The Accounting Onion

Let the "Condorsement" Games Begin

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

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

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

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

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

The Staff Paper Fizzles instead of Sizzles

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

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

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

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

The Big Four Tries to Pick up the Pieces

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

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

There's that word "inevitable" again!

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

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

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

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

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

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

Second:

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

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

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

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

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

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

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

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

SEC IFRS Roundtable Debrief: March of the Zombies

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

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

 The "Investor" Panel

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

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

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

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

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

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

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

 

The "Smaller Public Companies" Panel

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

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

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

 

The Regulators

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

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

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

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

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

* * * * *

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

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

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

 

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

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

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

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

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

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

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

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

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

The Token Investor Issues

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

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

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

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

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

* * * * * * *

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

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

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

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

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

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

The Fix Must Be In

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

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

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

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

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

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

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

 

The Hard Questions that Won't be Asked

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

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

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

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

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

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

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

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

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

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

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

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

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

* * * * * * *

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

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

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

Why Won't the SEC Investigate Motorola … Again?

The following is more (see my earlier post) from PCAOB chair Jim Doty's June 2^nd speech, describing an auditor's failure to correct an accounting misstatement that was "galling in its simplicity":

"PCAOB inspectors found at one large firm that an engagement team was aware that a significant contract was not signed until the early hours of the fourth quarter. Nevertheless, the audit partner allowed the company to book the transaction in the third quarter, which allowed the company to meet its earnings target. Although the firm discussed the timing of the transaction with the customer, it failed to obtain persuasive evidence of an arrangement for revenue recognition purposes in the third quarter. The company had been an audit client of the firm for close to 50 years." [Italics supplied]

Obviously, Doty used this case to illustrate the independence problems inherent in excessively long auditor tenure (in this case, nearly 50 years). And, consistent with long-standing, albeit questionable, PCAOB policies, Doty would not name names. But, once Bloomberg columnist Jonathan Weil plucked the parties' identities and some other sordid details from court records, this case appears to have left egg on the face of the SEC as well:

[KPMG's and] Motorola's identity [now known as Motorola Solutions Inc.] was disclosed in public records last month as part of a class-action shareholder lawsuit against the company in a federal district court in Chicago. The plaintiffs in the case … filed a transcript of a September 2010 deposition of a KPMG auditor, David Pratt … "

Jon goes on to report that the size of the alleged deception was just as galling as the simplicity decried by Doty. The plaintiffs are alleging that Motorola inappropriately recognized $275 million of earnings during the 2006 third quarter, or 28% of net income.

SEC MIA?

Why has the SEC apparently not followed up on the PCAOB's findings? For one thing, the PCAOB inspection report provides highly credible evidence of a very large accounting misstatement made by a high-profile registrant, and with the apparent complicity of its Big Four auditor. It doesn't necessarily mean that the PCAOB is correct in its allegations, but someone should called to account by the SEC: if not Motorola and/or KPMG, then the PCAOB for a faulty inspection report.

For another thing, this case is certainly not an isolated instance for KPMG, or for that matter, Motorola. In May 2007 the SEC found that Motorola knowingly helped Adelphia Communications Corp. cook its books way back in 2000 and 2001. The 'assistance' Motorola provided to its valued customer took the form of a sham "marketing support" transaction that amounted to nothing more than a roundtrip of cash. In settlement of the SEC's proceedings against it, Motorola agreed to pay a $25 million fine and consented (without admitting or denying guilt, of course) to the entry of a cease and desist order against cooking its own books -- or anyone else's.*

Technically, I suppose, Motorola can't be accused of violating the SEC's C&D order when it allegedly cooked its own books in 2006, since the C&D order wasn't issued until 2007. But, the C&D certainly does gum up the works. With hindsight, at least, the sanctions already imposed by the SEC on Motorola would have been more severe if the SEC had known about the 2006 violations, and which the PCAOB discovered soon afterwards. In particular, no individuals at Motorola were sanctioned. One might also ask whether the 2006 alleged violations could have been prevented by the SEC, if they had not taken so long to settle the earlier ones?

And, what should become of Motorola's long-standing auditors, KPMG? They apparently knew of Motorola's questionable accounting in 2006, because they consented to it. But, inquiring minds now want to know if KPMG had also been aware of (and perhaps complicit in) the sham transaction with Adelphia. But, even if their hands are clean on the Adelphia matter, how is KPMG going to defend its issuance of a clean attestation report covering Motorola's internal controls over financial reporting?

When I was at the SEC, way back in 1992-93, it seemed that the Enforcement staff would grab all of the low hanging fruit they could get their hands on. Most the time, the open and shut cases involved small issuers and small auditing firms. But, I was never under the impression that the largest issuers and their auditors were out of bounds. As the SEC's decision to not seek sanctions against Motorola and KPMG defies a reasoned or principled explanation, it looks like either politics, indifference or incompetence are to blame. 

What This Case Says about Auditor Term Limits

I had originally reported on Jim Doty's speech out of my interest in promoting enhanced audit reliability through mandatory audit firm term limits. The clear implication of Doty's remarks is that KPMG's decades-long relationship with Motorola eventually became more obstructive than protective. I'll close this post with the following observations and conjectures:

• Even apart from the effect on its brand and integrity, the actual direct costs and potential losses to Motorola from this litigation probably wiped out any of the 'audit efficiency savings' from its half-century monogamous relationship with KPMG. I see no legitimate justification for Motorola to retain the same auditor for that long.
• Would anyone be surprised if the allegedly improper accounting were also linked to questionable bonus payments?
• What is currently on the minds of the members of Motorola's audit committee? I would not be surprised if the committee has never even addressed whether KPMG bore some responsibility by failing to detect the existence of the sham transaction with Adelphia.
• Given the PCAOB's latest findings, the litigation and the latest publicity, does the audit committee still support retaining KPMG? If so, what are they thinking?

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

*The technical prohibitions, known as 'books and records provisions' are to be found in Sections 13(a) and 13(b)(2)(A) of the Securities Exchange Act of 1934 and SEC Rules 12b-20, 13a-1, and 13a-13 t him hereunder.

The Stars and Goats of the Senate Hearing on Accounting

I am trying hard to be optimistic, but there are more than a few indications that a Senate investigation of the accounting profession's role in the economy – which began last week with a two-hour hearing by the Subcommittee on Securities, Insurance, and Investment – will fizzle out before it gathers momentum. But, there are also reasons for hope.

The formal title of the hearing was "Role of the Accounting Profession in Preventing [Yet] Another Financial Crisis." Each of seven panelists were given about 10 minutes to make an opening presentation and to answer a few questions, mostly coming from the subcommittee chair, Jack Reed, Democrat from Rhode Island. Notably, not a single question came from Republicans; in fact, nary a one so much as deigned to attend.

There's politics for you, that not even a mother could love. Yet, I am encouraged somewhat that at least a few lawmakers are ready to fight the good fight. There were certainly some stars at the hearing, but even without the boycotting Republican senators, the hearing also had its share of goats.

The first star of the Senate hearing goes to James Doty, PCAOB chairperson. To appreciate just how important he was to the proceedings, imagine if he were replaced by some implacable apologist from some stonewalling AICPA committee. Were it not for provisions in S-OX that established a PCAOB to be governed by non-accountants (see S-OX sec. 101) that's the sort of audit profession leadership we would have. Doty is also being backed by what could be emerging as the most formidable and influential investor group, the PCAOB's own Investor Advisory Group, which certainly would not exist without S-OX.

Unlike the FASB, which seems to studiously ignore the protestations of its own Investors Technical Advisory Committee, Doty appears to have taken to heart the recent scathing indictments of auditors by the PCAOB's IAG. The most telling moment of the hearing was Doty's unequivocal acknowledgement that auditors should have delved deeper into valuation, going concern and end-of-period issues before issuing their clean opinions on financial institutions that ultimately disintegrated in one way or another. Moreover, these auditors lacked the independence from management to go to them or the audit committee to sound an alarm, even if they suspected a problem.

