savings primarily from increased purchasing power for raw materials and a reduction in other manufacturing input costs, expanded underground mining equipment sales opportunities in China and internationally, along with the acquired assembled workforce [many of whom were later fired because it was believed that they conspired to inflate the purchase price]."

One would have hoped that Caterpillar’s audit committee and due diligence team would have seen the large amount of goodwill for a manufacturing company to be a red flag – plus: key intangible assets were separately accounted for; ERA had recently obtained a backdoor listing on the Hong Kong stock exchange; and combined with all the other news we have heard about audits in China, there should have been a legitimate concern that the audit report should not be relied upon.

 As it turns out, such was the case.  From the 8-K announcing the impending goodwill impairment charge:

"Caterpillar first became concerned about an issue when discrepancies were identified in November 2012 between the inventory recorded in Siwei’s accounting records and the company’s actual physical inventory. This was determined by a physical inventory count conducted at Siwei as part of Caterpillar’s integration process. [whatever that is, and why ever it took so long] Caterpillar promptly launched a comprehensive review and investigation into the nature and source of this discrepancy. This extensive review has identified inappropriate accounting practices involving improper cost allocation that resulted in overstated profit. The review further identified improper revenue recognition practices involving early and, at times unsupported, revenue recognition."

For a company that strongly desires to project an image of adherence to high ethical standards, the above is not very forthcoming.  Caterpillar has not even deigned to tell us whether the inventory count was higher or lower than what was on the books.  And, what does inventory count have to do with “cost allocation”?

 We also know that, even though the investigation is not complete, Caterpillar is going to record a $580 million charge to goodwill, which as Jonathan Weil has observed is even more than the goodwill originally recognized and is almost as much as the original purchase price.  I can think of some scenarios under which the goodwill write-off is actually more than the goodwill originally recognized, but I shouldn’t have to speculate.* 

Although other account balances are clearly implicated, the company has not even deigned to tell us whether other assets (like the aforementioned inventory and customer receivables, or the finite-lived intangibles) will be adjusted.  In this regard, another factor to consider is that US GAAP allows for a period of time to adjust so-called “provisional” valuations of assets acquired and liabilities assumed as new information that the company is seeking becomes available.

But, surely Caterpillar’s valuations were not provisional until it could ascertain whether or not it was the victim of fraud.  Moreover, public companies have to be pretty careful when they adjust provisional amounts, especially if those amounts were previously filed in an annual or quarterly report; that’s because retrospective adjustments to amounts previous filed (and any impact on earnings) are required along with disclosures of the amounts of the adjustments.  If anything like that is going to happen, and I don’t think it will, Caterpillar is not talking about it.

 In summary, there is enough evidence to strongly suspect that the accounting entry to record the Siwei acquisition was incorrect.  It also seems to be the case that Caterpillar had adequate opportunity to become aware of its errors (and that it was the victim of an apparent fraudulent scheme) before it filed its 10-Q for the second quarter of 2012. From Caterpillar’s recent disclosures, we can be confident that inventories were misstated (over or under, we don’t know), customer receivables were recorded that did not exist, and goodwill was recorded that did not exist.   It could very well also be that other assets, including the values assigned to customer relationships and trade names were misstated as well.

US GAAP is quite clear as to the remedy for an accounting error: go back and restate all the prior periods presented.  So among other things, even if previous quarterly financial statements are not re-filed, when Caterpillar files its Form 10-K for 2012, it should have to report a loss of a few hundred million dollars from having been defrauded.  That’s not anything that can be waved away as a non-cash impairment charge.

Another interesting question to contemplate is whether Caterpillar has violated the securities laws.  Filing materially incorrect information to the SEC is, in and of itself, a violation, but that’s not what I’m thinking about:

• All companies have an obligation to keep adequate books and records, and the possibility exists that Caterpillar’s due diligence procedures did not adequately respond to the consequences of misstating the assets acquired and liabilities assumed from ERA. 

• On the filing of the Form 8-K itself onJanuary 18th, since Caterpillar admitted to having discovered material irregularities already in November, surely they must have come to the conclusion that a goodwill impairment charge in some amount would be necessary much sooner than mid-January.  Wasn’t the requirement to file an 8-K triggered long before Caterpillar’s actual filing date? 

* * * * *

The moral of the story is that fraud is not an asset.  Whatever you think about goodwill accounting, I hope you don’t think that the appropriate way for a company like Caterpillar to report that it has been the victim of a fraud is simply by a "non-cash" charge to goodwill.

 

 

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

*One possibility has to do with the “unit of account” when testing for goodwill impairment.  As soon as a company is acquired, it is assigned to a “reporting unit” (roughly speaking, one level below a reportable business segment), and the goodwill assigned by some magical formula to that reporting unit (perhaps from other Caterpillar acquisitions in China) is what is tested for impairment – not the goodwill solely from purchasing ERA.  In fact, it is entirely possible that a portion of the goodwill from the ERA acquisition wasn’t tested, because it could have been assigned to another reporting unit.  (Yes, the rules are that loosey goosey.) 

Autonomy: Investors are Entitled to Know what HP's Management Knows -- by New Year's Eve

Hewlett Packard Co. claims they were 'misled' (to put it mildly) by accounting 'misstatements' (to put it mildly) into overpaying, on the order of $8 billion, to acquire Autonomy. But, if anybody outside of HP has precise knowledge of those questionable accounting practices, they're not letting on in their public disclosures (e.g. Form 8-K):

"Following the completion of its annual review of its goodwill and purchased intangible assets for impairment, on November 20, 2012, HP announced that it recorded a non-cash charge for the impairment of goodwill and intangible assets within its Software segment of approximately $8.8 billion in the fourth quarter of its 2012 fiscal year. The majority of this impairment charge relates to accounting improprieties and disclosure failures at Autonomy Corporation plc ("Autonomy") that occurred prior to HP's acquisition of Autonomy, misrepresentations made to HP in connection with its acquisition of Autonomy, and the impact of those improprieties, failures and misrepresentations on the expected future financial performance [emphasis supplied] of the Autonomy business over the long-term…. HP does not expect the impairment charge to result in any future cash expenditures."

