Peeling away financial reporting issues one layer at a time

IFRS and the U.S. Auditing Profession: Not a Match Made for Investors

About 10 years ago (maybe more… the older I get, the faster time flies), I attended a conference at the SEC where an FASB board member, Michael Crooch, averred that IFRS was no better or worse than GAAP–but that GAAP was a lot more detailed.  Then, as now, the part about details was an understatement.  After all, GAAP, at 25K pages, has consistently been about ten times the size of IFRS. 

But now, and for the wrong reasons (see this post), the SEC is purported to be seriously considering whether to allow U.S. firms (not just foreign firms) to file IFRS financial statements without reconciliation to U.S. GAAP.  All of the politically-correct questions in respect to the effect on audits are being posed and discussed publicly by the PCAOB–the absence of specific guidance for certain industries in IFRS (e.g., insurance), whether technical modifications to auditing standards are necessary, IFRS training for professionals, university education for students, and even if the CPA exam should be modified.

Be we freakonomists know that these aren’t the questions that really matter.  The real questions, which must certainly be the subject of closed-door discussion, relate to how changes in regulations affect audtors’ incentives. Will U.S. auditors make more money by serving U.S.-based clients reporting in accordance with IFRS?  Will they be exposed to greater risk of investor lawsuits from IFRS audits?

The question of profitability is easy to answer. Less-detailed standards means fewer bells and whistles that auditors will be called upon to examine, and thus will have fewer hours to bill.  The answer to the question of audit risk is also easy if you believe, as I do, that the reason why U.S. GAAP became so detailed was not a quest for "high quality" accounting standards, but principally to protect auditors. 

The 1968 landmark case, Escott v. BarChris was a class action lawsuit against a corporation, which had publicly issued debt and subsequently declared bankruptcy, and against its auditors. Although auditors were found liable for misstatements, the case also established that auditors who met the minimum standards of their profession should not be held liable for insufficient due diligence required of them under federal securities law. 

Arguably, a legacy of the BarChris case is the incentives given to the audit industry to write detailed accounting rules and vague auditing standards liberally sprinkled with weasel worlds like "should" instead of "must." These "professional standards" were to be the armament against aggrieved investors, while simultaneously satisfying their real clients–the managers who hired "independent" auditors and paid their fees.

It is hard to know how much grief auditors were able to spare themselves, and how much incremental business they were able to secure.  Arthur Andersen, a co-captain of the cheerleading squad, is gone, and the strategy of vague audit standards combined with detailed accounting standards clearly hasn’t shielded auditor’s piggy banks from the havoc wreaked by client shenanigans.  Whatever the actual economic impact on auditors from their efforts to muck up accounting, it does not alter the 25K-page legacy we call Generally Accepted Accounting Principles (which are neither generally accepted, nor principles-based).

I may have once agreed with Mike Crooch’s assessment of ten years ago, but I don’t anymore.  I am not willing to say that IFRS is better than GAAP, but I am now willing to say that IFRS is less worse than GAAP.  That’s because the devil is the details. U.S. auditors won’t let go of their GAAP security blanket without a fight, and if history is a guide (most recently, SOX 404), the audit profession will still be calling the shots.

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