The protestations of another panelist notwithstanding, which I will get to below, there is no getting around the fact that audit failures played a significant role in the financial crises. But, while Doty's commitment that the PCAOB will look at the auditing model, which "has not changed in more than 60 years" is encouraging, there are indications that the PCAOB's project will not be as comprehensive as it needs to be. As I stated in an earlier post, merely changing the language of the audit report, and/or supplementing it with additional disclosure prepared by the auditor cannot be expected to fundamentally change audit effectiveness. Nothing less than a fundamental reassessment of the role of auditing in public company financial reporting can begin to accomplish what is needed after the three auditing Armageddons in three decades: the S&L crisis, Enron et al, and the 2008 financial crisis.

The second star goes to Senator Reed, who teed up the issues rather well in his opening remarks and questioning. Capital markets need effective audits, and the receipt of unqualified opinions by all of the major financial institutions in the period leading up to their demise has, only a few years after S-OX, raised the same questions regarding auditor independence, audit scope, and ultimately whether a clean audit opinion provides valuable information to capital market participants.

Reed didn't say this explicitly, but I think the subtext of his questions were this: it's one thing to say that the fundamental causes of the financial crisis was poor decision-making by managers; but it must also be asked how deficient accounting and auditing rules facilitated those actions. The disintegration of major financial institutions did not occur from a single blow, and warnings had been issued by numerous credible commentators. Yet, none of these seemed to have registered sufficiently with auditors and regulators. The apparent result is that all of the financial statement revelations of value destruction that was years in the making arrived too late to be of much benefit to investors and bank regulators.

The third star belongs to Lynn Turner, the last panelist to give his prepared remarks. Don't just compare Doty to the hack who would have sat in his place absent the PCAOB. Compare Lynn Turner, a former SEC chief accountant himself, to the current chief accountant, James Kroeker was obviously standing in for SEC chair Mary Schapiro. Schapiro would have risked revealing her ignorance of accounting and auditing if she had attended. As for Kroeker, stand in is just what he did; he might have had more affect on the hearings if he were an ashtray.

Turner observed, as Kroeker should have and with more than a trace of resignation, that the questions being asked that morning haven't changed for the last 25 years. The FASB has consistently failed to issue timely standards that work; and it should at least be requiring additional disclosures to when adherence to a rule results in misleading financial statements (think, for example, Lehman's repo transactions). Under the rules that we have, banks failed to report losses that had been incurred over a number of years, and the standards to limit off-balance sheet accounting have failed. Audit committees are not as engaged as they should be, and the SEC has been more like a lapdog than a watchdog.

To the Goats We Must

After Bob Herz was relieved of his duties as chair of the FASB – because he (rightly in my estimation)believed in reporting the fair value of loans and separating the informational needs of investors from the needs of bank regulators (my opinion) – the job of leading the FASB devolved to Leslie Seidman. The hearings hit rock bottom no less than three times while she was speaking.

First, Seidman's opening remarks were a waste of time. They were a by-the-book and useless overview of the FASB and the FAF, and an empty defense of independent standard setting. In other words, everything is under control; the SEC should remain the lapdog while the FASB fiddles, postures, and caves to special interests through some amorphous protocol masquerading as "due process." I am truly sorry to have to report my impression that, in comparison to Doty, Seidman was the bland bureaucrat, lacking energy, vision and no apparent purpose higher than self-preservation.

Second, Reed asked why the FASB had not eliminated the abuses from accounting for off-balance sheet transactions, as directed by S-OX? The best that Seidman could say was that the changes that had actually been made were an "improvement" over the standards that existed at the time. But, Reed wanted to know why OBS tricks couldn't be fixed and dealt with more comprehensively, as Congress intended?

No help. And, of course, Seidman did not volunteer that off-balance sheet lease accounting is, almost ten years later, still alive and well, and available for abuse.

The third nadir was plumbed when Seidman chose not to respond to Senator Reed's concerns about whether auditing is just a loss leader for other services, or whether the fear of telling truth to power will find the auditor out on the street. To the obvious bemusement of Reed, Seidman demurred on the basis that auditor backbone was not something she knows about – even though she worked as an auditor, and as an assistant director of implementation and practices at the FASB.

Cynthia Fornelli, executive director of the Center for Audit Quality is my second goat (or maybe even tied with Seidman) for stating with a straight face that "everybody agrees" that this was not a crisis caused by auditing and accounting; and following that up by suggesting that auditors could help prevent another financial crisis if they were to attest on more than just the financial statements.  Such a notion had been more or less summarily rejected by the SEC shortly after the S&L crisis. A few years later, the AICPA did promulgate a set of attestation standards that would cover MD&A, in hopes that some companies would voluntarily purchase an attestation report, but I know of not one company to have done so.

Most bothersome to me about Fornelli is that the substance and tone of her remarks foreshadow a pitched battle with any reforms that Jim Doty's PCAOB might attempt. She leaves little doubt that the CAQ will strenuously lobby against any proposal that could take money out of the pockets of auditors. While the PCAOB will be making a good faith effort to understand how the accounting profession contributed to past failures in order to find a way forward, don't count on the accounting profession to do anything except to erect roadblocks.

The Prospects for the Future

Taking the remarks of Turner and Doty together, the subcommittee cannot escape the conclusion that financial reporting is broke, and what's worse, key stewards of financial reporting are either misguided or dysfunctional.

On the bright side, Jim Doty, if his skin is thick enough, could make history at the PCAOB. But, without an SEC renaissance and a fundamental reform of accounting standards, a reform of auditing standards can't possibly be more than a half measure.

I wish I could be more optimistic.

Less from Auditors Would be More

The Senate Subcommittee on Securities, Insurance and Investment has announced that it will meet this Wednesday to conduct a hearing entitled "The Role of the Accounting Profession in Preventing Another Financial Crisis."

"The witnesses on Panel I will be: Mr. James R. Doty, Chairman, Public Company Accounting Oversight Board; Ms. Leslie F. Seidman, Chairman, Financial Accounting Standards Board; and Mr. James L. Kroeker, Chief Accountant, U.S. Securities and Exchange Commission. The witnesses on Panel II will be: Mr. Anton R. Valukas, Chairman, Jenner & Block LLP; and Mr. Lynn E. Turner, Former Chief Accountant, U. S. Securities and Exchange Commission.…" [bold in original]

If I could whisper in the Subcommittee's collective ear, I would congratulate them on picking a topic to investigate that finally has some chance of calling auditors and financial reporting regulators to account for their role in the financial crisis. But, if they actually want helpful responses, they should focus their questions to Panel I on Jim Doty. James Kroeker is obviously there to be the punching bag for Mary Schapiro, who surely won't risk revealing her ignorance of financial reporting to hostile members of Congress; and both Kroeker and Leslie Seidman have been so IFRS-fixated for so long, and have had so little to say on the Subcommittee's topic, it's doubtful they are in a position to do little more than defend and deflect. If they actually testify under oath that adoption of IFRS should be part of the solution, I think I might become sick.

Doty should be pressed for his opinion of the views recently expressed by the PCAOB's Investor Advisory Group (IAG), which recently stated:

"The recent financial crisis presented auditors, and by extension the Sarbanes-Oxley Act audit reforms, with their first big test since these reforms were put into place. By any objective measure, they failed that test." [italics supplied]

"… Serious questions have been raised both about the quality of these [failed] financial institutions' financial reporting practices and about the quality of audits that permitted those reporting practices to go unchecked."

"While auditors did not cause the financial crisis, it is difficult to look at the list of failed institutions that received an unqualified audit just months before they failed and conclude that auditors didn't play a role."

Even though Doty's PCAOB is discussing modifications to the auditor's report, the Subcommittee should question whether that alone is a sufficient – or even a logical first – response to the fundamental issues of audit processes and auditor independence that have been raised by the PCAOB's advisory group.

