One of the courses I teach is Intermediate Accounting 2. This semester’s paper assignment is to take a position on whether the U.S. should adopt IFRS (or some form of global accounting standards) or retain its unique GAAP. To improve the quality of papers I receive, I instituted a system of peer review, requiring each paper to go though one round of double non-blind review. The end result was 28 pretty good papers (21 for GAAP, 7 for IFRS or global accounting standards). I’ll be posting the three best. This paper is by Peter Zender, a junior in accounting.
GAAP VS IFRS: Protecting Investors
by Peter Zender
It is seventy-one degrees in Scottsdale, Arizona. Perfect weather for a round of eighteen holes (golf cart used of course), an early dinner (early bird special!), and then finish off the day with a relaxing evening sitting on the patio, cold beer in hand, feet up (we’ll skip the shuffle board to avoid stereotypes). Or, I could wake up in my kid’s basement, head for an eight hour shift at the local Wal-Mart, come home to an evening of the hectic rushing most American families face, all while enjoying the freezing cold temperatures of Minnesota. Which one do I want for my retirement? Let me think…I’m going to go with Option A. Currently standing between myself and the desired dream retirement is roughly fifty years of work to make some hard earned money and then using my hard earned cash to fund thoughtful, solid investment growth. And the key to making the right investments is correct and truthful business information, including financial statements. The Generally Accepted Accounting Principles (GAAP) currently provides investors with a reasonably acceptable amount of faith to make their investments and my belief is that a switch to International Financial Reporting Standards would only hamper that faith.
As the Securities and Exchange Commission continues their push to the use of International Financial Reporting Standards, one of their claimed “goals” is to provide the most accurate information possible. This sentiment is echoed in a February 24th, 2010 speech given by Commissioner Luis A. Aguilar, “A Path Toward Global Accounting Standards that Puts Investors First”. In the speech, Aguilar outlines three points discussing the transitional effects of a GAAP to IFRS switch on investors. These include: the “institutional framework” of IFRS, the use of convergence for more easily understood and comparable financial statements, and “truth (being) essential”. (Aguilar)
With the “institutional framework” section of his speech, Aguilar is reviewing the basis for control in the IFRS system. By doing so, he admits, “IFRS, (can) provide financial statement preparers with more discretion.” (Aguilar) More wiggle room for corporations means the scale tipping away from investors. Aguilar contends that this can be counteracted by a strong governing force of auditors and regulators. Even with GAAP’s strength in rule detailed requirements there are those still finding loopholes or perpetrating frauds.
Some may even be as illogical to argue that’s why a move to IFRS is needed. For those people, consider the following scenario. There is a highway that is a common to have driver’s going dangerously over the speed limit putting others at risk. Now instead of lowering the speed limit (creating new rules) in an attempt to slow down the drivers, the government removes the speed limit completely. Are you going to feel safe driving down that road?
All the corporations and companies are racing down a highway. The truth of the matter is one would be hard pressed to find a more competitive atmosphere than that of the Business World. In his 1651 work, Leviathan, Philosopher Thomas Hobbes lists competition as the first principal of quarrel. “To this war every man, against every man, this also is consequent; that nothing can be unjust. The notions of right and wrong, justice and injustice have no place.” (Hobbes) The necessary environment of competition in the world of business has been created in order to motivate the creation of innovative products and keep prices low, but is resulting in turning that world into the type of war Hobbes’ is speaking of. One can’t fault businesses for pushing the rules to their max, it is human nature, but crossing them is another story. The rules have to be in place like a rope holding businesses at the desired limit. If not, how can investor confidence exist?
Now, Aguilar’s point counteracting the wiggle room with a strong regulatory system is absolutely correct. This could be used instead of increased rules, increase investor security by policing the corporations. However, that is a dream, not a reality. If the SEC has difficulty keeping maintaining the accuracy of our system in just one country, it isn’t realistic that a board is going to be able to control the credibility of accounting statements from all the countries under IFRS, all with differing social customs and needs. Those companies are going to twist the principles to fit their culture and we will have just as many differing systems as we did before, just under one name.
This brings us to the point of convergence. There is no reason to drift away from our culture in order to appease Europe and the rest of the world. Blogger and Professor David Albrecht sets up an argument supporting separate accounting systems due to culture in his January 20th, 2009 blog post entitled, “One World Wide Accounting Language?” In the post, Albrecht uses the analogy of making the Chinese language the universal worldwide language reasoning that their population is the largest. “People would argue that the Chinese language evolved for a separate culture from what we have in the United States… If we were to switch to Chinese, then communications here in the U.S. simply would not be as rich, we’d lose a lot of meaning.” (Albrecht) Uniformity in communication is not worth giving up our cultural needs.
In his anti-IFRS paper, “SEC’s mandate will lead to a monopoly”, Yale Professor Shyam Sunder also uses the same type of points relating to cultural needs leading to better understanding to debunk the belief in IFRS creating comparable standards.
