August 27, 2007
Dear sirs,
I respectfully submit my responses to selected questions regarding Acceptance From Foreign Private Issuers of Financial Statements Prepared in Accordance With International Financial Reporting Standards Without Reconciliation to U.S. GAAP
I base my responses on approximately 10 years experience as a trainer / consultant instructing / advising preparers / auditors in the proper application / interpretation of IFRS / US GAAP in the Czech and Slovak republics, as well as an individual investor who heavily relies on published financial statements in making investment decisions.
3. Is there sufficient comparability among companies using IFRS as published by the IASB to allow investors and others to use and understand the financial statements of foreign private issuers prepared in accordance with IFRS as published by the IASB without a U.S. GAAP reconciliation?
Currently, the comparability between IFRS and US GAAP is sufficient to allow a sophisticated user to effectively compare an IFRS and US GAAP company.
Obviously, the above implies some very important caveats.
Primarily, the user must be sensitive to the significantly different approaches IFRS and US GAAP take to some key accounting issues. One of the most glaring is research and development.
Given that an IFRS balance sheet includes capitalized development, users must be aware of the difference and be able to adjust(over several prior periods) both the B/S and I/S to compare a US GAAP and IFRS company.
Also, I have spent considerable time analyzing reports of IFRS companies (including those that do not reconcile to US GAAP) and have encountered significant impairments of capitalized development at a significant number of companies. This implies that companies are applying IAS 38 aggressively (capitalizing costs that probably never met the conditions as outlined in IAS 38.57) exacerbating the problem.
Also, there is a related problem with the classification of RD expenses. While I believe that the guidance for the inclusion as RD (IAS 38.59 and SFAS 2.9) is broadly comparable, IAS 38 omits explicit exclusion guidance (SFAS 2.10). The result seems to be that a significant number of companies are classifying as RD costs that should have been classified differently.
Another issue is the different approach IFRS takes to valuation. Since IFRS allows fair value to be applied to a much wider range of items than US GAAP, if a company chooses the fair value model, its balance sheet, as a whole, becomes incomparable to US GAAP. Fortunately, with respect to PPE and intangible assets, this is an academic rather than practical problem (since few companies choose the revaluation model). Not so with companies holding significant real-estate. Here I have noted (and studies confirmed) that approximately 50% chose the revaluation model.
I suspect that this is so for two reasons. The first is that with investment property, unlike PPE and intangibles, the revaluation gain flows through the PL. The second is that (see my response to question 5) many of the companies purporting to publish IFRS statements are in reality putting out transformed local standard statements. They are then using the revaluation option to mask the fact that they set lives and depreciation periods according to these standards (in violation of IFRS 1.10 and 11).
A third difference is theoretical. IFRS (currently) accepts both the financial concept of capital maintenance as well as the physical. This difference often permeates the underlying approach to accounting (especially in countries such as Germany and France), and can lead to financial statements that are broadly incomparable.
For example, a company publishing a nature of expense income statement only (a option IFRS allows) could not be compared to any US GAAP company, which publishes a function of expense statement.
From the user's perspective, given sufficient footnote disclosure, most of these differences are not insurmountable. They do, however, require a great deal of relatively sophisticated accounting knowledge that I doubt the average user (who has never worked as accountant or CPA) posses.
5. What are commenters views on the faithful application and consistent application of IFRS by foreign companies that are registered under the Exchange Act and those that are not so registered?
No, I can state with absolute certainty (based on first hand experience) that IFRS is not being faithfully applied at a significant number of companies.
The reason is twofold.
First, most preparers applying IFRS do so not because they see the advantage of listing on a public market, but because IFRS is prescribed by national law (many are not even aware that this law is, in fact, a response to an EU regulation). The SEC has seen the result of this for itself, since practically all the companies publishing IFRS statements publish IFRS as ratified by the EU, not IFRS as issued by the IASB.
Congruently, companies approach IFRS the same way they approach national legislation: placing formal procedure ahead of faithful representation.
In my experience, when companies create IFRS statements, they do so in the following manner:
First step, prepare accounts according to local legislation.
This legislation, is procedural (prescribing things like a chart of accounts, financial statements, accounting procedures, etc.) not judgmental. This legislation is also subordinated to tax legislation, and (at a significant number of companies) applied exclusively for the purpose of generating / supporting a tax return (faithful presentation, as understood under US GAAP, is not even considered).
Step two, convert the statutory accounts to IFRS.
The conversion process generally starts at the chart of accounts level, where individual line items (as prescribed in local legislation) are renamed and reorganized to look like IFRS. Obviously, this procedure addresses only differences in disclosure, leaving untouched all but the most obvious recognition and measurement issues.