If I could also whisper in Doty's ear, I would congratulate him, too, for his apparent willingness to support whatever it might take to improve the quality of audits of public companies. I would also advise him to use the impetus of an outraged public and his own recent appointment to re-evaluate the foundations upon which financial reporting regulation is based. These can be found in the Securities Act of 1933:

[A prospectus of an issuer must include] "… a balance sheet… showing all of the assets of the issuer, the nature and cost thereof… [and an income statement] in such detail and in such form as the Commission shall prescribe… [and]… certified by an independent public or certified accountant." [15 USC §77aa(25), emphasis supplied]

I would argue that the IAG's conclusions and the Subcommittee's motivation spring from a common source of concern: the last two decades have convincingly demonstrated that it is no longer practicable to expect that auditors can serve the same watchdog role that the 1933 Congress envisaged for them. Auditors may still perform the same basic functions today, but their relative importance with respect to their impact on financial reporting quality has shifted drastically. Basically, I see auditors doing three distinct things:

1. Verification of those components of financial statements that can be verified — for example, cash receipts and disbursements; amounts owed; and amounts owing.
2. Assessments of the reasonableness of estimates made by others — for example, bad debt allowances, useful lives of long-lived assets, cost allocations, and the likelihood of future events.
3. Monitoring the application of accounting standards – for example, timing of revenue recognition, determination of the functional currency of foreign operations.

Of these three functions, I can't imagine that Congress was anything but focused primarily on verification processes, as the extant (limited) accounting rules and procedures largely prescribed cost-based measurements. We could have a wonderful discussion as to why accounting standards have become as complicated as they are today, but that is not the central point for the Subcommittee. The IAG's conclusion that auditors have repeatedly failed to keep management on the straight and narrow when the stakes were highest is practically inarguable. Whether this is the fault of poor-quality auditing standards, or poor implementation of those auditing standards is also not the fundamental issue. Stated bluntly, history should have taught us by now that auditors might be good at verification of things which are capable of being verified, and very little else. This, Mr. Doty and members of Congress, is the crux of the problem we must now confront.

While one is tempted to be cynical as to the real purpose of a congressional hearing on financial reporting, the possibility that an audit of the financial statements taken as a whole, a costly and legislatively-mandated process, has become obsolete suggests a proper role for today's Congress. It should amend the securities laws to enunciate a more appropriate (and limited) role for auditors in the modern economy – where the historic cost of tangible assets has become a largely irrelevant consideration. When financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – neither management, nor the auditor. As a result, the scope of the audit would be limited to:

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

In response to the Enron et al financial reporting crisis, Congress allowed itself to be persuaded that additional attestation services were an appropriate response to audit failures. If Jim Doty can manage to reverse the tide of higher audit fees as audit reliability continues to degrade, he will become my hero. And in the process, he should find that the questions that have recently been raised regarding independence, quality, the content of the audit report, and audit firm concentration will all become much easier to answer.

New PCAOB Chair Appears to Have His Heart in the Right Place

After I left the SEC, Executive Enterprise Institute signed me up to produce and chair various SEC and financial reporting courses. Our collaboration is still going strong, and they have given me lots of exposure to guest speakers, many of whom have played significant roles in capital markets regulation. Without wishing to make comparisons to others I have been privileged to meet, I distinctly remember James Doty, the new PCAOB chair, for his energy as a speaker, positive outlook, genuinely friendly demeanor, and openness to other points of view.

But, just because somebody is a genuinely nice fella, it doesn't necessarily mean he will lead the PCAOB as investor advocates believe it should be led. I decided to write this post after reading blogger Francine McKenna, who suspects that the SEC has sold investors down the river with the appointments of the three new board members. Francine's inculpatory evidence against Jim is that he did good business defending accountants and auditors in court. As you will see from reading this post, I am actually quite hopeful that Jim will follow in the footsteps of Charles Niemeier, former PCAOB chair, who himself did quite well in the same line of business. As with Niemeier (fomer enforcement chief accountant), I would expect that Doty's performance while at the SEC (former general counsel) is a better gauge of his fitness to lead the PCAOB.

Doty at the SEC – In His Own Words

The world has changed a lot since the early 90's, when Jim was the general counsel. The SEC brand had not yet been tarnished by partisan politics of the past ten years, and ignominious asleep-at-the-switch billions of dollars blunders. Jim Doty provided his personal take on his time at the SEC in a comprehensive interview sponsored by the SEC Historical Society. It could be the best glimpse we have at Doty's regulatory and financial reporting philosophies; so, what follows are a few snippets from the interview, mixed in with my own observations.

Derivatives – Doty thought very highly of Richard Breeden, who had indeed accomplished a great deal as SEC chair; and in the areas where Breeden failed to achieve his objectives, history has proved him tragically correct. For example, Breeden was strongly in favor of enhanced derivatives regulation, and he wanted to coordinate equities and derivatives regulation by merging the CFTC and the SEC; but, he ran into opposition from his own (Republican) party.

"[Breeden] saw, clearly, the need to do it [regulate derivatives]. He saw the fact that so much of the market's activity was shifting into this area that you couldn't monitor and determine capital requirements." [page 22]

And here we are, 20 years later, with bankers still insisting that we should measure capital adequacy under GAAP. (Kindly see my post on this vexing problem.)

Corporate governance –

"Richard believed, even then I think, that it was wrong for management to be self-perpetuating. People were tinkering with and considering proposals that looked like direct [proxy] access [to nominate board members], what we're now looking at." [p. 25]

Fair value – Breeden recognized that mark-to-market accounting for loans was the logical accounting policy response to the S&L crisis, and Doty is still singing the same tune:

"Regulatory accounting principles had been identified by everybody as having something to do with the failure of the system that had been in place to regulate the federally-insured depository institutions that were S&Ls. Richard very much believed in mark to market accounting and transparency. He believed that the volatility that occurred as a result of that transparency was better than the potential for serious misunderstanding and misstatement that occurred with historic cost accounting for financial instruments. He was in a very difficult position because he was also talking to Japanese, Mexican, European, and British regulators." [p. 34, italics supplied]

Nothing much has changed there! Elsewhere in the interview, Doty readily acknowledged that lack of high quality accounting standards for financial institutions played a significant role (although not the only role) in the banking debacles to come.

The status of GAAP – Against immense political pressure, Breeden held the line on compliance with GAAP by foreign issuers, while at the same time liberalizing other requirements to enable foreign companies to raise capital in the U.S.:

"[Breeden] also, of course, said, 'First of all, we're not going to abandon GAAP. If you're Deutsche Bank [sic, Daimler-Benz?] and if you want to offer your securities and list them on the New York Stock Exchange, you'd better provide a footnote that reconciles your earnings and your reserves to GAAP.' He, of course, was exactly right." [page 34, italics supplied]

And as to adoption of IFRS, Doty concludes the interview with this observation about Mary Schapiro:

"If you want to look at one that Richard Breeden was talking about … look at mark to market accounting, and look to GAAP and the principles-based accounting, and look at Mary [Schapiro], who's undergoing all these political pressures now, dealing with all these pressures, and what's she doing with IFRS? She's saying, of course, globalization is a fact of life: you can't be against harmonization, reconciliation and one uniform system accounting, but we're not there yet. We don't know what it is. Of course, she's right. They can't. They can't allow (or require) all companies to go to IFRS when there's Taiwanese IFRS and Milanese IFRS and Argentinean IFRS." [p. 48, italics supplied]

Will Jim Doty Walk the Talk?

