Top Ten Reasons Why U.S. Adoption of IFRS is a Terrible Idea
[Click here for the 2012 version.]
Now that the SEC has proposed its "roadmap" for jettisoning US GAAP in favor of IFRS, critics are finally starting to build momentum. Charles Niemeier, outgoing PCAOB board member, delivered a brilliant critique of the SEC's plans to the New York State Society of CPAs. As he faces the SEC Chair Christopher Cox's guillotine for daring to disagree, Niemeier might be thinking that speaking the truth as the end approaches can set him free. On SEC-related matters, Niemeier is among the most experienced, qualified and thoughtful persons in the federal government. Only greater opportunity must await him in a private sector position for which personal integrity counts for something. Not all bureaucrats are so lucky; rumor has it that Cox resorted to arm-twisting on at least one occasion to make his staff toe the party line.
On the overseas front, CFO.com reports that the UK-based Association of Investment Companies has expressed concern that investor needs are not being placed front and center in the deliberations of the IASB. And what's more, newly proposed changes to the IASB's makeup may be little more than going through the motions.
So, with inspiration from Charles Niemeier, and apologies to David Letterman, here are my "Top Ten Reasons Why US Adoption of IFRS Is a Terrible Idea."
#10: Another S-OX 404 Waiting to Happen
It is a certainty that direct costs of conversion to IFRS will be in the billions of dollars, and much of it will go to auditors for new "services" like training, systems rejiggering and whatever else companies can be induced to pay for. If the continuing saga of the S-OX 404 debacle is any guide, it is also a safe bet that initial estimates, bearing the imprimatur of the audit firms and/or the SEC, will understate the actual costs by orders of magnitude.
What will be the benefits? The politically correct answer is that conversion to IFRS will reduce the cost of capital by achieving comparability through principles-based standards. LOL. There is simply no evidence that IFRS will reduce the cost of capital, much less be able to cover the humongous costs of conversion.
In fact, we have nothing except wishful thinking to prevent an increase in the cost of capital. Generations have bought into the notion that our capital markets are preeminent because of the distinctiveness of our system of financial reporting. Now that the current administration has decided to foist IFRS on the public, we are supposed to believe that we had better adopt the conventional wisdom about IFRS, or globalization will pass us by.
IFRS conversion is also eerily similar to S-OX 404, in that we not only have a problem of uncertain cost and unquantifiable benefits, but we also have even more acute problems in justifying the costs for smaller companies. In the case of S-OX 404, costs were not incurred by stakeholders in any sense proportionate to the benefits they could have expected to realize. That's why it is taking the SEC far too long to figure out how to reasonably implement S-OX among smaller reporting companies. As many are coming to realize, there is no good solution to that problem; far too many companies are going to be spending far too much money on their internal controls over financial reporting and receiving far too little benefit. Likewise, there is no good solution to the IFRS conversion problem for smaller companies, and that's probably why nobody at the SEC is talking about it.
#9: "The Lady [actually, the AICPA] Doth Protest Too Much, Methinks"
Far too many of the people promoting a change to IFRS can't stop salivating over the effect it will have on their bank accounts. Who can't see that auditors push IFRS out of their own self-interests: a new revenue source that could exceed S-OX, plus the prospect of reduced exposure to litigation? Who can't see that the top executives of public companies push IFRS because it will be easier to make their numbers, and they won't be second-guessed by auditors, disgruntled investors or the SEC?
Of course, none of these are good reasons, and except for the shills at the SEC, we hear no one else promoting IFRS. If there is to be a legitimate evaluation of IFRS, we have to get auditors and issuers to shut up; especially, the auditors. Just for jollies, read the AICPA Code of Conduct, mindful of what the "P" in "CPA" is supposed to stand for: "Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism." Then, ask yourself whether the AICPA's one-sided promotion of IFRS constitutes an attempt to serve or to fleece the public. (See especially the incessant and unrepentant cheerleading of its CEO, Barry Melancon, and the misleading white papers put out by the AICPA's Center for Audit Quality.)
