Dave Albrecht--IFRS Critic

Note:  this is the final version of this essay.

This is part seven of an eight-part series in which I review the seven International Financial Reporting Standards (IFRS) critics (Sunder, Niemeier, Ball, Ketz, Selling, Jensen & Albrecht) of whom I am aware.  The series continues on regular posting dates, MWF.

In today’s essay, I review the anti-IFRS views of myself, David Albrecht, Ph.D.  An accounting professor at Bowling Green State University in Ohio, I have been a vocal opponent of the proposed switchover in accounting standards for quite a while.  Until starting this blog two months ago, my primary forum was via posts to AECM, the e-mail listserv for accounting professors.

I am opposed to IFRS for the U.S. because (1) the politics of the decision are unwarranted, (2)  I believe it will be bad for the country, and (3) it will not aid the world in creating an integrated financial system.

Unwarranted Politics

The United States has been interested in international accounting standards since the days (1959-1972) when the AICPA’s Accounting Principles Board (APB) wrote generally accepted accounting standards (GAAP) for the United States.  The Accounting Principles Board was part-time, had an insufficient budget for research, was influenced by lobbying, and wrote rules that lacked specificity.  The U.S. auditing industry was (and pretty much always has been) ineffective in forcing companies to conscientiously follow GAAP.  Add it all together and you get widespread earnings management.  Investors found the managed financial statements to be uninformative and problematic.

Given the problems and the inability of the APB to overcome them, the U.S. started considering various standard setting alternatives.  One such alternative considered was the establishment of an international standard setting body.  The U.S. sent a representative to the inaugural International Accounting Standards Committee (IASC) in the late 1960s.  However, the U.S. decided in favor of a domestic alternative.

In the early 1970s the Financial Accounting Standards Board (FASB) was created as an independent, better funded, full-time organization for writing GAAP.  Over time it produced thousands of pages of rules and implementation guidance.  Initially, the FASB permitted some choice and flexibility in accounting standards, but eventually sought to standardize the rules with “bright lines” and no treatment alternatives.  The push for “one-size fits all” was driven by systemic priority to protect investors by combating the propensity for corporate executives to circumvent the rules and manage their earnings.  For example, corporate lawyers were so inventive in avoiding lease capitalization that the leasing standard was rewritten several times.  The success of the FASB obviated the need for other standard setting alternatives.

Meanwhile, the IASC continued on, developing a set of accounting standards.  It’s original reason for existence gone, it worked on a set of model accounting standards.  In contrast to the FASB’s GAAP, the IASC’s International Accounting Standards (IAS) were more general, permitted alternatives and contained no “bright line” rules.  The push for flexible accounting standards was driven by a desire to help corporations raise capital.  The underlying assumption was that flexibility would allow companies to be more persuasive in telling their story.  The complete set of IAS was never adopted by any country.  However, they were marketed as prototypical standards that could assist countries as they developed their own rules.  Because they were not adopted by any country, there was some scepticism as to their credibilty.

By 2000, the financial market system of the U.S. was viewed as the world economic superpower, immensely wealthy compared to the rest of the world.  Finance and accounting academics convincingly showed that the U.S. financial markets gave American companies the lowest cost of capital in the world.  Success breeds success, and the market capitalization of the U.S. exchanges peaked at 50% of the world’s total market capitalization in January, 2002.

Fueled by wealth, this was a time when U.S. market participants were expanding their presence in various parts of the world.  The NYSE and NASDAQ started purchasing national stock exchanges in various parts of the world.  American investors increasingly diversified their portfolios by investing in foreign-listed companies.  U.S. companies cross-listed their stocks on the stock exchanges of other countries.  The Big Four auditing firms derived much of their revenue and influence from their operations in the U.S., and the U.S. arms dominated the rest of the international audit organizations.  Sarbanes Oxley contained provisions that can be interpreted as an attempt to spread the American financial way, as it required foreign companies listed in the U.S. to comply with the costly provision of maintaining internal controls.  In addition, foreign auditing firms would be required to register with the PCAOB and submit to inspections.  And, the Securities and Exchange Commission and FASB started lobbying the world for one set of international accounting standards, presumably GAAP.

