Merits and Challenges of Having Fewer Rules
AICPA | February 2, 2010
The “U.S. Perspective” panel at October’s AICPA/IASC Foundation Conference on IFRS, featuring six financial industry heavyweights, evolved into a discussion about the merits and challenges of a principles-based system of accounting. The panel was moderated by Thomas Jones, vice chairman of the International Accounting Standards Board (IASB) from its formation in 2001 until earlier this year.
“Perhaps I’m killing my own job, but I’ve gone on record in favor of convergence,” announced Neri Bukspan, Standard & Poor’s chief accountant and its global chief quality officer responsible for overseeing the rating agency’s operating standards and ratings quality assurance efforts. “I make my livelihood interpreting accounting, how it departs or not from economic reality,” he explained. “Do financial statements currently tell the entire story? No, they certainly do not. I’ve learned over the years that there are some things financial statements can never convey.”
Michael Young, a litigation partner with Willkie Farr & Gallagher LLP, whose practice focuses on securities and financial reporting with a particular emphasis on accounting irregularities, held up two documents as a way to crystallize the discussion about the differences between a principles-based approach and a rules-based one: FAS 133 Accounting for Derivate Instruments and Hedging Activities as a rules-based document and the United States Constitution as a principles-based example.
“FAS 133 and its supporting literature has about 800 pages, while the U.S. Constitution has six (including the Bill of Rights),” Young declared. “Our Constitution is the supreme law governing all our laws, as well as the interplay with other countries. FAS 133 covers only accounting for derivatives. Anyone who thinks they understand FAS 133 hasn’t read it carefully.”
Young debunked the notion that adherence to FAS 133 or any other rule under U.S. GAAP offers protection from liability. “Think of all the restatements by well-meaning people trying to adhere to sometimes counterintuitive rules,” he said. “Some say we need the protection of the rules, but I’ve spent 25 years defending accountants and have come to the conclusion that conforming to the rules does not necessarily get you off the hook. You might think you have a great argument, but if it doesn’t smell right, you cannot assume technical adherence to the rules will be enough.”
A Mindset Change
While James H. Quigley, CEO of Deloitte Touche Tohmatsu, said he was confident that the quality of financial reporting will be enhanced under one single set of global, principles-based standards, he warned that IFRS will necessitate a mindset change in everyone who uses them. “We have trained all our accountants on thousands and thousands of pages of rules, so the first question that will come to mind is where is the rule that tells me how to recognize and report and account for the transaction, not where is the principle that will give me some guidance,” Quigley explained. “My hope is that we will have a regulatory framework that reflects a judgment environment and that we will no longer be trying to run down the rule, but instead trying to exercise our judgment in areas that are not particularly clear. I would like the combination of judgment and transparency to be the bridge to new standards based on fundamental trust.”
“I define stability by trust, confidence and transparency,” said Bukspan. “With transparent information there are natural market forces at work. If there are no speed signs, oddly enough most cars will drive at a consistent speed. With sufficient transparency and sufficient information, hopefully it will be a race to the top and not a race to the bottom.”
Trust and transparency led to a discussion of the fundamental purpose of financial reporting. “What if we had just one rule?” Young wondered aloud. “Explain the best you can what has happened to your company over the last year. I said that to a director once and he spontaneously said to me, ‘Oh, we wouldn't want that; we'd have to disclose things we don’t want to.’”
Young cited Warren Buffett’s annual shareholder letter as an example of telling it like it is. “It’s interesting, entertaining and you get a sense of what happened at the company during the past year,” said Young. “Other than to tell the truth, there are no rules.”
The Train Has Left the Station
All the panelists recognized the eventuality of IFRS taking over most of the world. “I believe it is a train that has left the station and is moving down the tracks,” said Quigley.
At the same time, they also recognized that the ramifications of the changeover to IFRS will be profound. “Educating 100,000 employees on how they do their business is not a trivial activity,” noted Charles Noski, former chief financial officer and Vice Chairman of the Board of AT&T Corporation and a former Deloitte & Touche partner.