For legitimate acceptance of IFRS to occur, we need to hear from informed investors, and not just their putative surrogates, i.e., SEC and FASB, who receive far too much support from special interest groups to be legitimately perceived as being all for the investor all of the time. Rather than blowing their own smoke, the SEC should be discussing ways to obtain large quantities of investor input – not just from carefully selected attendees at carefully orchestrated roundtable events. Relative silence from investors should not be interpreted as approval of convergence, because a classic free rider problem is at work: What small investor would incur the opportunity cost to give the SEC their two cents on IFRS for practically nothing in return? Perhaps a very few good samaritans might, but the problem becomes even more acute when you consider the SEC's recent history of ignoring the investor feedback it does receive.
The SEC went ahead and eliminated the IFRS-to-US GAAP reconciliation despite significant and strident criticism from investor groups and academics. In order for democracy to work, one has to believe that one's vote has the potential to count for something, but this SEC has already sent too many signals that the fix is in.
#8: IFRS Is No More "Principles-Based" Than US GAAP
I have already written a number of posts exposing this myth: fuzzy-lined rules are not principles, and holding up the notion of "true and fair view" as the core principle underlying IFRS is undocumented, amorphous and vacuous. The IASB's track record is anything but principles-based, and there is plenty of recent evidence, which I've written about here and here, to support that statement.
#7: Research Strongly Indicates That GAAP Is At Least As Good, If Not Superior to IFRS, so Why Switch?
In her testimony to Congress, Teri Yohn of Indiana University, brought to bear about 25 high-quality academic research studies comparing IFRS to U.S. GAAP. Highlights of her testimony are that the studies indicate that investors appear to prefer U.S. GAAP over IFRS, and that IFRS has provided greater opportunities for earnings management. Duh.
The depressing part of all this is that the SEC gave her and the academics whose research she presented short shrift when deciding to permit foreign filers to provide IFRS financial statements without reconciliation to US GAAP. The unmistakable message from the Cox-administered SEC is "damn the evidence — full speed ahead to IFRS!" One can only hope that the Democratic commissioners will insist this time around that faith-based rulemaking will be supplanted by attention to the evidence. Who knows whether the new Republican commissioner, Troy Paredese, also an academic, can rise above partisan politics to do the right thing for investors?
#6: GAAP Is Better Than the IFRS
In 1999, the FASB concluded, in its extensive report on the similarities and differences between IFRS (technically IAS at the time) and US GAAP, that IFRS was lower quality than GAAP. Very little has happened in the ensuing eight years, except for some shuffling of the deck chairs, to change that conclusion. I am certainly not aware that anyone is claiming that significant progress in closing the gap between the GAAPs has been made. In fact, PwC is now questioning whether convergence efforts should continue, since they have produced so little over the years.
Chairman Cox, ever the salesman, is fond of pointing out that the IFRS SPE rules seem to have worked better during the current subprime mortgage crisis than US GAAP's FAS 140; but, that's something of a red herring. Here is what retired professor Bob Jensen (Trinity University) wrote on the AECM listserv:
"The main problem in the subprime crisis was not the accounting standards. It was the fraud that went on in real estate appraisals and self-serving loans way beyond what many buyers could ever be expected to pay off. This is fraud at a totally different level. It was in fact a Ponzi scheme.
Also, the auditors failed to properly audit bad debt reserves in the subprime crisis. This signals an independence problem between big banks and their auditors. It's not a problem with the FASB or the IASB standards themselves. It is more of a problem with auditing standards and professionalism. Where were the auditors in the options backdating scandals? Where were the auditors in correcting absurd bad debt allowances."
The most important event affecting the IFRS versus US GAAP debate was not any single substantive change in either IFRS or US GAAP, but actions taken by the European Union to stamp out the nascent trend of adoption of US GAAP in Europe before it could be given any real chance to take hold. The political forces that control the European Union were scared to death by changes in the German law in 1998 that allowed public companies a free choice between outmoded German GAAP, US GAAP and IFRS. Indeed, the hundreds of public corporations that did switch from German GAAP split more or less evenly among IFRS and US GAAP. Panicked, the EU abruptly issued Regulation 1606/2002, mandating adoption of IFRS for all public companies by 2005.
I admit to not having an in-depth grasp of this history as to why US GAAP came to be declared contraband in Europe. One thing that is clear, however, is that any notion that acceptance of IFRS grew organically in Europe is a myth. More likely, IFRS was seized upon as a defensive measure against US GAAP, which probably made the powers that be in countries like France fearful for their reserves. The rise of IFRS in Europe was simply a political power play, and the current US administration is using Europe's fervent desire to murder US GAAP as a bargaining chip, with the Republican faithful of the SEC playing the tune.
