To: The Securities and Exchange Commission
From: Ken Blair
Re: SEC Concept Release related to International Accounting Standards
This memo is in response to question 6 posed by the SEC, "Would acceptance of some or all of the IASC standard without a requirement to reconcile to U.S. GAAP put U.S. companies required to apply U.S. GAAP at a competitive disadvantage to foreign companies with respect to recognition, measurement, or disclosure requirements?"
Upon careful review of the IASC standards and their implementation by various companies, the evidence supports the case that domestic companies would be at a disadvantage if foreign companies were allowed to file under IASC standards with no reconciliation to GAAP. There are three major problems with the IASC standards.
These weaknesses in the IASC standards have the potential to allow foreign companies to manipulate their financial results so that they have an advantage over domestic companies. If there is no reconciliation from IAS to US GAAP the average US investor will assume that there is comparability between the two accounting standards. This assumption will lead to a disadvantage to the US company who must file its financial statements under US GAAP and the US investor, whose capital will not flow to the most attractive investment opportunity.
IASC REGULATIONS ARE OVERLY BROAD:
There are frequently inconsistent results when viewing two similar companies from the same country who are both using IASC standards. If there is no comparability between two companies who are both using IAS, then there is little hope of comparing a company using IAS to a company using US GAAP. Many studies have concluded that IASC standards are too broad and general to ensure that similar accounting methods are applied in similar circumstances or that similar results are consistently achieved. A quick review of the IAS standards will show that for most standards there are two rules, with one designated as a benchmark treatment and the other as an allowed alternative.1 This can potentially lead to an advantage to a foreign company who is not constrained by the same rigorous standards that US companies must face when preparing financial statements. By using IAS a foreign company has the ability to manage earnings by using the broad standards set in the IAS to meet wall street analysts expectations. It can be even more radically different when viewing two companies with different countries of origin. To meet the financial reporting standards goal of comparability, there needs to be a reconciliation with US GAAP in order to access the US Capital market.
As FASB has noted, even when there is similarity between IASC standards and US GAAP, the existence of alternatives, even within standards can create very different reported results. For example, IAS 23 borrowing costs, requires the capitalization of borrowing costs incurred in the acquisition, construction, or production of certain assets.2 But under the allowed alternative treatment these borrowing costs can be expensed creating a difference from US GAAP and from other companies using IAS standards.
Frequently the IAS standards are very vague and leave a lot to be determined by the corporate management. For example, while US standards set specific criteria to be met in determining whether a leased item should be capitalized, IAS 17 relies instead on management's assessment of the "substance" of the lease transaction.3 Free choice alternatives not only create problems in comparing financial statements based on different standard, but also in comparing financial statements based on the same set of standards.
IASC STANDARDS ARE NOT AS RIGOROUSLY APPLIED:
One major fault with the implementation of IAS is that companies will only partially comply with the standards. While US GAAP is strenuously applied by companies, so that they meet the requirements of the independent audit system in the US, the companies using IAS take a pick and choose attitude toward which standards they will adapt. Frequently companies will adopt IAS standards except for the standards the company feels show them in a negative light. For example, Renault, the French carmaker, complies with all the IAS standards except that on development costs. Lafarge, the French construction group, complies with all the standards except that on goodwill. Oerlikon-Buehrle, the Swiss deference group, complies with all standards except those on business segment information and development costs.4 To the average investor it can become confusing to see that a company, which claims to follow IAS standards, is only partially doing so. Many companies will only note the exceptions to full compliance deep within the notes to its financial statements. The most notable example is Roche, The Swiss pharmaceuticals company, which states in its accounting policies that its financial statement comply with IAS, except only on note 21 is it revealed that it has not disclosed operating profits and inter-segment sales for its geographical segments.5
The most disturbing trend with companies claiming to follow IAS are companies that claim compliance with IAS without exception, but where a cursor examination of the financial statements reveals material non-compliance. Nokia claims full compliance with IAS in a statement of its accounting policies, but does not disclose geographical segment information or many of the required disclosures about retirement benefits.6
If the auditors are not giving a thorough examination as to whether the financial statements meet IAS and instead focusing on the local accounting system, then IAS cannot be ready as a standard for the US market. In many cases the auditors who examine the financial statements do refer to the exceptions to full compliance with IAS. But in some cases such as the Nokia example above, the auditors state that the respective financial statements "present fairly" in accordance with IAS notwithstanding the omission of required IAS disclosures. Auditors are well informed on what is acceptable under US GAAP, but are frequently unprepared to audit IASC standards.
As Donald Gannon from the SEC recently noted at a conference for the AICPA, developing a body of international standards is not enough if they are not rigorously applied before companies set foot in the US. Frequently, companies accounting practices were not in compliance with IASC approve rules even when they compare favorable with US GAAP. The SEC has noticed numerous instances where a company was considered a subsidiary but not accounted for in accordance with IAS 27 - which covers accounting for investments in subsidiaries. Instead companies accounted for subsidiaries by using proportionate consolidation or as joint ventures.7 Gannon emphasized that none of these alternatives is acceptable under IAS 27, which, like US GAAP, requires full consolidations of all subsidiaries, with few exceptions. The SEC has also seen cases where presentation requirements of IAS 12 on income taxes have not been complied with. Some registrants fail to disclose separately deferred tax assets and liabilities in the balance sheet but include these amounts in "other assets" or "other liabilities".8 Gannon points out that the SEC has discovered that some foreign registrants have been preparing financial statements in accordance with home country GAAP, but in the footnotes claim that the financial statements were consistent with International Accounting Standards.