The PCAOB's formative years occurred while any small deviation from the party line as enunciated by Christopher Cox would not be tolerated (a true definition of 'political correctness'). Once again, the case of Charlie Niemeier is instructive, as he was the first government official to deliver a tour de force critique of the SEC's misguided plans to jettison GAAP in favor of IFRS. While there is nothing to suggest that Doty will need to be as confrontational with the current SEC administration, I hope (and predict) that he will, like Breeden, seek to leave his mark on financial reporting. It would be too easy to be a caretaker chair, merely overseeing incremental improvements to the practice of auditing without declaring any sense of larger purpose. For that, Doty should start with a forceful articulation of his vision for financial reporting, and the role auditors should be expected to play in a more investor-friendly system. Jim should be able to come up with about 80 percent of the necessary ingredients from his recent interview with the SEC Historical Society.

We know what Jim Doty stands for, and he has demonstrated that he knows how to play the role of regulator with conviction. Here's hoping for a repeat performance.

 

 

What's Going to Happen to Financial Reporting in 2011?

I predict that 2011 will be a year full of sound and fury, but signifying nothing to advance the cause of high quality financial reporting. You can take it to the bank – by which I mean any one of the banks fighting accounting reform tooth and nail.

If History is Any Guide, Watch Out!

If you are inclined to think that accounting is headed for a better place, then I implore you to consider recent history, as devastatingly portrayed by one of the most successful and smartest investors of our time, Charlie Munger. In an interview published in Spring 2009 (video here; magazine version here) with former SEC Commissioner Joseph Grundfest, Munger laid much of the responsibility for the current economic problems at the feet of the accounting profession:

"I would argue that a majority of the horrors we faced would not have happened if the accounting profession were organized properly. In other words, they have a position from which, if they behaved intelligently and correctly, they could prevent a huge amount of all that's wrong with the system. And they fail utterly, time after time, after time.

"And they are way too liberal in providing the kind of accounting the financial promoters want. They have sold out … Compared to what could reasonably be with intelligence and honor, the accounting profession is a sewer." [emphasis supplied]

… "Enron never could have happened if they hadn't changed the accounting rules, and what we have now is just a bigger, widespread Enron."

… "Idiot bubbles blessed by accountants are terrible for the whole civilization."

I happened upon the Munger interview more or less coincidentally with the recent news that the Financial Accounting Foundation promoted Leslie Seidman to chair of the FASB. "Probably more than others on the board, she brings a preparer's [italics supplied] perspective to the table," said a gratified pharmaceutical executive in the CFO.com report of Seidman's appointment. Substitute "banker" for "preparer" and you'll have an even better idea of what we're in for with Leslie Seidman as chair. In an interview she gave to Floyd Norris, Seidman has already announced that bankers will be awarded the loan accounting they so desperately covet.

Can the Reputation of Accounting Get Any Lower?

Continuing on the theme of coincidences, I also commend to you a series of brief commentaries in the online version of NYT that fits right in with Munger's complaint. "What's Wrong with Accountants?" is a must read with many provocative nuggets, but I'll confine myself to just the one for now; Columbia law professor John Coffee's commentary on Lehman's now infamous "Repo 105" device for dressing up its balance sheet with the apparent acquiescence of Ernst & Young:

"[In response to the Repo 105 affair,] the S.E.C. only issued a quiet release in September that requires greater corporate disclosure of 'short-term borrowings.' That was a modest step at best, and, by only providing 'interpretive guidance' for the future, the S.E.C. seemed to accept implicitly that 'window dressing' is not fraud. … [U]ntil the S.E.C. returns to its former view that a public statement can be both technically accurate and materially misleading, investors are at risk."

"Strong public enforcement is the best answer, because other alternatives simply will not work. … [T]here are only four global accounting firms … and none wish to compete on the basis of their relative integrity." [italics supplied]

Although Munger's criticisms of accounting standards setters are devastating and accurate, Coffee's point is that the ultimate responsibility for the fundamental weaknesses in our system of financial reporting, lies with the SEC and the bank regulators.

I agree with Coffee, and from a reading of the entire interview, I am confident that Munger would agree with him as well. No matter how one may have felt about the wisdom of outsourcing accounting standard setters to groups of individuals who themselves have vested interested in the rules they set, there have been numerous points in SEC's history when that financial reporting policy should have been seriously reassessed. Although lip service has been given from time to time, a serious reconsideration has never happened.

As for what we can expect from the current SEC leadership, Munger must be highly pessimistic. Mary Schapiro may have a record of integrity and effectiveness in some other areas of capital markets regulation, which I understand less well, but her past performance clearly indicates neither sufficient interest nor acumen for accounting. None of the other Commissioners for that matter have yet to stick their necks out or say anything profound on accounting matters either.

I wonder if the SEC even had much to say to the FAF about the appointment of Leslie Seidman? It appears that with the SEC standing idly by, the FAF's new scheme to stack the board away from fair value accounting and toward IFRS adoption (as I have already predicted) is effectively in place. Two newly-created, over-compensated Board seats remain unfilled, but this will be a largely perfunctory exercise. It's not that there aren't some great candidates whom Charlie Munger could not accuse of lacking intelligence or honor, but it's a sure thing that they will be either passed over or appointed as a mere token to investor interests once the majority voting bloc has been signed, sealed and delivered.

As for my own application, which I reluctantly announced in the interests of full disclosure, I will be sending a notification to FAF that I am withdrawing my name from consideration. For what it's worth, I am not aware that FAF did anything with my application other than to acknowledge receipt. I am also unaware of any attempt on their part to discuss my application with any one of my references.

The next time a spot on the board opens up, I'll be sure to ask Charlie Munger for permission to list him as a reference.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is GM's Equity For Real?

GM's recent filing of its registration statement with the SEC represents the collision of two topics I have written about. First, the fortuitous arrival of $30.2 billion of "goodwill" on GM's balance sheet so soon after the company crammed a bankruptcy organization down the throats of irate creditors and shareholders fits nicely into my collection of goodwill accounting curios. Second, GM's description of how that "goodwill" came to be will allow us to further consider the implications of my concern that the SEC's review of GM's IPO registration could be inadequate.

I became of aware of the goodwill issue from reading Jonathan Weil's article in Bloomberg last week. Out of all of the bad things that happened to GM, at least it became eligible for "fresh-start" accounting (see the Accounting Standards Codification starting at ASC 852-10-45-17). What it meant for GM is that measurement of all recognized assets and liabilities began anew on July 10, 2009, plus a fresh delivery of goodwill from being able to pretend that the reorganized shareholder group purchased the reorganized, "New GM," (which, of course, it didn't), and accounted for it by the rules for a business combination.

As set forth in the fresh-start accounting rules, the imaginary terms of the imaginary acquisition is that shareholders bought New GM for its "reorganization value" and assumed all of New GM's liabilities (of course, the shareholders of New GM don't actually pay anything). Any positive difference between the booked assets and liabilities is recognized as "goodwill"; and an asset shortfall would result in negative shareholders' equity.

Jon makes many interesting observations in his article, and I highly recommend that you read it, but the one point that I am going focus on is that GM's shareholders' equity at December 31, 2009 would have been a negative $6.2 billion if it were not able to book a whole bunch of goodwill. Even though everyone knows that goodwill is merely, as GM itself puts it, "a residual," it can be a pretty important residual. To say that few companies would be able to pull off a successful IPO with a negative number for shareholders' equity on its balance sheet would be an understatement. To say the same after applying fresh-start accounting would be a statement of fact.

Negative shareholders' equity is an accounting anomaly. If a balance sheet purports to portray financial position of the shareholders, then – just like a negative share price – negative shareholders' equity makes no sense. The only possible explanation is that assets and liabilities themselves are out of whack. Who wants to invest in a company, especially after fresh-start accounting is applied, whose assets and liabilities are so obviously out of whack?

Let's Play SEC

So, a couple of posts ago, I asked whether the SEC was capable of functioning as an effective gatekeeper of a GM IPO. GM's application of fresh-start accounting, especially the 'goodwill' part, could well be the acid test.

