This is part two of an eight part series in which I review the seven IFRS critics (Sunder, Niemeier, Ball, Ketz, Selling, Jensen & Albrecht) of whom I am aware. The series continues over the next two weeks on regular posting dates, MWF.
It has now been 30 days since Mr. Niemeier’s really big splash. The New York State Society of CPAs sponsors an annual conference featuring speakers from the Public Company Accounting Oversight Board (PCAOB). On September 10, 2008, outgoing PCAOB member Charles Niemeier assailed the Securities and Exchange Commission (SEC) push to replace U.S. generally accepted accounting principles (GAAP) with International Financial Reporting Standards (IFRS). In his strongest public comments (pdf version) to-date, Niemeier came out strongly in favor of retaining U.S. GAAP. Two public accounts of his remarks quickly became available, along with two commentaries:
- CFO.com Regulator Rips Into Global Accounting Plan by Marie Leone
- Reuters: Regulator Pans U.S. Move Toward IFRS Accounting by Emily Chasan.
- The Summa: Take This, Mr. Cox! by David Albrecht.
- NYTImes: The Rush to International Accounting by Floyd Norris
Before analyzing his speech, I’ll say a few words about his background. Niemeier’s brief biography is posted at the PCAOB website (but it may be removed after his term ends at the PCAOB in the next few days). It reads:
Charles D. Niemeier was named a member of the Public Company Accounting Oversight Board in October 2002, and served as acting chairman of the Board from January to June 2003. Prior to being appointed to the Board, Mr. Niemeier was the Chief Accountant in the Division of Enforcement of the U.S. Securities and Exchange Commission and co-chair of the Commission’s Financial Fraud Task Force. Earlier, he was a partner in the Washington, DC, law firm of Williams & Connolly LLP, where he worked for 11 years. Prior to joining Williams & Connolly, he was a practicing certified public accountant for 10 years. Mr. Niemeier received his JD from Georgetown University Law Center and his BBA from Baylor University in Waco, TX.
What the PCAOB biography does not say is that Mr. Niemeier possesses one of the few great minds in accounting practice and regulation. There are not that many great minds in accounting (or anywhere else for that matter), and the majority tend to proceed into academe where they can deal with accounting issues at the highest level of theory and abstraction. In my opinion, the other greatest minds to have worked recently in regulation are Dennis Beresford, James Leisenring and Lynn Turner. All have left their stamp on American accounting.
Mr. Niemeier’s two defining characteristics have been to work for the protection of the American investor and to support tight regulation of the financial markets. He believes the U.S. markets to be substantially unique from Europe’s because American investors heavily rely upon them for retirement savings. In Europe, pensions are supplied by government. Consequently, U.S. investors have much more at stake (from a personal sense) and have a pressing need to make sure that investments are as riskless as possible. When financial market participants in the U.S. do not comply with legal and regulatory rules, investor livelihood is threatened. This is not as true in Europe, where the focus is on wealth accumulation. Consequently, he approaches his work in market regulation as a sacred trust.
Charles Niemeier has long recognized the information asymmetry possessed by corporate executives when it comes time to report company progress to investors in the financial markets, and their tireless obsession to work on their own behalf instead of on the behalf of investors. Consequently, he has been a leading proponent of tight regulation of the financial markets, without it the system can’t work as intended. He sincerely believes in (1) the Sarbanes-Oxley Act of 2002, (2) a strong, independent PCAOB and (3) the high-minded mission of strengthening the auditing profession so that it can force corporate management to comply with securities laws and accounting rules. He believes that only through full and honest disclosure can investors be protected in the feral world of securities markets. He says in his keynote speech, “We have the lowest cost of capital, because we have the strongest system of investor protection in the world.”
In the three years of the Christopher Cox era at the SEC, things have changed in the world of regulation. Mr. Cox is not so inclined toward strong, tight regulation of the securities markets as Mr. Niemeier would like (see Ed Ketz’s editorial on The Accounting Cycle, A Pox on Christopher Cox, for more on Cox and regulation). Moreover, Mr. Cox seemingly has placed PCAOB independence (from auditing firm and corporate lobbying) at risk (for more on this see the excellent blog post on August 25, 2008 by Floyd Norris of the New York Times, Is the Accounting Oversight Board Really Independent? where he implies that the PCAOB’s independence certainly is threatened by Christopher Cox).
Finally, Mr. Niemeier believes that if the U.S. moves to IFRS, then investors will suffer because of certain factors that will mitigate the effectiveness of auditors.
Now, let’s get on to what Charles Niemeier actually said (pdf version) on September 10, 2008. As I explain in the conclusion to this article, Charles Niemeier’s speech could be as important to the 21st century American financial market system as was Thomas’s Paine’s Common Sense to the American Revolution.