The importance of GAAP to the financial expansion cannot possibly be overstated.  Financial accounting is the language of business.  As a language, it reflects the culture of those that communicate with it.  It also shapes the way that its users make reason.  U.S. GAAP is an embodiment of the mores and boundaries of the American financial market system.  The American financial market system is regulated by the SEC, formed to protect investors.  The SEC has the statutory authority to create and maintain U.S. GAAP.  The driving principle underlying U.S. GAAP is that it exists to benefit investors.  Metaphorically speaking, GAAP permits investors to cut through the crap that companies report about their financial results.  Because of GAAP, American investors are the best informed investors in the world.  Informed investors can make the best decisions in allocating their capital to those companies that can use it greatest advantage.  Companies incur the lowest cost to raise capital (of any country in the world) because the accounting rules do the best job of assisting investors in their decisions.  As a result, American investors have the most stable and highest rates of return of any country in the world.  The American financial market system was built by using GAAP.  Without it, the market dynamics just don’t work as well.

To (1) combat the growing influence of the U.S. in the financial markets of various parts of the world and (2) resist the onerous provisions of Sarbanes Oxley, the European Union declared its independence.  It did so in a very powerful way.  In 2004 the EU adopted the IFRS of the International Accounting Standards Board (IASC’s successor organization).  The EU’s choices had been to adopt the standards of one of its member countries (a political impossibility) or adopt the only independent alternative.  The EU decision gave the IFRS immediate credibility that it had previously lacked.  Almost immediately, the rest of the world’s countries adopted IFRS.  Most surprising was the Canadian adoption of IFRS, as it’s accounting rules had been completely aligned with GAAP.  The rapidity of IFRS acceptance can only be understood in the context of these countries wishing to resist American financial expansion.  Nothing else can explain why so many countries caved in to IFRS so suddenly.

The importance of IFRS to European financial market independence cannot be overstated.  In Europe, the regulatory focus is on helping companies raise capital.  IFRS is a language built for a financial market culture where corporate interests dominate those of investors.  IFRS permits companies the ability to be as persuasive as possible in attempting to raise new capital.  IFRS is all about giving companies flexibility in reporting.  Culture controls its own language.  Language, in turn, influences what actions and communications take place in the culture.  And IFRS was now the language of business in the EU.

Politically out-maneuvered, the SEC had a choice to make–continue with GAAP or call for acceptance of IFRS.  It chose IFRS.  I think the choice was motivated by more than simply accounting.  By 2006, the world was much different economically.  U.S. share of world market capitalization had shrunk to 35%.  The 15% decline share of market capitalization represents an enormous opportunity loss of several trillion USD.  Whether it was due to contraction after collapse of the 1990s bubble, reaction to business scandals, the impact of increasing trade imbalance, a natural contraction after expansion failure, or some other reason or reasons is immaterial.  I suggest the SEC contemplated how to keep the U.S. in the financial expansion game, and considered capitulating on accounting standards.  Meanwhile, the Big Four auditing firms sensed a gargantuan source of revenue from conversion fees and lobbied hard for the U.S. to adopt IFRS.  U.S. industry groups also lobbied hard for the business-friendly IFRS.  The pro-business presidency of George W. Bush did not oppose the switch.  Ultimately, the SEC capitulated.  Investor groups, dispersed with little organization, did little lobbying and had little influence on the SEC decision.   Leading accounting academics argued against IFRS adoption, but had no impact what-so-ever.

I react negatively to this sequence of events.  Switching to IFRS for U.S. companies will not make it easier for the U.S. financial system to expand, either by acquisition or growth.  The U.S. lost on that one, the game is over.  I don’t believe the U.S. should ever have fought the battle.  The American financial expansion was ugly economic colonialism clothed in the finest Wall Street attire.  It was a power play of unprecedented economic value, and it failed.

By switching to IFRS, the U.S. is gambling now that it can exert enough influence on the IASB to remake IFRS in GAAP’s image.  If it can do so, then perhaps its dream of financial colonialism can still march on.  Unfortunately, this effort is doomed to failure.  There are reasons why IFRS will not be converted into GAAP.  Not overnight, possibly not ever.