Which may explain why the reports in the press are all over the place. Roughly ordered from least to most egregious, here are some possibilities gleaned from what I have read thus far:

• Autonomy, as a UK company, allegedly exploited the mutability of International Financial Reporting Standards (earnestly referred to by its promoters as "principles") to recognize revenues earlier than would have been permitted by U.S. GAAP. This allegation is founded on the belief that Autonomy often bundled two products in its contracts with customers: software and data storage services. If Autonomy wanted to be as aggressive as possible in its revenue recognition, it would maximize the allocation of the total consideration to be received under the arrangement to the software element under a contract (which might have been recognized upon delivery) and too little to the storage services (which is recognized over time).
• To add insult to injury, the revenue from the software sales in the forgoing scenario could have been recognized prematurely if they were in the form of licenses, which perhaps should have been accrued over time. Again, I'm not sure that IFRS provides much in the way of practical constraints. The applicable standard (IAS 18, para. 20), provides that licensing revenue would be recognized up-front when the agreement is for a fixed fee and the licensor has no further obligations. But, whether that fits the facts and circumstances of Autonomy's business is not known. Moreover, IFRS does not explicitly state that these are the only fact patterns that would support up-front recognition of license fees.
• Expenses were allegedly shifted out of 'cost of sales' and into marketing to give the impression of investments in the brand, and to inflate current gross margins.
• Software was sold or licensed (I don't know which) through third-party resellers. The most serious allegations could be that either the resellers or Autonomy itself fabricated these transactions.

As an aside, it's also very curious that none of the information HP has put out squares with the views of Autonomy's auditor before the acquisition, Deloitte. They firmly stand by their audit – if you want to call it that, for if judged by U.S. rules (SEC, S-OX, PCAOB) Deloitte was not in a position to be considered independent. The very nature of the non-audit services provided – for example, providing advice on executive compensation schemes – makes it so. Moreover, Deloitte's revenues from those non-audit services were pretty lucrative: it has been reported that for every dollar collected from audit services, Deloitte collected approximately $1.10 from providing non-audit services. If Autonomy's accounting practices were too aggressive, would Deloitte's staff have had the gumption to push back given the stakes?  I'm just asking.

As another aside, I wonder about the accuracy of the last sentence in the disclosure tidbit I provided above:  "HP does not expect the impairment charge to result in any future cash expenditures."  In a narrow sense, this is too obvious to have to mention:  that recording an impairment charge does not affect cash flows in and of itself.  But if HP is actually stating that there will be no future cash outflow effects resulting from the Autonomy affair, then that should raise a big red flag.  What about future legal costs in an attempt to recover damages from Autonomy's former managers and shareholders?  Or, if business is a lot worse than they thought, are restructuring costs imminent?

Getting back to HP's disclosures about the facts and circumstances surrounding the goodwill impairment charge, it may have complied thus far with the letter of the SEC's rules, but there are still far too many unknowns to conclude that HP has been adequately forthcoming. What I do know, however, is that SEC rules will eventually compel HP to tell the public in clear language what all the fuss has been about.

The rules I am referring to are set forth in Item 303 of Regulation S-K, Management's Discussion and Analysis of financial Condition and Results of Operations (MD&A). According to my calculations, HP's next MD&A should be filed no later than the last day of 2012 in its annual report on Form 10-K.

The clearest indication of what that MD&A is supposed to contain with regard to the Autonomy affair is from well-known and oft-repeated SEC's interpretive guidance from 1989. It reminds filers that the purpose of MD&A has always been, from the time it was first proposed, to give investors the opportunity to see the company "through the eyes of management." In this instance, such a statement can only mean that investors are entitled to the following specifics: what management knows as of the date of the filing; how they know it and when they came to know it; how it changes expectations of future profitability and liquidity (quantified to the extent possible), and most important, the actions that management is currently taking, and may likely take, to mitigate the negative developments.

Sarbanes-Oxley only requires that the SEC review (in unspecified detail) HP's disclosures every once in three years. But, following on the heels of an announcement of an $8 billion impairment charge to goodwill and a 12% shock to the share price of such a high profile company, the only accetable staff response to the events at HP would be to review HP's MD&A and related disclosures with a fine-toothed comb as soon as its collective New Year's Eve buzz wears off.

One could reasonably argue that the SEC's interpretive guidance on MD&A is too general to be enforceable; and even if it were, that it takes disclosure regulation a bit too far. But, it seems to me that this is the kind of situation that belies such propositions.  We, the public, are counting on the SEC staff -- under its new chair Elisse Walter -- to hold HP's feet to the fire.

I hope that Ms. Walter's is thinking that this could be her first big test -- and is eager to face the challenge.

A Lesson in Loan Accounting from an Unexpected Source: Oil and Gas Companies

[This is my fourth consecutive post on loan accounting. Here are the first, second and third.]

I love finding accounting lessons buried in stories that on their surface seem to have little to do with accounting. See, for example, my post on the appalling politics of joint replacement databases, "No Escaping the Politics of Information." The example I'm going to describe here is a little bit closer to home than body parts: an August 11th, WSJ article headlined, "For Chesapeake, a Question on How it Counts Reserves."

Some background: in January 2004, Royal Dutch Shell announced that it would have to reduce its "proved" oil and gas reserves by 3.9 billion barrels, which was about 20% of their reserves. Another 2 billion barrels were written off in the ensuing months.

The gist of the WSJ article is that ever since the Royal Dutch Shell writedowns and the ensuing securities fraud claims, reserve quantity reporting practices evolved to obtaining some level of outside assurance from independent experts. Consequently, Chesapeake's share price may be discounted by investors because, "[Only] seventy-seven percent of the reserve estimates … reported for 2011 were produced by independent engineering firms, while the rest came from a growing team of in-house reservoir engineers. A survey of nine of Chesapeake's competitors in the same year showed third-party involvement in 89% of reserve estimates, on average."

Chesapeake challenges the claim that its share price is depressed by the possibility of unreliable reserve estimates. While "third-party involvement" could take the form of audits of in-house estimates, or independent estimates, a Chesapeake spokesman claims that its use of third party estimates is more heavily weighted toward independent estimates, while its peers go the other way.

 

An Analogy to Accounting for Loans

But, whatever the particulars of the facts and circumstances surrounding Chesapeake, there are interesting comparisons to be made about loan loss reserves and oil and gas reserves.

The first thing to consider is that accurate estimates of future loan defaults are extremely critical to any evaluation of the financial health of banks, just as "proved" oil and gas reserve quantities are to energy companies.

