The Convergence Blog™

The Genuine Reason for Allowing U.S. Companies to Use IFRSs

My blog post of January 6, 2008 explored two phenomena that have led many people in the United States to mis-perceive rationales for why we should consider allowing U.S.-listed companies to use IFRSs. One of those phenomena was the widespread conversion to IFRSs by countries other than the U.S., and the other was the SEC's recent decision to accept IFRS-compliant financial statements as-is from foreign companies that are listed in the U.S. Those phenomena are distinct from each other and have different genuine rationales from each other. Those phenomena are also distinct from the SEC's expressed interest in allowing domestic public companies to use IFRSs, which has its own genuine rationale. In today's blog post, we finally get to the genuine reason for allowing U.S. companies to use IFRSs. And we'll see that once again, to the surprise of many, the genuine rationale for allowing U.S. companies to use IFRSs is not the patently-incorrect assertion that "IFRSs are superior to U.S. GAAP."

The genuine rationale for allowing U.S. companies to use IFRSs is that at least some U.S. companies will find themselves at a competitive disadvantage if they are not permitted to use the same financial reporting standards that their competitors use. Specifically, U.S. companies that are forced to use U.S. GAAP instead of IFRSs

• Might be precluded from competing effectively, on a global basis, for the lowest-cost capital (global capital market participants seek comparability in financial reporting among peers in an industry and non-U.S. markets are increasingly exhibiting a preference for IFRSs as the basis for financial reporting);
• Might experience higher operating costs for accounting, auditing, other compliance-related activities, especially for multi-national parent entities that must consolidate foreign subsidiaries' financial statements
• Might not be able to source accounting talent as flexibly as competitors who, as a result of using IFRSs, have the option to source accounting talent globally.

We still have many mis-perceptions to debunk regarding the role of IFRSs in the phenomenon of Convergence. Stay tuned.

More Mis-inferred Rationales for Using IFRSs in the U.S.

In last week's blog post, I indicated that a major reason people in the U.S. are confused about Convergence is that they mis-perceive the rationales for why we should be considering the use of IFRSs in the U.S. Those mis-perceptions have, in many cases, led to illogical opposition to the use of IFRSs in this country.

In my previous post, I gave several specific examples of mis-inferred rationales, i.e., reasons that folks mistakenly believe are being offered for using IFRSs in the U.S. by those who are promoting the use of IFRSs in the U.S. In this week's post, I'm going to share a couple more examples of mis-inferred rationales.

The first example arises from the widespread conversion to IFRSs by countries other than the U.S. Some folks think that the U.S. is being pushed into using IFRSs because "everyone else is doing it," and reject IFRSs using parental logic: if everyone else jumps off a bridge, that doesn't mean you should too. But "everyone else is doing it" or " it's a good idea for everyone else so it must be a good idea for the U.S." are NOT genuine rationales for using IFRSs in the U.S. To reject IFRSs on the basis of such mis-perceived rationales would be illogical. (Furthermore, such rationales do not adequately explain why the vast majority of capital markets outside of the U.S. have embraced IFRSs. The proper explanation is that (1) IFRSs are largely superior to the country-specific GAAPs that other countries used before converting to IFRSs, which is not true for the U.S.; and (2) the capital markets of other countries would suffer far greater harm than U.S. capital markets would suffer as a result of not using country-neutral financial reporting standards.)

The second example arises from the SEC's recent decision to accept IFRS-compliant financial statements as-is from non-U.S. companies that are listed in the U.S. Some folks assume--incorrectly--that the SEC has concluded that IFRSs are of high-enough quality for use by all issuers under the SEC's jurisdiction. In opposing that imagined conclusion without realizing that it is only imagined, folks have once again come to oppose IFRSs for the wrong reasons.

The fact is that the SEC has not concluded that IFRSs are of high-enough quality for use by all issuers under the SEC's jurisdiction. The genuine rationale for the SEC's recent decision to eliminate the GAAP reconciliation requirement for foreign companies listed in the U.S. who file IFRS-compliant financial statements was three-fold. First, dropping the reconciliation for IFRSs filers would lower costs to issuers and therefore increase returns to investors without depriving investors of any information of value. Second, dropping the reconciliation requirement for IFRSs filers would potentially increase future opportunities that U.S. investors would have to invest in foreign companies that use financial reporting standards of adequately high (though not necessarily the highest) quality. And third, the SEC wanted to avoid provoking other jurisdictions into implementing retaliatory reconciliation requirements on U.S. companies listed abroad.