First, the EU will continue to fight to make sure this doesn’t happen.  The EU has the language of business it wants and needs in IFRS.  The EU recently forced the IASB to change its accounting rule on fair value to be more business-friendly, and it will forever step in to protect the corporate function of raising capital.

Second, the battleground where the U.S. will attempt to remake IFRS is not conducive to making such a change.  In military jargon, it is bad and unfriendly ground.  History has consistently shown that standard setting is a political process arbitrating the goals of competing economic interests.  The IASB has a United Nations type structure based on one vote for every nation (for those 14 nations currently permitted to join).  In order to attract enough votes to get its way, the U.S. will need to find ways to forge a coalition large enough to overcome the numerically large EU voting block.  In its initial move, the U.S. has suggested an alternate structure for the IASB where votes are parsed on regional groupings.  Under this scenario, North America would be ceded as many votes as Europe.  The EU has every reason to resist this proposal, and the U.S. will never gain sufficient support on the IASC to get its way.

Third, the convergence project is doomed to failure, primarily because oil and water do not mix.  At their core, GAAP and IFRS are incompatible.  Convergence is a red herring, designed by Sir David Tweedie and other IASB members to gain IFRS approval by the U.S.  There is no motivation for the IASB to drop its core belief of prioritizing corporate interests over investor interests.  If it does, the EU will pressure it to stop.  It is said that a successful compromise makes both parties equally unhappy.  Europe has the power here, and will have no need to become or remain unhappy with any convergence compromises.

Fourth, IFRS is built on an underlying foundation that what is good for corporations will trickle down and be good for investors.  Enough theoretical work has been done over the past few decades that all should have been disabused from this idea.  Apparently not.  Corporate executives are motivated to bias financial statements so as to maximize their own interests.  Principal-agent theory explains that there is a basic incongruity between shareholder interests and executive interests.  There is no reason to support the IFRS focus on giving executives as much flexibility as they desire in creating their financial statements.  Indeed, there is every reason to resist the IFRS on this one.  Granting corporate executives flexibility in financial reporting will enrich them at the expense of investors.

Fifth, the adage, “If you can’t beat them, join them,” is not a prescription for how to your side can rally and eventually win, it is a prescription for solidifying the opposition’s win.  Switching to IFRS will make it easier only for the U.S. to remake itself in Europe’s image.

In conclusion, I do not believe that the politics surrounding IFRS adoption by the U.S. justify the U.S. taking such an action.  IFRS adoption does not benefit the U.S. politically.  The U.S. has lost a battle.  It can retreat to its position of strength–the U.S. financial market system.  It no longer is as wealthy as it once was, but it is still the biggest in the world.  No one is forcing the U.S. to make a change in accounting standards, so why should it?  There simply is nothing to gain.  As explained in the next section, there is actually much to be lost by going ahead with the switch to IFRS.

Bad for the Country

In my opinion, the SEC, stating its intention to adopt IFRS as the generally accepted accounting principles of the U.S., has made a terrible mistake.  This will end up costing trillions of dollars.  My argument for why dropping GAAP and adopting IFRS is bad for the U.S. is outlined as:

1. U.S. generally accepted accounting principles are good accounting standards optimized for this country because they frequently contain “bright line” rules.
2. U.S. GAAP is better then IFRS because it contain more “bright line” rules.
3. U.S. corporate executives will manipulate financial statements to a much greater extent under IFRS.
4. Flexibility resulting from executive judgment permitted under IFRS will make it more difficult to compare financial results between companies.
5. Cost of capital to U.S. companies will increase significantly under IFRS, and investor returns will decrease.
6. Corporate executives and large auditing firms will benefit greatly, investors will suffer.

U.S. generally accepted accounting principles are good accounting standards optimized for this country because they frequently contain “bright line” rules.