Second, I would argue that estimates of oil and gas reserves are inherently more reliable than estimates of loan loss reserves. Even though oil and gas reserves could be thousands of feet underground, they are tangible, and they can be sampled and probed. Please don't ask me to cite any of it, but there must be scads of theoretical and empirical scientific studies to support the validity of the methods employed.

In contrast, estimates of loan loss reserves are ineffable; and methodologies for predicting future losses are, to say the least, controversial.  It's a paradox that oil and gas managers engage outside experts to estimate reserves for financial reporting purposes; yet bank managers, who have the more subjective task, think they know enough to estimate loan loss reserves all by themselves.

Third, the SEC requires a financial statement audit of every public company, including banks and energy companies; however, it doesn't require an audit of oil and gas reserves [see Regulation S-K Item 1202(a)(7) and (8)]. Largely in response to the Royal Dutch Shell debacle, managers of oil and gas companies have voluntarily engaged independent experts, whose reputations must perforce depend on their track records, to provide a higher level of assurance to investors than required by law. Obviously, the same can't be said for banks' measures of loan loss reserves.

Fourth, estimates of loan loss reserves are much more critical to the global economy than estimates of energy reserves. Given the market forces that moved oil and gas company managers to act, it seems that another debacle like Royal Dutch Shell is unlikely; but if it did occur, it probably wouldn't shake up the markets as much as a major restatement from a too-big-fail bank.

And what's the likelihood of a bank having to correct its loan loss reserves? There are whole countries in Europe whose banking systems could be on the brink of collapse!

Are financial statement audits of banks helping to allay your fears? Not mine!

Consider as well that audits of loan loss reserves are at the top of the list of deficiencies uncovered by the PCAOB. Even setting aside the question of whether auditors are capable of evaluating bank managers' clairvoyance, all too frequently, it seems, auditors have not even adhered to their own protocols.

 

The Moral of the Story

If you buy into the analogy, and I believe it is quite compelling, then, just as energy companies employ independent scientists, banks should be required to obtain estimates of loan loss reserves or market values (I would much, much prefer the latter) from outside financial experts. Maybe then, market prices of bank stocks and book values would converge. As it is now, investors don't believe the banks' "audited" numbers. Investors surely understand that auditors can and should verify facts, but they are not qualified to predict the future, or even to merely offer an opinion that management's prediction of the future appears reasonable.

In the case of oil and gas companies, the vicissitudes of capital markets led to higher quality financial reporting. But alas, vested interests in entrenched and outdated regulations are preventing it from happening at banks. I am a strong proponent of securities regulation, but sometimes it can get in the way of needed improvements to the information available to investors.

This is one of those times.

Accounting and World Peace: It's Time for the SEC to get Real

This is my second post reviewing the SEC Staff's Report on its IFRS Work Plan. My first post is here.

To recap only slightly, the best news to come out of the Staff Report is a forthright acknowledgement that outright IFRS adoption is clearly not feasible. Now for the bad news: the Staff is still desperately seeking any excuse possible for remaining in bed with the IASB.

I know this because no matter how damning the arguments against any form of endorsement of IASB standards, the staff's mantra is unaltered: that investors, issuers and regulators generally support "the concept of a single set of high-quality globally accepted accounting standards":

[I]nvestors and other users of financial statements generally expressed support for the concept of a single set of high-quality, globally accepted accounting standards. (page 79)

Regulators generally agreed that they would benefit from a single set of high-quality, globally accepted accounting standards that fosters transparent and consistent reporting. (page 92)

Issuers generally supported the objective of a single set of high-quality, globally accepted accounting standards. (page 104).

And, from these and similar statements we have this confident inference:

"[T]he Staff found there to be substantial support for exploring other methods of incorporating IFRS that demonstrate the U.S. commitment to the objective of a single set of high-quality, globally accepted accounting standards while addressing some of the aforementioned concerns. (page 4)

In other words, three generalities sum to a "substantial."

Whirled Peas, or World Peace?

To be fair, a great many comment letters I read, even those most critical of the SEC's IFRS proposals, begin with, "We support the concept of a single set of high quality globally accepted accounting standards." However, for two reasons, such a statement is almost always severable from the substance of the detailed comments that follow them.

First, it's boilerplate. Everyone thinks they know that in order to be on good terms with the SEC – whether to have access to policymakers or to avoid being put in the dog house by reviewers of your filings – one must be at all times outwardly deferential to the Staff.

To illustrate, let's take one of the few direct quotes (an actual data point, if you will) in the Staff Report. It comes from a May 2011 comment letter submitted by the CFA Institute:

"[t]he results [of a survey] show that our membership overwhelmingly (over 90%) supports the premise of a single set of high-quality global accounting standards as a goal to be ultimately achieved by standard setters and regulators around the world." (page 79)

This looks like pretty strong confirming evidence of the Staff's views, which no doubt is why they proudly featured it. After all, CFA Institute represents over 100,000 investment professionals, But, the Staff misleadingly fails to mention that a significant number, if not a strong majority, of CFA members do not reside in the U.S. This, along with the manner in which the survey was conducted (perhaps in order to reflect the bias of the survey's sponsor) could have highly skewed the results. (Why didn't the Staff conduct its own survey?)

Moreover, and more directly speaking to my "boilerplate" hypothesis, the Staff Report doesn't mention that CFA Institute submitted multiple comment letters in which the same statement can be found. In a subsequent comment letter the CFA Institute also expressed numerous concerns that are much more substantive and are still highly problematic. For example, CFA Institute observed that little has been done to: define what "high quality standards" means, and whether IFRS standards measure up; address IASB infrastructure and governance; or to address enforcement questions adequately.

Second, it's trite boilerplate. No contributor to a policy debate wants to be perceived as a fringe lunatic, thereby lacking credibility and hence, influence. Consequently, no matter how deep one's reservations run on IFRS, everyone as a matter of course will pledge their commitment to the accounting equivalent of world peace.

Again, to be fair, it's understandable how the staff would lap up this sort of faint praise with a spoon. After all, we should all constantly be working toward world peace; hence, to advocate for world accounting harmony is unequivocally to fight the good fight, right?

Actually, no. While every reasonably moral person has agreed for ages that world peace is a desirable outcome, we know they don't all agree that, given the current and reasonably possible future states of the world, a single set of accounting standards is a desirable outcome in the foreseeable future.