This could make pretty dry reading, but I'm going to play the role of an SEC staffer who is actually drafting comments to GM.  To avoid dry becoming turgid, I'm dispensing with a lot of the formalties to be found in a genuine comment letter, and virtually all of the standard form.  Anyway, here goes nothing.

Comment #1 – Overstatement of reorganization value

On page 125 of your registration statement, you state that reorganization value is the sum of four components: (1) a discounted forecast of expected future cash flows; (2) "the fair value of operating liabilities"; (3) the fair value of non-consolidated investments, and (4) excess cash balances as of July 10, 2009. The following comment pertains to the fair value of operating liabilities (the second component), which you indicate on page 127 was $80,832 million.

We do not believe that you have determined reorganization value in accordance with GAAP. ASC 852-10-05-10 states as follows regarding the determination of reorganization value:

"…Reorganization value generally approximates fair value of the entity before considering liabilities…." [italics supplied]

PLEASE RESTATE to exclude the "fair value of operating liabilities" from the determination of reorganization value [and perhaps wipe out all of the goodwill in the process!].

Comment #2 – Definition of "operating liabilities"

The definition of "operating liabilities" is provided on page 127:

"Operating liabilities are our total liabilities excluding the liabilities listed in the reconciliation above …"

Nothwithstanding any effect of Comment #1 on your registration statement, the forgoing definition is deficient; it does not actually describe "operating liabilities," except in terms of an apparently arbitrary calculation. Should it become necessary to provide a substantive definition of "operating liabilities" after you have taken into consideration our Comment #1, you should provide a definition that is independent of total liabilities and its non-operating liability components. If necessary, restate the amount of "operating liabilities" to conform to the revised definition.

Comment #3 – Excess cash included in reorganization value

On page 126, you state that the excess cash component of the reorganization value was $33.8 billion, and that $21.2 of cash and marketable securities were restricted as to their use.

We note that if there were no excess cash balances, then reorganization value would be reduced such that goodwill recognized by fresh start accounting would be completely wiped out. In consideration of its materiality, PLEASE AMEND your registration statement to provide additional details as to how excess cash was determined. Provide an explanation of the cash flow forecasting model used, its key assumptions, how those assumptions adequately reflect the exceptionally high risks that New GM faces, and provide a sensitivity analysis on those assumptions in a tabular format. Also, provide a description of the negotiations with creditors that granted you the ability to retain excess cash; specifically, how it came to be that creditors did not successfully claim these amounts (if they were truly excess) for themselves. 

In summary, we are skeptical that, with the possible exception of your restricted cash, that New GM should consider itself to be in possession of excess cash balances.

Comment #4 – Effect of Taxes and Pensions on Goodwill

On page 136, you stated the following:

When applying fresh-start reporting, certain accounts, primarily employee benefit and income tax related, were recorded at amounts determined under specific U.S. GAAP rather than fair value, and the difference between the U.S. GAAP and fair value amounts gives rise to goodwill, which is a residual. … If all identifiable assets and liabilities had been recorded at fair value upon application of fresh-start reporting, no goodwill would have resulted." [italics supplied]

The last sentence, above, is incorrect because goodwill is also a function of reorganization value. Therefore, PLEASE AMEND your registration statement to correctly state the calculation of goodwill, and as follows:  

• Provide, preferably in tabular format, the following: the balance sheet categories for which fair value and recorded amounts differed as of July 10, 2009; their recorded amounts and respective estimated fair values; and the difference.
• In separate tables, disaggregate the forgoing differences by the variables that significantly contributed to the differences. State any assumptions that were required for the preparation of this table.

[Note: the deferred tax asset valuation allowance determination is a fertile source of earnings management. At the date of the fresh-start accounting, a "conservatively high" valuation allowance increases goodwill; and in subsequent periods, reductions in the allowance also reduce reported income tax expense. Therefore, it would behoove the SEC reviewer to examine the determination of the initial deferred tax valuation allowance very closely.]

What Will the Real Comment Letter Contain?

In summary, I reviewed only about ten pages of GM's registration statement, and generated the above comments. Among other things, I found three reasons why New GM probably doesn't have any goodwill, and as a consequence, negative shareholders' equity:

1. Overstated reorganization value due to inclusion of operating liabilities;
2. Overstated reorganization value due to overstated excess cash and marketable securities;
3. Potential overstatement of the deferred tax asset valuation allowance, with the added consequence of creating an earnings bank which can be drawn down by reducing the valuation  allowance.

Eventually, the SEC's comment letter on GM's registration statement will have to be made public. Here's hoping the Commission's staff is doing its job—even if it means that GM's IPO doesn't go forward.

GM's Future IPO: Whom Can Investors Trust?

Not only does General Motors' CEO, Edward E. Whitacre Jr., want to take GM public ASAP, he is asking the federal government to sell its $50 billion (!) stake at the same time. That's all well and good, but I have two concerns: (1) whether the SEC will, or can possibly be, an effective gatekeeper of a GM IPO; and (2) whether the contemplated timing (before the end of 2010) would be in the best interests of investors.

Concern #1: We Have Seen the Issuer, and It Is U. S.

A cornerstone of financial reporting regulation in the U.S. is the requirement that an offering of securities to the public must be preceded by a registration statement. This is the means by which required disclosures become public, while at the same time providing the SEC with all the time it needs (usually around 30 days) to review the disclosures for compliance with its rules.

Other jurisdictions claim to have similar protections for its investors, but nothing matches the thoroughness of the SEC's review of prospective IPOs. It is not uncommon for an IPO registration statement to generate dozens of comments, each one of which the issuer must address to the SEC's satisfaction before it will permit the offering to go forward.

The IPO review process isn't perfect, and the SEC in no way guarantees that they caught every "deficiency" in a document they reviewed. Yet, the SEC's reputation as the most active and effective securities regulator in the world is derived in large part from how seriously they take this most basic aspect of their work. But, the imminent IPO registration statement filing by GM could put that reputation to the test—not so much because of the record size of the transaction, but because the issuer and the regulator are one and the same.

Please forgive me for stating the obvious: the federal government holds a 61% of the outstanding shares of GM; GM's disclosures are expected to affect the offering price; and, the government has a direct and significant interest in the offering price. There is just no getting around the fact that the issuer is the government, and that selfsame government will be reviewing what is effectively the sales brochure for the offering for truth in advertising.

I would venture to say that the circumstances of the GM pose a singular challenge to the SEC, and they could be receiving the registration statement in just a few months.  To start the conversation on it can most appropriately defray itsconflict of interests, I humbly submit these ideas for the SEC's consideration:

Make the review process fully transparent.

Comments on registration statements and issuer responses are not normally made public until long after the offering has taken place. As a general matter, some could argue that confidential treatment of "deficiency letters" unnecessarily coddles issuers; but setting that cavil aside, nothing prevents the SEC from making an exception to its own policies. For example, the SEC could keep its initial comment letter confidential until GM provides its written responses. Concurrent with GM's response, both letters could be posted to the SEC's website.

Outsource the registration statement review to an independent third party.

There must be dozens of former SEC staffers in private practice who are qualified and willing to review GM's registration statement. The SEC could appoint, after a transparent selection process, a few individuals from among their alumni to serve on an independent committee whose sole responsibilities would be to review GM's registration statement, and ultimately to draft the comment letter. After appointing the committee, the SEC should recuse itself from the decision to allow the registration statement to become effective.

Review the reviewer

The SEC could hire one accountant and one attorney to oversee and report on the SEC's review of GM. Recusal, as described above, would be preferable, but an additional layer of review from an independent source is more acceptable than business as usual.

Of course, the SEC could choose to nothing special whatsoever -- i.e., proceed as if GM were like every other issuer. But, that would be a denial of reality, something which the SEC has recently become too prone to do (see Bernie Madoff, International Financial Reporting Standards, Bear Stearns, Pequod Capital and too many more). It would be acting as if a conflict between investor protection and the financial interest of the government doesn't even exist—yet that's what I am afraid will happen in the absent calls from investor groups and (gasp) politicians to undertake a singular review process that would be beyond reproach. When the government plays the issuer in the largest IPO in history, the safeguards investors are entitled to require even more reliability than deepwater blowout preventers.