Two key points:

1. Genuine rationales for the above phenomena never include "IFRSs are superior to U.S. GAAP." Understanding that simple fact helps explain why debates about the superiority of one set of standards over the other have gotten us nowhere.


2. None of the genuine rationales for allowing foreign companies listed in the U.S. to use IFRSs are genuine rationales for allowing domestic companies to use IFRSs—which I'll address in my next blog post.

Clearing Up Misunderstandings About IFRSs

As I mentioned in last week's blog post, I now realize that much of the confusion about Convergence comes from certain widespread misunderstandings about International Financial Reporting Standards (IFRSs). I have begun to catalog those misunderstandings, and I plan to clear them up through my blog posts over the next several months.

In this post, I'll introduce a major reason that people in the U.S. are confused about IFRSs: they mis-perceive rationales for considering the use of IFRSs in the U.S.

Because such mis-perceived rationales can often be easily refuted, folks who mis-perceive the rationales often end up opposing IFRSs for wrong reasons.

Here are some examples of rationales for using IFRSs in the U.S. that are often wrongly inferred from publicized statements of individuals and organizations:

• Financial statements prepared using current IFRSs are essentially the same as financial statements prepared using current U.S. GAAP.


• Financial statements prepared using current IFRSs are demonstrably superior to financial statements prepared using current U.S. GAAP.


• It is inherently and demonstrably easier to prepare financial statements using current IFRSs than it is to prepare financial statements using current U.S. GAAP.


• IFRSs are developed and maintained by an organization that exhibits superior governance, financial viability, and/or due process versus the FASB.

In each of the above examples, the rationale can be easily refuted because it is patently incorrect. Although a patently-incorrect genuine rationale is a logical basis for rejecting the use of IFRSs, it is not logical to reject the use of IFRSs on the basis of patently-incorrect rationales that do not represent anyone's actual, valid opinion on why we should be considering the use of IFRSs in the U.S. In other words, it would be logical to reject IFRSs if genuine rationales for using IFRSs were patently incorrect, but it would NOT be logical to reject using IFRSs because imaginary rationales (such as the ones above) are patently incorrect.

Understanding the genuine rationales for considering the use of IFRSs in the U.S. is critically important to understanding the phenomenon of Convergence and its impact on financial reporting in the U.S. Before we get to the genuine rationales, I have identified a few more kinds of errors in thinking about rationales for the use of IFRSs in the U.S. and I'll describe those errors in my next post.

Dec. 17th SEC Roundtable on the Use of IFRSs in U.S. Capital Markets

On December 17, 2007, the U.S. Securities and Exchange Commission (SEC) held a roundtable discussion on the use of International Financial Reporting Standards (IFRSs) in the capital markets of the United States. Specifically, the roundtable focused on "practical issues surrounding the use of IFRS in the U.S. in recent years and its potential expanded use in future years." This roundtable and an earlier roundtable on December 13, 2007 (see my blog post) relate directly to the SEC's "Concept Release On Allowing U.S. Issuers To Prepare Financial Statements In Accordance With International Financial Reporting Standards," which I previously wrote about here.

The December 17th roundtable consisted of two separate panel discussions. Each panel included individuals representing various stakeholders in the capital markets. Both panels addressed the issues of whether, when, and how the SEC should permit or require U.S. companies to transition to IFRSs, with the first panel exploring the issues from the perspective of U.S. capital market participants and the second panel exploring the issues from a global perspective.

Webcast archives and a raw transcript of both panel discussions may be found here.

Commentary

I would like to say again that I applaud the SEC for conducting the roundtables and that I have high regard for the individuals who participated in the roundtable panel discussions. I attended the December 17th roundtable in person and had the opportunity to talk to several panelists with whom I was not previously acquainted.

Despite the subject matter of this roundtable being somewhat different from that of the December 13th roundtable, the nature of both roundtables was disappointingly similar -- as I put it in last week's post, "rambling and disjointed; occasionally nonsensical but occasionally brilliant as well."

Prior to the roundtables, I had started to suspect that most individuals and organizations who express opinions on the use of IFRSs in the United States actually have no idea what they are talking about. Now, after observing the roundtable discussions, I am convinced of it. More importantly, now I know why -- that is, why there is so much confusion and disagreement about the use of IFRSs in the United States. Understanding the "why" puts me in a better position to fulfill the purpose of this blog (and my forthcoming book), which is to educate corporate managers about the growing impact of the global convergence of financial reporting standards on financial reporting in the U.S.