But, for the sake of argument, let's assume that it is a desirable outcome. Even then, it is too simplistic to assume that progress can only be made by moving closer to the goal. In their classic book, Human Problem Solving (1972), Allen Newell and Nobel laureate Herbert Simon demonstrated that such a pure "means-end analysis" can fail. A more sophisticated view of goal seeking behavior also places a value on the opportunity to 'take a step backward' in order to eventually achieve the desired outcome. As an extreme example, a reasonable person who is committed to working for world peace could also justify going to war under some circumstances.

Along those lines, I believe that current conditions are not suitable for moving towards the goal of a single set of standards. We first need to move backward; to promote competition among standard setting jurisdictions in the hope and expectation that it will eventually lead to higher quality accounting standards than currently exist. It may well be that standards across jurisdictions need to get more different before convergence to a single set of sufficiently robust and high-quality standards can begin.

 If the SEC even considered this kind of reasoning, it appears nowhere in their report. Perhaps it's because they loved the boilerplate too much.

SEC Kicks IFRS Further Down the Road(map)

I am proud to announce that I did my civic duty yesterday. I turned off all of my electronic devices for the entire day and actually read the entire final SEC Staff report on its IFRS Work Plan.

After finishing, I skipped dinner and headed straight for the wet bar.

I mean this in all seriousness: it took me just a few minutes to figure out that the SEC doesn't want anyone to read this report. I know this because, despite years of the Staff's researching, round-tabling, surveying, conferencing, reading, analyzing, monitoring and speechifying since the 2008 Roadmap release, its 127-page single-spaced report does not contain a single table, chart or graph. The SEC is doing its best to paper over the fact that the Staff has not made any recommendations to the Commission at this point, but there can be no excuse for its failure to provide even a modicum of usable data.

It's not because data isn't available to be had:

 

Now, that's data! In fact, it's the data that foretells the doom of IFRS incorporation: public companies opposed IFRS adoption by 2:1 and total comments ran against IFRS adoption by an even greater margin. 

Into the valley of Death
Rode the six hundred.

It's the data the SEC could have easily tabulated for itself from the comments to the original Roadmap release, but it proved itself incapable of dealing with reality:

"Forward, the Light Brigade!"
Was there a man dismay'd?
Not tho' the soldier knew
Some one had blunder'd.

"Some one"? It can't be a coincidence that the Staff's report was released on the last day of work for James Kroeker; so that everyone remaining can point fingers at each other with seeming impunity.

Or Crazy Like a Fox?

I have long suspected that the SEC is trying to put the EU in the lead for the final tricks (bridge metaphor), and that's what the Staff's report may have catalyzed. Indeed, there is mounting evidence that every single SEC commissioner and staffer who understands a wit about accounting must be waiting and hoping for the EU to finally come to the end of its tether, and to be the one to declare l'engager est terminée.

First, there is this little nugget from the Staff report itself, indicating that other IASB constituencies are not going to take kindly to any half-baked commitment from the SEC toward IFRS. The U.S. must be subservient or else:

"The Monitoring Board [of the IFRS Foundation] decided to … include as criteria for membership on the Monitoring Board the 'domestic use of IFRS in the relevant jurisdiction and financial contribution by the jurisdiction to the setting of IFRSs.'" [p. 39, bold italics supplied]

Second, Reuters reported yesterday that the process to kick the U.S. out of the club has already begun:

"The United States may have to give up its seat on a top global accounting body if it continues to drag its feet over the adoption of international book-keeping rules, the European Union's executive said on Wednesday.

Discussions over whether the United States would adopt … [IFRS] … have been going on for a 'very long time and, despite repeatedly expressed commitments from the U.S., things are advancing very slowly.'…

'The lack of a clear vision from the U.S. creates uncertainty and hampers the IFRS from becoming a truly global accounting language,' said [Stefaan] De Rynck, who speaks on behalf of Michel Barnier, the EU commissioner responsible for financial services.

'It is also becoming more difficult to justify the representation of jurisdictions not applying IFRS in the IASB governance framework,' he added in remarks seen as taking a swipe at the United States.

…

The IASB declined to comment." [bold italics supplied]

 

Third, the FASB is starting to re-assert itself. It has recently backed away from – at least until it gets more feedback – its tentative agreement with the IASB on loan-loss accounting. According to the WSJ, this sudden development has Hans Hoogervorst worrying that one of the three litmus-test projects will revert to square one. In other words, loan accounting could be the straw that breaks the camel's back.

Thus, I have concluded that, given neither data nor recommendations, there can only be two purposes for the Staff report: (1) to get under the skin of the EU; or (2) to buy time for the commissioners to personally extricate themselves from the mess. With Mr. Kroeker, Chair Schapiro's handpicked chief accountant gone, it seems it is just a matter of time – but not until after the presidential election – before Schapiro herself vacates the battlefield.

Picking up the Pieces

But, what will be left for Ms. Schapiro's successor to decide? It is clear even from the Staff's three-page summary that convergence is dead; and "condorsement" is, at very best, on life support.

That leaves only endorsement. An endorsement policy on the part of the U.S. would be the very worst of all possible scenarios for the EU. Imagine that the IASB continues to promulgate its putatively principles-based standards, and that the FASB incorporates them into U.S. GAAP; and then to be interpreted in excruciating detail by the EITF. That should either bring down implementation chaos, or IASB standard setting will come to a screeching halt (it's already as slow as molasses) for fear of opening up a Pandora's box of niggling rules and restatements on the rest of the world.

Methinks the screeching halt scenario is more likely, and it could lead to the next schism; where consequently, the EU will break off from the IASB to set its own standards. Then, what will happen to the IASB?

La commedia è finite! – almost.

* * * * *

PS – I'll have more detailed comments about specific assertions made in the Staff report in a later post. Yes, the report is almost an information dump; nonetheless it is also quite perceptive and thoughtful in sections; while also misleadingly inaccurate in others. I'll try to point out some of both.

Why the SEC's 'Neither-Admit-Nor-Deny' Settlement Criteria is Seriously Flawed: Two Clear Examples

Four years ago, I wrote of my extreme frustration over the SEC's settlement with the two Arthur Andersen partners who planned and supervised the 2001 audit of WorldCom. Six years after the fact, the SEC's slam-dunk case was settled with little more than slaps on the wrists: both auditors were suspended from practicing before the SEC for three years (as if they would have been hirable anyway); no penalties were assessed; and worst of all the settlement provided that both auditors would "neither admit nor deny" (NANDy) any breaches of professional conduct.