THE IASC STANDARDS DO NOT ACCOUNT FOR AS MANY ITEMS AS US GAAP:
There are numerous issues where there is a large difference between the recognition for an item under US GAAP and IAS. One major difference would be the expenses for equity compensation benefits (ie employee stock options), which is not recognized under IAS but under US GAAP recognition is required.9 This could have an enormous impact in the high tech industries where stock options are common for all employees and not just executives. Because the US capital market is key for keeping these companies afloat in the early stages of the company this could put the US software industry at a severe disadvantage to foreign competitors using IAS.
While there are many similarities between IAS 33 and FASB no. 128 regarding Earnings per Share the FASB method provides more specific implementation guidance for some of the calculations required. In the absence of implementation guidance, enterprises following IAS 33 would not be prohibited from using alternative bases for determining the impact of contingently issued shares.10 Another significant difference between US GAAP and IAS is the treatment of the development costs associated with research and development. Under US GAAP these items are required to be expensed as incurred, whereas under IAS 38 there is the option to capitalize these items under certain circumstances. This will be another hit to the US high tech sector of the economy, which has been the spur of so much of the recent growth and wealth in the US.
There are numerous industries where US GAAP provides guidance for specialized transactions that are not specifically mentioned in IASC standards. IASC lacks specific guidance in the insurance, not for profit, oil and gas, health care, entertainment, agricultural and employee stock compensation plans. This handicaps US firms who are tied down as to how they will account for certain transactions whereas a foreign company will have flexibility in the method it wishes to use in accounting for the transaction.
The general standards set by the IASC which allow several alternatives will lead to increased earnings management by market participants. Arthur Levitt , Chairman of the SEC, stated that if earnings management, if not addressed soon, will have adverse consequences for America's financial reporting system. The motivation to meet Wall Street earnings expectations may be overriding common sense business practices.11 The IAS standards will allow companies to elect standards that will best help the company meet the earnings estimates set by Wall Street. Many in corporate America are concerned about this trend when their competitors are able to operate in the gray area of accounting and show higher earnings.
Both the FASB and AICPA have issued statements that they do not feel that IAS standards is ready to issue accounting standards that will be accepted worldwide. According to FASB chairman Edmund Jenkins, the IASC proposal "doesn't go far enough in creating a high quality, independent standard setter that would be acceptable worldwide."12 There is no doubt that the IASC has made significant leaps in the quality of its standards and structure of its organization, but nonetheless still has a lot to do before all the major international financial markets are sufficiently encourage to adopt IAS's for their listings.
The US should not subordinate its own standards to IAS's, which is less rigorous than its own. There is little to lose by holding things up until IAS looks more like US GAAP. By holding up the use of IAS standards by foreign companies, the IASC will be forced to begin to clarify and narrow how its standards are used. Until that time, the US should require a company to reconcile its financial statements under IAS to US GAAP.
Most countries who allow a foreign company to list on their stock exchange have recognized the weaknesses that IAS presents to the investors who need to evaluate that company in relation to other companies on the exchange. To resolve the weaknesses of IAS these countries require a reconciliation to the GAAP of the home country currency. This is a prudent step that a country should take so that foreign companies do not manipulate the alternative treatments allowed under IAS to their benefit, at the expense of the companies who are using that countries GAAP.
America's capital markets are the envy of the world. Due to our efficiency, liquidity, and resiliency, foreign companies have an overwhelming desire to raise capital in the US market.
Currently, the US has the most rigorous accounting standards in the world, but if foreign companies are allowed to compete for capital using less rigorous standards that could change. US companies will face increased pressure to bend accounting rules and operate in the gray to better compete with these foreign companies.
1 The IASC-U.S. Comparison Project: A report on the Similarities and Differences between IASC standards and US CAAP. Chapter 2.
2 The IASC-U.S. Comparison Project: A report on the Similarities and Differences between IASC standards and US CAAP. Chapter 2.
3 Same as Above
4 The Financial Times, Not Quite Standardised, pg. 23, David Cairns, August 12th 1999.
5 Same as Above.
6 Same as Above.
7 The Accountant, Regulator Flags Deficiencies of IAS Reports, pg. 3, February 21, 2000.
8 The Accountant, Regulator Flags Deficiencies of IAS Reports, pg. 3, February 21, 2000.
9 The IASC-U.S. Comparison Project:A report on the Similarities and Differences between IASC standards and US CAAP. Chapter 2.
10 Same as Above.
11 The "Numbers Game", Remarks of Arthur Levitt, www.iasc.org.uk/news/cen8_125.htm
12 The Journal of Accountancy, Calls Heard for More Independent IASC, June 99