I have concluded that misunderstandings about IFRSs represent the biggest obstacles to understanding the phenomenon of Convergence and its impact on financial reporting in the U.S. The roundtable discussions have inspired me to begin to cataloging dozens of misunderstandings that folks have about the role of IFRSs in the phenomenon of Convergence. Going forward, my blog posts will focus on addressing those misunderstandings.

Dec. 13th SEC Roundtable on the Use of IFRSs in U.S. Capital Markets

On December 13, 2007, the U.S. Securities and Exchange Commission (SEC) held a roundtable discussion on the use of International Financial Reporting Standards (IFRSs) in the capital markets of the United States. The roundtable focused specifically on issues arising from the co-existence of multiple sets of financial reporting standards in U.S. markets. This roundtable and a second roundtable scheduled for tomorrow relate directly to the SEC's "Concept Release on Allowing U.S. Issuers to Prepare Financial Statements In Accordance With International Financial Reporting Standards," which I previously wrote about here.

Background

IFRSs have emerged as commonly-used financial reporting standards among foreign companies that participate in the U.S. capital markets largely due to the European Union's decision to mandate IFRSs for all public-company consolidated groups listed in the EU, many of which are also listed in the U.S.

The SEC has traditionally required non-U.S. companies that are listed in the U.S. to either (1) prepare their financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP) or (2) reconcile financial statements prepared under other standards (such as IFRSs) to U.S. GAAP. However, as permitted under SEC rules, foreign companies often file reconciliations many months after filing original non-GAAP statements. Thus, as established in the SEC's roundtable of March 6, 2007, the reconciliations are nearly useless to U.S. investors and other users of the financial statements, who long ago acclimated themselves to analyzing and comparing financial statements prepared under multiple sets of standards rather than waiting months to be able to do "apples to apples" comparisons.

The uselessness of the reconciliations led the SEC recently to eliminate the reconciliation requirement for foreign companies under its jurisdiction if the foreign companies prepare their financial statements in accordance with IFRSs (see my previous blog post here). Thus, while U.S. companies must still use U.S. GAAP, non-U.S. companies that participate in U.S. capital markets may now use either U.S. GAAP or IFRSs.

The December 13th Roundtable

The December 13th roundtable consisted of two panel discussions, both of which revolved around the same key question posed by SEC Chairman Christopher Cox in his opening remarks: "What is the effect of allowing foreign companies the choice of whether to use IFRS or U.S. GAAP, and denying that same choice to U.S. companies?" Panelists included individuals representing institutional investors, educators, issuers, auditors, credit rating agencies, and exchanges. The first panel explored the effects primarily from the perspective of U.S. capital market participants, whereas the second panel explored the effects primarily from a global perspective.

Webcast archives and a raw transcript of both panel discussions may be found here.

Commentary

The SEC's roundtables represent major milestones in advancing the dialog about Convergence and related issues here in the United States. Let me say for the record that I applaud the SEC for conducting the roundtables and that I have high regard for the individuals who participated in the panel discussions of this past week's roundtable. But having said that, I must say that I often felt uncomfortable observing the roundtable proceedings, as if I were witnessing the ancient fable of "The Blind Men and the Elephant" being played out in real life.

There are different versions of the fable, but in the one that I was reminded of, a group of blind men encounter an elephant -- a creature previously unknown to any of the men. Each man, touching a different part of the elephant (tusk, ear, trunk, leg, etc.) and lacking the ability to see the whole elephant, announces a different conclusion about what the strange animal is like. The fact that their individual perceptions differ so dramatically from each other baffles the group. And failing to reconcile their idiosyncratic experiences, the group ends the encounter with none of the men any wiser about the true nature of the elephant, or how each of their individual observations was actually valid but incomplete.

The comments of the December 13th roundtable panelists reflected a variety of subjective perspectives that often related poorly to each other. The overall result was rambling and disjointed; occasionally nonsensical but occasionally brilliant as well. Fortunately, from the discussions, I have begun to gain a deeper understanding of why there has been so much confusion and disagreement in the U.S. about the global convergence of financial reporting standards and the various issues related to Convergence. I'll have more to say about that in next week's blog post after I attend tomorrow's roundtable in person.

FASB Issues Standards on Business Combinations and Noncontrolling Interests

On December 4, 2007, the U.S. Financial Accounting Standards Board (FASB) issued a revised Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, as well as the related new SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements. Both statements represent significant changes to financial reporting under U.S. GAAP resulting from the FASB's joint efforts with the International Accounting Standards Board to converge U.S. GAAP with International Financial Reporting Standards. And as is often the case with the Boards' joint efforts, the newly-issued standards are intended to improve and simplify financial reporting while moving closer to a common set of financial reporting standards.

