By Don Schwartz
In Brief
Hurdles Remain for Global Accounting Standards
In 1999, the International Accounting Standards Committee (IASC) completed the list of core standards that the International Organization of Securities Commissions (IOSCO) had agreed to four years earlier. In February 2000, the SEC asked professionals whether they thought that IASC standards were of sufficient comprehensiveness and high quality to be used without reconciliation to U.S. GAAP. Respondents emphasized deficiencies in quality (AICPA), inadequate infrastructure to ensure rigorous enforcement (Arthur Andersen), and significant conceptual differences between IASC standards and U.S. GAAP (PricewaterhouseCoopers). All three respondents concluded: “No, not at this time.”
No one responded to the SEC’s question, “Under what conditions should we accept financial statements of foreign private issuers that are prepared using the standards promulgated by the IASC?” The author analyzes the quality issues, identifies the principal differences between IASC standards and U.S. GAAP, and suggests ways in which they might be overcome.
If anyone doubts the disparate effects that different accounting practices can have, consider again the case of Daimler-Benz. Under German accounting standards, Daimler reported a profit of 168 million deutsche marks in 1993. Under U.S. GAAP standards, the company reported a loss of almost a billion deutsche marks for the exact same period. You can just imagine an investor’s confusion and concern.… As more investors seek access to foreign markets, and more companies seek capital worldwide, the need for a common business language has become compelling. Broader horizons for new business opportunities demand financial reporting standards that supersede national borders and cultural customs. These standards are not merely an ideal for a better global marketplace—they are fundamental to its very existence. (emphasis added)
—SEC Chairman Arthur Levitt, 1999
The SEC requires financial statements prepared under IASC standards to be reconciled to U.S. GAAP, regardless of whether they are prepared under Canadian GAAP, German GAAP, or Zimbabwe GAAP. Consequently, there is no incentive for multinational companies to apply IASC standards in place of (or in addition to) their home country’s standards. SEC acceptance of financial statements prepared under IASC standards without reconciliation would provide a powerful incentive for their widespread adoption. Financial statements prepared and audited under IASC standards would gain worldwide respect, resulting in substantial progress toward the goal shared by all constituencies, that of Levitt’s “common business language.”
In the preamble of its “Concept Release on International Accounting Standards” (February 2000), the SEC made a clear statement of its objectives:
With the activities and interests of investors, lenders, and companies becoming increasingly global, the Commission is increasing its involvement in a number of forums to develop a globally accepted, high-quality financial reporting framework. Our efforts, at both the domestic and international levels, consistently have been based on the view that the only way to achieve fair, liquid, and efficient capital markets worldwide is by providing investors with information that is comparable, transparent, and reliable. That is why we have pursued a dual objective of upholding the quality of financial reporting domestically while encouraging convergence toward a high-quality global financial reporting framework internationally. In this release, we are seeking comment on the necessary elements of such a framework, as well as on ways to achieve this objective. One aspect of this is seeking input to determine under what conditions we should accept financial statements of foreign private issuers that are prepared using the standards promulgated by the IASC. (emphasis added)
Some of the essential questions posed by the concept release were:
Question No. 1: “Do the IASC core standards provide a sufficiently comprehensive accounting framework to provide a basis to address the fundamental accounting issues that are encountered in a broad range of industries and a variety of transactions without the need to look to other accounting regimes?”
Question No. 4: “Are the IASC standards of sufficiently high quality to be used without reconciliation to U.S. GAAP in cross-border filings in the United States?”
Question No. 8: “Is the level of guidance provided in IASC standards sufficient to result in a rigorous and consistent application?”
Question No. 12: “Do you believe that an effective infrastructure exists to ensure [rigorous and] consistent application of the IASC standards?”
Comments were due in May 2000.
Important Responses
Two dozen respondents e-mailed their response letters for posting on the SEC website. Approximately half of these, mostly originating from other countries, responded affirmatively. The other respondents, including the AICPA, Arthur Andersen, and PricewaterhouseCoopers, strongly advised against acceptance of IASC standards without reconciliation at this time.
The AICPA’s response: “Although individual IAS may be of high quality, we do not believe the body of IAS is of sufficiently high quality to be used without reconciliation to U.S. GAAP in cross-border filings in the U.S. at this time.… The existing core standards contain significant recognition and measurement alternatives and are, as a whole, written generally and susceptible to varied interpretation. Consequently, different companies following IAS might apply IAS differently for similar transactions. Therefore, we believe that the requirement to include reconciliation to U.S. GAAP should be retained until industry-specific guidance and interpretive guidance that reduces inconsistent application can be promulgated by the IASC.
