Peeling away financial reporting issues one layer at a time

The Politics of Accounting Convergence: Who’s Got the Power?

The gap between U.S. GAAP (unintentional pun) and International Financial Reporting Standards is a Grand Canyon.  How could it not be so, when U.S. GAAP takes up about 25,000 pages, while IFRS is a measly 2,500? And, that doesn’t tell the full story, since about half of IFRS is on only one topic, hedge accounting.  Convergence of accounting regimes could be a good thing, but we have a long way to go.

So, the SEC’s proposal to permit foreign companies to present their financial statements in accordance with IFRS sans reconciliation to U.S. GAAP could only owe its existence to political influences.  In 2006, the Committee of European Securities Regulators (CESR) announced that, unless the SEC dropped the requirement to reconcile IFRS to GAAP, they would retaliate by requiring U.S. companies listed on European exchanges to go the other way–i.e., reconcile from GAAP to IFRS.  For reasons you can well imagine, that got the attention of pro-business (as opposed to pro-investor) powers that be.

Here is just one example why elimination of the IFRS-GAAP reconciliation would be a really terrible disservice to investors:

Companies U and I are identical in every respect, except  U applies U.S. GAAP and I applies IFRS.  Both companies have an operating unit (perhaps an oil field) whose assets have a book value of $1,000,000.  Expected cash flows from operating the oil field are $200,000 per year for five years.  The fair value of the oil field is $600,000.

U, applying FAS 144, will not report an impairment, because the undiscounted sum of the estimated future cash flows from the asset is not less than its carrying amount.  I, applying IAS 36, will report a loss of $400,000.

Without a reconciliation to U.S. GAAP, investors would be clueless as to why U’s profit differed from I’s profit.  The problem would spill over into subsequent periods as depreciation expense for the assets will differ.

There are at least two other reasons why the reconciliation should not be eliminated.  First, regulators need to be able to see whether convergence is working.  If it is, we should observe net income under IFRS literally converging with GAAP.  Second, elimination of the reconciliation may reduce incentives to converge. (Actually, given the way convergence is currently being bungled, that may not be such a bad thing.)

It may also turn out that CESR overplayed its hand.  The very last thing European companies want is for the SEC to be enforcing compliance with IFRS with the same zeal and rigor it brings to bear on U.S. GAAP.  For more on this, see this recent article from CFO.com.

Finally, although not directly related to this topic, I can’t resist pointing out that FAS 144 is a deeply flawed standard, making IAS 36 far superior.  I’ll explain why in a post soon to follow.


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