If the U.S. Securities and Exchange Commission (SEC) gives domestic public companies the choice of using either U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRSs), as the SEC has effectively done for foreign companies listed in the United States, will "market forces" drive us to Convergence? This blog post will address that question, which has been raised by observers of the phenomenon of Convergence in the U.S.
Set-Level Convergence vs. Standard-Level Convergence
Before answering the question, a distinction must be made between set-level Convergence and standard-level Convergence. Set-level Convergence occurs when companies in a country adopt an entire existing set of country-neutral standards that have been (or will be) adopted by companies in other countries. In contrast, standard-level Convergence occurs when standard-setters change individual standards within each of their respective sets of standards in order to make the individual standards more similar to each other.
Furthermore, standard-level Convergence comes in two variations. In the first variation, a standard-setter replaces one of its existing standards with a different standard from another set of standards, whereas in the second variation, each standard-setter replaces an existing standard with one that is different from any of their existing standards.
Market Forces and Set-Level Convergence
Some observers have suggested that creating a "free market" for financial reporting standards would foster set-level Convergence. I myself have argued that when sets of standards compete, an economic phenomenon known as the "network effect" kicks in and one set of standards tends to drive out the others (see my blog post here).
But the "catch" of the free-market approach is that while market forces would be highly effective and efficient at getting entities that prepare financial statements to choose a single set of standards, the resulting dominant set of standards would not necessarily be the highest-quality alternative nor would it necessarily be the alternative that best serves investors, who are widely considered to be the primary constituency for whom financial reporting standards are set and enforced.
In fact, in the classic case of competing standards--VHS vs. Beta videocassette formats--the lower-quality standard won the competition. And if management, rather than investors, makes the choice of a set of financial reporting standards, there is a real danger that management will choose a set of standards that benefits themselves to the detriment of investors.
Market Forces and Standard-Level Convergence
Many folks have asserted that allowing U.S. companies to choose between U.S. GAAP and IFRSs would bring the FASB's and IASB's current pursuit of standard-level Convergence between U.S. GAAP and IFRSs to a halt. I believe that market forces would not foster standard-level Convergence, but by the same token, market forces would not interfere with the motivation of the FASB and IASB to work towards set-level Convergence on a set of standards that is superior in quality to both existing sets of standards. That motivation would not disappear if U.S. companies are given a choice between U.S. GAAP and IFRSs, and because the Boards view standard-level Convergence (especially the second variation) as a necessary precursor to set-level Convergence on a higher-quality set of standards, standard-level Convergence efforts are likely to continue even if U.S. GAAP and IFRSs end up competing against each other in the U.S.
Market Forces and Standards Improvement
Some observers have argued that allowing competition between U.S. GAAP and IFRSs might not foster Convergence but rather ongoing innovation by the FASB and IASB, which would in turn result in a continual stream of non-converging, "leap-frogging" improvements in each competing set of standards. This is usually what happens in markets characterized by differentiated products and vigorous rivalry.
But standards markets aren't like other markets, and in the case of financial reporting standards, the dominant "competing" standard-setters aren't rivals with opposing goals or interests. In my opinion, the network effect in a market for financial reporting standards would be so strong and the interests of the standard-setters would be so closely aligned that the standard-setters would neither be willing nor able to engage in an ongoing game of one-upmanship.
Conclusion
In a free market for financial reporting standards, market forces will result in set-level Convergence. However, market forces by themselves will not ensure Convergence on a set of standards of "high-enough" quality nor on a set that serves the best interests of investors. Fortunately, there are other forces that are likely to ensure both sufficient quality and alignment with investor interests, and market forces are not likely to interfere with those other forces.
Next week's post will address whether market forces will solve the problems associated with a transition to different standards, such as the re-education of participants in the financial reporting supply chain.
Market Forces and Convergence, Part 2
Last week's post explored the role that "market forces" will play in Convergence. On the assumption that some kind of transition to different financial reporting standards is inevitable in the United States, this week's post will explore the role of market forces in resolving the problems associated with a transition to different standards, such as the problem of re-educating stakeholders in the financial reporting supply chain.
A transition to different financial reporting standards in the U.S. is likely to be triggered by the U.S. Securities and Exchange Commission (SEC) either allowing or requiring domestic public companies to use financial reporting standards other than current U.S. Generally Accepted Accounting Principles (GAAP). As I have explained in prior posts, some kinds of transitions that the SEC is contemplating represent Convergence (specifically, set-level Convergence), and some don't.
The aggressive actions of the Financial Accounting Standards Board (FASB) to attain Convergence (specifically, standard-level Convergence) between U.S. GAAP and with International Financial Reporting Standards (IFRSs) may also result in a transition to substantially different financial reporting standards, even if the resulting standards are still called "U.S. GAAP."
In any case, it is important to remember that both publicly-held and privately-held companies would need to deal with such transitions, although possibly in differing timeframes and manners.
Regardless of the kind of transition that awaits us, the transition from current U.S. GAAP to different financial reporting standards won't be easy, fast, or cheap. The obvious challenges that would accompany a standards transition have led to obvious questions: What exactly will happen? How? When? Who will do what? And how much will it all cost?
In response to such questions, many stakeholders in the financial reporting supply chain have begun to express the vague-but-confident opinion that market forces will resolve any issues that may arise from a transition to different financial reporting standards. The expression of such an opinion became increasingly common after March 6, 2007, when the SEC held a roundtable discussion to solicit and obtain feedback from stakeholders in the financial reporting supply chain regarding the SEC's then-contemplated acceptance, from "foreign private issuers" (FPIs), of financial statements prepared using IFRSs as issued by the International Accounting Standards Board (IASB) without reconciliation to U.S. GAAP. That roundtable can be credited with convincing many people in the U.S. that significant changes in financial reporting standards were indeed coming.
But back to the focus of this post: Can we rely on "market forces" to resolve the many issues that will arise as the United States transitions to different financial reporting standards? My answer is no. That's not to say that market forces won't play a role in resolving the issues that will arise; I simply reject the notion that market forces alone will lead us to desirable resolutions of those issues. Here's why . . .
From a micro-economic perspective, market forces are efficient and effective at producing desired outcomes for market participants when
Unfortunately, these conditions generally don't exist in the markets that so many folks are relying on to resolve the issues that will arise as the U.S. transitions to different financial reporting standards. And it is for this reason that market forces alone should not be relied on to solve the problems associated with Convergence or any other kind of transition to different financial reporting standards in the United States. In my opinion, it is precisely the lack of the above conditions that represents one of the most fundamental challenges that the U.S. faces in attempting to move towards a future of improved, converged standards.
In my next post, I will examine a kind of market that is perhaps the most relevant to the challenges of transitioning to different financial reporting standards: the market for education. Specifically, I will illustrate how education markets generally fail to exhibit the above conditions. And I will propose an approach to transitioning to different financial reporting standards that relies on sound principles of supply-chain governance rather than on blind faith in free-market economics, i.e., an approach to fostering the market conditions described above before relying on market participants to do what comes naturally to them.
Posted by Bruce Pounder | Permalink