Accounting theory explains that corporate executives have many incentives leading them to succumb to temptation and bias financial statements in their own favor.  Revenues frequently are overstated and expenses understated in an attempt to meet reporting targets and earn bonus compensation.  This is recognized as a long-time constant condition in the U.S., and is called earnings management or income smoothing.  Over time, alternative accounting treatments permitted under GAAP have been removed and one-size-fits-all rules have become the norm, especially under the FASB.  Moreover, GAAP has many standards that incorporate a “bright line”, where meeting a particular numerical threshhold means that a company must make a particular disclosure.  An example of a bright line would be the 90% present value test or the 75% lease term test in rules governing the accounting for leases.

Bright lines are important because they set bounds on corporate executives when they choose what to report in financial statements.  Although there is a great deal of game-playing and non-compliance with U.S. GAAP, rules shape general reporting behavior (William Bratton 2004, “Rules, Principles, and the Accounting Crisis in the United States” European Business Organization Law Review).  Moreover, the U.S. has a tradition of prioritizing investor access to unbiased information about corporate financial performance.  Bright-line accounting rules benefit investors by requiring all companies to report certain transactions the same way.  This promotes comparability.

Over time, GAAP has seen the addition of more bright lines.  As corporate lawyers devise methods of structuring transactions to avoid existing accounting rules, the FASB responds by creating even more stringent bright-line rules.

U.S. GAAP is better than IFRS for the U.S. because it contain more “bright line” rules.

For many years U.S. GAAP has been universally considered to be the top set of accounting standards in the world.  The consensus view is formed from numerous experts, a FASB sanctioned study in 1999, academics and administrators  More precisely, U.S. GAAP is superior to IFRS for U.S. financial market participants.  IFRS might be superior to U.S. GAAP for European financial markets, but no theory has been developed to support this notion.  Why is GAAP superior to IFRS for the U.S. financial market system?

The U.S. and Europe financial markets differ from each other in several important dimensions.  American corporations tend to be owned mostly by widely dispersed ownership groups, none of which own significantly influential amounts of stock.  American corporations raise significant amounts of capital in equity markets.  American equity investors merit more societal protection because stock serve the basic function of wealth accretion for personal retirement purposes.  American financial markets are driven by a focus myopic short-term returns.  To be able to compare different companies for purposes of deciding in which one to invest, it is beneficial for all companies to report transactions the same way.  Because of the focus on the short-term, rules need to contain bright lines so as to be obvious when a company is fudging.  U.S. GAAP evolved to fill these very needs.

European corporations tend to be majority owned by large blocks of related shareholders.  European corporations primarily raise capital from bank loans.  European companies need flexibility to make their best case with bankers, who will closely investigate companies before lending to them.  Moreover, bank loans contain covenants that tie European corporate executives to certain courses of action (not available to American equity investors).  European equity investors do not need equity investments to save for retirement as pensions are provided by socialist governments.  European financial markets have more of a long-run perspective, as the focus is on control instead of make in a quick profit from an investment.  Probably, IFRS does a good job of meeting the needs of European financial market participants.  The lack of bright-line rules and alternative accounting treatments is something that bankers and corporate executives can deal with.

There are many instances where the IFRS counterpart to a GAAP accounting standard lacks bright lines.  The standard for leases is one of them.  Like the GAAP standard, IFRS permits lessee corporations to use both operating and capital lease treatments (going one further, IFRS permits a corporation to use both simultaneously for a real estate lease).  Under IFRS, the choice is left up to the “professional judgment” of corporate executives, there are no bright lines.  Under GAAP, a lease must meet one criterion out of four, and the criteria include a 75% test and a 90% test.

U.S. executives will manipulate financial statements to a much greater extent under IFRS.

U.S. corporate executives have a long and storied history of managing reported earnings.  Depending on who is commenting on the practice, it can be described as desirable (income smoothing) or undesirable (earnings manipulation, cooking the books, accounting fraud).

There is no doubt that earnings management was quite common in decades past.  However, the practice was not observable to outsiders.  Outsiders could only view the final published statements.  If asked whether they had manipulated the numbers to produce more positive results, corporate executives had no incentive to tell the truth.  Never-the-less, corporate accountants knew it was a common practice.  So did auditors.  So did executives.  Why did income smoothing take place?  There are two theories.  The first is that income smoothing provides valuable information.  The second theory is that earnings manipulation is a tool used by corporate executives for personal enrichment and wealth maximization.