For example, being legalistic, local standards classify leases as either capital or operating based on the text of the agreement. An IFRS conversion thus involves merely changing the accounting procedure for those leases classified as capital, without reexamining where they should have been classified as operating, or vice versa.
Step three, have their local auditor / affiliate sign off on the conversion.
Most countries currently requiring IFRS have no specific licensing requirement for auditors auditing IFRS. Instead, auditors trained and experienced in auditing local, statutory accounts also express an opinion on IFRS reports.
Worse, local legislation often does not bar auditors from performing the IFRS conversion themselves (a violation of the Sarbanes-Oxley Act, I believe, since they are, in effect, auditing their own work).
And, as if that were not enough, staffing problems at auditing firms (including the local affiliates of the largest international firms) mean that they subcontract the IFRS conversion to outside consultants (often academics or doctoral students, with no actual accounting and/or auditing experience whatsoever).
The result is, that auditors often sign off on local standards that have been made up to look like IFRS, and face no penalty for doing so.
And this problem will not disappear any time soon. Most local universities are staffed by woefully underpaid professors with no first hand experience of either IFRS or (in the central Europe) a market economy / capital market. They also invariably lose their best and brightest to the private sector, leaving the chaff. Thus, while the current generation of auditors and accountants has few qualifications to apply IFRS, the incoming generation has fewer still.
Fortunately, large international companies / firms rotate their staff internationally, but this process is slow. As a result, of the professionals applying IFRS, only around 10% have any first hand experience applying them in an environment comparable to the US. The remaining 90% face a very steep learning curve and have few people to turn to, to help them climb it.
6. Should the timing of our acceptance of IFRS as published by the IASB without a U.S. GAAP reconciliation depend upon foreign issuers, audit firms and other constituencies having more experience with preparing IFRS financial statements?
Yes. I believe that practitioners / auditors should have several more years experience. Three would be nice. Five would be better (also see my response to the previous question).
9. How should the Commission consider the implication of its role with regard to the IASB, which is different and less direct than our oversight role with the FASB?
I believe that the commission should limit the amount of direct influence it seeks to expert on the IASB.
My reason is pragmatic. Since the IASB primarily serves two economic blocks, if the SEC attempts to exert direct influence on the IASB, the EC will respond by redoubling its effort to do the same. The result will be a transatlantic soccer match, with the IASB being the ball.
I think that the SEC, being the more mature standard setter, should take the high road, set an example for its European counterpart and reiterate its commitment to an independent IASB by explicitly forsaking any attempt to directly influence its deliberations (after which it can, obviously, press the EU - and other interested parties - reciprocate).
In any event, the SECs special relationship with the FASB ensures that, as long as the convergence process continues, the SEC will continue to have significant (albeit indirect) influence on the IASBs decision making. In this way, the SEC can, for the foreseeable future, act as a counterweight to the EC (without having to resort to the heavy-handed tactics that the EC tries to use to get its way).
Closing remarks
In conclusion, at this time, I consider dropping the reconciliation requirement to US GAAP (unless certain precautions were taken) a mistake.
First, it will do nothing to ease tensions between the SEC and EC. Quite the opposite, the EC wants the SEC to drop reconciliation for IFRS as approved for use in Europe, and will consider anything less an affront to EU sovereignty.
Second, the cost of reconciliation is so great, that it motivates IFRS companies to apply IFRS in a way that is comparable to US GAAP. Similarly, violating SEC requirements is so great, that audit firms are motivated to assign competent staff, rather people with only local knowledge.
Finally, while IFRS and US GAAP are broadly comparable, they are not (as yet) interchangeable. If the reconciliation requirement were dropped, motivation to finish convergence would dissipate and the process would either slow considerably or stop altogether.
In any event, if the decision to drop reconciliation were made, I believe that the following conditions should be attached:
One: IFRS companies must apply IFRS as approved by the IASB (applying any local variation is unacceptable).
Two: IFRS companies must either apply the IFRS alternatives / models that are consistent with US GAAP or reconcile to those alternatives / models.
Three: accounting firms auditing IFRS must be subject to the same rigorous (by a regulator that understands and appreciates IFRS as well as the PCAOB understands and appreciates US GAAP) oversight internationally as they are subject to in the US.
Four: the IASB and FASB must recommit to full convergence. Mutual recognition of divergent standards (a panacea for Brussels bureaucrats) would be a disservice to investors of historical proportion.
Unless these precautions are taken, dropping the reconciliation requirement would not only cause irreparable harm to US citizens (causing them to turn even more against globalization), but to all investors everywhere (who would lose a once in a lifetime opportunity to see what faithful presentation really is).
Yours respectfully,
Robert Mladek