Issue #2: If Timing Is Everything, Then Somebody May Be Getting Fleeced

GM seems to be poised to base its registration statement on its earnings from the third quarter of its current fiscal year. It is not uncommon for a company to time its public offering to follow on the heels of a couple of good fiscal quarters.  Under even normal circumstances, investors would have two concerns with that kind of timing: (1) whether anything like that gangbuster last six months or so can be sustained over the long term, and (2), whether the reported profits of an audited "stub" period will hold up to the scrutiny of the independent auditors.

I know that it has been the government's policy to let the management of GM run things, but after GM gets its money, Mr. Whitacre plans to take the next stagecoach out of Dodge (I noticed the pun only on the third reading). In the case of a restatement or other material error in the registration statement, Whitacre won't be around to take full responsibility for misleading investors, and the new gang in charge will be pointing fingers right and left.

For these reasons, the government needs to dictate the timing of the offering. First and foremost, it must assure that the latest balance sheet and income statement included in the registration statement will be audited (Note: interim period financial statements in the registration statement don't have to be audited under SEC rules).

Second, the CEO who signs that registration statement has to be on the hot seat for at least a year after the IPO. And, third, despite Whitacre's express wishes, the federal government needs to keep its own shares for another year after the IPO takes place. If investors are going to lose money because the IPO was mispriced, the government shouldn't be adding its shares to the public float until GM's share price is determined through a sufficient period of secondary market trading.

I can already hear in my head what the response of GM's management and IPO promoters will be: "Look, we're the ones that brought GM back from the brink. You can trust us."

Right.

An IASB Member Unleashed

I can't cite chapter and verse for this, but experience tells me that there is a cardinal rule for IASB and FASB members that goes something like this: 'If you can't say something nice about board deliberations, then don't say anything at all.' Thus, I was surprised to read that IASB member James Leisenring recently made some more-than-bland comments in regard to the quality of the sausage spewing forth out of the IASB/FASB's high-speed grinders and packers.

But, before I continue, a caveat is in order. I was not in attendance when Leisenring made the remarks that are the subject of this post. After an arduous 15-minute search I am compelled to notify readers that my only source for his comments is a very brief news article credited to one Simon Brown and entitled, IASB Member Calls Lessor Accounting Discussions with FASB "Hopeless." The report was sent to me via email by a much-respected source, who must remain nameless. I have not even been able to discover the title of the publication in which Brown's article appeared.

According to Brown's report, Leisenring made colorful comments on three topics: leases, pensions, and a disagreement among IASB members as to what constitutes "high quality accounting standards" (which I will abbreviate to "HQAS"). As lease accounting holds a special place in my pet-peeve riddled heart, I'll have more to say about the lease accounting comments at a later time. The topic for this post will be restricted to the HQAS remark.

According to Brown:

"Leisenring also explained an interpretive disagreement he has with some IASB members regarding what is meant by 'high quality standards.' He said some consider high quality accounting standards can be standards that are unambiguous, such that a practitioner 'can't fail to comply with them.' An unambiguous standard, however, could still allow 'for implicit alternatives' to the standard, Leisenring argued. He did not offer an alternative model."

Actually, I can't say that I even know from Simon's account what Leisenring is specifically referring to. What grabbed my attention was simply that the IASB members are still trying to figure out for themselves what constitutes an HQAS, especially if it will be used as a benchmark against which to judge the results of IFFRS/GAAP convergence. I'm also surprised that the dialogue among the players seems to be: (1) strictly amongst the IASB members; and (2) apparently restricted to the compliance side of standards – as opposed to whether the numbers reported in the financial statements actually will mean anything.

Regarding the strictly intramural aspect of the discussion, I have noted previously that James Kroeker, SEC Chief Accountant has stated that the SEC would want to determine whether convergence has resulted in demonstrably higher quality accounting standards before moving further down the IFRS adoption path. Leaving aside my concern that "demonstrably higher" is neither very ambitious nor specific, the SEC's view of what HQAS means should count for something to the IASB, assuming they actually care about making a case for convergence.

Moreover, if there are some doubts as to what HQAS is, the SEC's view could have been attended to more closely at the outset of formal convergence efforts (October 2002); for surely the SEC had convergence in mind when they published their congressionally mandated (see the Sarbanes Oxley Act, Section 108(d)) report on the feasibility of "principles-based" accounting standards in August 2003. According to the SEC, the "objectives-oriented" standards they are looking for from a standard setter should possess the following qualities:

"Be based on an improved and consistently applied conceptual framework;

Clearly state the accounting objective of the standard;

Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis;

Minimize exceptions from the standard;

Avoid use of percentage tests ("bright-lines") that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard."

Now, seven years later, the SEC's battle plans have been subordinated by the din and desperation of convergence wars. Are any new standards from either board "based on an improved and consistently applied conceptual framework"? Obviously not, for nary a single alteration to any conceptual framework document has occurred in the last seven years. The existing definitions for assets and liabilities are like wooden ships sent to battle against nuclear submarines.

Does each new standard, or revised standard "clearly state the accounting objective"? In a strict compliance sense, the answer could be 'yes,' but otherwise not. Take IFRS 3R on business combinations:

"The objective of this IFRS is to improve the relevance, reliability and comparability of the information that a reporting entity provides in its financial statements about a business combination and its effects. To accomplish that, this IFRS … [establishes a bunch of new rules].

Fair enough, I suppose. But, every new IFRS should "improve relevance, reliability and comparability"—so what contribution to HQAS is there from from stating what should be the objective for all accounting standards? For example, the IASB has an outstanding exposure draft proposing to continue to give companies the option to fair value financial liabilities.  "The objective of this statement is to diminish comparability and reliability by allowing companies to arbitrarily choose to measure some of their liabilities at fair value, and to measure the remainder of its liabilities according to the rules of this statement." 

As to "minimize exceptions to the standard," why did the IASB propose to exclude insurance companies from the scope of its putatively "principles-based" revenue recognition exposure draft (at earlier stages of the project, insurance was not excluded); or to exclude extractive industries from its leasing ED; or, again in IFRS 3R, and without exposing it for comment, to give acquirors the option of measuring noncontrolling interests at historic cost instead of fair value?

A High Quality Recipe -- If I May Be Allowed to Say So Myself

Up to this point, I have set aside my misgivings with the SEC's 2003 report, and especially the apparent lack of monitoring by the SEC to ensure that its recommendations were adopted.   I wanted to focus first on my misgivings with the IASB/FASB convergence project as a producer of HQAS; for taken as a whole, the last seven years have done little more than to add filler and artificial coloring to the old sausage recipes.  Now, finally, here is my very own recipe for making HQAS.

First and foremost, for there to be a higher quality accounting standard, there must be higher "earnings quality," defined as the strength of association between reported earnings and economic earnings. Higher earnings quality can, and must, be established from standard economic logic. For example, I believe that every post I have written in which I have suggested an alternative accounting standard has been based on a logical link between whatever I proposed and economic earnings. On the other hand, the Boards' leasing exposure drafts, for example, would fail this test; because, although all leases would be capitalized, the numbers put on the financial statements are arbitrarily determined.

Second, accounting should never be determined by management's intent, strategy, or even industry. An asset is an asset and a liability is a liability.

Third, do not twist perfectly clear English words into misleading terms of art. The lump left over from IFRS 3R's additions and subtractions is not "goodwill"; and multiplying an historic cost denominated in a foreign currency by a current exchange rate is not "translation." A balance sheet is not a statement of "financial position" (because of omitted economic assets and liabilities); and a statement of recognized revenues, expenses, gains is not an "income" statement. And, please don't refer to a liability or a contra-asset as a "provision" unless one is legally required to prefund a future obligation.

