June 5, 2000
Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Concept Release: International Accounting Standards (File No. S7-04-00)
The Global Financial Reporting Advocacy Committee (GFRAC) of the Association for Investment Management and Research (AIMR)1 is pleased to respond to the U.S. Securities and Exchange Commission's Concept Release on International Accounting Standards. The GFRAC is a standing committee of AIMR charged with representing the views of investors to and maintaining liaison with bodies that set financial accounting and reporting standards in a global context, particularly the International Accounting Standards Committee. The committee is also charged with responding to requests for comment from national standard setters and regulators on international financial reporting issues. The committee is developing a position paper on the quality of International Accounting Standards and their acceptability as a reporting regime for financial analysis and valuation of cross-border securities listings. The committee's work on this position paper forms the basis for their comments on the Commission's concept release.
The GFRAC is currently comprised of AIMR members from the United States, the United Kingdom, Canada, Malaysia, and Hong Kong. They have familiarity with various accounting standards and financial reporting regimes and are well versed in the issues addressed by the Commission's concept release.
Scope of Comment
The primary objective of GFRAC in fulfilling its charge by AIMR is to promote efficiency and transparency in global financial markets through development, maintenance and use of high quality financial reporting and disclosure standards. Such standards cannot stand alone. To be effective, financial reporting and disclosure standards must be part of a financial reporting and disclosure system or infrastructure that ensures these standards are properly and consistently applied. We believe that such a system must have the following five elements:
(1) Well-specified and understandable financial reporting and disclosure standards;
(2) Ethical, trained preparers;
(3) Ethical, trained and independent auditors;
(4) Effective regulatory oversight and enforcement, including the threat of litigation, economic and criminal penalties for fraud and non-compliance; and
(5) Shareholder and investor responsibility and involvement in corporate governance.
We believe that only a comprehensive and integrated financial reporting system that includes high quality accounting standards can produce financial statements that are comprehensive, neutral, timely, and most importantly, relevant and reliable.
A majority of the Committee believes that IAS standards meet the requirements set forth in element (1) above and this letter presents our reasons for that view. We wish to be extremely clear, however, that in forming our views on the suitability of IAS for use by foreign issuers in the U.S. capital markets, we assume that the quality of financial statement preparation, auditing, regulatory oversight and enforcement, and corporate governance will be of the same level and caliber as currently exists for U.S. registrants. We understand that this is a significant, and perhaps unrealistic, assumption. However, in order to be fair and impartial in our assessment of IAS, we must provide these standards with a level playing field vis a vis U.S. GAAP. Therefore, our conclusions are predicated on the following four assumptions being true:
(1) The financial statements of foreign issuers will be subject to the Commission's additional financial reporting and disclosure requirements.
(2) The Commission will enforce compliance with IAS and those additional requirements.
(3) The Commission will require that auditors comply with U.S. Generally Accepted Auditing Standards in determining whether an issuer's financial statements are in compliance with IAS.
(4) Investors will be afforded the same level of involvement in corporate governance as they have with domestic issuers.
We believe that accounting standards are only one piece of an integrated financial reporting system. These standards can only be effective when combined with consistent interpretation and enforcement by high quality, independent audits, and regulatory enforcement with consequences for lack of compliance. We firmly believe that clear and consistent interpretation of the standards cannot rest solely with the standard setter, whether it be the Financial Accounting Standards Board (FASB) or the International Accounting Standards Committee (IASC), but must also be the responsibility of the independent auditors when addressing practice questions. With respect to enforcement, no private-sector standard setter, including the FASB, enforces its own standards. Only regulators have that power. The Commission must commit to enforce compliance with IAS standards with the same diligence and attention with which it enforces U.S. GAAP.
We are emphasizing these assumptions because we are concerned that many who criticize IAS have confounded these various elements of a comprehensive financial reporting and disclosure system. Even the most "perfect" accounting standards, if they should exist, would be of little use to investors if they were expected to stand alone without the other elements of the reporting system in place and fully operational.
One member of the GFRAC disagrees with this view. He strongly believes that the IAS (as of June 5, 2000) cannot be regarded as a set of "high quality" standards for the following reasons:
(1) IAS often contain too many acceptable accounting alternatives.
(2) IAS does not provide adequate disclosures and implementation guidance.
(3) Some IAS are perfunctory (e.g., accounting for leases).
(4) Too many IAS have not yet been applied.
