The Spirit of Accounting: What good are principles without principles?

Like others, we heard loud gushing sounds following the Securities and Exchange Commission's August announcement of its timetable for converting the U.S. public financial reporting system to compliance with IFRS instead of GAAP.Unlike most commentators, we're skeptical, nay, cynical about this movement, and cannot join in the clamor with enthusiasm. Like virtually everything that comes out of Washington, we don't think this idea is as good as the press releases suggest. As much as we criticize GAAP, we are not at all ready to endorse moving to another system without really good reasons.

As we've analyzed this situation, we've raised questions that cry out for answers, but nobody seems to be asking them, so we're stepping into the minefield by laying them out, along with our tentative answers and caveats.

IS IT GOOD FOR INVESTORS?

The title of the SEC's release is SEC Proposes Roadmap Toward Global Accounting Standards to Help Investors Compare Financial Information More Easily.

Notice the equivocation in this statement made later on: "A common accounting language around the world could give investors greater comparability and greater confidence in the transparency of financial reporting worldwide."

The word "could" changes everything. Specifically, it reveals this venture for what it is - an experiment that might be costly beyond imagination.

We don't think the change will be good for investors if the new standards don't lead to telling the truth with transparency, completeness and timeliness. Unless these improvements occur (which seems unlikely to us), it won't be worth all the trouble. Nonetheless, the proposal's scope and its last-minute timing tend to make us think it may be a last-minute effort by SEC Chairman Christopher Cox to make one more mark before he steps aside for the new president.

There's more on this point later, but we think the best answer to the question of whether investors will benefit is, "Perhaps, but don't count on it."

IS THIS LEGAL?

Federal securities statutes gave the SEC authority to establish reporting standards to be used in public filings. In 1973, the commission issued ASR 150 that essentially delegated that task to the newly hatched Financial Accounting Standards Board. Although some rumblings have arisen when unpopular standards have been published, no one has ever really opened up the issue of whether the SEC can legally dish off this authority to a non-governmental entity, even if it retains strong oversight, as it has over FASB.

The issue is even more pressing now because the commission wants to delegate this authority to an offshore private body that lies well beyond its oversight and influence. We can imagine the IASB chair being told by an assistant, "The SEC chair is on the phone and wants to talk to you," and replying, "Oh, really? Which one?"

Because the IASB has so many constituents to deal with, about the only tool in the SEC oversight kit will be the threat of rejecting a standard for use by American companies in U.S filings. The ineffectiveness of that blunt instrument is so obvious that we're confident some members of Congress will call on the commission to study the shift further, as in forever.

WHO'S PAYING?

Furthermore, we're scratching our heads over what's to be done with Sarbanes-Oxley Section 108 (b)(1)(A)(iii), which requires the standard-setting body identified as the source of generally accepted accounting principles (now FASB) to be "funded as provided in Section 109."

Section 109 requires the designated body to be funded by an "annual accounting support fee" imposed on U.S. public corporations in proportion to their market capitalization. There's just no way that the IASB can be funded under this arrangement, which means Congress would have to agree to amend a law that has been publicly lauded as protecting investors. The fact that the money would go overseas also has to be troubling.

As for the IASB, it is still functioning under the old contribution-based system that FASB struggled under in its first 30 years. It was an albatross because it led to dependence on "gifts" from corporations and accounting firms, the very entities it is charged with regulating. By analogy, we wonder whether it would make sense to have drug companies fund the Food and Drug Administration.

We would rather see funding by user entities, including but not limited to stock exchanges around the world. A minuscule fee on trades would not only raise more than enough money, but finally put in place direct accountability to users, instead of preparers and auditors.

WHAT KIND OF STANDARDS WOULD WE GET?

The quality of accounting standards can be no better than the politics that shape their contents. It's been tough enough for FASB when it's operated only in the U.S. It will surely be much more complicated for an international body with many cultures, economies and languages. With so many diverse constituents and with cross-cultural constraints on what can be said or not said, it's inevitable that international standards will be even more subject to compromise than U.S. GAAP, with the ultimate consequence that usefulness could decline. Contrary to glib analyses we've seen, comparability will not be automatically enhanced if the standards offer managers more leeway.

Much has been said about the advantages of "principles-based" standards over those that are "rules-based," and we've already seen that connection mentioned in press descriptions of the SEC proposal. As theoreticians, we're inclined to go with the former over the latter. But, as critical observers of how financial reporting is actually accomplished, we are highly skeptical.

In particular, for principles-driven accounting to work, those doing the driving must have the right principles. The current worldwide management corps is clearly lacking in that respect. Instead, they seem to have only one self-interested scruple: "Do whatever is needed to present lovely pictures in the financial statements." They continually stretch, bend, twist and otherwise distort the concepts behind public accountability, all in pursuit of the misbegotten goal of fooling efficient capital markets into paying too much for their securities.

Giving these people flexible accounting standards is like feeding wild animals by hand. It won't be long until someone gets bitten. The victims here will be all of us, because the markets will never bid security prices higher in response to more information uncertainty and risk. Instead, capital costs will go way up, driving those prices lower, even way lower.

WHO IS BEHIND IT?

In light of these pitfalls, we have wondered who can possibly be supporting this drive to supplant GAAP with IFRS.

Once we asked, the answer became obvious.

As background, the drumbeat of substantive reform has been louder over the last seven years since Enron went down. As mentioned earlier, one achievement is FASB's budgetary liberation, which allows its members and staff to frame, analyze and resolve issues from the users' point of view without worrying very much about how the preparer constituency will react. This freedom has been expressed, we think, in the lava flow of hot new standards that call for fair value accounting. The same direction is clearly evident in the Conceptual Framework project, where preliminary publications have shown that the two boards are not afraid (at least so far) to identify fair value as the relevant attribute to be used in financial reporting.

This direction is abhorrent to corporate executives, because value-based reporting tends to reveal the true results of management decisions and policies far more completely and quickly than traditional cost-based reports. And, of course, it gives many auditors apoplexy.

Thus, it makes sense to us that managers and auditors are encouraging this effort by Chairman Cox and others as a way to get standard-setting back under their control. We are not cynical enough to suggest that the SEC is acting at the behest of these interests, but pursuing this goal could have an unanticipated negative consequence.

Are we crackpots? Maybe, maybe not.

But we can say that the past provides plenty of examples where managers stopped at nothing to defang new standards. Thus, we have no qualms about hypothesizing that this effort to globalize accounting standards is a smokescreen that thinly conceals a plan to regress back to what it was like in the 20th century.

ON BALANCE ...

When the dust settles, we cannot support an effort to outsource accounting rule-making to an international body beyond the reach of U.S. regulators but within the reach of corporate managers. We think the promise of greater benefits to investors is vacuous political language that could, if others believe and act on it, produce chronically misinformed capital markets and inefficient allocations of capital at the wrong prices.

We're especially concerned that a drift toward so-called principles-based reporting will not produce the desired results because of the shortage of ethical and economic principles in the current generation of management and auditors.

BUT ...

On the other hand, we also have a great deal of respect for the IASB and its people. We harbor the strong suspicion that big surprises await any managers and auditors who think they're going to dodge the fair value bullet and get a free ride to report only good news. It's quite possible that today's reform-minded head of steam at both FASB and the IASB will not run out any time soon.

And that's a principle we want to hold onto.

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 authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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