IFRS: A Lot of Debate, But Inevitable - www.thecorporatecounsel.net

June 02, 2008

IFRS: A Lot of Debate, But Inevitable

Last Thursday, SEC Chair Chris Cox delivered a speech
on the future of IFRS - including a public policy oversight body that
would oversee the IASB trustees (the speech notes that the IASC Foundation
will consider a new monitor as part of its '08 Constitution review).
This is an important topic that I could literally blog about every day.
But, to be honest, I'm not following it as closely as I probably should
because I'm only human and there are still so many other developments
to cover.

From reading comment letters, etc., I understand one considerable
concern is the lack of a strong IFRS enforcement mechanism. The amazing
circumstances of the fraud at Société Générale are often held up to
illustrate the point of how easy it is for a company to break
international accounting rules, get away with it, have its independent
auditors bless it, with no major regulatory ramifications (read this
Floyd Norris column and an Accounting Onion blog for more). Also held up is the fact that the IASB standards have not been enforced in the past. Finally, there have been concerns raised about how the FAF recently has managed the FASB.

So there are these - and many other - issues to deal with, but it's
clear that the globalization of accounting standards is something that
is inevitable. We just need strong regulators - and ones that work
together. This will be quite a feat to pull off since there are many
cultural obstacles and regulatory differences among jurisdictions. But
it is happening - here is a February statement
from IOSCO urging companies to clarify which accounting standards they
use. IOSCO is the organization whose members are comprised of
securities regulators from around the world and who will be a key
player in this movement.



Is IFRS Compatible with US-Style Corporate Governance?

This blog below from Tom Selling's "The Accounting Onion" is several months old, but still interesting and relevant reading:

I
just finished reading a brief, highly readable and interesting article
by a Columbia Law School professor, John C. Coffee, Jr., entitled "A Theory of Corporate Scandals: Why the U.S. and Europe Differ."
The purpose of this post is to piggyback on his framework to also
provide an explanation for the difference in basic approaches between
U.S. GAAP and IFRS; and most importantly, why political pressure to
trash U.S. GAAP and adopt IFRS should be resisted.

How and Why, According to Coffee, U.S. and European Scandals Differ

Coffee's thesis is that corporate governance of majority-owned
corporations (predominant in Europe) should be fundamentally different
than corporate governance of corporations that lack a controlling
shareholder group (predominant in the U.S.). It's not necessarily
because there are fewer incentives to rip off other shareholders, but
the feasible means to do so will differ.

Scandals in Europe involving majority-owned corporations usually do
not feature an accounting manipulation. First, financial reporting is
less important to the majority owners because they rarely sell shares;
and if they do, they usually receive a control premium that is
uncorrelated with recent earnings (and generally larger than control
premia in U.S. transactions). Second, fraud is more easily accomplished
by misappropriation of the private benefits of control: authorization
of related-party transactions at advantageous prices, below-market
tender offers, are prime examples. Any trading that takes place between
minority owners has less to do with recent earnings reports, and more
to do with an assessment of how minority shareholders will be treated
by controlling interests.

In dispersed-ownership corporations, managers do not possess private
benefits of control. Moreover, a significant portion of manager's
compensation may be in the form of stock options or other forms of
equity. Therefore, stock price can have a significant effect on a
manager's compensation, providing them with strong incentives to
manipulate accounting earnings.

The Implications for Accounting

Professor Coffee's thesis is that differences in ownership patterns
have important implications for the selection of gatekeepers: auditors,
analysts, independent directors, etc. His observations and
recommendations are interesting, but I want to advance a related
thesis, namely that different ownership patterns call for different
types of accounting regimes.

It stands to reason that accounting should be difficult to
manipulate, if it can be used to rip off shareholders. Thus, 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.

Thus, it should be self-evident that IFRS-style accounting, replete
with gray areas, would be a gift to U.S. managers. Outright fraud would
be replaced by more subtle means of "earnings management," rendering
the SEC and private attorneys much less potent. Is it any wonder why
U.S. corporations and their auditors are practically begging to have
IFRS available to them?

In short, it would be a grave mistake to adopt IFRS in the U.S.
simply because it seems to work well elsewhere. As corporate ownership
patterns in Europe change, it may well be that IFRS may evolve to look
more like U.S. GAAP. Only after that occurs may it make more sense to
have a single worldwide financial reporting regime.

Imagine if Enron Had Applied IFRS

One of the scapegoats of the Enron scandal was "rules-based" U.S.
GAAP. The libel was that Andrew Fastow was a mad genius, capable of
walking an accounting tightrope by creating complex special-purpose
entities (SPEs). But, GAAP wasn't the culprit in the Enron scandal.
Frustrated Fastow was only able to get the accounting treatment he
needed past the auditors by hiding from them side agreements that
unwound critical provisions requiring the new investors to have a
sufficient amount of capital at risk in the SPEs.

The enduring legacy of the libel is the erroneous conventional
wisdom that GAAP is responsible for Enron; and what's more, Enron et.
al. might not have happened if our financial reporting system were more
like IFRS. More likely, if IFRS had been the basis of accounting for
Enron instead of GAAP, it might have taken longer to discover the
fraud, or to pin the blame for the fraud where it belonged.

Neither GAAP nor IFRS are principles-based, but GAAP certainly has
more rules and bright lines. At least there seems to be some method to
the madness, but it would be nice if more of the rules were based on
sound principles.