He believes that these deficiencies make it impossible to conclude that IAS can be consistently applied and are capable of rigorous interpretation. He is also alarmed by the absence of any comprehensive discussion of plans to achieve acceptable levels of compliance by preparers and enforcement by auditors and regulators. Because he believes that (1) it is not possible to conclude that IAS are of acceptable "high quality' and (2) there is not enough evidence that adequate compliance or enforcement exists today, he dissents from the views expressed in the remainder of this letter.
Non-GAAP Elements of Financial Reporting and Disclosure System
As noted above, the GFRAC believes that it may not be realistic to assume that the non-GAAP elements of the financial reporting and disclosure system surrounding IAS are of comparable quality to those surrounding U.S. GAAP. Elements (2) and (3) of the financial reporting and disclosure system described above, for example, relate to the responsibilities of issuers and auditors respectively. The GFRAC believes that these elements have two important characteristics in common: ethics and training. In addition, auditors must be independent from their clients. We believe that there is considerable work to be done in all three areas.
Training on IAS can be achieved in a variety of ways. We do not believe that it should take very long for preparers and auditors to be adequately trained. Some of us have seen evidence that the global accounting firms have already begun to address this issue. We believe that acceptance of IAS will of necessity expedite this process.
Ethics and independence are more problematic. The Independence Standards Board was initiated to address these issues with respect to those who audit U.S. financial statements. We believe that, given both cultural and legal differences that exist in an international context, it is reasonable for investors to be more concerned about compliance with both the spirit and letter of IAS.
Therefore, although we believe that independent auditors make significant contributions to effective enforcement, the true burden of enforcement of IAS will rest with the Commission and its staff. We understand that the most important issue for the Commission will be having adequate numbers of trained staff to undertake this responsibility. Once adequate staff is in place the Commission must review IAS financial statements with as much, if not more, care as they currently do U.S. GAAP financial statements. When non-compliance or fraud is detected, the Commission must use all of the remedial actions available including threats of litigation, punitive damages, and criminal proceedings.
Finally, shareholders and investors must accept responsibility and be afforded the opportunity to participate in corporate governance to insure that the companies in which they invest provide them with sufficient, reliable, and relevant information. And to penalize those companies who fail to do so with reduced share prices and increased cost of capital.
Comments on Convergence of Accounting Standards
The GFRAC strongly supports the IASC's mandate and its efforts to procure convergence of international accounting standards and practices to one high quality standard. As noted by the FAPC in Financial Reporting, globalization and increased correlation of international capital markets heightens the need for high quality, complete, accessible, and understandable financial statements that provide comparability across companies regardless of the country of domicile. Financial analysis and investment decision-making has for some time focused on analyzing and comparing companies in global industries, not merely domestic. Therefore, improved transparency and comparability of financial information will (1) provide the better companies with additional sources of capital at lower cost and (2) provide investors with additional investment opportunities and the ability to assess them appropriately.
By design, IAS are not as detailed or comprehensive as U.S. GAAP. Rather than providing detailed rules, IAS focus on the principles that when followed appropriately will provide the same quality and quantity of information in financial statements. Current IAS GAAP has benefited greatly from both the Improvements Project and the development of the other standards that comprised the IOSCO work program. The interpretations and the guidance that have been and continues to be provided by the IASC Standard Interpreting Committee (SIC) is critical to providing the consistency of interpretation that is provided in the U.S. by the Emerging Issues Task Force (EITF).
If IAS are considered as part of the Commission's financial reporting system, the GFRAC generally supports allowing foreign issuers to file their primary financial statements with the Commission using IAS. We believe the core standards provide as high quality and comprehensive a framework for financial reporting as U.S. GAAP and are suitable for use in the financial statements of foreign issuers in the United States. We believe that allowing foreign issuers to prepare their primary financial statements using IAS when they file these statements with the Commission will have three significant benefits:
Though the GFRAC recommends that the Commission allow foreign issuers to file financial statements based on IAS GAAP, this recommendation is not without trepidation. Our concerns stem primarily from the experience we have had analyzing financial statements currently prepared using IAS. First, a number of key standards have effective dates in 2000 and 2001 and there is no experience on whether the standards are being applied appropriately or consistently. Second, even for standards that are effective, we have seen inconsistent interpretation by the audit profession and a singular lack of enforcement. Some of these problems may be due to lack of knowledge and experience by both auditors and regulators. But continuance of such a situation is unacceptable to us.