SFAS No. 141R and SFAS No. 160 "represent the completion of the FASB’s first major joint project with the International Accounting Standards Board (IASB), as well as a significant convergence milestone," according to FASB member G. Michael Crooch, who added "These standards and the counterpart standards issued by the IASB will improve reporting while eliminating a source of some of the most significant and pervasive differences between International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP)." While the FASB and IASB have been conducting many joint Convergence projects for several years, this is the first project that the Boards consider "done" -- at least for now, and despite the fact that U.S. GAAP and IFRSs are not fully converged on the issues that the standards address. When it comes to Convergence on these issues, "close enough" seems to have been "good enough" for the Boards, who apparently believe they have bigger fish to fry and are therefore unlikely to revisit these issues anytime soon.

In particular, SFAS No. 160 is just one example of how willing the FASB is to implement a new U.S. financial reporting standard when that standard represents a significant improvement over prior GAAP and is converged with existing IFRSs. But the Convergence of U.S. GAAP and IFRSs is a two-way street -- there are many examples of the IASB changing IFRSs to improve them and converge them with existing U.S. GAAP (e.g., IFRS 8, Operating Segments). Most important of all, U.S. financial managers should know that the Boards are conducting other longer-term projects that will converge U.S. GAAP and IFRS by introducing improved standards that are very different from either Board's existing standards.

FEI's Current Financial Reporting Issues Conference

On November 12 and 13, 2007, Financial Executives International (FEI) held their 26th Annual Current Financial Reporting Issues (CFRI) Conference in New York City. Presenters and panelists included representatives from the U.S. Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB), and the U.S. Securities and Exchange Commission (SEC). A common theme throughout many of the presentations was Convergence -- the global convergence of financial reporting standards in general and the convergence of U.S. GAAP and IFRSs in particular. An excellent summary of the topics discussed appears in KPMG's Defining Issues (#07-37).

"Domino One"

As reported in my previous blog post, on November 15, 2007, the U.S. Securities and Exchange Commission (SEC) voted unanimously to accept from "foreign private issuers" (FPIs) financial statements that are prepared using International Financial Reporting Standards (IFRSs) as issued by the International Accounting Standards Board (IASB) without reconciliation to U.S. Generally Accepted Accounting Principles (GAAP). That vote indicates that the SEC considers IFRSs to possess quality and comparability similar to U.S. GAAP. In other words, U.S. GAAP is still sufficient but no longer necessary to protect the interests of U.S. investors.

Of course, the SEC and the world's capitalists know that when it comes to financial reporting standards, it doesn't make economic sense to be different if it's not necessary. Back in March of this year when I was interviewed for a Forbes.com article, I had characterized the SEC's then-potential removal of the reconciliation requirement for FPIs as being likely to represent "Domino One" in triggering significant changes in the U.S. financial reporting environment. On November 15, "Domino One" tumbled. In particular, I believe that one consequence of the SEC's vote is to increase the likelihood of the SEC requiring all public companies under its jurisdiction (both domestic and foreign) to use IFRSs in the future.

The likelihood of the SEC requiring the use of IFRSs by registrants has been bolstered by the FASB and AICPA, who have each recently encouraged the SEC to require U.S. public companies to prepare financial statements using an improved version of IFRSs rather than U.S. GAAP. It seems that U.S GAAP's biggest supporters are falling like, well, dominoes.

An interesting question to ponder is whether we will end up with two sets of accounting standards in the U.S.–one for public companies and another for private companies. I see three possible scenarios as being more likely than others:

1. We do end up with two sets of standards: Public companies will use IFRSs but private companies will use U.S. GAAP. However, if public companies stop using U.S. GAAP, advocates of differential standards for private companies (e.g., The Private Company Financial Reporting Committee) will finally get the opportunity they've always wanted: to transform what we now know as U.S. GAAP into a radically simplified, more cost-effective set of standards that is no longer biased towards the needs and capabilities of public companies.
2. We don't end up with two sets of standards: Private companies will use IFRSs just like public companies.
3. We sort of end up with two sets of standards: Private companies will have the option to use "IFRSs for SMEs," a differential variant of full IFRSs that the IASB recently introduced specifically for "Small to Medium Entities."

The most important implication is this: Under each of the most-likely scenarios, accounting and financial reporting standards for both public and private companies will be significantly different from current U.S. GAAP.

It will certainly be interesting to see how the dominoes continue to tumble.

