In this essay, I apply a well known accounting framework to the issue of whether or not to adopt IFRS as a basis for U.S. corporations to use when preparing financial statements. The conclusion I draw is that adopting IFRS costs trillions of U.S. dollars to the American investment community.
In the course Managerial Accounting the primary topic is the inclusion of accounting information for making decisions. The framework we use is called incremental analysis. Essentially, the benefits from taking the proposed course of action should exceed the costs of taking the proposed course of action. Not profound in any way, it is plain common sense. The incremental analysis is shown in the following chart:
When performing an incremental analysis, it is absolutely essential to tie down the party that is receiving the benefits and incurring the cost. Here, it is easy. The SEC states:
The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. As more and more first-time investors turn to the markets to help secure their futures, pay for homes, and send children to college, our investor protection mission is more compelling than ever.
So in this analysis, the identified group for whom the incremental analysis is performed is most definitely U.S. investors. It is likely that if another group were identified, such as corporate executives or partners of large auditing firms, then the incremental analysis would lead to different results. Never-the-less, the Securities and Exchange Commission was created to bring order to U.S. securities markets and to protect investors. Therefore, investors is the group that matters today.
The two key characteristics of the current system of financial markets related to companies following U.S. GAAP, pertain to the corporate cost of capital and investor return. First, companies seeking capital in the U.S. incur the lowest cost of capital in the world. Second, U.S. investors reap the highest expected returns on their investment when compared to any other world financial markets.
Many believe that having good accounting rules is a fundamental reason for why it works so well. That we have good rules (better than any other set ever created) results from a process that has evolved over the years. Essentially, many U.S. executives that run corporations will bend/break/disregard any rule that gets in the way of reporting numbers the executives want reported. U.S. auditors have had little success over the years in getting companies to report good faith, honest numbers. There have been cycles of prosecutors taking company execs to court, courts requiring more specific rules for convictions, and then rule makers tightening the rules. It is frequently said that American accounting rules now have many “bright lines” that companies must absolutely follow when they prepare financial statements. The entire system of compliance and jurisprudence has resulted in the U.S. making very expensive investments in creating the accounting rules.
IFRS rules, while a step up for many (or even most) of the countries that have adopted them, actually represent a step backwards for the U.S., at least in the bright line department. Supporters of IFRS say the bright lines are not needed because company execs are supposed to do what is right. Sure. What universe do they live in? Certainly not mine. Certainly not the good ole U.S. of A. There are exceptions, such as the reporting for contingencies, but for the most part it is U.S. GAAP that has bright lines and IFRS that doesn’t. Consequently, companies that use IFRS get to massage their numbers, and reported earnings are at least 10-15% higher on average under IFRS than GAAP. All of this is indisputable scientific fact.
To make a long story very short, if the U.S. switches from GAAP to IFRS, the market values for stocks and bonds are going to go down. The amount of decline is one of the additional costs to put into the benefit/cost frame work. How much? I tried to build a contraption or model, but it contained so many assumptions it was indefensible. But we need a numbers, so I’ll say approximately $3 trillion USD, could be more or a lot more.
$3 trillion, when U.S. market capitalization is somewhere in the range of $15 trillion to $18 trillion, is very very significant. To get it I take the $1.5 trillion USD market decline from Monday’s defeat of the bail-out and double it. It is a nice round number and probably conservative (I might have chosen to triple or quadruple it).
Other costs? The CEO of British Petroleum said that the conversion for his company in the first year was $100 million USD. Second and third year costs could expand the total to $150 million USD. Apply this to 10,000 SEC reporting companies, and then add in several thousand privately held companies, hospitals, universities, etc. and the number is easily $1 trillion USD.
Investors and accountants need education and training, so they can learn to read and interpret IFRS-based financial statements. How much is this worth? There is absolutely no way of knowing. How much did itc ost when President Clinton shut down LAX for three hours so he could get a haircut on Air Force One? He only inconvenienced at least 100,000 people, costing them three hours or more of productivity. WRT IFRS, we’re talking about more than a million accountants and 50 million investors. The number is huge. But we need a number. Let’s say another trillion.
OK, now for the benefits. Except for reduced audit fees in previous years (auditors will have to take corporate numbers at face value), there are none. Reduced audit fees will amount to $100 billion over time and present valued. Stock market returns are lower, not higher, and are already factored in.
There are no other benefits, at least to U.S. investors. The U.S. switching to IFRS does not save investors any money for interpreting the statements of foreign companies, because those statements already need to be interpreted. What U.S. companies do has no impact on the effort U.S. investors expend to review company financials from of the parts of the world. The SEC and IASB talk about benefits from switching to IFRS, but the benefits accrue to U.S. corporate execs, U.S. auditors, and European investors, not U.S. investors.
Updating our chart, we get:
So, it will cost five trillion USD if the U.S. switches to IFRS from GAAP. This is such a huge number that it boggles the mind. It shows that moving to IFRS is not in the national interest of the United States of America, and it is the reason why I oppose switching from GAAP to IFRS.
Over and out – – David Albrecht