Adequate and consistent enforcement is critical to the acceptance and survival of the IAS. Since there is no global regulatory body charged with enforcing the IASs, this task will be the responsibility of separate national regulators and independent auditors. Both will need ample training on the IASs themselves and on cultural issues that may interfere with the correct application of the standards. If the Commission should accept IAS, it will be its responsibility to ensure its staff has sufficient knowledge and expertise to perform the enforcement role effectively.
Standard-by-Standard Evaluation of IAS
The GFRAC is in the process of completing a standard-by-standard evaluation of IAS. In performing this evaluation, we did not believe that simple comparison to the U.S. GAAP requirements would be sufficient to determine whether the standard was of high quality. Rather, we felt that it is also necessary to compare the standards to an ideal set of criteria. In doing so we are employing the criteria outlined in Criteria Employed by the AIMR Financial Accounting Policy Committee [FAPC] in Evaluating Financial Accounting Standards.2 In this paper, the FAPC provided eight criteria that they considered most critical to the promulgation of high quality accounting standards. The GFRAC believes that the FAPC's criteria provide an important framework for analysis and we are relying on these criteria in performing our evaluation of International Accounting Standards (IAS). These criteria are:
1. A new standard should improve the information that is available to investment decision makers.
2. The information that results from applying a new standard should be relevant to the investment evaluation process.
3. Certain financial information is better presented outside the audited financial statements, and should not be included in the scope of a financial accounting standard.
4. The information that results from applying a new standard should fit the double-entry accounting model or should enhance understanding of the data contained in the model.
5. Economic phenomena that are similar or equivalent should be depicted as such in financial statements. That depiction ought to conform to underlying economic reality.
6. Current values usually are more useful than historic amounts, subject to reliability of their measurement.
7. Extensive disclosures usually must be required as an integral part of a new accounting standard. Disclosures are necessary:
a. To overcome the deficiencies of a mixed-attribute accounting model; and
b. To help users understand the effects and implications of management's accounting choices. Disclosures are not, however, a substitute for measurement and recognition.
8. "Smoothing" and "normalization" is a function of analysis, not financial reporting.
Although our evaluation of all the IAS standards is not complete3, a consensus has emerged on a sufficient number of standards for us to respond to the Concept Release.
The remainder of our comments address the specific questions the Commission raised in its concept release. Answers to most of the questions are implicit in the substance of our comments reflected below.
The GFRAC believes that IAS provide a comprehensive accounting framework. These standards address the basic and fundamental accounting issues that are encountered in a broad range of industries. Our standard-by-standard evaluation addresses the strengths and weaknesses of individual standards both with respect to our "ideal" standard and with respect to U.S. GAAP.
Although the GFRAC does not hold the U.S. GAAP reconciliation in high regard, the committee could not agree that it should be eliminated. There was agreement among Committee members that, if the reconciliation is retained in the short term, it should not be viewed as a permanent part of the Commission's requirements.
In evaluating the usefulness of the reconciliation, the committee identified its shortcomings. It imposes an additional and costly reporting burden on foreign issuers. It cannot be used to construct a U.S. GAAP income statement and there is not sufficient information to construct a U.S. GAAP balance sheet. Hence, this information cannot be used to perform ratio analysis. We are also concerned that issuers manage the reconciliation as much as they might manage reported earnings. We are not convinced that reconciled net income is the income that would be reported if the issuer had prepared its financial statements using U.S. GAAP. This is not to say that the additional information provided in the reconciliation cannot be used at all. (See comments under Quality and Usefulness of U.S. GAAP Reconciliation.) However, we believe the benefits of accepting IAS outweigh this limited usefulness.
One difficulty arises when there is no equivalent IAS for a U.S. GAAP standard. Absent specific guidance by the Commission, we believe that companies would tend to choose between U.S. GAAP and a national GAAP standard, if one exists. Since we support maintaining the reconciliation requirement where issuers prepare financial statements using national accounting standards, we recommend that, in cases where an issuer who prepared IAS financial statements but applied a national standard rather than U.S. GAAP when no IAS existed, the reconciliation requirement should be maintained.
As noted above, the GFRAC is in the process of evaluating IAS on a standard-by-standard basis. Nevertheless, we have already identified several differences that we consider important in evaluating the overall quality of IAS. We considered the following to be shortcomings in IAS:
Conversely, we believe the following aspects of IAS provide better information than US GAAP:
(1) Revaluation of fixed assets
(2) Business combinations
(3) Segment disclosures
Although we have enumerated several differences between IAS and U.S. GAAP, we would like to remind the Commission that "accounting standards" are always in a state of flux. Sometimes, the FASB takes the initiative to improve accounting for a particular issue. At other times, we have seen the IASC take the initiative. This is the case with accounting for business combinations. The IASC limited the "pooling of interests" exception to only those situations where no acquirer could be identified. The FASB is now taking this one step further and eliminating the exception altogether. We hope that the IASC will reopen this issue in the near future as well.