SEC to FPIs: No need to reconcile IFRSs to U.S. GAAP

On November 15, 2007, the U.S. Securities and Exchange Commission (SEC) voted unanimously to accept from "foreign private issuers" (FPIs) financial statements that are prepared using International Financial Reporting Standards (IFRSs) as issued by the International Accounting Standards Board (IASB) without reconciliation to U.S. Generally Accepted Accounting Principles (GAAP). The SEC's vote represents the official adoption of a rule change that had been proposed earlier this year (see my blog post on the proposal here).

FPIs are private-sector companies based outside of the United States that, for a variety of possible reasons, fall under the jurisdiction of the SEC. Prior to the SEC's vote, FPIs had been required to file either (1) financial statements prepared in accordance with U.S. GAAP or (2) financial statements prepared in accordance with other standards plus a reconciliation of those statements to U.S. GAAP. Now, FPIs that prepare financial statements using IFRSs as issued by the IASB will no longer need to supply a U.S. GAAP reconciliation -- IFRS statements will be accepted "as is" by the SEC.

In contrast to the multiple filing options available to FPIs, domestic companies that fall under the jurisdiction of the SEC have no choice regarding the standards that they must use when preparing financial statements. All U.S. issuers continue to be required to prepare financial statements in accordance with U.S. GAAP.

The SEC's action had been widely expected. However, at the meeting in which the SEC voted to adopt its previously-proposed rule change, the SEC's staff introduced two "surprises," both of which were approved as a result of the subsequent vote. The first was a recommendation that the rule change should be effective immediately. This significantly accelerated the attainment of the objective of the SEC's "IFRS Roadmap," which had targeted the reconciliation requirement for FPIs who prepare financial statements using IFRSs to be removed by 2009. Thus, as adopted, the rule change provides IFRS-filing FPIs with relief from the requirement to provide a U.S. GAAP reconciliation for financial statements covering any fiscal year that ends after November 15, 2007.

The second surprise gives FPIs yet another filing option, albeit a temporary one. During the next two years, the SEC agreed to accept from FPIs financial statements prepared using IFRSs as adopted by the European Union if those statements are accompanied by a reconciliation to IFRSs as issued by the IASB. While this concession to European issuers is likely to have virtually no impact in practice, it was a moral victory for those who had advocated such permissiveness in the face of widespread opposition to the SEC's recognition of so-called "jurisdictional IFRSs."

The SEC's press release regarding its action also contains some surprises. First, there is no mention of the temporary concession made for FPIs preparing financial statements in accordance with IFRSs as adopted by the European Union. Second, the press release characterizes the SEC's action rather oddly -- the headline reads "SEC Takes Action to Improve Consistency of Disclosure to U.S. Investors in Foreign Companies." I'm baffled by the "Consistency" part.

From a historical perspective, the SEC's decision is truly unprecedented. No issuer has ever been allowed to prepare financial statements using standards other than U.S. GAAP without being required to reconcile those statements to U.S. GAAP. The decision is also unusual in that the SEC is giving some issuers a significant filing option that is unavailable to other issuers, i.e., foreign issuers may now choose between IFRSs and U.S. GAAP while domestic issuers must continue to use U.S. GAAP.

For anyone who wants to see and hear exactly what transpired in Thursday's meeting, here's a link to a recorded version of the original webcast. The portion of the meeting related to the rule change for FPIs begins 55 minutes into the recording and ends at 2:34. Bonus: Watch for an "America's Funniest Videos" moment between 1:54 and 1:55 during Commissioner Atkins' Q&A.

Next Week: My post-Thanksgiving post will address the implications of the SEC's action for both public and private U.S. companies.

E&Y Chairman on IFRSs

In its November 9, 2007 issue, The Wall Street Journal ran "Mind the GAAP", an op-ed piece written by James S. Turley, Chairman and CEO of Ernst & Young. If you're a Journal subscriber (which you must be in order to access the article), I highly recommend Jim's piece as it bears directly on this week's SEC vote regarding the elimination of the requirement for "foreign private issuers" (i.e., non-U.S. private-sector entities whose securities trade publicly in the U.S.) to reconcile their financial statements to U.S. GAAP if they prepare the statements in accordance with IFRSs as issued by the IASB. It is also relevant to the conclusion this week of the comment period on the SEC's Concept Release regarding the possibility of allowing U.S. issuers the option to prepare financial statements under either IFRSs or U.S. GAAP.

Key Quote: "At Ernst & Young, we will weigh in with strong support for the SEC to set a certain date for a shift to IFRS."