“Communicating the changes to the investment community is also going to be a bigger effort than has been implied. If you have a compensation plan, for example, it will have to be changed, maybe necessitating shareholder approval. There will be savings opportunities, but there will also be one-time hidden costs.”
“The challenge is not small,” agreed Quigley. “You have to take the long view to say benefits will outweigh costs. We could naively think it’s like switching on a light, but it’s going to be a fundamental change that needs to be put in place from top to bottom. We will have to train a whole generation of new accountants. I support the roadmap with the idea of a five-year timetable because to move to IFRS will require new financial reporting throughout the supply chain to provide reliable reporting that we all can depend on.”
Ken Kuykendall, a partner in the Chicago office of PricewaterhouseCoopers and the leader of PwC’s U.S. IFRS tax practice, noted the considerable tax ramifications, reminding the audience that the U.S. tax code is heavily oriented to U.S. GAAP. He said that during roundtable meetings earlier this year, the Internal Revenue Service spent considerable time discussing five areas: transfer pricing, inventory methods, revenue recognition, tax accounting method changes and LIFO.
Laying the Groundwork
Since most large companies see the handwriting on the wall, they are well into their preparation strategies. “Morgan Stanley and Microsoft both support the goal of single set of high-quality international accounting standards,” said Noski, who is now on the board of both companies. “They have devoted a lot of effort in thinking about and planning for IFRS.” Noski noted that Morgan Stanley has a very large UK subsidiary, so it has already gone through a sort of a dress rehearsal. “There are things I’m concerned about,” Noski explained, “beginning with how it will impact financial reporting. If accounting is the language of business, this is certainly going to give us a different accent. My other questions are: Will IFRS provide more uncertainty or less? Will the benefits outweigh the costs, and how will the Securities and Exchange Commission relate to standard-setters, regulators and financial statement preparers around the world?”
Noski said it was going to be interesting to see how different companies take different approaches to adapting to IFRS. He cited one large European company that was able to fit their U.S. GAAP reporting into an IFRS umbrella so that everyone could report the way they had always reported. “In contrast, a U.S. competitor took a clean sheet paper approach and came back with completely different conclusions and rather substantial changes,” Noski recalled.
Differences within Uniformity
The panelists also expressed concern whether one plus zero equals one. “I worry that the SEC or its counterparts around the world will be pressured to move in variance with IFRS and we end up with something different from our goal of a single set of standards,” said Noski. The moderator, Thomas Jones, agreed, noting that “No country is going to give up enforcement, so that’s always going to spark differences.” And Bukspan added: “I’ve learned that comparability doesn’t even exist in U.S. GAAP: LIFO vs. FIFO, for example.”
Back to Principles
The panel concluded with a return to a discussion about the risks of a principles-based approach to financial reporting. “Some people argue that board members and companies need rules because of our culture and history and the fact we are a litigious society,” said Young. “But rules lead to more rules. They feed on themselves and you lose sight of the principles. They might even become counterintuitive, at which point they lead to risk. These days in particular, the test is not conformity to the rules. “What’s the objective? What are you trying to accomplish? What is the best way to communicate the facts? There is no better protection from liability than that. I think you get to the point where rules made by well-meaning people actually get in the way. You end up with a lot of compliance but not a lot of useful information.”
Young described a case he was trying years ago in which his client was suing a company for not filing bankruptcy. He asked the defendant if it were true that on such and such a date he had made a strong argument to his partners in favor of bankruptcy. “’Yes,’ he answered. ‘Every one of us changed our mind three or four times, and ultimately we thought we could salvage the business.’ I thought to myself, I’m in trouble. How do you touch that kind of thinking? Now I advise my clients, if you have a judgment call, talk about both sides with everyone, and I mean everyone, and document those discussions.”
“Can judgment calls be second guessed?” Young concluded, before answering his own question. “Yes, but it’s very difficult to prove bad faith. The law in its own slow, slow way is coming to understand that judgment matters.”