Income smoothing provides valuable information. In decades past, it was argued that periodic income statements had difficult to interpret bumpy net income trend lines because seasonal recurring transactions don’t always occur at the same stage in yearly accounting periods.  For example, Figure One below shows both pre-smoothed and post-smoothed earnings streams.  Corporate executives have argued that smoothed earnings provides a service to investors by informing them of the executive perspective on corporate earnings over time.

Figure One. Income Smoothing as applied to a bumpy stream of actual net income.

Earnings manipulation enriches managers. On the other hand, critics of income smoothing argue that in reality, corporate executives have economic incentives that motivate them to manipulate earnings for personal gain instead of investor benefit (Paul Healy).  Figure Two below shows some of the dynamics.  At the upper echelons of large corporations, executives are paid by bonus instead of salary.  The amount of reported net income triggers if a bonus is to be paid, and how much.  Typical bonus plans require at least a certain minimum level of net income for a bonus to be paid at all.  Also, the amount of bonus is usually capped.  Report net income below the lower limit, and the income is wasted from the perspective of executives because it doesn’t result in any bonus payment.  Report too much net income, and the excess is similarly wasted.

Figure Two. Bonus incentive plans depend upon net income from the income statement.

This second theory predicts that corporate executives manipulate earnings largely for personal gain instead of providing an interpretation service to investors.  This theory struck a chord with accountants, auditors, regulators and academics.  By consensus, it was deemed to be descriptive of the common executive practice.   Hundreds of academic research studies provide support for the theory.

Attempting to control income smoothing, the FASB in the early 1970s embarked on a program to force all companies to account the same way for a given transaction.  When coupled with increased auditor effectiveness as a result of Sarbanes Oxley, it has resulted in greater compliance with the “bright line” rules.  Never-the-less, corporate executives frequently have disobeyed the rules.  When discovered, such scandals usually make front page headlines.  Good behavior cannot be forced, but bad behavior can be punished.  It expected that the punishment acts as a deterrence.  Has it worked?  The general consensus has been to influence most corporate accounting behavior to follow the rules.  Never-the-less, not all rules are followed.  Corporate executives still attempt to manipulate earnings.

IFRS proponents point to the instances of corporate disobedience (to accounting rules) as prima facie evidence that the system of rules and punishment does not work.  If it did, then all companies would fear punishment and account correctly all of the time.  They are wrong.  That corporate executives continue to disobey accounting rules is evidence of how strong are the incentives to motivate executives to act in an illegal and selfish manner.  It is naive to expect that removing rules and punishments, replacing them with simple requests to do a better job of accounting, will have the desired result of improving corporate accounting behavior.

If the U.S. were to adopt IFRS, corporate executives would have a field day.  The lack of bright-line rules in favor of heavy reliance on executive professional judgment would make it  easy for corporate executives to manage their reported earnings, something that they’ve shown an aptitude at for decades.  I fear that corporate executives will be able to report any trend they so desire, whether or not it relates to the uncerlying economic reality.   Figure Three shows how a positive trend line could be super imposed on a random stream of reported earnings.

Figure Three. Gross earnings manipulation.

Flexibility resulting from executive judgment permitted under IFRS will make it more difficult to compare financial results between companies.

Christopher Cox, Robert Herz, and David Tweedie keep saying that the primary reason for switching to IFRS is that if every company in the world follows the same rules in preparing financial statements, then those financial statements will be highly comparable.  I keep hearing this, and I just don’t get it.   Have they never heard of the apples/oranges challenge?

The two indisputable IFRS conditions–lack of bright lines and reliance upon corporate professional judgment– have been used by IFRS proponents to predict that under IFRS: (1) companies in one industry may account differently for a transaction than companies in another industry, (2) companies in the same industry may not account for a transaction in a similar manner, and (3) a company need not account for identical transactions the same way.  There is no way that such variation will make it easier to compare company A to company B.  Just what have these guys been smoking?