Fourth, if a standard must exclude certain transactions or industries from its scope, justification for a scope limitation should be based only on a comparison of the cost of producing information to its value. Why are derivatives contracts with physical settlement provisions ignored, but net-settled derivatives are recognized and measured at their fair values? Why should there be different revenue recognition rules for insurance companies than for companies that issue product warranties? I believe these are examples of political tradeoffs, as opposed to tradeoffs made with the interests of investors in mind and heart.

A recipe for high quality accounting standards doesn't have to be complicated. But, it's more like baking a cake than making sausage: if you skimp on key ingredients, it will fall flat.

ASU 2010-19: When a Dollar of Cash Is More Than a Dollar on the Balance Sheet

If you think you can find a larger wart on the backside of US GAAP than the one I am about to describe, then give it your best shot.

Here it is in a nutshell: a careful and cynical application of the foreign currency accounting rules (either US GAAP or IFRS) could result in a $10 million bank account balance being reported on the balance sheet at $25 million. That's right: balance sheet cash isn't the cash balance. I double dare you to top that one!

As you may have guessed, the rules I am referring to are part of FAS 52, Foreign Currency Translation (now Topic 830 of the Codification), which was finalized by a 4-3 vote. They have sat there unremarked upon for thirty years, until relatively recently as negative economic developments in Venezuela have elevated them from a few ounces of cream cheese on a bagel to six tons of chopped liver on a Ritz cracker.

So, into the muck gingerly wades the SEC with new guidance in the form of a staff announcement at a recent meeting of the Emerging Issues Task Force. The FASB has codified that guidance with the issuance of ASU 2010-19. As you'll see, the SEC's message to investors is ambivalent, to say the least, on an issue that is as black and white as it gets.

Setting the Stage for the Big Whopper

You may wish to refer to a related post, which I wrote almost 3 years ago, and in which I described how consolidated financial statements could actually report foreign exchange gains and losses on U.S. dollars. Here's an example from that post, albeit slightly tweaked, to set the stage for the whopper to come.

Alpha Co. is based in the U.S. and presents its financial statements in U.S. dollars (USD). Beta is Alpha's Venezuelan subsidiary, and its functional currency is the local currency of Venezuela, the Bolivar (VEB). Inflation has been high in Venezuela in recent years. For this reason, Beta holds its cash balances, worth $10 million, in USD-denominated accounts. Also, as a result of the high rate of inflation, the VEB has been steadily devaluing against the USD.

For simplicity, let's assume that the cash balances I mentioned are Beta's only asset. Under normal circumstances, this is the way that consolidation of Beta with Alpha would work:

1. The USD cash balances held by Beta would be "remeasured" into VEBs; the resulting gain (because the VEB is losing value) would be reported on Beta's income statement (in VEBs).
2. Beta's VEB financial statements (including the gain on holding USDs in Venezuela) would be "translated" to dollars for the purpose of consolidating Beta's financial statements with Alpha's.
3. The effects of the "translation" process on equity would be reported in a separate "translation adjustment" category, which would not affect income.

Thus, although total owners' equity does not change from the roundtrip that the USD is taking in the accounting records — USD Þ VEB (on the sub's books) Þ USD (in the consolidated financial statements) — the gain from the outbound leg of the trip would be reported in income, but the loss from the homeward leg would bypass the income statement and only be reported in a separate component of owners' equity, i.e., the so-called "translation adjustment."

Of course, it's a ludicrous outcome buttressed by extremely flimsy logic, but I have already beaten that drum. Here comes the whopper I've been fixin' to tell you about.

The Dual Exchange Rate Problem

Even if you absolutely detest the effect of FAS 52's remeasurement/translate procedures on reported earnings, there is the small consolation that cash (and other monetary items) are correctly stated—even after their round trip. However, this is not always the case for two reasons: (1) currency exchange controls by the country in which a foreign subsidiary is located; and (2) more bad accounting rules.

As to those currency exchange controls, they can result in multiple exchange rates. Here, for example, is how the SEC staff, in ASU 2010-19, describes the current situation in Venezuela:

"[C]urrent restrictions of foreign currency exchange in Venezuela provide that entities use the official rate of exchange to exchange funds.... As an alternative to the use of the official rate it may also be legal to utilize the parallel rate. It is possible that the parallel rate provides entities with a more liquid exchange and entities can access the parallel rate using a series of transactions via a broker."

When multiple exchange rates exist, US GAAP may permit the use of one of those exchange rates for remeasurement (per ASC 830-20-30-1, the "current rate of exchange") and another for translation (per ASC 830-30-45-6, the "dividends remittance rate"). Thus spake the SEC staff on these provisions as they apply to Venezuelan operations:

"[T]he staff has recently become aware that... certain entities may have used the parallel rate to remeasure certain US dollar denominated balances that the Venezuelan subsidiary held and then subsequently translated the Venezuelan subsidiary's assets, liabilities, and operations using the official rate. The effect of this accounting treatment resulted in reported balances in an entity's financial statements that differed from their underlying US dollar denominated values."

 [For example,] assume that at a period end … a U.S. entity's Venezuelan subsidiary held $10 million of cash denominated in U.S. dollars. Further assume that at the end of the period, the parallel rate was 5 Bolivars to every 1 U.S. dollar and the official rate was 2 Bolivars to every 1 U.S. dollar. Upon the remeasurement of the U.S. denominated cash to Bolivars and the subsequent translation of the Venezuelan subsidiary's financial statements, an entity would have reported cash of $25 million for financial reporting purposes. [Italics supplied]

 

Finally, after 30 years of sitting on its hands, the SEC has acknowledged the insanity of using one rate for remeasurement and another for translation: among other crazy things, $10 million in cash is transformed to $25 million on the balance sheet—with a hefty income statement gain in the process (due to the declining VEB).

Unfortunately, though, the SEC's solution is to soft pedal. If you're in Venezuela, but nowhere else, kindly provide some additional disclosures. Everybody else: you can keep doing that thing you do with multiple exchange rates. To all you investors out there, take comfort in knowng that the EITF, staffed with your good friends from the Big Four, has this 30-year-old emerging issue on its agenda; they'll know how to make things right—eventually.

I expect the SEC would respond that their longstanding policy is to stay away from overriding FASB rules until the Board has had its chance to fix a problem—no matter how insane and damaging those rules may be. My response is: that's not even close to good enough.  The feeling I'm left with is that the SEC, in ASU 2010-19, is conducting the orchestra with a wet noodle instead of a baton.

To help see why I think that the SEC's response is inadequate, let's try look at the problem from an auditor's perspective; or stated another way, how an investor should have expected an auditor to have resolved these kinds of problems as they arose. Let's imagine that an issuer shows the auditor the GAAP rules that lead to an actual $10 million in cash being reported as a fictitious $25 million; and the auditor perforce concludes that the issuer adhered to the letter of those rules. The auditor knows that the client's balance sheet is materially misleading: is there nothing more to be done?

For the answer to that question, I refer to Interpretation 203-1 of the AICPA's Code of Professional Conduct, Departures from Established Accounting Principles, which states as follows:

"[I]n the establishment of accounting principles it is difficult to anticipate all of the circumstances to which such principles might be applied. This rule therefore recognizes that upon occasion there may be unusual circumstances where the literal application of pronouncements on accounting principles would have the effect of rendering financial statements misleading. In such cases, the proper accounting treatment is that which will render the financial statements not misleading." [italics supplied]

 

If Interpretation 203-1 is anything more than hot air, then surely it must be invoked by an auditor faced with the now-codified Venezuela fact pattern. Never happened and never will, you say? Conclusion: Interpretation 203-1 is hot air.

