Peeling away financial reporting issues one layer at a time

EU and IASB Ratchet Up Pressure on the U.S. to Abandon GAAP

The European Commission sponsored a two-day conference last week entitled "Financial Reporting in a Changing World." I was not invited to speak (J), but if I had been, this is what I would have said: Let's not use this 'changing world' stuff as an excuse to make more silly rules! Financial reporting is much less than it could be, and will remain so unless we recognize that it can only serve one master, investors. If we cannot come to agreement on that simple proposition, then we are doomed to more decades of posturing and squabbling, and with little to show for our efforts.

But it was Charlie McCreevy (EU Internal Markets Commissioner), and not I, who was tasked with giving the "keynote" address.

"We have important lessons to learn for the future role of accounting. … The crisis has thrown up certain issues which need to be addressed. Did the accounting rules accelerate the crisis or aggravate it? Moving forward, there are also medium- to long-term reflections, such as to what extent buffers should be in place and what model we should use for this. Another broader issue is whether the current corporate reporting model serves the information needs of investors and those that run the businesses."

If McCreevy's thinking is any indication of changes to come for IFRS, then I hope the U.S. has the good sense to say 'thanks, but no thanks.' The most "important lesson" we should finally have learned, but apparently have not, is that financial reporting cannot serve more than one master (I know, I already said that). It has been almost 90 years since a University of Chicago economist/accountant, J. Maurice Clark, coined the maxim, "different costs for different purposes."* Obviously, it applies to more than costs; in fact, it applies to all manner of decision making. If government regulators want to measure the capital adequacy of financial institutions, they must develop their own rules; if corporate boards want to measure the performance of management, they must develop and implement their own systems; if accounting standard setters are to respond to the needs of investors, then they must tell all other 'stakeholders' to take a hike.

If we can maintain separate systems for taxation and financial reporting, why can't we do the same for investors? What McCreevy won't confess is that institutions (financial and otherwise), by dint of their magnanimous contributions to the coffers of the politicians that tolerate his presence, insist on being able to massage their financial statements.

So, to McCreevy, how accounting serves the information needs of investors is just "another" issue; and not THE ISSUE. According to his speech, the "lessons" we are supposed to have learned are that: accounting does not allow for sufficient "flexibility" in the application of accounting standards; fair value accounting has been applied too widely; and believe it or not, accounting rules should "broaden" the use of loan loss provisioning because it "…has served many banks well in the past."

Perhaps, loan loss provisioning has worked better in Europe, although I seriously doubt it, but Americans and Japanese investors may have more vivid recollections of their own banking crises of the '80s and '90s. Those debacles were inarguably caused to a great extent by a financial reporting system that permitted managers to delay their day of reckoning until the trumpets of hell had sputtered silent. Moreover, in the years after the crisis, standard setters sat idly by as banks once again abused the provisioning rules: this time to create those "rainy day reserves" that former SEC Commissioner Arthur Levitt so eloquently decried.

McCreevy evidently has no qualms with going back in time to those chicken salad days when German-style reserves and "judgment" infected European financial reporting – and unintentionally helped fuel the boom of foreign listings on U.S. stock exchanges. When U.S. GAAP threatened to take over Germany, the EU hit the panic button and adopted (or should I say, 'acquired') IFRS.

 

Message to the U.S.: "Don't Make Us Angry!"

On the role of the U.S., McCreevy had this to say:

"It is very important that all major jurisdictions sign up to the international system. For us, it is crucial that the US come on board." [emphasis supplied]

If McCreevy is so confident that IFRS can be the standards he wants them to be, why must the U.S. play along? The answer is to be found in the peculiarly institution-friendly approach to financial reporting he so stridently promotes: since companies compete globally to show the highest reported earnings, no one jurisdiction should be able to create an 'unfair' advantage for its constituent companies.

On the other hand, an investor-friendly approach to financial reporting reasonably assumes that investors will seek to lower their risk of buying overpriced securities by tending toward investments listed in jurisdictions known for promulgating and enforcing full and fair disclosure rules. Such is the nature of the competition that the Europeans fear, because the U.S. can, and should, easily win. Like German GAAP before it, IFRS would shrivel up and die.

Even more strident in calling for the U.S. to play nice was John Smith, IASB member. While still smarting from McCreevy's bullying comments that the IASB wasn't jumping high and fast enough to suit the European financial institutions, he thought he would see how it feels to play the bully himself:

"If it [the United States] doesn't adopt, it will be the outlier and those countries already adopting and committing themselves to IFRSs will not accept a situation where the United States remains outside the system indefinitely, yet has a seat at the table."

I really am sorry to have to say this, but I channeled good ole George W. Bush as I read Smith's ultimatum. I hear Smith saying, "If you are not with us, you are against us." I hear myself saying to Smith and McCreevy, "Bring it on!"

The only way that McCreevy's institution-friendly vision for financial reporting can be realized is to wipe out any real competition among capital markets—by brilliantly and completely executing a grand plan to corner the market on accounting standards. But, the stridency of Smith's remarks is the first indication that a certain smugness on the part of the EU and IASB is rapidly devolving into a panicked fear that the U.S. has finally come to its senses.  

While we don't yet know much about President Obama's ultimate position, it is undeniable that the SEC seems to be getting its groove back under Mary Schapiro. Her delay in appointing a chief accountant notwithstanding, I am pretty sure the fears on the other side of the pond are justified.

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*J. Maurice Clark, Studies in the Economics of Overhead, University of Chicago Press, 1923.

3 Comments

  1. Reply Raza May 14, 2009

    Excellent post, Tom. Couldn’t agree with you more on McCreevy and Smith. I hope to see a complete halt on this transition thing.

  2. Reply Darrell Williamson May 18, 2009

    In my recent dealings, I have detected to notable change in the tone of those supporting a global transition to IFRS consistent with the McCreevy/Smith arguments. Initially, there was the cause of promoting global harmonization for the benefit of investors (sort of like the old Coke ads, where everyone is singing together). More recently, the tone has shifted to a “now or never”, “don’t get left behind” or “better get in the kitchen or you won’t like the taste” argument.
    It will be (sadly) ironic if one major outcome of the economic crisis is a worse set of accounting standards for investors.

  3. Reply Superheater May 21, 2009

    “The only way that McCreevy’s institution-friendly vision for financial reporting can be realized is to wipe out any real competition among capital markets—by brilliantly and completely executing a grand plan to corner the market on accounting standards.”
    There was a time Europe’s imperial impulses and ambitions were satisfied through the deployment of armies-now its legions of bureacrats that wish to subdue the world.
    Perhaps we need to rent a ship, and throw copies of IFRS into the Boston Harbor with some tea.
    Europe is a economic, demographic and cultural mess. Nobody should be eager to follow them into oblivion.

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