Transatlantic strain still threatens global accounting standards

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Gerrit Zalm, the former Dutch finance minister who took over as head of the International Accounting Standards Board (IASB) last month, acknowledged at the outset that he has limited time in which to rescue its pursuit of a common world financial reporting language. "One of my first priorities," he told the Financial Times, "will be no new carve-outs in Europe and trying to get rid of the existing carve-out."

He was referring to the EU's decision to back a modified version of IAS 39, the International Accounting Standard (IAS) on hedge funds, which established the principle that Europe could develop its own version of IASB's international financial reporting standards (IFRS). Once it does so, the chance of simplifying dialogue with EU and U.S. shareholders will be lost, since the Securities and Exchange Commission (SEC) has said it will only allow European companies to report to it in IFRS if they use the original version as set out by the Board.

U.S. corporations remain uninformed and unenthused about IFRS

Even if the integrity of the IFRS is maintained, the SEC has a problem getting it accepted alongside America's current generally accepted accounting principles (GAAP). Its proposal to allow foreign companies to report against IFRS without reconciliation to GAAP is rejected by 56% of U.S. CFOs, according to a Grant Thornton survey just published. A similar proportion opposes letting U.S. companies switch to IFRS. This is largely a fear of the unknown: the survey also found that 77 percent of CFOs have no experience of preparing accounts according to IFRS. This chimes with a recent Duke University survey which found only 9 percent of U.S. companies firmly intending to adopt IFRS, and 70 percent are equally resolved not to do so.

The EU still hopes that its experience of unifying accounting standards across Europe has given it the edge in creating global standards, whose adoption by the increasing number of emerging-market multinationals will force the U.S. to abandon its GAAP and switch to the IFRS language. IFRS has been accepted by more than 100 countries, including China, India, and Japan. In the UK, Financial Reporting Council chief executive Paul Boyle expressed reservations about convergence earlier this year, but has since commended IFRS as a "high quality set of accounting standards which is capable of ensuring adequate disclosure for the protection of investors and the promotion of fair, orderly, and efficient markets."

U.S. Financial Accounting Standards Board (FASB) chair Robert Herz staged a show of unity with IASB chair Sir David Tweedie in Connecticut last month to underline the process made in negotiating convergence and preventing either an American or European breakaway. Herz expressed confidence that U.S. companies would shift to IFRS once the remaining disagreements with GAAP are resolved, but admitted this may not be achieved until 2011 or 2012.

… while Europe tries to rewrite them in its own image

Although the IASB has talked European standards-setters out of several other variations to IFRS, their hold-out over IAS 39 has sown fear of EU exceptionalism provoking the U.S. to go its own way again. Ian Mackintosh, chair of the UK Accounting Standards Board, says "the vision of a single set of high-quality, global standards, which provide a passport for companies to raise money in global capital markets, is very much intact." But he sides with the SEC in telling Europe that IFRS must be adopted without any local variation. "It would be strange indeed if, while many others are rapidly converging... Europe deconverged."

The SEC surprised many analysts with its willingness to consider IFRS-only accounts, and its all-or-nothing approach is the price foreign companies must pay for avoiding the large additional costs of reconciling with GAAP. However, SEC enthusiasm for IFRS may have been kindled by fear that the current need for translation into GAAP is one of the reasons fewer global companies are going to the U.S. to list shares and raise capital.

"There has been a definite de-listing from the New York Stock Exchange and Nasdaq by international companies that were cross-listed," says Professor Bob Garratt, a corporate governance expert at London's Cass Business School. He cites 20 recent cases including Germany's Bayer, Sweden's SKF, Hong Kong's PCCW, and France's Danone, and estimates that these have saved $50m on average by reducing their compliance needs.

Principles winning in debate vs rules

Among the basic obstacles to a common accounting language remains the basic grammatical difference, with U.S. GAAP founded on a rules-based approach applying identical treatment in all cases, whereas IFRS takes a principles-based approach leaving room for professional judgement over classification and measurement of particular items in the company context. Here, the Grant Thornton survey holds out some hope for IFRS. The same CFOs that appear wedded to GAAP also complain about its complexity – and
67 percent express preference for a principles-based approach, with only 30 percent explicitly favoring rules.

Tweedie confirmed at last month's FASB-IASB meeting that, "Both sides have signed up for principles-based standards." New York attorney-general turned govenor and scourge of misbehaving companies Eliot Spitzer, and Federal Reserve chair Ben Bernanke, are among others that have influentially backed the principles approach.

But the flexibility this allows remains at odds with the American belief in subjecting all to the same standard, exemplified by Sarbanes-Oxley compliance. Europe's attempts to carve out its own way of evaluating financial instruments looks more awkward at a time when many of its balance sheets are showing the scars of omitting or mis-valuing exposures to some of the more complex ones. Its growing emphasis on "narrative reporting," telling a story around the data, also clashes with an American belief in letting numbers speak for themselves.

U.S. drawn to IFRS by need for tougher governance

U.S. regulators favor a switch to principles-based accounting not least because it would reduce their own workload, European experience showing that leaving accountants to exercise judgement means fewer time-consuming appeals to central referees like the UK's Urgent Issues Task Force. America's rules-based approach has not prevented some flagrant breaches of the rules, in letter and spirit, with the Enron tricks that prompted Sarbanes-Oxley still etched in recent market memory.

The U.S. will get a strong push towards IFRS, says Garratt, from the weakness of its current federal laws on corporate governance. Sarbanes-Oxley was the first piece of federal legislation on company conduct since the 1932 Companies Act; and most companies still register in the low-regulation state of Delaware, allowing powerful combined CEO-chairmen (and women) to run them with little accountability to shareholders.

Danger of three systems before convergence into one

"When you see most of the rest of the world having moved towards IFRS, the time has come for us to say 'Okay, when are we joining them and how do we envisage that occurring?'" the FASB's Herz summed up his showcase meeting with Tweedie. But with hedge fund valuations now at the center of a global financial storm, Europe's exceptionalism on IAS 39 could mean a lot more tough talking before any answer can be given.

With potentially another five years to go before convergence is achieved, reporting for many UK companies may get more complicated before it gets simpler. From next year the 2006 Companies Act will add another reference point to a system that already contains elements both of IFRS and GAAP.

This article is reprinted from our sister site, FinanceWeek.

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