IFRS in the Offing

By Cydney Posner

SEC Chairman Cox and Director of Corp Fin John White have been engaging in some intense foreshadowing, seeking to acclimate the accounting profession and the securities bar to the anticipated shift away from U.S. GAAP to IFRS (International Financial Reporting Standards). Cox addressed the 33rd Annual Conference of the International Organization of Securities Commissions in Paris in late May, and White spoke to the Financial Executives International Global Financial Reporting Convergence Conference in New York in June, each focusing on IFRS. Very generally, U.S. GAAP is a defined and relatively prescriptive (overly prescriptive, in the view of some) set of accounting rules that has developed over decades; IFRS is a more principles-based set of standards, which would allow more judgment by management, developed by the IASB (International Accounting Standards Board) over approximately the past seven years.

According to Cox, all of Europe and nearly 100 countries around the world currently require or permit the use of IFRS, notwithstanding its brief history. Cox believes that there are several keys necessary for the success of IFRS, including investor protection, transparent process with broad participation by all stakeholders and an independent and accountable standard setter. Nevertheless, for Cox, the pace of worldwide acceptance of IFRS holds considerable promise: "Just as the conquistadors searched for El Dorado, the world's capital markets have long searched for a single set of high quality accounting standards that could be used anywhere on earth." (Hmmm, an interesting choice of simile--does he mean to suggest a journey of madness and folly? A city of gold that proved to be completely mythical? A group of marauders that left death and disease in their wake?) Cox argues that international standards would improve investor confidence in global capital markets by increasing transparency and comparability. Toward these ends, the IASC Foundation will be considering a new monitoring group to ensure the accountability of the global IFRS standard setter to the various national authorities charged with protecting the capital markets and the public interest, while preserving the independence of the IASB.

Is the U.S. about to join the IFRS crowd? The WSJ has reported that Cox expects a proposal that would allow U.S. companies to use IFRS instead of U.S. GAAP to be proposed as soon as this summer. White's speech shed a bit more light on that prospect, concluding that he truly believes that "the endpoint will be U.S. issuers using IFRS and that it is time to move in this direction." The SEC first broke ground on the use of IFRS by eliminating the U.S. GAAP reconciliation requirement for foreign private issuers that file their financial statements with the SEC using IFRS (as issued by the IASB). The potential use of IFRS by domestic companies was introduced by the SEC in an August 2007 concept release, which asked whether U.S. issuers should be allowed or required to prepare financial statements under IFRS. In early 2008, after two IFRS roundtables, the SEC staff was charged with developing an IFRS roadmap that would formally propose a schedule and appropriate milestones for U.S. adoption of IFRS.

White then touched on, but without examining in depth, the substantive policy issue of whether the U.S. should permit, or even require, the use of IFRS for domestic companies. The SEC has long believed that uniform global standards would provide significant benefits to all stakeholders in the global capital markets, including those in the U.S. capital markets, ranging from increased comparability to reduced regulatory and compliance costs. However, as White has previously observed (see my email of 1/24/08), it is an "inconvenient truth" for us in the U.S. that the rest of the world is heading in the direction of IFRS, not U.S. GAAP, as that global standard. While White believes that there is no single rationale for considering IFRS for U.S. companies and that questions remain as to whether IFRS can support the investor confidence that is essential to the functioning of a liquid capital market, he recognizes that use of IFRS has become a global movement. Accordingly, he contends that it would be a disservice for the SEC not to at least examine the benefits of IFRS.

• The roadmap for U.S. companies involves a number of key questions:
• Should all U.S. companies simply be mandated to start using IFRS in their SEC filings as of a certain date?
• Should there first be a period in which U.S. companies have the option to use IFRS in their financial statements and, if so, how long should that period be?
• If there were a period of optional use, would U.S. companies feel inclined to change to IFRS unless it were clear that mandated use of IFRS was in the foreseeable future?

In roundtables hosted by the SEC, panelists were apparently not enthusiastic about a period of optional use without a date certain as to mandatory use of IFRS. White notes that most major capital markets that have moved to IFRS have done so on an all-at-once, mandatory basis for almost all domestic public companies in that market. He adds, however, that he "can see the value of a transition, or voluntary, period in a change of this potential magnitude."

Neither Cox nor White use their presentations to address the positive or negative aspects of IFRS itself; instead the focus is on the benefits of having a global system. This view has been echoed by NYSE Euronext Inc's CEO, Duncan Niederauer, who said on Tuesday that the fact that most countries use international accounting standards while the U.S. uses its own set of globally accepted accounting standards deters foreign companies from listing in the U.S. But are there policy reasons why IFRS might not be appropriate for the U.S.? A number of commentators have raised issues regarding the weakness of IFRS enforcement mechanisms in the absence of an international regulatory body. That problem appears to be one that is being addressed, at least in part, by the development of the monitoring group referenced above. In addition, one accounting commentator (thanks to Corporate Counsel for the reference), piggybacking on a theory by Columbia's Prof. John Coffee, has argued that differences in ownership patterns between U.S. and foreign corporations have important implications for the appropriate selection of an accounting model. (Coffee's paper, entitled "A Theory of Corporate Scandals: Why the U.S. and Europe Differ, " questions why, given the more severe market declines in Europe as compared with the U.S. and the higher level of public and private enforcement in the U.S. for securities fraud, did the U.S. experience a much more significant wave of securities fraud? Coffee submits that different kinds of scandals characterize different systems of corporate governance. In particular, U.S. corporations tend to have dispersed ownership systems of governance, which he argues are prone to the forms of earnings management that scandalized the U.S., but European corporations tend to have concentrated ownership systems, which he views as much less vulnerable to that type of problem. Instead, the characteristic scandal in concentrated ownership economics, he asserts, is the appropriation of private benefits of control. Coffee asserts that this distinction has important implications for the selection of gatekeepers, such as auditors, analysts and independent directors.) This commentator contends that a prescriptive rules-based system like U.S. GAAP is necessary under U.S. governance structures to prevent the misuse of management judgment in light of the absence of truly independent gatekeepers: "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." He concludes that the prevalence of gray areas within IFRS presents too many opportunities for "earnings management" that regulatory authorities would be powerless to address.