Accounting for financial assets and liabilities is another example where different standard setters continue to expand the debate initiated by another standard setter. The FASB introduced the concept of recognizing certain financial assets and liabilities at fair value. The IASC produced a discussion document that recommended that all financial assets and liabilities be accounted for at fair value. These efforts have culminated in the formation of the Joint Working Group of Standard Setters to address these issues and make recommendations for standards in this area.
In the final analysis, however, we conclude that investors would not be disadvantaged if they relied on IAS financial statements. We believe that if users were suspicious about the quality of the data provided then they would assess issuers a higher cost of capital. The market will penalize those companies that make questionable accounting choices or omit adequate disclosures. We believe that IAS provide users with sufficient information to separate "good" issuers from "bad" issuers in that regard and make valuation decisions accordingly.
The GFRAC does not believe that U.S. companies would be disadvantaged if foreign issuers are allowed to use IAS. On the contrary, we believe that there is a general belief by most users that U.S. GAAP provides better information, even if that is not the case. Therefore, we suspect that, if a U.S. company sought permission to prepare its financial statements under IAS, investors would assume this to be a change to lower quality earnings and value them under that impression.
The GFRAC found the questions related to implementation guidance, consistent application and rigorous interpretation difficult to address. Many of the more complex standards have not yet been implemented. Other recently issued and implemented standards have not been "stress tested" and the effectiveness of existing guidance and consistency of application can only be evaluated with time.
We believe that the IASC's Standing Interpretation Committee has acted in a timely manner to address issues and has provided guidance and interpretation where necessary. In addition, the IASC convened a working group to address questions related to IAS 39, Financial Instruments: Recognition and Measurement. This group has already issued a series of questions and answers for public comment. We believe that these mechanisms should provide the same level of guidance and interpretation provided by the FASB, EITF and Derivatives Implementation Group in the U.S.
Although the GFRAC believes that the SIC is effective within its mandate to rely on existing standards to support interpretations, its effectiveness could be improved if it had the same latitude to set standards as the EITF.
The GFRAC does not believe that it is necessary for the Commission to condition its acceptance of IAS on the new structure. We believe that the IASC is committed to the new structure and that once the transition is complete, it will be better able to develop well-specified and understandable accounting standards.
Trained, ethical and independent auditors are critical to a sound financial reporting infrastructure. Although we recognize that there may be cultural issues that make this difficult, if not impossible, in some jurisdictions, the GFRAC believes that auditors who certify financial statements are in compliance with IAS must be subject to the same quality control requirements as those who certify U.S. GAAP statements, if those statements are filed with the Commission. If not, the Commission's enforcement task would be exacerbated. We believe that such a requirement should be the case for auditors regardless of the accounting standards used as the basis for financial statements filed with the Commission.
The GFRAC is only aware of variations in practice due to the issues being addressed by the SIC. However, the SIC can only provide "legal" interpretations of the standards. It cannot ensure that preparers and auditors comply with the interpretation, any more than the IASC can do so with respect to the basic standards. We are aware that the global accounting firms have instituted either centralized practice departments with respect to IAS interpretations or have global committees to insure that there is consistent interpretations and to identify issues that should be addressed by the SIC.
National regulators must take a greater role in enforcement of the standards. Although we do not envision the Commission as the "regulator of last resort," we believe that if the Commission accepts IAS, it will become the de facto enforcer of the standards. We also believe that the Commission can have influence over auditors, particularly the global accounting firms, to provide consistent interpretation and application of IAS.
The GFRAC does not see how accepting IAS could have a negative effect on the Commission's ability to take effective enforcement actions. We are not aware of the Commission undertaking an enforcement action against a foreign issuer for failure to comply with foreign GAAP or for preparing an incorrect reconciliation. Therefore, we believe that if a majority of foreign issuers report under IAS rather than a national GAAP the Commission can only become more effective in detecting financial reporting irregularities and fraud. We believe that if more foreign issuers file IAS financial statements then the Commission's staff will develop sufficient expertise in IAS to perform effective reviews. It would seem to us that the efficiency and effectiveness that would come with this increased expertise would enhance the Commission's ability to take effective enforcement actions rather than decrease it.