“With convergence of IAS and national regimes around high-quality standards, fewer reconciling items will exist over time, and, at a future date, a reconciliation will become unnecessary.”
Arthur Andersen’s response: “Until further steps have been taken to provide that an adequate global infrastructure is in place, the SEC should not eliminate its reconciliation requirement to U.S. GAAP for foreign registrants.
“Our experience in auditing and reviewing the IAS financial statements of companies worldwide indicates that consistent interpretations and application of IAS are not yet a reality. In our opinion, this is primarily due to the lack of global infrastructure in interpreting, applying, and enforcing IAS; the process of creating ‘international GAAP’ is still in the early stages. It is for this reason that … we do not believe it is appropriate at this time to remove the U.S. GAAP reconciliation requirement for foreign filers using IAS. We believe that users will wish to have the reconciliation at least in the short term while confidence in and knowledge of IAS increases.”
PricewaterhouseCoopers’ response: “We do not believe that a solid case has been presented for relaxing the reconciliation requirement. In recent years, U.S. markets have shown themselves to be significantly focused on a single figure of earnings. Bringing IAS into the domestic marketplace at this point means that there would be two (quite different) measures of earnings, which is apt to lead to confusion.
“A fundamental element of financial reporting is comparability. If non-U.S. companies were to report under IAS without reconciling their financial statements with U.S. GAAP, U.S. investors would lose this comparability.”
A Strategy to Facilitate SEC Acceptance of IASC Standards
The respondents that opposed relaxation of the reconciliation requirement did so for one or more of the following reasons:
IASC Standards Are Not Sufficiently Comprehensive
U.S. GAAP provides guidance for a number of specialized industries, such as insurance and rate-regulated enterprises, not-for-profit entities, health care, and entertainment. IASC standards do not provide such guidance. Respondents identified other topics which they feel should be added; for example, Arthur Andersen mentioned stock-based compensation, transactions between entities under common control, accounting by joint ventures, e-business reporting issues, valuation of intellectual rights, and definition of financial performance.
Nevertheless, standards setting is a continuously evolving process. If the IASC (like FASB) continues to add new topics over time, what standard would be used to determine when IASC standards have achieved sufficient comprehensiveness?
Alternatively, the SEC could identify fundamental issues and guidance omitted by current IASC standards but addressed by U.S. GAAP and remind registrants that IASC standards themselves (IAS 1, paragraph 22) call for the consideration of “pronouncements of other standard setting bodies” as long as those pronouncements are consistent with “the definitions, recognition, and measurement criteria for assets, liabilities, income, and expenses set out in the IASC framework.” (If inconsistent, it would constitute a GAAP departure requiring footnote disclosure and reference to the departure in a qualified opinion by the auditor.)
Current IASC Standards Are Not of Sufficiently High Quality
Critics referred to one or more of the following quality issues:
Too many allowed alternatives. Allowing alternative accounting treatments for the same economic event directly contravenes one of the principal purposes of standards: comparability. They are often a political expedient to gain the acceptance of disparate interests. IASC standards permit LIFO accounting for inventory costing and pooling-of-interests accounting for business combinations in order to accommodate U.S. business demands; these alternative treatments generally do not reflect the realities of the economic event for which they are accounting and are rarely used outside the United States. In turn, the allowed alternative of revaluing long-lived assets accommodates U.K. and Australian practice. Examples of such political accommodations abound.
As part of its early ’90s improvement project, the IASC eliminated many previously allowed alternatives. Eleven of the 30 IASC core standards still permit more than one accounting treatment. However, in all but one, an allowed alternative corresponds with U.S. GAAP. Comparability could be achieved by requiring SEC registrants to apply that alternative. (The single exception is IAS 7, Cash Flow Statements; the SEC already allows application of IAS 7 without reconciliation to U.S. GAAP.)
Nonetheless, the IASC should be encouraged to further reduce the number of allowed alternatives. Indeed, if the SEC requires the use of a particular alternative, non-U.S. registrants would tend to choose that alternative, and the IASC would face less opposition to dropping the others. However, comparability—at least between IASC financial statements and U.S. GAAP statements—should not be conditioned upon the removal of all the remaining alternatives.
