Peeling away financial reporting issues one layer at a time

Is IFRS Compatible with U.S.-Style Corporate Governance?

I just finished reading a brief, highly readable and interesting article by a Columbia Law School professor, John C. Coffee, Jr., entitled A Theory of Corporate Scandals: Why the U.S. and Europe Differ.*  The purpose of this post is to piggyback on his framework to also provide an explanation for the difference in basic approaches between U.S. GAAP and IFRS; and most importantly, why political pressure to trash U.S. GAAP and adopt IFRS should be resisted. 

How and Why, According to Coffee, U.S. and European Scandals Differ

Coffee's thesis is that corporate governance of majority-owned corporations (predominant in Europe) should be fundamentally different than corporate governance of corporations that lack a controlling shareholder group (predominant in the U.S.). It's not necessarily because there are fewer incentives to rip off other shareholders, but the feasible means to do so will differ.

Scandals in Europe involving majority-owned corporations usually do not feature an accounting manipulation. First, financial reporting is less important to the majority owners because they rarely sell shares; and if they do, they usually receive a control premium that is uncorrelated with recent earnings (and generally larger than control premia in U.S. transactions).  Second, fraud is more easily accomplished by misappropriation of the private benefits of control: authorization of related-party transactions at advantageous prices, below-market tender offers, are prime examples.  Any trading that takes place between minority owners has less to do with recent earnings reports, and more to do with an assessment of how minority shareholders will be treated by controlling interests. 

In dispersed-ownership corporations, managers do not possess private benefits of control.  Moreover, a significant portion of manager's compensation may be in the form of stock options or other forms of equity.  Therefore, stock price can have a significant effect on a manager's compensation, providing them with strong incentives to manipulate accounting earnings.

The Implications for Accounting

Professor Coffee's thesis is that differences in ownership patterns have important implications for the selection of gatekeepers: auditors, analysts, independent directors, etc.  His observations and recommendations are interesting, but I want to advance a related thesis, namely that different ownership patterns call for different types of accounting regimes. 

It stands to reason that accounting should be difficult to manipulate, if it can be used to rip off shareholders.  Thus, the evolution of U.S. GAAP can be seen as a response to the need for specific rules that minimized the role of management judgment because of their strong self-interest in the reported earnings and financial position.  This has occurred in part because U.S. gatekeepers have shown themselves to often lack sufficient resolve or power to prevent management from under-reserving, overvaluing, or just plain ole making up numbers.  U.S. managers effectively control the "independent" directors and auditors; and prior to Regulation FD, analysts bartered glowing assessment in exchange for tidbits inside information.  Without empowered gatekeepers to prevent accounting fraud, we have had to place our hopes on very inflexible accounting rules, and sheriffs like the SEC and private attorneys to catch the cases where management has attempted to surreptitiously cross the bright line.

Thus, it should be self-evident that IFRS-style accounting, replete with gray areas, would be a gift to U.S. managers.  Outright fraud would be replaced by more subtle means of "earnings management," rendering the SEC and private attorneys much less potent. Is it any wonder why U.S. corporations and their auditors are practically begging to have IFRS available to them? 

In short, it would be a grave mistake to adopt IFRS in the U.S. simply because it seems to work well elsewhere.  As corporate ownership patterns in Europe change, it may well be that IFRS may evolve to look more like U.S. GAAP.  Only after that occurs may it make more sense to have a single worldwide financial reporting regime.      

Imagine if Enron Had Applied IFRS

One of the scapegoats of the Enron scandal was "rules-based"  U.S. GAAP. The libel was that Andrew Fastow was a mad genius, capable of walking an accounting tightrope by creating complex special-purpose entities (SPEs).  But, GAAP wasn't the culprit in the Enron scandal. Frustrated Fastow was only able to get the accounting treatment he needed past the auditors by hiding from them side agreements that unwound critical provisions requiring the new investors to have a sufficient amount of capital at risk in the SPEs. 

The enduring legacy of the libel is the erroneous conventional wisdom that GAAP is responsible for Enron; and what's more, Enron et. al. might not have happened if our financial reporting system were more like IFRS.  More likely, if IFRS had been the basis of accounting for Enron instead of GAAP, it might have taken longer to discover the fraud, or to pin the blame for the fraud where it belonged.

Neither GAAP nor IFRS are principles-based, but GAAP certainly has more rules and bright lines.  At least there seems to be some method to the madness, but it would be nice if more of the rules were based on sound principles. 

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*There are two versions of this paper.  The working paper is available at no charge from the Social Sciences Research Network electronic library at http://ssrn.com/abstract=694581.  The published version is in Oxford Review of Economic Policy, Vol. 21, No. 2 (2005).

3 Comments

  1. Reply George Weinbaum December 11, 2007

    I don’t cut Arthur Andersen any slack. I don’t care what supposed “side agreements” were kept from AA. AA didn’t do the job. It’s that simple. I agree with you and oppose US adoption of International Accounting Rules.

  2. Reply John Coffee December 17, 2007

    A very interesting piece. I had not focused on that application of my thesis and you make your point well. I do not want to abandon the hope for common accounting principles and the best answer may be to place more responsibility on the auditors in the U.S. You might be interested in the fuller statement of my views in a later book: Coffee, GATEKEEPERS: The Professions and Corporate Governance (OUP 2006).

  3. Reply David Albrecht February 20, 2008

    Very interesting position you take. Your reasons seems sound and sophisticated (not sophist at all).
    I have never bought into the idea that the US needs principles based GAAP. Rather, given the long history of business fraud and lax auditing over the decades, it never seemed to me that there would be any benefit to investors.
    Principles based accounting makes income smoothing easier to accomplish, and what is accounting fraud but aggressive income smoothing?
    Actually, classic arguments favoring principles based accounting can best be understood in the context of management attempting to smooth income so that the true or intrinsic performance of the company is being reported. Why deal with the vagaries of rules when subtle and necessary adjustments by managers are all that are needed to better report the performance of the company?
    Your argument against adoption of IFRS is important at this time, when so few are standing up in opposition to the wave of IFRS.

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