To Niemeier’s way of thinking, everything revolves around the central issue of how tightly financial markets should be regulated. The opposing sides believe that either (1) market regulation is too tight and counterproductive in the U.S., or (2) recent failures show that the system of regulation still needs to be improved. Clearly belonging with the second side, Mr. Niemeier sends a message to Mr. Cox:
One would think talk of over-regulation would have been silenced. Not so. Some corners of Washington continue to pursue initiatives rooted in contentions that U.S. securities regulation was causing managers to shun U.S. markets in favor of more lightly regulated ones elsewhere. To my mind, those initiatives are misguided and could weaken the competitiveness of our markets. [italics supplied by me]
Mr. Niemeier’s speech is a focused rebuttal of three “misguided initiatives”:
- Switching to international accounting standards, proposed by SEC.
- Reliance on non-U.S. regimes for auditor oversight, proposed by PCAOB.
- Converging U.S. auditing standards to those developed by the International Federation of Accountants, discussed by PCAOB.
Misguided Initiative #1–Switching to IFRS
Charles Niemier says that IFRS are not likely to produce benefits for either U.S. investors or the U.S. economy, and that a better alternative exists. He puts forth five clear reasons for why IFRS won’t benefit U.S. investors.
First, responding to Cox’s claim that switching to IFRS will contribute to a convergence of the the best parts of both IFRS and GAAP, Niemeier says plans to switch to IFRS will undermine efforts to converge U.S. GAAP and IFRS. Rather, it is about pitching GAAP in the trash can and adopting a weaker IFRS.
Perhaps the most candid explanation for the new approach was provided by FASB Chairman Bob Herz, who said recently, “We do have the best reporting system, but the rest of the world will not accept it.” The truth is that the new approach is not about convergence, but about capitulation. It’s an exit strategy. It’s not a way of gaining comparability, but a way of getting away from GAAP. It does not address the real challenges we face. And therefore it’s not going to take us where we need to go to achieve comparability in financial reporting.
It seems to me as if Niemeier has really hit the nail squarely on the head. Truer words have rarely, if ever, been spoken. The IASB has no incentive to work with the SEC. Moreover, SEC arrogance creates unnecessary resistance to good U.S. ideas. There is little point to burning bridges before you even approach the river crossing.
Second, responding to Cox’s claim that IFRS are superior to GAAP because they are principle based, Niemeier says both are about equally principle-based. The difference lies in the detailed guidance contained in the rules. It is the lack of detail that will lead many corporate executives to perceive that they can present a rosier picture than justified. Niemeier reasons that this could come back to haunt those executives when they are taken to court. I agree that U.S. GAAP is based on principles as enunciated in the Conceptual framework. I also agree using IFRS will tempt execs to paint that rosier picture I’m unsure about the legal implications.
Third, responding to Cox’s claim that switching to IFRS will enhance comparability of financial reports, Niemeier says no, it will not. One must realize that many countries adopt IFRS but still cling to local treatments or exceptions. In addition, if IFRS are crafted to permit more flexibility, then it stands to reason that comparability will not occur.
This is where the two objectives I discussed at the outset – comparability for investors and flexibility for managers – conflict. Calls for U.S. regulators to acknowledge that IFRS are not designed to achieve comparability have already begun. For example, the AICPA has said that “a decision by the SEC to permit an IFRS option should carry with it an expectation by regulators and investors that the use of reasoned, professional judgment may yield different outcomes in similar circumstances more often under IFRS than U.S. GAAP. Comparability is also affected by cultural differences. There is nothing unique about IFRS that addresses these differences to make reporting more comparable. Research by Ray Ball of the University of Chicago and others has explored the connection between standards and comparability of reporting in depth. In their words, claiming that uniform standards produce comparable results is “substantially and misleadingly incomplete, because financial reporting practice under a given set of standards is sensitive to the incentives of the managers and auditors responsible for financial statement preparation.”
Niemeier than makes his strongest comment, “If IFRS are not going to deliver comparability, then claims that GAAP is obsolete are misplaced as well.” Niemeier again squarely hits the nail on the head. I believe this to be the single greatest reason against switching to IFRS. It simply has no chance of realizing its greatest advantage. If it is impossible to realize advantage from IFRS, then the U.S. should not make the switch. I argue that U.S. will lose the ability to compare financials among U.S. companies, which will lower their returns and cost them trillions.
Fourth, Niemeier responds to Cox’s claim that IFRS will strengthen investor protection by saying that it won’t in the U.S. Allowing corporate executive more flexibility as they prepare financial statements will only make it more difficulty to evaluate the appropriateness of their disclosures, which means that enforceability becomes more difficult. I agree. U.S. executives have a very long record of covering their tracks as they circumvent the rules. At least form was enforceable if substance wasn’t. Now, corporate executives will have carte blanche to paint any picture they so choose, and regulators will have a devil of a time in trying to figure out what the executives are up to.