Surely, when looking to the FASB for accounting standards, the SEC must hold itself and the Board to a standard that meets or exceeds the minimum (albeit nominal) ethical responsibilities of CPAs. In applying those standards to ASU 2010-19, I can only conclude that once again, little more than hot air has been produced.  If a GAAP rule fails to report dollars sitting in a bank account on the balance sheet according to their bank balances, that rule must be so arbitrary that it cannot be anything but misleading.  I cringe at the fact that such a rule is referred to by people who should know better as "accounting."   

 Chief Accountant Kroeker, I challenge you to find me an uglier wart in GAAP than this one. If you won't act decisively, and with the integrity expected of all CPAs, to repair dysfunctional rules that materially misstate cash no less, then kindly explain to investors what exactly it is that you are doing.

Is Mary Schapiro a "Mythbuster" or a Myth Maker?

On the science/entertainment TV show, Mythbusters, a zany cast of characters attempt to smash various colorful or popular myths to smithereens (often literally) using the scientific method (sort of). Can duct tape really be used to float a boat? Which would be worse: being beaten over the head with an empty beer bottle, or with a full one?

SEC Chair Mary Schapiro's speech last week at the CFA Institute's annual convention reminded me of the TV show, except that science and reason took the day off. Also, the myths she busted were neither colorful nor popular, but all of her own creation – convenient straw men to be blasted to smithereens by the stiff winds of rhetoric. In the process, Chair Schapiro attempted to created her own mythology regarding IFRS convergence.  Here's just three of them.

Myth #1: Convergence is 'Apple Pie'

"…I especially wanted to re-affirm our dedication to developing a single set of high-quality, globally-accepted accounting standards which will benefit U.S. investors…"

As Dave Albrecht pointed out in his blog, before the political push for IFRS adoption was begun in earnest, the accepted wisdom was that even if a single set of standards were attainable, that should not be the goal.

I even co-wrote a book on it. The "right" system depends on applicable laws and business regulations, corporate governance, and culture. Taking these considerations together, different jurisdictions will recognize and weight stakeholder groups differently. To Chair Schapiro's credit, for example, she unequivocally acknowledged in her speech that financial reporting exists only to serve investors. But, to her detriment, she did not mention that few other capital markets regulators in the world agree with her—and that those disagreements have recently been coming to a head.

It is also true that there are some practical advantages to a single set of standards, but the SEC has done absolutely nothing to investigate or document them in any depth. Instead, its strategy has been to repeat their Kumbaya-esque mantra in the hope that it will program us to believe that convergence is like apple pie -- that's Chief Accountant James Kroeker's metaphor, not mine. The delicious irony for convergence skeptics like myself is that apple pie is junk food.

Myth #2: Convergence is Just a Matter of Finishing a Few Projects

"While the FASB and the IASB have been working diligently to reach common solutions to difficult financial reporting issues, U.S. GAAP and IFRS are currently not converged in a number of key areas. These include the accounting for financial assets (the very types of securities at the center of the financial crisis), revenue recognition, consolidation principles, and leases."

As Jim Peterson pointed out in his own wide-ranging post, these specific issues are so politically charged, that convergence on any of them may be a practical impossibility. To Jim's point I would also add that these are issues where I am quite confident that the FASB would be able to come up with better standards than the sacrifices they may be forced to make for the sake of convergence. But, a much larger problem is that they only scratch the surface of the many significant differences between U.S. GAAP and IFRS.   There are no plans to converge any of these, and for most, I would venture to say that U.S. GAAP is demonstrably superior to IFRS.

Here is a wee list of off-the-table issues off the top of me little head (believe me, there's lots more; I just don't have the time to write about them):

Research and development – In R&D we have the case of a convergence project that was abandoned after many months of back and forth debate; and in the end, nary a comma of either GAAP or IFRS met its demise. The characteristically vague language of IFRS designed to give issuers wide latitude in determining when and how to capitalize development costs—and which was categorically rejected by the FASB in its earliest days—has survived. U.S. GAAP is better.

Business combinations – Thisis one of the most complex topics for which convergence is claimed to have been achieved. However, substantial differences remain, because the IASB couldn't bring itself to go against issuer interests. As I described in a previous post, the IFRS version gives issuers comparability-defeating free choices and watered-down disclosures in key areas. U.S. GAAP is better.

Interest and other borrowing costs – This is my favorite example for showing that convergence is hurting the quality of accounting standards rather than helping. 'Shameful' is the mildest adjective that I can think of to adequately describe both the process and the outcome of the IASB's deliberations that ultimately lead to the revisions to IAS 23. As it currently stands, both boards agree that interest costs on self-constructed assets should be capitalized, but the IASB's approach to capitalization further sweetens the opportunities for earnings management. U.S. GAAP is better.

Statement of cash flows—The IASB proudly trumpets its sham principles-based emphasis on substance over form. There can be no greater exposure of the falsity of these claims than IAS 7, which permits (but does not require) overdrafts (i.e., loans masquerading as negative cash balances) to be offset against cash accounts with positive balances. U.S. GAAP is better.

Contingent liabilities—The IASB is proposing that management will decide whether or not a particular contingent liability can be measured reliably. That's an open invitation to earnings management. U.S. GAAP has its own problems regarding contingent liabilities, but I'll still take it over what the IASB has proposed.

Impairment—This may be the area in which U.S. GAAP and IFRS are most different, yet it's not on the convergence agenda. That's an incredible omission. While it is true that U.S. GAAP facilitates "big bath" charges, IFRS facilitates quarter-by-quarter earnings micro-management. Both approaches are terrible, but U.S. GAAP is better.

Inventories – There is not just the infamous LIFO problem (I do think it's time to get rid of LIFO for financial reporting in the US), there is also a little-known yet significant IFRS requirement to value biological assets at net fair value. It sounds principles-based, but it's just another opportunity to manage earnings.  Do you prefer to recognize revenue on your current apple crop in the quarter before or after selling it on the market? IFRS gives you a choice, which you can take by the timing of your harvest. U.S. GAAP is better.

 Myth #3 – The Big Whopper: When it Comes to Accounting, Mary Schapiro Knows What She is Talking About

"Comprehensive and neutral [italics supplied] accounting standards are the bedrock upon which our securities laws are based — standards that generate accurate, consistent, comparable, relevant, and reliable information for investors, lenders, creditors, and all others who make capital allocation decisions. We have not, cannot, and will not lose sight of that fundamental principle."

Did Mary Schapiro ever take Accounting 101? If she had taken it from me, I would have taught her that there is very little about accounting standards that can be considered "neutral." If anything, "conservative" accounting standards were considered the "bedrock" of financial reporting for decades; and conservatism, of necessity, still abounds.

For example, the SEC's own rules prohibit revenue recognition until collectability of the amount owed is "reasonably assured." That's not neutral, it's conservative and essential for protecting against fraud. Similarly, both IFRS and U.S. GAAP prohibit the capitalization of research costs out of conservatism, not neutrality; and it's a prohibition that may never change. And most recently, IFRS is proposing that contingent liabilities not be recognized unless they can be measured with an unspecified degree of precision. That's also conservatism.

Neutrality, Chair Schapiro, has a role in accounting, but it is certainly not the "bedrock" of accounting standards. It would have been more accurate for you to state that, whatever an accounting standard may require, those requirements must be applied in a neutral manner. When an issuer is called upon to make an estimate when measuring an asset or liability, it should strive in good faith to make an unbiased estimate; one may not measure an allowance for bad debts conservatively, nor a fair value, nor a contingent liability.

Rather than engaging in puffery of her own, the real work of the SEC Chair should be to deploy the limited resources at her disposal for achieving greater compliance with the kind of neutrality that investors actually need and want.  Convergence as a priority pales in comparison to making sure that managers and auditors fulfill their financial reporting responsibilities as they should be expected to.  

"A lot of [the SEC's work] involves attention to the vital but sometimes overlooked field of accounting."

Quite true, but I can't help but take away from your speech, Chair Schapiro, that you have managed to overlook accounting for your entire career. You didn't even know enough to figure out that someone gave you a lousy speech to read.