The Securities and Exchange Commission (SEC), charged with the responsibility to regulate all aspects of the American financial markets, has recently announced a tentative road map for the transition from requiring companies to prepare their financial statements under American generally accepted accounting principles (GAAP) to requiring the use of international financial reporting standards (IFRS). Reactions range along a continuum from enthusiastic acceptance of the plan one end to the opposite end of rejection and shock over having beloved GAAP thrown in the proverbial trash can. Many have observed that the transition is like a frenzied rush. There has been no opportunity for a consensus to develop that a move from GAAP to IFRS is the right thing to do. The SEC simply announced its intention of making the switch. There have been no answers provided to public questions.
Why now? Why so fast? Some have commented (I was one of the first) that SEC chairman Christopher Cox hopes to commit irrevocably the U.S. before President Bush leaves office and a new SEC chairman is appointed. Recognizing the impact of partisan politics provides a reasonable rationale for the SEC push when there are no obvious economic benefits for the U.S. to make the switch.
Before getting to the meat of today’s post (reviewing important remarks by Robert E. Jensen), let me provide some background to this regulatory issue. The U.S. financial system is based on the bedrock principle that investors can make the best decisions and are best protected if all have equal access to accurate financial disclosures. The result of applying this principle has been the creation of financial markets that are the unbridled envy of the world. Compared to financial markets in other parts of the world (i.e., Europe), U.S. investors experience the highest rates of return and U.S. companies incur the lowest costs of raising capital. A key reason for such success is GAAP. The U.S. has made and continues to make expensive investments in the creation of its GAAP. It has evolved over time to a set of uniform rules with embedded bright lines. Why so? Precise rules are needed by the legal system as regulators seek to enforce corporate obedience to disclosure requirements. IFRS, created by the International Accounting Standards Board, differs from GAAP in several important regards. First, IFRS is created to make it easier for companies to raise capital across national lines. IFRS is not intended to assist investors in making decisions, it is intended to assist companies in raising capital. Second, IFRS permit companies to use judgment in reporting results from operations. Investors are not secure in knowing that all companies followed IFRS in the same manner. Third, much less money has been invested in the creation of IFRS. There is an adage that reminds, you get what you pay for
Enter Robert E. Jensen, Trinity University emeritus professor and American Accounting Association 2002 Outstanding Accounting Educator. A prolific commentator on financial reporting and its regulation, derivatives and all matters related to accounting professors, Bob has been a leading critic not only of the S.E.C.-led rush to adopt IFRS, but also of adopting IFRS in at all. Retirement to a New Hampshire mountain does not seem to have slowed him.
In a landmark post to AECM (the international listserv for accounting professors) on Monday, September 14, Jensen states clearly and unequivacably, “For me the IFRS transition just does not pass the smell test.” Jensen starts his post with a poignant history of the U.S. audit industry. He summarizes;
The poor [quality of] services of auditing firms became a focal point in the U.S. Congress when equity markets appeared of the verge of collapse due to fear and distrust of the financial reporting of corporations dependent upon equity markets for capital. The Roaring 1990s burned and crashed. In a desperation move Congress passed the Sarbanes-Oxley Act (SOX) of 2002.
SOX was a shot in the arm for the auditing industry. SOX forced the auditing industry to upgrade services with SOX legal backing that doubled or even tripled or quadrupled fees for such services. Clients continue to grumble about the soaring costs of audits, but in my opinion SOX was a small price to pay for saving our equity capital markets.
He then introduces a new development:
In 2007 and 2008, the international auditing firms commenced to lobby intensively for worldwide adoption of the “IFRS” international accounting standards of the International Accounting Standards Board (IASB).
Jensen convincingly explains that IFRS cover the same topics as GAAP, but leave out many of the “bright line” rules. Hence [IFRS] generated a reputation for principles-based standards instead of rules-based standards”. He then points out:
Many of the nations, especially in Europe, that adopted IFRS do not have strong equity capital markets given their historic traditions of raising corporate capital via banks instead of individual investors buying and selling shares of common stock. Protection of investors has not had the same priorities for these nations as it has in the U.S. where faith in equity capital market integrity is vital to our market-based capitalism.
The bottom line is that IFRS is a weaker set of equity capital market accounting standards than the present FASB standards in the United States.
To summarize. Jensen started with a history that leads to a conclusion that the large U.S. auditing firms have a poor track record of influencing corporations in the United States to make honest financial disclosures. This explanable in part because there was more financial reward for providing consulting services than auditing. So auditing was deemphasized. He then contrasts how the needs of American financial markets have led to creation of strong accounting standards. Because European financial markets are different in many ways, Europe has accepted a weaker set of accounting rules. He then observes that the large auditing firms are strongly in favor of moving the U.S. toward weaker accounting standards and have a willing accomplice in SEC chairman Christopher Cox.
This begs the question of why the large auditing firms are lobbying so hard for IFRS standards to replace FASB standards? There are legitimate reasons given the complexity of auditing international firms having operations subject to varying domestic and international accounting standards. And there may be less litigation risk when bright line rules are replaced by principles-based standards that give auditors and clients much more flexibility in accounting for transactions.
But for me there are also smell test concerns here. Auditing firms love the soaring revenues from SOX, but they will love even more the soaring revenues from clients having to transition from FASB standards to IFRS international standards. Firstly, auditing firm clients will not understand IFRS such that auditing firms will make fortunes educating and training each of their clients about IFRS. Secondly, accounting systems, including enormous databases and software systems, will have to be overhauled. For example, all the firms in the U.S. who use LIFO inventory valuation will have to be changed to something else since IFRS does not allow LIFO. Walla — the consulting service revenue surge becomes remindful of the Roaring 1990s.
The added auditing firm revenue from the IFRS transition may be as much or more than the added revenue from SOX. … But to me this whole IFRS transition in the U.S. and the race to lock it in place just does not pass the smell test.
So there you have it. The entire issue of transitioning to IFRS is about money. Great, big, heaping, towering mountains and mountains of money. Eventually the large firms will donate a fraction of this wealth to university accounting programs, and I will be much less than thrilled. Coincidentally, Floyd Norris has blogged that the Big Four are intensely lobbying Christopher Cox to appoint a Big Four accountant to replace Charlie Niemeier on the PCAOB. No decision has yet been made, but for some reason I’m worried about what it will be. I leave you with an image that expresses my concern.
Over and out – - David Albrecht
Just in–Tom Selling published a post on the top 10 reasons not to adopt IFRS in the U.S. It is well written and compelling.