The subject of today’s essay is to debate the notion that the time is right to kill off United States Generally Accepted Accounting Principles (GAAP). As we all are aware now, the Securities and Exchange Commission (SEC) announced on August 27, 2008, a road map for the transition from GAAP to International Financial Reporting Standards (IFRS).
In this article I argue that the U.S. moving to IFRS cannot be successful because there is no infrastructure for an integrated international financial system. Such an infrastructure is necessary for the potential of IFRS to be realized. If the potential of IFRS cannot be realized, then there is no reason for the U.S. to adopt IFRS.
The stated reason for the United States to adopt IFRS is to hasten the day’s arrival when the entire world uses one set of accounting standards for companies to report the results of operations and for investors to analyze investments world-wide.
The justification goes like this. Every time IFRS is adopted by another country, it enhances the ability of that country’s companies to raise capital across national borders. It also enhances the ability of investors anywhere in the world to compare that company’s financial reports against other companies in the world that also report under IFRS. Eventually, IFRS-using companies will have the lowest possible cost of capital and investors reading IFRS financial statement will have the greatest possible investment returns. Sounds great, doesn’t it. Can it ever work? Can you say pie in the sky or United Nations?
How much money are we talking about? As of January, 2008 (the latest month for which data are available from the World Federation of Exchanges, total market capitalization is $55 trillion USD from all major world stock exchanges. This is down $5 trillion USD from $60 trillion USD on December, 2007, and less than the all-time high of $63 trillion USD.
In January, 2008, the total market capitalization of the three major U.S exchanges is $18.6 trillion USD (mostly from the NYSE). The rest of the Americas stand at $4.1 trillion USD, Asia & Pacific stand at $17.4 trillion USD and Europe-Middle East-Africa stand at $16.7 trillion USD. OF course, these figures are impacted heavily by exchange rates and short term market conditions. Roughly speaking, the market capitalization of SEC reporting companies is approximately one-third of total world market capitalization. This percentage is about as low as it has ever been (in 2001 the U.S. share was over 50%). Never-the-less, the United States is still considered the world’s super financial power.
Infrastructure of the U.S. equity markets. The cost of capital for U.S. companies is lower than any where else in the world. This is the result of an extremely tight regulated market system with several key characteristics that reduce risks to investors. Less risk to investors results in their willingness to pay more for investments and consequently there is a lower cost of capital to companies. The regulated system requires companies to disclose credible information (U.S. accounting rules are the most stringent in the world and give companies little latitude in how to report results.). It requires national auditing firms consistently to perform reliable audits of the financial systems (U.S. auditors must register with the PCAOB and are subject to annual investigations). It requires that no one benefit from insider information. It has a rigid system of enforcement that investigates companies and investors to maintain proper functioning of all components. Rules and laws can be intentionally disregarded, but legal penalties are quickly determined and fairly meted out.
The following chart summarizes the structure and various parts of the U.S. financial system. It is the infrastructure that makes it possible for companies to raise capital and for investors to place investments.
For an international system to work as well as the system in the United States, it would need to mimic the U.S. system as closely as possible. So far, the international system is not the equal of the U.S. system in any of the key structural components. In other words, it has a poorly developed infrastructure that severely limits how well it can perform. Without an adequate infrastructure, there is no way that the system will function well enough for companies to easily attract capital across national borders, nor will the system funtion well enough for an investor to put the IFRS-based financial statements of two companies side-by-side and make a good evaluation of the relative prospects of the two companies.
These are the problems I see with the international financial system infrastructure. These are also the reasons that the the U.S. will never realize touted benefits if it transitions away from GAAP to IFRS.
First, the IASB’s IFRS permit managers to exercise their judgment when deciding what to report in financial statements. US investors do not want this, as it introduces considerable uncertainty into evaluating financial statements. Moreover, the relative absence of bright lines in IFRS make it more difficult for auditors and SEC enforcement to force compliance.
Second, world investors will never be able to easily compare IFRS-financials from companies in different parts of the world because some countries are legislating exceptions to IFRS. Consistent implementation of IFRS is essential, but probably impossible because the national interest of country A naturally differs from country B. Therefore, IFRS will be applied uniquely in each country.
Third, the U.S. system works so well because national auditing firms perform the audits of the vast majority of SEC reporting companies. Having national auditing firms makes audit opinions more consistent from company to company within the national market. Although there is some movement toward international auditing firms, in all truth we do not have it yet. What we have are mostly loose associations of firms from various countries carrying a common name brand. So far, only two of the six largest firms have made any sort of progress toward integrating operations across national borders–Ernst & Young and BDO. And these two firms are not completely integrated around the globe. Without homogeneous international auditing firms, it is impossible to adequately compare the financial statements from companies in different parts of the world.
Fourth, the PCAOB is a regulatory agency (operating as part of SEC) that enforces the Sarbanes Oxley Act of 2002 and forces U.S. auditing firms to rigorously audit public reporting companies. Having rigorous audits peformed by audit firms with backbone is a necessary first line of defense in getting companies to follow the rules honestly when preparing financial statements. The history of auditing is the U.S. clearly shows that without a government supplied exo-skeleton, auditors have great difficulty in standing up to corporate management.
Fifth, there is no unified system of securities markets, working together to eliminate opportunities for arbitrage profits. The U.S. exchanges, NYSE and NASDAQ, have acquired some exchanges in Europe, but there is no true cross national boundary integration.
Sixth, there is no international version of SEC enforcement, nor is there a unified legal system judging infractions. Until there is one true international government with abilty to levy taxes anywhere in the world and authority to pass laws regulating all financial markets in any part of the world and to consistently try offenders, then it does not matter who makes the accounting rules. Various parts of the world will be playing by different rules and there will never be enough consistency to compare companies easily.
So there you have it. For a company to raise capital easily across national boundaries and for investors to use equally transparent financial statements for comparing the financial performance of different companies anywhere in the world, it will take an international infrastructure of accounting rules, auditing firms, securities markets and government regulation. As this infrastructure does not exist, then transitioning to IFRS by the U.S. has no positive value. Actually, U.S. corporations and investors would lose the many advantages they currently hold.
Over and out – - David Albrecht