On the science/entertainment TV show, Mythbusters, a zany cast of characters attempt to smash various colorful or popular myths to smithereens (often literally) using the scientific method (sort of). Can duct tape really be used to float a boat? Which would be worse: being beaten over the head with an empty beer bottle, or with a full one?
SEC Chair Mary Schapiro's speech last week at the CFA Institute's annual convention reminded me of the TV show, except that science and reason took the day off. Also, the myths she busted were neither colorful nor popular, but all of her own creation – convenient straw men to be blasted to smithereens by the stiff winds of rhetoric. In the process, Chair Schapiro attempted to created her own mythology regarding IFRS convergence. Here's just three of them.
Myth #1: Convergence is 'Apple Pie'
"…I especially wanted to re-affirm our dedication to developing a single set of high-quality, globally-accepted accounting standards which will benefit U.S. investors…"
As Dave Albrecht pointed out in his blog, before the political push for IFRS adoption was begun in earnest, the accepted wisdom was that even if a single set of standards were attainable, that should not be the goal.
I even co-wrote a book on it. The "right" system depends on applicable laws and business regulations, corporate governance, and culture. Taking these considerations together, different jurisdictions will recognize and weight stakeholder groups differently. To Chair Schapiro's credit, for example, she unequivocally acknowledged in her speech that financial reporting exists only to serve investors. But, to her detriment, she did not mention that few other capital markets regulators in the world agree with her—and that those disagreements have recently been coming to a head.
It is also true that there are some practical advantages to a single set of standards, but the SEC has done absolutely nothing to investigate or document them in any depth. Instead, its strategy has been to repeat their Kumbaya-esque mantra in the hope that it will program us to believe that convergence is like apple pie — that's Chief Accountant James Kroeker's metaphor, not mine. The delicious irony for convergence skeptics like myself is that apple pie is junk food.
Myth #2: Convergence is Just a Matter of Finishing a Few Projects
"While the FASB and the IASB have been working diligently to reach common solutions to difficult financial reporting issues, U.S. GAAP and IFRS are currently not converged in a number of key areas. These include the accounting for financial assets (the very types of securities at the center of the financial crisis), revenue recognition, consolidation principles, and leases."
As Jim Peterson pointed out in his own wide-ranging post, these specific issues are so politically charged, that convergence on any of them may be a practical impossibility. To Jim's point I would also add that these are issues where I am quite confident that the FASB would be able to come up with better standards than the sacrifices they may be forced to make for the sake of convergence. But, a much larger problem is that they only scratch the surface of the many significant differences between U.S. GAAP and IFRS. There are no plans to converge any of these, and for most, I would venture to say that U.S. GAAP is demonstrably superior to IFRS.
Here is a wee list of off-the-table issues off the top of me little head (believe me, there's lots more; I just don't have the time to write about them):
Research and development – In R&D we have the case of a convergence project that was abandoned after many months of back and forth debate; and in the end, nary a comma of either GAAP or IFRS met its demise. The characteristically vague language of IFRS designed to give issuers wide latitude in determining when and how to capitalize development costs—and which was categorically rejected by the FASB in its earliest days—has survived. U.S. GAAP is better.
Business combinations – Thisis one of the most complex topics for which convergence is claimed to have been achieved. However, substantial differences remain, because the IASB couldn't bring itself to go against issuer interests. As I described in a previous post, the IFRS version gives issuers comparability-defeating free choices and watered-down disclosures in key areas. U.S. GAAP is better.
Interest and other borrowing costs – This is my favorite example for showing that convergence is hurting the quality of accounting standards rather than helping. 'Shameful' is the mildest adjective that I can think of to adequately describe both the process and the outcome of the IASB's deliberations that ultimately lead to the revisions to IAS 23. As it currently stands, both boards agree that interest costs on self-constructed assets should be capitalized, but the IASB's approach to capitalization further sweetens the opportunities for earnings management. U.S. GAAP is better.
Statement of cash flows—The IASB proudly trumpets its sham principles-based emphasis on substance over form. There can be no greater exposure of the falsity of these claims than IAS 7, which permits (but does not require) overdrafts (i.e., loans masquerading as negative cash balances) to be offset against cash accounts with positive balances. U.S. GAAP is better.
Contingent liabilities—The IASB is proposing that management will decide whether or not a particular contingent liability can be measured reliably. That's an open invitation to earnings management. U.S. GAAP has its own problems regarding contingent liabilities, but I'll still take it over what the IASB has proposed.
Impairment—This may be the area in which U.S. GAAP and IFRS are most different, yet it's not on the convergence agenda. That's an incredible omission. While it is true that U.S. GAAP facilitates "big bath" charges, IFRS facilitates quarter-by-quarter earnings micro-management. Both approaches are terrible, but U.S. GAAP is better.
Inventories – There is not just the infamous LIFO problem (I do think it's time to get rid of LIFO for financial reporting in the US), there is also a little-known yet significant IFRS requirement to value biological assets at net fair value. It sounds principles-based, but it's just another opportunity to manage earnings. Do you prefer to recognize revenue on your current apple crop in the quarter before or after selling it on the market? IFRS gives you a choice, which you can take by the timing of your harvest. U.S. GAAP is better.
Myth #3 – The Big Whopper: When it Comes to Accounting, Mary Schapiro Knows What She is Talking About
"Comprehensive and neutral [italics supplied] accounting standards are the bedrock upon which our securities laws are based — standards that generate accurate, consistent, comparable, relevant, and reliable information for investors, lenders, creditors, and all others who make capital allocation decisions. We have not, cannot, and will not lose sight of that fundamental principle."
Did Mary Schapiro ever take Accounting 101? If she had taken it from me, I would have taught her that there is very little about accounting standards that can be considered "neutral." If anything, "conservative" accounting standards were considered the "bedrock" of financial reporting for decades; and conservatism, of necessity, still abounds.
For example, the SEC's own rules prohibit revenue recognition until collectability of the amount owed is "reasonably assured." That's not neutral, it's conservative and essential for protecting against fraud. Similarly, both IFRS and U.S. GAAP prohibit the capitalization of research costs out of conservatism, not neutrality; and it's a prohibition that may never change. And most recently, IFRS is proposing that contingent liabilities not be recognized unless they can be measured with an unspecified degree of precision. That's also conservatism.
Neutrality, Chair Schapiro, has a role in accounting, but it is certainly not the "bedrock" of accounting standards. It would have been more accurate for you to state that, whatever an accounting standard may require, those requirements must be applied in a neutral manner. When an issuer is called upon to make an estimate when measuring an asset or liability, it should strive in good faith to make an unbiased estimate; one may not measure an allowance for bad debts conservatively, nor a fair value, nor a contingent liability.
Rather than engaging in puffery of her own, the real work of the SEC Chair should be to deploy the limited resources at her disposal for achieving greater compliance with the kind of neutrality that investors actually need and want. Convergence as a priority pales in comparison to making sure that managers and auditors fulfill their financial reporting responsibilities as they should be expected to.
"A lot of [the SEC's work] involves attention to the vital but sometimes overlooked field of accounting."
Quite true, but I can't help but take away from your speech, Chair Schapiro, that you have managed to overlook accounting for your entire career. You didn't even know enough to figure out that someone gave you a lousy speech to read.