Lo and behold, the SEC's often-used NANDy policy became national news when Judge Jed Rakoff of the Federal Court of the Southern District of New York threw out the SEC's $285 million settlement with Citigroup. He did so in part because NANDy meant that he did not have established facts for determining whether the monetary amounts agreed to were appropriate.

The Rakoff decision clearly got the attention of the public, and inevitably Congress would have to show some interest. On May 17th, Robert Khuzami, the SEC's Director of the Division of Enforcement, presented written testimony in which he laid out a defense of the SEC's longstanding practice of including the NANDy provision in virtually all of its settlements. (Mr. Khuzami clearly was not trying to provide more than one side of the argument, but only to justify the SEC's practices; which is why I believe that "defense" is the appropriate descriptor.)

"[T]he Division of Enforcement recommends that the Commission settle a case only when our informed judgment tells us that the settlement agreement is within the range of outcomes we reasonably can expect if we litigate through trial. [bold italics supplied] In making that determination, we take into account many factors, including:

(i) the strength of the evidence and the potential defenses, including the possibility that the Commission might not prevail at trial, or prevail but be awarded less than the proposed settlement achieves;

(ii) the delay in returning funds to harmed investors caused by litigation; and

(iii) the resources required for a trial, including, most importantly, the opportunity costs of litigating rather than devoting those resources to investigating other cases."

In the entirety of that written testimony, I found no mention of any of the other "many factors" that the SEC might take into account. Thus, if this is all the SEC considers, then it must perforce be concluded that SEC litigation policy has been reduced to nothing more or less than profit maximization. The sole objective of profit maximization may be fine and good for a private litigator, but the mission of a government agency must certainly be more than that. At bottom, enforcement must show concern for producing fair and just outcomes to society as a whole. There is not a breath of that in Mr. Khuzami's testimony.

 

Justice versus Cash Flow

Not being a lawyer, I don't feel qualified to either comment directly on the quality of Judge Rakoff's reasoning for rejecting the Citi settlement; or on that of the appeals court, which reversed it. But, the message the SEC seems to be ignoring at its peril is not Judge Rakoff himself, but the public reaction to his decision. That reaction is frustration with enforcement policies that seem to focus only on the number of cases sent through the pipeline, and the money collected at the end.

Mr. Khuzami, the public wants justice. And, justice in the eyes of the public often requires adjudication. This is not economic, as much as it is sociological. The general public has been victimized by high-profile financial wrongdoers, and victims have a right to expect that their victimizers will have their comeuppance. Conversely, a significant deterrent to wrongdoing should be that victimizers will expect to be humiliated if they are exposed.

A comeuppance can also have a rehabilitative effect. One of the German sayings that my mother had me memorize went something like this: "Self-recognition is the first step toward improvement."* We know that works for (some) individual violators of securities law – witness the post incarceration mea culpas of Sam Antar, Michael Milliken, Ira Fastow to name a few who have tried hard to make positive gestures out of contrition. On the other side of the coin, look at the recidivism rates of the too-big-to-fail banks whom the SEC allows to settle with NANDy and a monetary fine.

I see at least two other problems with NANDy that Mr. Khuzami should have addressed. First, how can we know whether the SEC isn't being run by racketeers, seeking easy targets to shakedown without having to actually prove allegations to an impartial judge or jury? Second, and relatedly, if the SEC believes there is any sort of reasonable possibility that a defendant could prevail at a lawful trial, then how does it serve the public interest to settle – just in order to avoid that possibility? This is the mentality of a private litigator, and it does not become a public servant to have that attitude.

The Case of Spencer Barasch

If I haven't yet managed to persuade you that the SEC settles with a NANDy much more often than it should, perhaps the case of Spencer Barasch will bring you over to my side. Ironically, the SEC NANDy-settled its case with Barasch just days before Mr. Khuzami testified to Congress. Here are some of the facts I have pieced together from the recent Commission Order Instituting Proceedings, a March 2010 report by its inspector general, David Kotz, on the matter, Congressional testimony of the inspector general, and reports in iWatch News and NYT.

Spencer Barasch was an associate director of enforcement in the SEC's Forth Worth office from 1998 – 2005. In total he had worked for 20 years at the SEC. In April 2005, he left the SEC to join a law firm in Dallas. "Every lawyer in Texas and beyond is going to get rich over this case. Okay? And I hated being on the sidelines," said Barasch, when asked why he was so insistent on representing Robert Allen Stanford.

According to the Commission's Order Instituting Proceedings, between 1998 and 2003, "…[Barasch] participated personally and substantially in several decisions relating to" the investigation of Stanford's $7 billion Ponzi scheme that decimated the savings of thousands. A report by the Commission's Inspector General goes even further: that he played a big part in delaying and limiting the agency's investigation.

Federal laws prohibit former federal officers and employees from knowingly seeking to influence or appear before any agency on a matter in which they had "participated personally and substantially" during their federal employment. Such actions also constitute "improper professional conduct" under Rule 102(e) of the Commission's rules of practice. Yet, after leaving the SEC, Barasch repeatedly attempted to represent Stanford, even though he was told by the SEC's ethics office that his previous involvement with the Stanford case prohibited him from doing so. Nonetheless, within two years of his departure from the SEC, Stanford hired Barasch to represent it in connection with the SEC's investigation.

Barasch didn't notify the SEC, and according to the Commission's Order, Barasch even went so far as to communicate with the SEC staff working on the Stanford case "with the intent to influence them."

Ultimately, in January 2012, Mr. Barasch avoided criminal prosecution and agreed to settle the case brought by the Department of Justice by paying the maximum civil penalty of $50,000. His lawyer stated, "At no time has he [Barasch] compromised his honor or ethics, and we vigorously dispute any suggestion to the contrary."

Finally, on May 24^th, Mr. Barasch NANDy-settled with the SEC, only agreeing to be barred from practicing before the SEC as an attorney for one year. No monetary fine, no nothing. Mr. Barasch's lawyer stated that his client chose to settle only "… to avoid the expense and uncertainty of protracted litigation."

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If there has ever been a case where the SEC could have sent an unequivocal message to the audit profession by prosecuting the auditors to the fullest extent of the law, Worldcom was it. Moreover, the public has a right to know how WorldCom's auditors violated the basic standards of their profession without allowing any sort of equivocation to be a part of the story.