“…the economic substance of business transactions depends on their legal, commercial, market, governance and managerial environment. Even within the US, the same set of accounting rules does not yield similar results across industries. Greater comparability of financial reports of all public firms across more than 100 countries is a pipedream. Within the European Union, accountants find little comparability between the financial reports of, say, Italian and Dutch firms – and both report under IFRS.” (Sunder)
The conclusion is that the “institutional framework” of IFRS needs a massive overhaul. If the main reason the United States is switching to IFRS is for greater comparability and the simple fact is that the accounting system does not provide those results, there is no reason to make the change. What is the sense in lowering our own standards and moving away from the social needs of our country? When I speak of social needs, I mean investing as a culture. It’s important to financial planning, especially concerning retirement, and has the potential in the future to be vital to that planning.
In Europe, retired workers generally make a higher percentage of their income through social security-programs, in addition to receiving more health care benefits than here in America. This has taken less pressure on the investing nature of the citizens and allows for more power to firms in their quest for capital through the use of IFRS. Though, there is a problem on the horizon. Declining populations and the generation “baby boomers” are putting a strain on these retirement programs in countries across the globe, including the U.S. If people can’t get the retirement funds they need from the government, a new plan would need to be enacted. During his Presidency, George W. Bush proposed a movement to privatized investing, but the proposal didn’t merit much enthusiasm. Truth told however, this may be the best option for future. The other, non attractive option is raising social security taxes substantially. This begs the question, if the world as investors is going to likely become more independent upon investment, why is our accounting system presenting firms with more power rather than the other way around? (Schifferes)
Aguilar’s final discussion point, the necessity for truth to be reflected in financial statements, goes fairly hand in hand with necessity for strong institutional framework. A framework of general regulation and rules opens the door for lack of truth and negative consequences for investors. There could also be the possibility of serious effects on the stock market as well.
In Finance, an efficient market is defined as “(a) stock market in which the price for any given stock effectively represents the expected net present value.” (Hirschey 161) In layman’s terms it means that stock prices are correctly priced and “reflect all available information”. (Hirschey 162) You can insert truthful between all and available if you’d like. Because if one is looking at levels of efficiency, they are dependent on information. In our current markets with GAAP, we have “semi strong efficiency”, meaning that markets adjust and “reflect public information” fast enough so that no unpredictable gains can be made (Hirschey 163).
Now this of course can be argued because individual investors such as Warren Buffet have been able to make abnormal returns but in general with the Internet Boom, public and some private information has been expressed much more quickly and effectively to investors. So for arguments sake let’s assume we have efficient markets. Because Investors can gain fast and easy access to information about companies they are able to make decisions quicker, and lead to more efficient markets that have a higher percentage of accurately priced stocks. However, if that information is distorted the level of efficiency will drop. The consequence of a lower efficiency includes stock prices being over or under-valued, essentially creating more volatility and more risk.
I know my initial introduction of the contrasting retirement situations was somewhat over dramatized. A switch from GAAP to IFRS doesn’t mean we’re all going to end up living in our son’s or daughter’s basement and a shift at Wal-Mart. Even with GAAP, there are always going to be winners and losers in the market. But the point is, personally, as an investor, I want a fair shake at the market. What that means is clearest and transparent financial accounting our system can provide, that also fits in with our culture. I refuse to give up reliability just to “join the club”. And that is why I do not support the SEC moving the United States to IFRS. My only hope is that Aguilar, Chairwoman Mary Schapiro, and the rest of the SEC follow through with their “careful considerations” before pushing full steam ahead for IFRS adoption.
- Aguilar, Luis A. 24 Feb 2010. “A Path Toward Global Accounting Standards That Puts Investors First.” Speech. U.S. Security and Exchange Commission. United States Security and Exchange Commission. Online. Available on internet at <http://www.sec.gov/news/speech/2010/spch022410laa-accounting.htm>.
- Albrecht, David. 29 Jan 2009. “One World-wide Accounting Language?” Web Blog post. The Summa. David Albrecht. Online. Available on internet at <https://profalbrecht.wordpress.com/2009/01/20/one-world-wide-accounting-language/>. Accessed 25 March 2010.
- Hobbes, Thomas. 1660. Leviathon: Chapter XIII Of The Natural Condition of Man as Concerning Their Felicity and Misery. Oregon State University. Online. Available on internet at <http://oregonstate.edu/instruct/phl302/texts/hobbes/leviathan-contents.html>
- Hirschey, Mark, and John Nofsinger. 2010. Investments: Analysis and Behavior. 2nd ed. Boston: McGraw Hill/Irwin. Print.
- Schifferes, Steve. 24 Nov 2005. “Pension Reform: What Other Countries Do.” BBC News. British Broadcasting Corporation. Online. Available on internet at <http://news.bbc.co.uk/2/hi/business/4462404.stm> Accessed on 25 Mar 2010.
- Sunder, Shyam. 18 Sept 2008 “SEC’s Mandate Will Lead to a Monopoly.” Financial Times. The Financial Times Ltd. Online. Available on internet at <http://www.ft.com/cms/s/0/9e3cd374-8519-11dd-b148-0000779fd18c.html> Accessed on 25 Mar 2010.