Wednesday, March 31, 2010

Contrary Opinions on IFRS

J. Edward Ketz is a professor at Pennsylvania State University. He wrote an interesting article recently on the U.S. approach to IFRS.

On February 24, the SEC issued its "Statement in Support of Convergence and Global Accounting Standards." Curiously, while the SEC did indeed affirm its "strong commitment" to IFRS, it may have unwittingly given voice to the concerns of dissidents. Finally!

The report begins with a documentation of the SEC’s commitment to a set of high-quality accounting standards. Quite naturally, this history includes a discussion of its own report on a principles-based accounting system. The reader should recall that this previous study merely provides a list of unproven assertions about principles-based accounting, including greater comparability for investors and lowered costs of capital for corporations. Rather than providing evidence, the SEC merely enumerates these articles of faith.

At least this time around the SEC adopted a go-slow policy and hoped that the IASB would improve its IFRS in six areas. These concerns question whether IFRS is the Holy Grail it is portrayed to be primarily because of various implementation and administrative issues. Let’s turn to these issues.

First, the SEC says that IFRS must be sufficiently developed to apply the system to the U.S. reporting system. The SEC then indicates there are concerns with respect to the comprehensiveness, the auditability and enforceability, and the consistent and high-quality application of IFRS. The SEC staff notes that commentators have criticized IFRS because they allow savvy managers significant wiggle room to manipulate accounting numbers and disclosures and thwart efforts by auditors to perform high-quality audits. Indeed, some wonder whether principles-based annual reports are even capable of being audited. Another issue raised by the SEC is whether standards will be uniformly enforced around the globe—the answer is of course not. The real questions are how divergent will this enforceability be and what will be its significance.

Second, the SEC probes the independence of the IASB, especially since much of its operating funds comes from corporate donations. Do you think that maybe, just maybe, corporate donors want something in return? Whether the board is free from undue influence won’t require much research since economic theory posits that managers have huge incentives to gain control over the IASB. As an aside, many have criticized the FASB for moving at the pace of a tortoise. Do they realize that the IASB will make the FASB seem like a hare?

Third, will investors understand IFRS? The SEC staff promises to empirically assess the current knowledge of investors about the IFRS. I wouldn’t waste the resources. Except for institutional investors, the answer is they don’t understand IFRS, and they won’t have any incentives to learn until the change is imminent. More importantly, as the costs for learning IFRS are large, we probably shouldn’t worry about investors. Let them depend on the skills and independence of financial statement researchers and analysts.

Fourth, IFRS could have unknown effects in areas other than investments, the domain of the SEC. For example, financial statements are used by industry and anti-trust regulators and federal and state taxing agencies. Will an adoption of IFRS have a perverse effect on national and state policies?

Fifth, the SEC speculates about the impact of adopting IFRS on issuers, including changes to accounting information systems, implications for contracts that depend on accounting numbers, and concerns about corporate governance. My short response is that it’s about time the SEC started thinking about these issues. It is fairly clear to me that the adoption of IFRS will require many issuers to keep dual systems for several years. Annual reports are utilized for too many things to move wholly to IFRS. In turn this will add to the costs of adoption and to its complexity.

Sixth, the SEC mentions human capital readiness. Except for the Big Four and some of the largest corporations, is anybody ready for the transition? If the IASB opened up its data base and supplied users with free training materials, then maybe managers and analysts and accountants could prepare themselves for the transition—unless the banking industry or Congress decides to introduce new and worse problems for the business community.

As I survey this list, I again marvel at the rush to IFRS. The benefits do not appear to match or exceed the costs of the adoption. Nonetheless, I suppose we shall find ourselves employing IFRS within a decade. Hopefully this pause by the SEC will address some of the most glaring challenges.

Of all the issues listed, the most important is this: whether IFRS statements can be audited and what will happen in the courtroom after a firm experiences severe declines in its stock price. I predict that principles-based accounting will become rules as judges and juries fill in the details left out by the accounting profession and create accounting case law. And then where will the benefit be?


Michael L. said...

I'm curious as to the comment "can IFRS statements be audited"????? They are audited

Also - one common fear is increased litigation arising from "less rules based" guidance.....but academic research contradicts that fear....

Anyway - love the bog!

Michael L. said...

one more comment.......I firmly believe the "benefit", regardless of which "rules" we use, will simply be a global set of rules. I believe that once adopted, our cost of capital (for US firms) will decrease.

That, to me, is certainly a benefit.

Anonymous said...

The process should be learning form each other to improve. The article made valid points on the weakness of IFRS, but we shouldn't forget that US GAAP are far from being perfect either, in spite of its enormous complexiity.

Anonymous said...

nice post!