The majority of GFRAC members believe that the US GAAP reconciliation has limited usefulness. These members prefer high quality primary financial statements to poor quality primary statements with the reconciliation.
We believe that investors do not generally take the time to convert the reconciliation into a useful income statement. Even if investors could use the information to prepare a relatively complete U.S. GAAP income statement, there is not sufficient information to prepare a U.S. GAAP balance sheet. In addition to an income statement, a balance sheet is needed in order to do ratio analysis including calculation of such items as inventory or receivables turnover or an analysis of fixed assets.
Some analysts do use the reconciliation in their analysis of companies in a global sector. The use, however, is not generally to restate information to U.S. GAAP. A series of reports by Morgan Stanley, Apples to Apples, provides some insight into how this reconciliation information may be used. It is important to note that these reports do not recommend restating reported financial information to U.S. GAAP, IAS GAAP, or to any other national GAAP. All information provided in the financial statements, including the reconciliation, is used to restate information to a "common" GAAP. In fact, even if all companies report using U.S. GAAP, some financial information might still be restated, if possible, to a consistent and more analytically useful number. We believe the limited usefulness of this information does not warrant retention of the reconciliation requirement for issuers preparing IAS financial statements.
Those on the committee who support retaining the reconciliation requirement believe that analysis of the information it provides is best used to assess the validity of management's accounting choices. We believe that the importance of the reconciliation increases when the financial statements are weak.
Some GFRAC members noted that there were contradicting academic studies on the usefulness of the information in the reconciliation.
The GFRAC agreed that requirements to provide the reconciliation should not depend on the type of securities to be registered or the type of company seeking registration. Nor are we supportive of providing a "bottom line" number if only a partial reconciliation were required. Such a number would be meaningless since it would not be based on any GAAP.
The majority of the GFRAC believe that IAS are of sufficient quality to be accepted by the Commission for use by foreign registrants without reconciliation given that the other elements of the financial reporting and disclosure system are in place and are comparable to those in the current system applicable to domestic registrants. We believe there are three benefits to accepting the core standards that should be reiterated here. First, acceptance will encourage more companies to adopt IAS. Second, acceptance will foster further improvement of the standards. Finally, acceptance will test the market implications of using IAS.
The dissenting member of the Committee is willing to support these conclusions only if the reconciliation requirement is retained. However, the majority of the committee disagrees with retention of the reconciliation requirement. They believe that if the reconciliation is retained any test of the market implications of IAS will be confounded by the availability of US GAAP information.
The Global Financial Reporting Advocacy Committee appreciates the opportunity to express its views on the Concept Release, International Accounting Standards. If the Commission or its staff have questions or seek amplification of our views, we would be pleased to answer any questions or provide any additional information you might request.
/s/ Trevor W. Nysetvold
Trevor W. Nysetvold, CFA
Global Financial Reporting Advocacy Committee AIMR
/s/ Patricia Doran Walters
Patricia Doran Walters, CFA
Vice President, Advocacy
Members of the AIMR Global Financial Reporting Advocacy Committee:
Low Kwong Chong Malaysia
Robin J. G. Fox, CFA Hong Kong
Trevor W. Nysetvold, CFA, Chair Canada/United States
Nazir S. V. Rahemtulla, CA Canada
Kenrick R. M. Ramlochan, CFA United Kingdom
Gary S. Schieneman United States
Ashwinpaul C. (Tony) Sondhi United States
Patricia A. McConnell, CA, Observer United States
Patricia Doran Walters, CFA, Staff Liaison
Cc: International Accounting Standards Committee
Patricia A. McConnell
AIMR Distribution List
Michael S. Caccese, Senior Vice President, General Counsel & Secretary, AIMR
Maria J.A. Clark, Associate, AIMR
1 The Association for Investment Management and Research (AIMR) is a global, not-for-profit organization of over 42,000 investment professionals in 95 countries. Through its headquarters in Charlottesville, VA, and more than 94 Member Societies and Chapters throughout the world, AIMR provides global leadership in investment education, professional standards, and advocacy programs.
2 This paper was prepared by Peter Knutson, PhD, CPA, and Gabrielle U. Napolitano, CFA, former Chair and Chair, respectively, of the FAPC to be presented at the 1997 Financial Reporting Issues Conference of the American Accounting Association and the Financial Accounting Standards Board.
3 A copy of the complete analysis will be provided to the Commission when it becomes available.