Here’s an example.  Under GAAP, all expenditures for research and development must be expensed.  Under IFRS, expenditures can be capitalized once it is determined that the discovery is commerically viable.  Commercial viability is undefined and left up to the professional judgment of corporate executives making the accounting choice.  It is conceivable under IFRS that some companies will be aggressive in seeking to defer as much as possible R&D expenditure until future periods, and it is conceivable that some companies will be extremely conservative in declaring a new process to be viable.  How then, is R&D reporting under IFRS more comparable than under GAAP, when all companies must account for R&D expenditures the same way?

Cost of capital to U.S. companies will increase significantly under IFRS, and investor returns will decrease.

This statement has been a staple of corporate finance for at thirty years, possibly longer.  It is based on relationships explained by agency theory.   Here is my attempt at a simple explanation.

Assume a case where a manager wants to start and operate a business, but must use capital supplied by outside investors for financing.  Outside investors are willing to invest, but only if the manager agrees to provide information about the status of the enterprise and agree to independent monitoring so that the outside investor can trust the supplied information.  Without any monitoring, no money whatsoever will be invested.  With poor quality monitoring perhaps some money will be invested.  With high quality monitoring more money will be invested.  From the manager’s perspective, getting more capital from investors for a given amount of effort means that raising capital is easier and hence less costly.  Investor returns increase in such circumstances because investors only invest in good opportunities.  Better information means that poor choices can be avoided.

The GAAP or IFRS issue is all about information quality.  GAAP has bright lines and limited alternatives.  IFRS has the reverse.  GAAP-based accounting disclosures are more informative and help investors make better investment decisions.  IFRS-based accounting disclosures are less informative and contribute to poorer investment decisions.  Hence, switching to IFRS will increase the average cost of capital and decrease average investor returns.  These conclusions are verified from extensive research by accounting academics.

Corporate executives and large auditing firms will benefit greatly, investors will suffer.

The United States push for switching to IFRS is being driven by politicians who are responding to corporate and accounting firm lobbying.

Corporate executives will personally benefit from U.S. adoption of IFRS because it will be much easier for the to manage earnings and report actual earnings that are right on target with expectations.  As a reult, they will be able to steer corporate results so as to maximize their bonus income, and will be better able to predict future stock prices so as to maximize profits from exercising options.

Large auditing firms with many SEC-reporting clients will also benefit greatly, as they provide educational and training services to companies that must make the swtich.  I estimate the profit to be as large as one trillion USD if IFRS are eventually required for all U.S. corporations

In an earlier essay, Benefits and Costs to U.S. Adoption of IFRS, I estimate that aggregate impact on U.S. stock market capitalization to be approximately three trillion USD.  I think it entirely possible that much of this has already been incorporated into stock prices as it appears ever more likely that U.S. switch to IFRS is a done deal.

U.S. Adoption of IFRS Will Not Aid the World in Creating an Integrated Financial System.

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.

The most heavily regulated financial system in the world is also the best system.

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.   Clifford Cox apparently agrees.  Here are his comments from Monday, November 18, 2008:

“But it is unrealistic to think we could or should make [international securities regulation] identical, because of differences in national laws, economic conditions, and objectives. These differences are healthy and normal. It is entirely reasonable for a nation to view its responsibility to its own citizens and markets as paramount. The Securities and Exchange Commission is responsible for the protection of American investors, and it will never compromise that mission. Nor should any other national regulator. One of the reasons for the remarkable success of IOSCO is that it understands this very well.

“There is yet another reason that global consultative bodies should not aspire to become global regulators. As we have learned to our misfortune time and again, international agencies often are forced to regulate to the lowest common denominator. Of necessity, they must yield to the average rather than the highest standards of their members in order to achieve consensus. Worse, the tensions that every national regulator is bound to reconcile – of factions and stakeholders, not to mention of parliaments, legislatures, and executive authorities – are multiplied a hundredfold in international bodies. These are concerns that should be considered seriously before assigning the function of global systemic risk “czar” or any similar responsibility to an international body

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.

In conclusion, I believe that I adequately dealt with the significant issues related to IFRS adoption by the U.S.  I hope that my thoughts are not irrelevant, but who know?