Recently, we came across this observation by H.L. Mencken, a noted cynic from the 1920s: "There is always an easy solution to every human problem - neat, plausible and wrong."
As soon as we read it, we connected it to the unnecessary and unproductive risks associated with both forms of convergence between U.S. GAAP and International Financial Reporting Standards. (For clarity, we identify Type One as calling for the Financial Accounting Standards Board and the International Accounting Standards Board to issue common standards while keeping their own powers and constituencies, and Type Two as calling for eliminating FASB and GAAP in favor of the IASB and IFRS.)
We think those who find convergence to be a great idea only see the "easy," "neat" and "plausible" parts, while conveniently missing that it's just plain "wrong." Their focus on simplicity and disdain for the obstacles reflect their elevation of their own questionable interests ahead of the capital markets' need for useful information.
This column analyzes one notable person's take on the issue, including a background that suggests possible motives behind his support for Type Two convergence. We then look at a research report that should convince auditors that their headlong rush to converge is a bad idea. Finally, we note a letter coming out from the FEI and a recent joint announcement from FASB and the IASB.
TOM JONES
A name familiar to us popped up this spring, specifically Tom Jones, formerly an executive vice president of Citigroup. Among other roles, Tom played a key part in the Business Roundtable's eventually thwarted efforts in the 1980s and 1990s to compromise FASB's independence by stacking the Financial Accounting Foundation's board of directors with statement preparers and auditors. Like today, the FAF's duties back then included selecting and re-appointing FASB's members.
Tom later became a member of the IASB, eventually becoming its vice chairman. After leaving the board last year, he landed at Pace University in New York City, where he was made both a distinguished professor and director of their Center for the Study of International Accounting Standards. Among other things, the center sponsors the annual Lubin Forum on Contemporary Accounting Issues.
Tom's support for Type Two convergence was expressed at the April 2010 forum and paraphrased on WebCPA.com as follows: "[He] believes that adoption of IFRS is inevitable, and he sees limitations in the convergence process of U.S. GAAP with IFRS." He was then quoted directly as saying, "You can't converge 17,000 pages with 2,000 pages ... You have to adopt at some point."
While he thinks his solution is easy, neat and plausible, we believe he fails to see that Type Two convergence is just wrong because he, and more than a few others, don't fully grasp the U.S. regulatory system's complexity, don't admit that both GAAP and IFRS produce low-quality information, don't acknowledge why rules are present in U.S. standards, and have a vested interest in abolishing FASB and embracing the IASB.
We also point out that Tom disregards the clear fact that GAAP contains so many rules because he and his preparer colleagues have labored for decades to twist principles into pretzels, all with the self-serving and misdirected purpose of producing falsely positive financial images to fool capital markets. While we won't rehearse the details of Tom's efforts to rein in FASB, which we described in three columns some years back, suffice it to say his plans then didn't put users' information needs anywhere near the top priority. The same is true today.
PRINCIPLES WITHOUT PRINCIPLES?
Unlike the IASB, which, being multinational, cannot play a direct role in actual regulation in any single country, U.S. standard-setters and the Securities and Exchange Commission have often collaborated to craft detailed rules to constrain corporate managers and their auditors and force more truth into financial statements. (Most obviously, a prime purpose of the Emerging Issues Task Force is to assist the chief accountant in squelching bad accounting by SEC registrants.)
Tom's proposal to retreat, not advance, to broad principles must sound like Nirvana to preparers who aspire to continue escaping accountability by creating false but great images. We, for two, are not fooled by the purported preferability of principles over rules when the claim comes from the management constituency, especially from one who wanted to extinguish FASB's independence and gain control over its standards' content.
KROEKER ON PRINCIPLES
Perhaps to Tom's dismay, SEC Chief Accountant James Kroeker spoke at the same forum, saying: "U.S. GAAP is founded upon principles. ... That's what the P is supposed to stand for." He then went on to suggest that principles-based standards "don't work if the people behind them aren't principled."
Thus, Jim put his finger on the exact reason for rules-based standards: The preparer and auditor constituencies have displayed unsuitable ethics when it comes to telling the whole truth with transparency. In fact, we think the only thing transparent about their support for principles-based standards is their motivation.
OOPSIE!
We also read an article by Sarah Johnson on CFO.com dated May 12, 2010, describing a research paper by Dain Donelson and John McInnis of the University of Texas at Austin and Richard Mergenthaler of the University of Iowa. The paper, titled "Rules-Based Accounting Standards and Litigation," examines the history of suits against managers and auditors, assessing whether significantly different outcomes occur when litigated issues involve principles-based or rules-based standards.
Totally consistent with common-sense expectations, the report confirms that rules-based standards provide a much stronger defensive shield against litigation than principles-based standards.
We have to believe that this bit of news, albeit based on only one study, will take the wind out of the many sails raised by advocates for Type Two convergence. We expect many managers and auditors to quietly withdraw their support when they realize that their convergence gambit and principles-based accounting aren't such good ideas after all.
PRINCIPLES AND RULES
Just to be clear, we'll repeat our stand on the principles vs. rules issue. Certainly, we're all in favor of principles, but only at the conceptual framework level where they can help standard-setters produce detailed rules that generate useful information for decisions. What's needed are enforceable and discretion-removing rules based on principles that support decision-usefulness.
STRANGE BEDFELLOWS
Just when we were thinking it could not get any better, Financial Executives International sent a letter dated May 7, 2010, to the chairs of both FASB and the IASB, signed by Arnold Hanish, chair of the FEI's Committee on Corporate Reporting. For decades, the CCR has opposed essentially every new proposed standard, usually claiming the insurmountability of such obstacles as compliance cost and recording effort, as well as complexity, but virtually never (if ever) seriously addressing the question of whether the proposal would produce decision-useful information. In this case, Hanish asked the boards to slow down the fast pace of coming Type One converged standards.
Despite the difference in the FEI's views and ours, Hanish's words ironically echoed ours from a few columns back ("To the SEC: Forget the Timetable and Stop the Runaway Train," March 15, 2010) when we questioned the wisdom of trying to complete 10 or more major projects with simultaneous multiple exposure drafts over the next 12 months.
As we see it, only bad things will happen if the boards hastily develop compromises that merely address the pragmatic political issue (i.e., "Do we have enough votes to pass this standard?"), instead of the real underlying market-efficiency issue (i.e., "Will this standard unveil truth that users need?"). Given that standards tend to last for decades, it's a major misstep to rush through the process as the boards set out to do.
We're not prepared to take credit for the boards' June announcement that they're going to back off from their breakneck agenda, but perhaps our voices had some impact, along with those of the FEI and Jim Kroeker. In any case, we got it right, just as Mencken did.
SO THERE!
Whether it's taking Tom Jones' words with a grain of salt, comprehending the chief accountant's messages, reading the research out of Texas and Iowa on litigation, seeing the FEI oppose a rushed convergence, or heaving a sigh of relief over the two boards' decision to tap the brakes, momentum against the urge to converge (both Types One and Two) is losing steam.
And that is a good thing.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authorsome impact, along with those of the FEI and Jim Kroeker. In any case, we got it right, just