#5: There Must Be a Better Way to Improve US Financial Reporting Than This!
Just because accounting standard setting in the United States has become a political process dominated by non-investor "stakeholders," it doesn't mean that the only path to reform is to ship the process overseas! Instead of cutting the size of the FASB, the Financial Accounting Foundation, its governing body, should have been looking for ways to increase investor influence on standard-setting. Raising awareness of this issue was one of the many positive legacies of Arthur Levitt's tenure as the SEC chair, but except for token compliance, it went largely unheeded.
You can forget about any pretense of investor influence at the IASB once US GAAP is out of the picture. China, a world leader in opacity, is now beginning to hold more sway over deliberations, while simultaneously the IASB comes increasingly under the spell of the many parliamentary approval processes it has to negotiate. Effective "board membership" will swell as every major economic power will insist on having its say.
#4: IFRS Is Not Compatible with US-Style Corporate Governance
As I wrote in a previous post, John Coffee of the Columbia Law School sees the corporate scandals taking place in Europe as fundamentally different from those in the U.S., due to significant differences in ownership structure. The scandals in Europe generally involve majority-owned corporations and do not feature an accounting manipulation. There are two reasons for this. First, financial reporting is less important to the majority owners because they rarely sell shares. Second, fraud is more easily accomplished by authorization of related-party transactions at advantageous prices, below-market tender offers, and other forms of misappropriation. 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 that are prevalent in the U.S., stock price can have a significant effect on a manager's compensation, providing them with strong incentives to manipulate accounting earnings. Thus, it stands to reason that accounting should be difficult to manipulate if it can be used to rip off shareholders. 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 management's a strong self-interest in the reported earnings and financial position. Lacking empowered gatekeepers to prevent accounting fraud, we have had to place our hopes on very inflexible accounting rules, 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 fuzzy lines, "judgment" and "reliable measurement" tests, 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.
Even accepting the assertions that IFRS works well in the 100 or so countries in which it is used, we have no way to tell whether it can work well in our environment. Anyone who says that IFRS properly applied in the US would have prevented Enron, or WorldCom, or Adelphia should have their head examined. No basis of accounting can stop fraud, but rules-based accounting will help put the fraud feasors in the clinker.
The libel against U.S. GAAP that found its way into S-OX was that Andrew Fastow was a mad genius, capable of walking an accounting tightrope by creating complex special-purpose entities (SPEs). Not true. 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. 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.
#3: Would You Have the United Nations Rewrite the US Uniform Commercial Code?
Such was the way that Bob Jensen expressed the problem of lack of sovereignty over IFRS. No matter what motions the SEC will go through, or resolutions Congress may enact, the risk of near total loss of US influence over accounting standards is a real possibility. Rising economic powers like China will have their own agendas, virtually assuring that any place at the table we would be given in exchange for abdicating our sovereignty over accounting standards used by US companies would be temporary.
And, I seriously wonder how IFRS can flourish if US GAAP is dead. Without having US GAAP for a benchmark, the race to a lowest common denominator version of financial reporting would begin in earnest. In addition to the obvious harm to investors, the US could lose one of its comparative advantages as a financial center; listings on our markets would shrink instead of grow.
#2: There Is No #2 — Can't Have a Top 10 List with Just Nine Reasons!
#1: If It Ain't Broke, Don't Fix It!
One of my colleagues at the Tuck School was Brian Quinn, who championed the approach to business policy known as "logical incrementalism." The premise is that business processes in large corporations are so complex that it is usually too risky to undertake radical change. A more effective approach would be to make smaller course adjustments over time.
Granted, sometimes things are so bad, radical change is unavoidable, but no one can say that US GAAP has put us between the proverbial rock and a hard place. US GAAP is plenty complex and has plenty of its own problems, but it is far from broken, if not still the best system of its kind that has ever been produced. While it is true that some accounting standards have done more to harm investors than to help them, the majority have resulted in incremental improvements. In other words, the process, though far from perfect, works.
Can we say the same for IFRS? Will it work as well, if at all, in the US? One answer is being brought to you by the people who said our troops would be greeted as heroes by the citizens of Iraq. I give you 10 — okay, only 9 — reasons to have a different answer.