Fifth, Niemeier says IFRS are more at risk from lobbying and other political pressure than GAAP, not less. I agree, and even Cox admits this in the proposed road map.
Niemeier then suggests an alternative to Cox’s policy of moving to IFRS. Neimeier’s alternative includes these points.
- “… we should stop pursuing an agenda of enhancing management discretion and instead write accounting standards in a manner that fosters, indeed requires, comparability.”
- “Whoever sets the standards should be independently funded.” Moreover, “…we need to go beyond funding, and focus on adopting and sticking to national policies of protecting the standards-setter … from influences unrelated to the quality of its standards.”
- “We should return to a policy of convergence, not planned capitulation. The focus should be on quality, not speed. …GAAP and IFRS should be virtually identical.”
- “The best way to combat bad incentives is to create a stronger counter-incentive by enforcing the standards. We need to acknowledge that enforcement is the reason for the benefits that companies get from a U.S. listing, not a detractor to the supremacy of U.S. markets.”
Misguided Initiative #2
Relying on others for international auditor oversight
Mr. Niemeier’s comments on this topic are brief and to the point. First, he says Sarbanes-Oxley gives the SEC and PCAOB better tools for regulating foreign audit firms than regulators in other countries currently possess. Second, he says that the PCAOB December 2007 proposal (that it rely upon qualifying oversight bodies in other countries to inspect their own auditors) is a bad idea.
I am concerned that some countries may have established oversight bodies not so much for their own purposes, such as to strengthen investor protection locally, but rather to persuade the PCAOB not to conduct inspections directly. … research shows that variation in local enforcement intensity can dramatically affect reporting quality. Yet the proposal would effectively balkanize inspections of audits, undermining a key mechanism to enforce consistency and quality in reporting.
I agree with Mr. Niemeier here. I have long felt this way (see Why IFRS Won’t Work in the United States. Moreover, he has so clearly hit the nail on the head that nail head is now indistinguishable from the wood’s surface.
Misguided Initiative #3
Converging U.S. and International Auditing Standards
In this section of his speech, Mr. Niemeier refers to an ongoing consideration by the PCAOB of another initiative: Converging U.S. auditing standards to those developed by the International Federation of Accountants.
Niemeier is against this because the auditing standards created by the IFA are not designed to be used for regulatory purposes. He believes that if the U.S. were to abdicate its current responsibility to create auditing standards, it would be tantamount to permitting the auditing profession to create its own standards. This, he believes will weak the regulation of auditing firms, and this will weaken protection of U.S. investor interests.
Charles Niemeier’s speech is a masterpiece, in my opinion. It should be required reading by all students of accounting, the entire body of professional accountants in the U.S., presidential candidates John McCain and Barack Obama, and as many investors as possible that make up their own mind sometimes instead of relying wholly upon specialists for their investment strategies.
The first reason that this speech is so worthwhile is that it places the IFRS debate in its proper position in the grand scheme of securities regulation in the United States. The IFRS question is all about two paradigms that are (as all paradigms inevitably are) mutually exclusive. Either less regulation is better, or more regulation is better. In this issue it is impossible to both have cake and eat it too. That Mr. Niemeier chose to frame the debate in this context speaks volumes about the quality of his mind.
The second reason why this speech is so worthwhile is that a major regulator has come out against trashing GAAP and adopting IFRS. There seems to be considerable discontent amongst the common folk of the accounting world. The decision to move to IFRS was made at the highest level and without consulting with us. Consequently, the common folk have largely adopted a fatalistic perspective on it. It is not cost effective to voice dissent, because the issue is perceived as a done deal. That such a prominent official as Charles Niemeier has come out against it has instantly put the IFRS issue into play. It isn’t a done deal if there is dissension in the regulatory ranks. There is a thought that after Cox steps down, who know what might happen.
The third reason that this speech is so worthwhile is that it provides such a great and succinct rebuttal of Cox’s misguided crusade to move the U.S. from GAAP to IFRS. If you are only going to read one document about the IFRS issue, then this is the single best document to read.
The SEC under Christopher Cox has done a great disservice to the accounting profession and to the larger investment community in the U.S. It has taken the initiative to scrap GAAP without seeking to determine the will of the people or the greater good of the people. As has been pointed out by Bob Jensen, the IFRS movement has questionable motives and simply does not pass the smell test.
The September 10, 2008 speech by Charles Niemeier is to the 21st century American financial market system as was Common Sense by Thomas Paine to the American Revolution. Here’s hoping that the common sense of Charles Niemeier will do as much good as the Common Sense of Thomas Paine;.