The Barasch case is particularly notable because of the message the SEC is sending to its own staff: if you act no more egregiously than Barasch, the downside risk is pretty low: a one-year sabbatical from SEC clients plus 10% of the salary you hope to make in the private sector. And, your lawyer can thumb his nose at the SEC for you.

Unlike the WorldCom auditors case, I have no feel for its merits; but if it was not a slam-dunk, then that's even more reason why the SEC should have felt obliged to take it to trial. What I do know is that Barasch was no ordinary respondent: he was a former SEC staff member for goodness sake. What does it say when we allow a member of the fraternity to get off with hardly a slap on the wrist – and with his dignity apparently intact?

Finally, neither of these cases was about the money. So, what was the point of bringing the cases, and then settling for nothing more than a symbolic victory – just two more cases to put in the 'win' column?

NANDy is just not right, especially when the harm to society has been great and felt by a broad swath of the citizenry. We have a legitimate wish for the legal process to fully run its course, justice and a modicum of closure. The SEC should provide all of these things; even if it risks leaving money on the table because the SEC lacks the resources to make its case in court. It that's the situation, then it is what Mr. Khuzami should have been telling Congress.

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*Selbsterkenntnis ist der erste Schritt zur Besserung.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

False Claim #4: IFRS is already widely adopted elsewhere

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

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

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

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

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

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

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

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

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

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

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

 CLICK HERE FOR PART THREE OF THIS ESSAY.

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

Dear Reader,

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

Best,
Tom

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

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

How We Got Here

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

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

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

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

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

The Ten False Claims for IFRS Adoption

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

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

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

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

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

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

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

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

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

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

CLICK HERE FOR PART TWO OF THIS ESSAY.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The JOBS Act: Plutocracy in Action

The Jumpstart Our Business Act (H.R. 3606) was recently passed by the House of Representatives and sent to the Senate. Without meaning to put words into anyone's mouth, the JOBS Act appears to be based on three highly uncertain premises:

• "Emerging growth companies" (basically, companies with revenues under $1 billion) are the principal driver of jobs growth – Floyd Norris reports that recent data from the Bureau of Labor Statistics challenges that notion.
• Scaling back on disclosure and other capital markets regulations will reduce the cost of capital for these companies – SEC Commissioner Luis Aguilar has published his own comments and cites research that suggests this to be a highly dubious and dangerous notion. If anything, evidence suggests that some of the provisions in the H.R. 3606 could raise the cost of capital.
• If emerging companies could raise capital less expensively, there would be more investment, and new jobs would follow – That, of course, depends on the validity of the first two premises.

Here's a quick taste of what investors would be in store for, should H.R. 3606 be passed in its present form by the Senate:

Although an IPO prospectus would still have to be filed with the SEC, "research reports" (read advertising) would not.

There would be no assurance that all investors would have equal access to those "research reports", and no SEC review would assure that the information is not misleading. Think Groupon's misleading "non-GAAP performance measures," which it eventually was compelled to repudiate. If the JOBS Act had been in effect, these could have been published (or selectively distributed) as non-filed "research reports" beyond the purview of the SEC.

These so-called emerging growth companies (for all practical purposes, nearly all of the companies that would file a registration statement) would be allowed to skimp on their IPO disclosures, be given five subsequent years to ramp up to full disclosures, and be exempted for five years from the requirement to obtain an audit of internal controls over financial reporting (S-OX 404(b)).

Recent history of SEC accommodations to small business has shown that relaxed prospectus disclosure requirements (i.e., registration statement) will not be helpful to legitimate capital raising. Prior to February 2008, the applicable rules for smaller reporting companies (then referred to as small business issuers) were set forth in Regulation S-B, which along with the related small business registration statements and periodic forms was rescinded. One reason they were rescinded was that instances of companies electing abbreviated IPO disclosures (by filing old Form SB-2) were extremely rare. The perception in the market was that "SB-2 companies" could be hiding something important, so the advisors and underwriters essentially insisted on filing a Form S-1, the long-form registration document. Once a small business issuer had gone public, however, and exposure to liability was only under the less-threatening Exchange Act, nearly all of the companies eligible to do so would use any opportunity they could to "scale" their disclosures – fewer years of financial statements, less-detailed risk disclosures, abbreviated disclosures of executive compensation, etc.

In short, based on past history of SEC initiatives to scale disclosures to a reasonable level, one would expect that companies having nothing to hide will eschew the accommodations and provide full disclosure in the IPO prospectus, and those that do have something to hide, won't – or won't go public anyway.

Companies could raise up to $2 million through "crowd funding" via the internet without an SEC filing. If the offering is for less than $1 million, an issuer wouldn't even have to provide financial statements to potential investors. Fire up them boiler rooms!

Underwriters would no longer be required to separate investment bankers and research analysts who work in the same firm.

Think of the days of secret deals between investment bankers who promised favorable "research reports" in return for a piece of the deal. Think Jack Grubman and Worldcom.

Emerging growth companies would be exempt from complying with any new or revised accounting standards.

This makes transparency and comparability a joke.

Read More and Gag

If you want to learn more about this terrible and potentially disastrous piece of legislation, I suggest the following additional readings:

• SEC Chairperson Mary Schapiro's letter to the Senate Banking Committee is fairly tepid (Aguilar's is much better), but it's a pretty good road map on the regulatory issues. Notably, she states that rulemaking required to implement the new legislation would take 18 months – as opposed to the 6 months the SEC would be directed to do the work in.
• The following editorials and commentaries are just a few of the many stating/implying that investor protection is being trashed in favor of Wall Street special interests:
  • Bloomberg
  • NYT
  • Floyd Norris
  • The Motley Fool Funds

If a bill has a snazzy name, it means the anti-all-government-regulations Republicans want to claim credit for it. But, the JOBS Act is sailing through Congress in a bipartisan effort at election-year fundraising from the financial services industry plutocrats: Wall Street is in New York, and that's where the Democrat, financial-industry-water-carrier Senator Charles Schumer lives.

It's an ugly piece of securities legislation that only a fraudster – or an investment banker – could love. I'll be the first to admit that the securities laws may not be perfect, but surely this is not one of the first places to look if one wants to create an environment that is more hospitable to real jobs growth.

