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U.S. Changing to Looser Accounting Standards

by Michael W. Stocker and Craig A. Martin
Executive Counsel |
Convergence Means Less Transparency

U.S. investors are about to face a new threat to their peace of mind:dramatically changing accounting standards. Barring a sudden change of course at the Securities and Exchange Commission, a coming shift from U.S. accounting rules to international guidelines will likely decrease financial transparency when it is needed more than ever.

Most rules governing accounting under traditional U.S. standards are embodied in Generally Accepted Accounting Principles, or GAAP. GAAP is a set of accounting principles that have been developed over seventy-five years in response to changes in the economy, business and products.

Although the SEC is vested with the statutory authority for establishing accounting rules for publicly traded companies, the Commission delegated this responsibility to the Financial Accounting Standards Board (FASB). FASB is responsible for establishing the specific accounting rules that govern the preparation and presentation of financial statements, including publicly traded companies.

International Financial Reporting Standards, or IFRS, on the other had, are the accounting standards used in almost every region of the world except the United States. IFRS are issued by the International Accounting Standards Board, a rule-making body based in London responsible for preparing and issuing the specific standards under IFRS.

In contrast to the very detailed rules set out in GAAP, IFRS is a principles-based system that focuses only on reporting the economic substance of transactions, and relies heavily on management judgment. As a result, IFRS rules generally provide considerably less guidance than GAAP.

IFRS consists of only about 2,000 pages of standards and interpretations, compared to 30,000 for GAAP. In instances where a transaction fails to fall neatly into a specific standard or application, IFRS gives management considerable latitude in deciding how information should be reported.

Moreover, unlike the FASB, which is funded through mandatory contributions from publicly listed companies, IASB is largely dependent on contributions from donors such as the central banks and other international organizations, as well as individual companies and organizations in the U.S., including the Big Four accounting firms. This funding structure has left the IASB especially vulnerable to political pressure. Indeed, in 2010, Michel Barnier, the EU's internal market commissioner, suggested that IASB funding should be dependent on the IASB's willingness to make changes to its governance suggested by the European Commission.

This vulnerability to political pressure was apparent in the recent financial crisis, when the IASB quickly acceded to European Commission demands for an immediate rule change enabling European banks to reclassify securities to avoid write-downs in the value of the securities, and consequently avoid billions of dollars in impairment charges. But for these rule changes, the European banks would likely have violated capital requirements.

In fact, the rule change enabled many bank managers to distort the economic reality of their financial performance during the third quarter of 2008. Reclassification allowed Deutsche Bank to convert loss into a profit for the third quarter of 2008, driving up Deutsche Bank shares by 19 percent. Even Sir David Tweedie, the former head of the IASB, conceded that rule change, driven by pressure from the European Commission, had compromised the IASB's independence.

Despite these concerns, the SEC has been moving rapidly towards adopting IASB standards through a process called convergence, a process to reduce the differences between GAAP and IFRS. This shift began in 2007, when the SEC began to permit foreign issuers to file, with the Commission, IFRS financial statements without a reconciliation to GAAP.

Convergence began to move more rapidly when, on November 14, 2008, the SEC published a "roadmap" that set out specific milestones that, if achieved, could lead to the adoption of IFRS by all U.S. issuers. The "roadmap" included seven milestones that identified issues that needed to be addressed before U.S. issuers adopted IFRS. Among other things, the SEC required improvements in IFRS accounting, and in the accountability and funding of the IASB-a tacit reference to the IASB's vulnerability to political pressure. The roadmap also established a proposed timeline whereby certain issuers would phase-in mandatory use of IFRS between 2014 and 2016.

In a May 2011 staff paper, the SEC has still left itself with some room to avoid wholesale incorporation of IFRS into GAAP, keeping U.S. public companies under more familiar standards. Under this proposal, the IFRS would replace GAAP over a period of five to seven years. During this transitional period, the FASB would work to eliminate differences between GAAP and IFRS and then endorse and incorporate individual IFRS rules into GAAP. However, as part of this approach, FASB would still retain the authority to modify or add to individual IFRS being incorporated into GAAP.

According to the paper, the SEC envisions that ultimately U.S. issuers, by complying with GAAP, could represent that they are also IFRS compliant. Comments on the "Framework" are due to the SEC by July 31, 2011.

Whatever course the SEC ultimately pursues, U.S. investors with an eye to the future will need to follow closely the convergence process. Globalization, at least in the case of accounting standards, may make the world a riskier place for U.S. markets.