"Choice" is not "Convergence"

Some financial executives in the United States believe that the "convergence" of U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRSs) refers to U.S. companies gaining the ability to choose which of the two sets of standards they will use in preparing financial statements. That mistaken belief has been fueled by the considerable attention given to rule changes recently proposed by the Securities and Exchange Commission (SEC); if adopted, the SEC's proposals would give companies under its jurisdiction the choice of using either U.S. GAAP or IFRSs when preparing the periodic financial statements that must be filed with the Commission.

The main thing I want to do in this blog post is reinforce that such a "choice" is NOT "convergence." But I also want to explain how "choice" may actually be one of the most effective and efficient ways to foster the achievement of "true" convergence.

Choice vs. Convergence

Many advocates of Convergence have criticized "choice" as being the very antithesis of Convergence. And they're right. Convergence is about all companies in all countries using the same set of country-neutral accounting and financial reporting standards. If different SEC registrants are allowed to use different sets of standards instead of being required to use a single set of standards, that's certainly not Convergence.

And not only would the SEC's proposed rule changes result in the exact opposite of Convergence in the short term, there's also a risk that they would delay or even prevent Convergence from happening in the long term. The SEC's "choice" proposals have been subject to the criticism that allowing filers to choose between U.S. GAAP and IFRSs would destroy much of the incentive to eliminate existing differences between the two sets of standards. And without strong incentives to eliminate differences between U.S. GAAP and IFRSs, both sets of standards could linger indefinitely without converging.

Stumbling Block or Stepping Stone?

Most observers believe that the SEC's "choice" proposals are very likely to be adopted despite the above criticisms (and despite other criticisms that are unrelated to Convergence, such as the "race to the bottom" argument). So if you believe in the desirability of Convergence, should you view the SEC's proposals as cause for despair?

I contend that advocates of Convergence should be encouraged by the SEC's proposals and welcome them. In other words, "choice" will be a stepping stone to Convergence rather than a stumbling block. Here's why:

• The SEC's proposals send a strong signal that the Convergence of U.S. GAAP and IFRSs is within reach. If the SEC deems U.S. GAAP and IFRSs to each be acceptable in meeting the needs of U.S. capital market participants despite the differences between them, then it's hard to argue that the differences are meaningful. And if the differences aren't meaningful, U.S. GAAP and IFRSs must be considered immanently convergable.
• The ability to use IFRSs now would give U.S. capital market participants a taste of the benefits of country-neutral standards. This can be expected to accelerate the erosion of support for multiple sets of standards in the U.S. and thus drive Convergence to happen sooner rather than later.
• Competition among standards is ultimately a winner-take-all game. A set of standards (such as U.S. GAAP or IFRSs) typically has a certain degree of intrinsic value, but that value tends to increase exponentially the more widely the set of standards is used; this is known in economics as a "network effect". The existence of such a network effect usually results in a phenomenon whereby the first set of standards to "snowball" in terms of usage will eventually come to dominate all other competing standards -- assuming that users have an unconstrained choice of which standards to use. Interestingly, the standards that end up winning are not necessarily the first nor even the highest-quality standards (VHS vs. Beta videocassette formats are a classic example). But the main point is that when given a choice in a "free market" for standards, users overwhelmingly adopt whatever users overwhelmingly adopt, in a kind of self-fulfilling popularity contest. And in a free market, the phenomenon tends to play out to its conclusion rather quickly. So if the SEC allows companies to choose between U.S. GAAP or IFRSs, one of those sets of standards is likely to become the dominant choice rather quickly. And given that the rest of the world has adopted or is adopting IFRSs, it's not hard to predict what the dominant choice in the U.S. is likely to be -- leaving us with a single set of country-neutral standards in use throughout the world -- in other words, Convergence.

To summarize: Regardless of whether you're for or against "choice," or for or against Convergence, if "choice" happens, expect Convergence to follow.