The Convergence Blog™

Improve and Adopt: The Future of IFRSs in the U.S.

On October 24, 2007, the Securities, Insurance, and Investment Subcommittee of the U.S. Senate Committee on Banking, Housing and Urban Affairs held a hearing on "International Accounting Standards: Opportunities, Challenges, and Global Convergence Issues" in Washington, DC [see the hearing web page]. Here are some highlights of the testimony provided at that hearing:

Robert H. Herz, Chairman of the U.S. Financial Accounting Standards Board (FASB): "[W]e do not support permitting U.S. companies a choice between IFRS and U.S. GAAP for any extended period of time. Rather, we believe it would be preferable to move all U.S. public companies to an improved IFRS over a transition period of several years following the blueprint we are advocating be developed."

Charles E. Landes, Vice President, American Institute of Certified Public Accountants (AICPA): "I want to state as directly as possible that the AICPA supports the goal of a single set of high-quality, comprehensive accounting standards to be used by public companies in the preparation of transparent and comparable financial reports throughout the world. The debate or question should no longer be whether we move to convergence of high quality accounting standards, but how soon we can accomplish convergence. . . Is there still hard work to be done towards convergence? Yes. Will there be bumps in the road as we take this journey? Absolutely. But it is a journey that must be taken."

In summary: The FASB, the AICPA, and other providers of testimony expressed strong support for the movement of all public companies away from U.S GAAP to an improved versions of IFRS as the only acceptable set of standards to use in preparing financial statements. And all agreed that the transition process would work better if it was based on a well-conceived "blueprint," which has yet to be developed. But while the AICPA and SEC expressed strong support for the SEC's proposal to eliminate the U.S. GAAP reconciliation requirement for foreign private issuers using IFRSs and the SEC's Concept Release regarding giving U.S. issuers an option to prepare financial statements in accordance with IFRS, other hearing participants were generally either neutral or opposed to the SEC accepting IFRS-compliant filings as-is prior to the development of an improved version of IFRSs, with respect to which U.S. GAAP will either be converged or simply no longer relevant.

Commentary: Regardless of what the SEC does in the short-term, the long-term trend is unmistakable: U.S. public companies (and possibly privately-held companies as well) will eventually use a version of IFRSs that will be significantly different from either current IFRSs or current U.S. GAAP. And it is that yet-undefined set of standards that U.S. financial executives need to begin preparing themselves and their organizations for, knowing that both U.S. GAAP and IFRSs will undergo rapid, profound change along the way.

The Challenge of Change

I write this blog primarily for financial statement preparers, but a recent high-level discussion about the impact of Convergence on financial statement auditors provides some insight into how various participants in the financial reporting supply chain view the challenge of educating, training, and developing U.S. accounting and finance professionals as U.S. GAAP and IFRSs converge.

On October 18, 2007, the Standing Advisory Group (SAG) of the U.S. Public Company Accounting Oversight Board (PCAOB) met in Washington, DC, to discuss, among other things, "Audit Implications of IFRS Financial Statements in U.S. SEC Filings." See the meeting page for links to audio recordings of the meeting and a Briefing Paper for the IFRS discussion. There's also a detailed summary of the meeting at FEI's Financial Reporting Blog.

To date, most discussions about Convergence education, training, and development (such as those held during the recent PCAOB SAG meeting) have focused on how to get accounting and finance students and professionals who are familiar with current U.S. GAAP to learn current IFRSs. But such discussions ignore a bigger issue: Because U.S. GAAP and IFRSs as we now know them will undergo rapid, profound change as they converge into a single set of global standards, accounting and finance students and professionals throughout the world will need to absorb many significant changes that will be made to existing standards, which will be a far bigger challenge than simply learning the current differences between U.S. GAAP and IFRSs. And the bigger challenge would essentially be doubled if companies are given the choice of preparing financial statements under either U.S. GAAP or IFRSs prior to Convergence.

Here are some quotes from the PCAOB SAG meeting that I found particularly relevant to the issue of educating, training, and developing U.S. accounting and finance professionals:

• Jeffrey C. Steinhoff, U.S. Government Accountability Office: "[C]hange is something that happens all the time. Accounting standards, accounting treatments, business -- it’s changing all the time. So education's a lifetime job."
• Vincent P. Colman, PricewaterhouseCoopers: "[I]f the environment is changing, . . . we must change with that environment."
• Samuel J. Ranzilla, KPMG: "[T]aking some of our people who are very good in U.S. GAAP and making them very good in IFRS is not really a whole lot about what’s in the two standards -- it’s actually much more around change management . . ."

In particular, I concur with Sam Ranzilla's characterization of the challenge as being much more about change management than about the technical differences between the two sets of standards. In my opinion, this is indeed a major issue that financial executives will need to contend with in the coming years: "How should we prepare for a future that will be very different from the present, not because we'll be adopting existing IFRSs but because the FASB and IASB are working aggressively to change both U.S. GAAP and IFRSs significantly in a short period of time in order to converge the standards with each other?"

"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.

"Accounting Changing with the Times"

The October 3, 2007 edition of The Houston Chronicle contained an interview with Charles Swanson, managing partner of Ernst & Young's Houston office. The story, part of the newspaper's "Moneymakers" series, is titled "Accounting Changing with the Times". In the standard series format, Chronicle reporter Tom Fowler asks Swanson five questions, one of which is "The industry seems to have adapted to the demands of Sarbanes-Oxley. What's the next big change lurking over the horizon?" Swanson begins his response with "One of the big changes that could impact Houston specifically is the use of IFRS, International Financial Reporting Standards. There's been a long convergence between our rules, U.S. GAAP (Generally Accepted Accounting Principles) and international rules . . ."

As most of you know, the subtitles of my blog and forthcoming book refer to the convergence of U.S. GAAP and IFRSs as "the next big challenge in corporate financial reporting." What makes the Chronicle story striking to me is not so much that Mr. Fowler asked an excellent question as one of his allotted five, or that Mr. Swanson and I apparently think alike ("great minds"?), but rather that the Chronicle story is the first I have seen in a general-readership newspaper to deal specifically with IFRSs and Convergence.

When Convergence literally starts to show up on your doorstep in the morning, you no longer have the luxury of ignoring it. And when your mother-in-law reads about it before you do and calls to talk about it (as was the case with me and the Chronicle story), then you REALLY don't have the luxury of ignoring it.