 

The SEC's "90% Convergence" Fantasy

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

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

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

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

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

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

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

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

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

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

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

* * * * *

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

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

Is the Judiciary about to Give the SEC a Backbone?*

I have long been frustrated by the SEC's practice of settling cases of financial misconduct without making the defendants admit to the allegations. That policy gives a defendant a significant economic incentive to settle with the SEC, because one who admits guilt to the government may not later deny it in a private action – where the money penalties could be much bigger. For its part, the SEC loves settlements; it makes for many positive press releases and hedges against the embarassing possibility that a case could actually be lost in a court of law.

In general, I despise settlements 'without admitting or denying.' Especially where the illegal conduct is extreme and obvious, I can't possibly see how the public interest is being served by settling without an admission of guilt. I first exclaimed my frustration in a blog post back in 2008 in reaction to the SEC's settlements with Worldcom's auditors. If there has ever been a case where the SEC could have sent an unequivocal message to the audit profession by prosecuting the auditors to the fullest extent of the law, Worldcom was it. Moreover, the public has a right to know how WorldCom's auditors violated the basic standards of their profession without allowing any sort of equivocation to be a part of the story.

Today, however, I am happy to report that I may have one less pet peeve to write about. Indeed, the days of SEC settlements without obtaining admissions of guilt could be over. NYT reports that Judge Jed Rakoff, of the Federal Court of the Southern District of New York threw out the SEC's $285 million settlement with Citigroup because it "did not satisfy the law." Moreover, the judge found that the Citigroup settlement paled in comparison to an earlier settlement with Goldman Sachs, which was ultimately approved last year with no small amount of reluctance.

Below are excerpts (highlighting supplied) from today's scathing 15-page ruling by Judge Rakoff.

From page 15:

Finally, in any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency's contrivances.

From page 1:

According to the S.E.C.'s Complaint, after Citigroup realized in 2007 that the market for mortgage backed securities was beginning to weaken, Citigroup created a billion-dollar Fund (known as "Class V Funding III") that allowed it to dump some dubious assets on misinformed investors. This was accomplished by Citigroup's misrepresenting that the Fund's assets were attractive investments rigorously selected by an independent investment adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negative projected assets and had then taken a short position in those very assets it had helped select. Complaint ¶¶ I, 2, 58.

From page 2:

Although this would appear to be tantamount to an allegation of knowing and fraudulent intent ("scienter," in the lingo of securities law), the S.E.C., for reasons of its own, chose to charge Citigroup only with negligence.

From page 4:

Since then the Court has spent long hours trying to determine whether, in view of the substantial deference due the S.E.C. in matters of this kind, the Court can somehow approve this problematic Consent Judgment. In the end, the Court concludes that cannot approve it because the Court has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment.

From page 5:

In its most recent filing in this case, however, the S.E.C. partly reverses its previous position and asserts that, while the Consent Judgment must still be shown to be fair, adequate, and reasonable, "the public interest ... is not part of [the] applicable standard of judicial review." SEC Mem. at 4 n. 1. This is erroneous. A large part of what the S.E.C. requests, in this and most other such consent judgments, is injunctive relief, both broadly, in the request for an injunction forbidding future violations, and more narrowly, in the request that the Court enforce future prophylactic measures (here, for a three-year period). The Supreme Court has repeatedly made clear, however, that a court cannot grant the extraordinary remedy of injunctive relief without considering the public interest.

From page 8:

Applying these standards to the case in hand, the Court concludes, regretfully, that the proposed Consent Judgment is neither fair, nor reasonable, nor adequate, nor in the public interest. Most fundamentally, this is because it does not provide the Court with a sufficient evidentiary basis to know whether the requested relief is justified under any of these standards.

From page 9

Here, the S.E.C.'s long-standing policy - hallowed by history, but not by reason - of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations, deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.

From page 9:

The S.E.C., by contrast, took the position that, because Citigroup did not expressly deny the allegations, the Court, and the public, somehow knew the truth of the allegations. Tr. 12-13. This is wrong as a matter of law and unpersuasive as a matter of fact.

From page 10:

[A] consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies. This, indeed, is Citigroup's position in this very case.

From page 11:

It is harder to discern from the limited information before the Court what the S.E.C. is getting from this settlement other than a quick headline. By the S.E.C.'s own account, Citigroup is a recidivist, SEC Mem. at 21, and yet, in terms of deterrence, the $95 million civil penalty that the Consent Judgment proposes is pocket change to any entity as large as Citigroup.

From page 11:

While the S.E.C. claims, that it is devoted, not just to the protection of investors but also to helping them recover their losses, the proposed Consent Judgment, in the form submitted to the Court, does not commit the S.E.C. to returning any of the total of $285 million obtained from Citigroup to the defrauded investors but only suggests that the S.E.C. "may" do so. Consent Judgment at 3. In any event, this still leaves the defrauded investors substantially short-changed.

From page 13:

The Court is also troubled when it compares the proposed Consent Judgment with the consent judgment entered last year between the SEC and Goldman Sachs... Goldman involved a similar but arguably less egregious factual scenario … Nonetheless, the consent judgment in Goldman required Goldman to pay a $535 million penalty, even though it made only $15 million in profits. … [T]he SEC does not explain how Goldman's actions were more culpable or scienter-based than Citigroup's actions here. Furthermore, the consent judgment in Goldman contained several terms that are notably missing from the proposed Consent Judgment here. First, the consent judgment included …[an] express admission from Goldman … By contrast, Citigroup has not agreed to cooperate with the SEC in any cognizable respect.

* * * * * *

As one can plainly see, Judge Rakoff has frequently rejected the SEC's interpretation of the law and the facts. It deeply saddens me to see how the agency that I worked with and long admired has become a shell of its former self – brought on by a lack of resources, a lack of will among its leadership to pursue cases, and the ever spinning revolving door.

But, the SEC needs more than a single ruling in a federal district court to get it back on track. The SEC sorely needs new leadership: someone with a sense of history, vision and a backbone.

Actually, it needs someone like Judge Rakoff. But, at least for today, I'll have the satisfaction of knowing that someone is finally insisting on making securities law violators, no matter how well politically connected, fully accountable for their actions.

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

*Thanks to Roger Collins of Thompson Rivers University in Canada for giving me the title for this post; and thanks to Lynn Turner for supplying the key excerpts to Judge Rakoff's ruling.