Inadequate interpretive guidance or specificity. There are a number of IASC standards that call for the same accounting treatment as U.S. GAAP, but, because they are less prescriptive than their U.S. counterparts, they leave room for very different interpretations and, correspondingly, different results. An example is IAS 17’s definition of a capital lease as one that “transfers substantially all the risks and rewards incident to ownership.” In contrast, SFAS No. 13 provides quantitative “bright-line” criteria: “Capitalize if the term of the lease is 75% or more of the estimated life of the asset.” The solution in such cases could be to require IAS filers to apply the same bright-line guidance as required by U.S. GAAP. However, while prescriptive rules and bright-line criteria promote consistency and comparability, they also encourage the structuring of a transaction to meet the criteria in form even when its substance suggests otherwise.
Troublesome differences in recognition and measurement principles. A number of IASC standards call for an accounting treatment (some better, others worse) that is very different from U.S. GAAP. An example is the IAS 38 requirement to capitalize qualifying development costs, a treatment more in concert with U.S. GAAP’s own conceptual framework than SFAS No. 2’s requirement to expense them. To those who oppose IAS because of too many such differences or room for varying interpretation, it could be asked: At what point will a sufficient number of differences have been eliminated and sufficient interpretive guidance provided to warrant a passing grade from the SEC?
The SEC could identify those recognition and measurement differences that are particularly troublesome and for any that apply to a given set of financial statements, require the issuer to show adjustments to earnings in footnote disclosure. As a starting point, the following are some of the concerns raised by the SEC staff and listed in the concept release:
Insufficient disclosure requirements leading to impaired transparency. As suggested by the FASB staff analysis in the IASC-U.S. Comparative Project, six of the 30 core IASC standards require less disclosure than do their U.S. GAAP counterparts; however, 14 require more. By leaving those 14 intact but increasing the disclosure requirements for the six, financial statements filed under IAS would provide even more disclosure than those prepared under U.S. GAAP.
Insufficient Infrastructure
While implementation of the recently reengineered standards-setting infrastructure of IASC is well under way, IFAC’s plans for an enforcement infrastructure appear to be at a much earlier stage. In his response to the concept release, IFAC Technical Director James Sylph indicated that IFAC Council has been considering for some months proposals for the strengthening of IFAC and its abilities to monitor the compliance of its member bodies with its policies (including ethical and auditing standards). In addition, he said that steps were under way to introduce a program that would provide accreditation to individual accountants possessing knowledge and competency in International Accounting and Auditing Standards. At its May 2000, meeting, IFAC Council considered these proposals, but deferred further action.
To address these issues, the SEC (or IOSCO) could urge IFAC to prepare a comprehensive plan that will enable it to function effectively as an enforcement agency and the AICPA, with help from the academic and practitioner communities, could prepare an analysis (modeled after FASB’s IASC-U.S. Comparison Project) that compares IFAC’s International Standards for Auditing with U.S. GAAS. If an effective enforcement infrastructure becomes the one obstacle preventing acceptance of IASC standards, then an interim solution would be for the SEC to accept only those IASC financial statements that have been audited by a member of the AICPA SEC Practice Section.
Looking Forward
Reconciliation should continue until the necessary infrastructures for both standards setting and enforcement have been judged adequate and effective by IOSCO and, by extension, the SEC. By that time, there will have been some narrowing of differences by the cooperative efforts of standards setters: The IASC will have addressed some additional issues, removed some alternatives (though probably not all), provided additional interpretive guidance (but still less than U.S. GAAP), and increased its disclosure requirements. At that point, barring some unresolved, overriding fatal deficiency, the SEC should discontinue the reconciliation requirement altogether. Although reconciliation of some but not all IAS is not an unworkable option, a better solution would be to require the use of the IAS alternative that parallels U.S. GAAP, and to require additional disclosure for those material differences in recognition, measurement, or disclosure that remain.
Most importantly, the SEC should facilitate convergence of U.S. and international standards by identifying now, in very specific terms, the most important issues needing attention—enforcement infrastructure, fundamental accounting issues not addressed by IASC standards, and interpretive guidance for specified IASC standards—so that the IASC and IFAC, with support from the AICPA, FASB, and others, can focus attention and resources on those issues.
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