What Should "Investor Protection" Mean to Accounting Standards Setters?

If you were to ask a financial regulator what 'investor protection' means in the context of accounting standards, the textbook response will have something to do with ensuring that investors have enough information to make informed investment and voting decisions.* Indeed, that's what also has been taken as gospel since 1978 when the FASB published its Statement of Financial Accounting Concepts No. 1:

"[F]inancial reporting should provide information to help investors, creditors, and others assess the amounts, timing and uncertainty of prospective net cash inflows to the related enterprise." (¶ 37)

I believe this has been the guiding philosophy of standard setting ever since. It is time to recognize that it is a failed philosophy.

Informativeness is in the Eyes of the Lobbyist with the Most Juice

First, to rank accounting alternatives on the dimensions of their 'informativeness' is deceptively difficult, if not just downright impossible. That's why FASB "due process" takes forever, and is more about politics than reasoned thinking. But, even if the goal of enhancing informativeness were the correct goal for regulators, what can be said about the progress toward informativeness that has been made over the ensuing one-third of a century? Not a whole heck of a lot.

Lawrence Summers gave a speech in 1999, when he was deputy Treasury secretary, which contained this remark about financial reporting:

"If you ask why the American financial system succeeds, at least my reading of the history would be that there is no innovation more important than that of generally accepted accounting principles; it means that every investor gets to see information presented on a comparable basis; that there is discipline on company managements in the way they report and monitor their activities." (source: a 2009 NYT column by Paul Krugman)

I am resurrecting those remarks from an earlier post because they demonstrate how central financial accounting is to the functioning of our economy; and conversely, the vast destruction that can occur when accounting doesn't work as it should. Perhaps, from Summers' perspective in 1999, accounting standards were more or less okay, even though he ignores the S&L debacle and the role played by inadequate loan accounting standards. But from the perspective of 2011, after all that has befallen us in the ensuing 12 years, surely he would have to recognize that accounting has become more a part of the problem than holding out much promise for being a part of the solution. (For a more contemporaneous viewpoint, I suggest you read Floyd Norris's recent column on the utter mess and disgrace that is the accounting for financial instruments.)

Some would say that the mission of the FASB has been to institute improvements to accounting standards, and on a case-by-case basis, there is no disputing that some improvements have been made. But, despite all the new rules and complexities, it's still much too easy to smooth income, and to obfuscate or just plain hide important information about risks and uncertainties. All in the name of informativeness, U.S. GAAP (more so, IFRS) gifts issuers with free choices (explicitly or often implicitly) among accounting treatments, and the privilege to make highly subjective and self-serving estimates. Nowadays, few are surprised at how powerless or unwilling, auditors are to stop issuers from making two plus two seem like something other than four. (Indeed, an important lesson here is that audit reform may not be possible without accounting standards reform.)

Accounting Standards as Weapons of Financial Destruction

Second, there is an aspect of reality that goes essentially unacknowledged in the FASB, SEC or IASB literatures: financial statements issued for public consumption routinely double as convenient, albeit very dangerous, management control systems.

For example, the attainment of a pre-determined amount of earnings under U.S. GAAP can be a surrogate for achieving underlying economic goals. This may ostensibly be the case because of the difficulty in measuring achievement of real targets. I say "ostensibly," because I'm not confident that enough corporate board members sufficiently appreciate the tradeoffs involved; in particular, the difference between reported net income and real profitability. Even granting a genuine willingness on the part of board members to exercise due care, they seem to be too easily won over to the point of view that game-conducive earnings-based compensation is the most effective way to achieve congruency between management's preferences and shareholder value maximization.

In short, "what gets measured gets done." Yet, by fixating on informativeness, the FASB has succeeded in ignoring this self-evident maxim throughout its entire history. And in doing so, the FASB (with the SEC standing idly by) has enabled a national tragedy at many levels: obscene levels of compensation awarded to management, impairment of U.S. competitiveness, mass disruptions of financial markets, shareholder value destruction – not to mention the chaos and misery inflicted on honest, hardworking and capable individuals.

Give Accounting Back to Shareholders

We desperately need to figure out how to make accounting part of the solution instead of a big, big part of the problem.

To start, we need to shift the primary emphasis of accounting standard setting from informativeness to 'stewardship' and 'external control.' By stewardship, I mean economic reality: the identification and valid measurement of the net resources that management has been entrusted to invest and utilize; whether management is taking the appropriate level of risk; and whether management has generated a satisfactory return to shareholders. External control is an outcome of a focus on stewardship in financial reporting, and by stewardship I am referring to the need to explicitly recognize that accounting standards have had, and will continue to have a profound impact on corporate decision making. (Pardon the digression, but this consideration by itself should be sufficient reason to stop all the IASB adoption nonsense.)

Granted, no set of rules can result in an accounting for all of the assets and obligations of an enterprise; and by extension, no set of internal and external controls can be expected to put a complete halt to shareholder value destruction through accounting-based managerial decision making. But, the least regulators can do is to endeavor to recognize a reasonable set of an entity's assets and liabilities, and to measure them in sensible economic terms. For a start, we should be using constant units of purchasing power instead of nominal currency units in comparisons. Even in times of merely low inflation, It is not true that a bank earns an economic profit when it ultimately collects $1,001 on a 10-year $1000 loan; yet, that's the way that bankers appear to think, largely because accounting rules permit them to act like it's okay to think in such naïve terms. And, just like Floyd Norris points out, we don't need about a dozen different free choices and all the subjectivity involved in accounting for stocks, bonds and loans.

* * * * *

My reading of history is more critical than Lawrence Summers'. It tells me that tight regulation of financial markets is necessary, because bad things happen when managers could end up being rewarded for decisions that destroy shareholder value. But, focusing on stewardship and external control does not mean that informativeness gets thrown out the window. In fact, I think the resulting financial statements would be more informative than those prepared in compliance with today's U.S. GAAP or IFRS. If done right, they should also be more auditable, but that's a topic for another post.

If investor protection were a horse, then when it comes to accounting standards the SEC and FASB have spent far too much time looking at the wrong end. (Don't ask me where I think the IASB has been looking!)

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

*And also to prevent misleading disclosures, but that's not central to what I am thinking about here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Will the SEC Sneak IFRS in Through the Back Door?

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

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

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

 The Back Door Gambit

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

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

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

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

Send in the Shills

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

* * * * *

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

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

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