Wednesday, August 27, 2008

IFRS Insights; Update on FAS 5 on Contingencies; COSO

With the SEC slated to vote on Aug. 27 whether to propose an IFRS roadmap laying out if and when U.S. public companies will be permitted – or required – to file with the SEC using International Financial Reporting Standards (IFRS) instead of U.S. Generally Accepted Accounting Principles (U.S. GAAP), we thought we’d provide, as promised, some highlights from SEC's IFRS roundtable held earlier this month.

As noted in SEC’s press release announcing the Aug. 4 roundtable, the focus was, in part, on “the performance of [IFRS] and U.S. [GAAP] during the recent period of market turmoil.” And, as noted in the FEI summary posted earlier this month (accessible to FEI members only), SEC Chairman Christopher Cox summed up themes at the conclusion of the roundtable, including, among other things, that “IFRS kept Special Purpose Entities (SPEs) on the balance sheet to a far greater extent than did U.S. GAAP,” that, “Fair Value is presenting challenges for both sets of standards,” and “Not only convergence, but improvement is needed in both [sets of] standards, in areas such as reductions in the value of a company’s own debt, which anomalously results in companies showing more phantom income - the more their business is doing worse.”

In brief, the parts of SEC’s Aug. 4 roundtable which I found most interesting, and perhaps most telling in advance of the Aug. 27 vote, were the remarks of SEC Deputy Chief Accountant
Julie Erhardt, who, for the past four years, has served as the primary liaison in the Office of the Chief Accountant working on International matters. With the perspective of familiarity with Corp Fin’s reviews of IFRS filings, and involvement representing the SEC in various international groups including IOSCO, Erhardt responded to two criticisms of a potential U.S. move to IFRS floated by investor representatives on the panel: an alleged reduction in comparability under the more principles-based IFRS, and an alleged inflation of earnings under IFRS.

On the comparability front, in response to a question from Commissioner Elisse Walter, panelist Tom Robinson of the CFA Institute said, “One thing that would help things along [would be] if regulators put in place a system to ensure uniform application of the standards as they exist, and currently that’s not in place.”

Erhardt responded, “[To] Tom, you talk about uniform application… arguably, despite all the best efforts of the 3,000 people at the SEC, we don’t have every U.S. issuer [lined up] like a tin soldier in their filings, and the cost of getting either 6,000 of us to ride herd a little closer, or standards that are twice as thick to provide for every eventuality - it seems like there’s a cost there; and doubling the size of the standard to get more prescriptive is then what people call complexity.” She continued, “it seems like this is a classic tradeoff type question,” and asked Robinson, “do you have a suggestion, how do you see this uniformity thing going forward, is it – they’re lined up like tin soldiers, or is it just a little more meat on the bones of IFRS?”

Robinson responded, “John [White, Director of the Division of Corporation Finance] said earlier over 100 countries permit or require IFRS - some permit, some don’t require, and those that require IFRS oftentimes don’t require IFRS as adopted by the IASB, and there’s a lot of differences there, so if we can get at least get that level of uniformity, where the regulators around the world agree that it is going to be one set of high quality standard that we’re going to follow, and not have every jurisdiction tweaking the standards - that just adds another degree of inconsistency within that set of standards.” He continued, “even though you’re right, within the U.S. we may not have perfect consistency, comparability among companies, at least they are following U.S. GAAP to some degree.”

Erhardt noted, “IOSCO went on record in November, saying, if you’re not doing IFRS as issued by the IASB, you need to be clear about what your framework is, so I think we’re singing out of the same hymnal in that regard - that I understand; the lining up at all the detailed level seems like a different discussion.”

Separately, in response to remarks of panelist Jeff Mahoney of the Council of Institutional Investors, Erhardt challenged some studies that allegedly showed an earnings advantage to switching to IFRS.

Mahoney noted, “My friend Jack Ciesielski has done great deal of work, identified two dozen areas of significant differences, [including] pension, OPEBs (other post-employment benefits), share-based compensation, derivatives.” Mahoney noted that Ciesielski (one of the panelists at FEI’s June 5 IFRS conference) “… has pointed out these differences [are] very significant, in many cases, not all, would result by higher earnings [in a] median amount of 6.5%.” Additionally, Mahoney noted Ciesielski’s studies have shown “a lot of legacy differences, resulting from differences in asset bases, [that] will linger quite a long time; U.S. investors will have to deal with those differences, including business combinations, revaluing other long-term assets, R&D, other intangible assets; in most cases, but not always, IFRS because of legacy differences will exceed U.S. earnings by 4.3%.”

Mahoney also referenced a “Citigroup study,” which he said showed that, “if U.S. companies were given the option of IFRS… they estimate U.S. companies adopting IFRS would see an increase of about 23% in net income on average.” He added, “There is going to be burden shifting to us analysts, and like U.S. accountants, there are many U.S. analysts not very familiar with IFRS; some experts pointed out it will take more than three years before we have the kind of educational materials in place to retrain, reeducate - not just accountants, but others - to use IFRS in the U.S.”

Erhardt responded, “Needless to say, I’ve looked at some of that information myself, and I’m always struck by the comments about income, in two respects.”

“One is, it seems like… intellectually, one system can’t perpetually forever be higher than the other, at some time it all comes back to the cash you collected, accrual accounting isn’t that powerful,” observed Erhardt. “So, [for example] you might defer development costs under IFRS, which allows you to report higher income, but sooner or later those have to be amortized, which then in essence allows lower income; so, I think those studies are instructive, but I always like to look at the timeframes that they cover.

“And the second thing is,” she noted, “I don’t know if there is any information about equity, about the balance sheet, e.g. in IFRS, actuarial losses in the pension, IFRS says… if you’ll book that loss, and put that obligation on the balance sheet immediately when it happens, sort of the quid pro quo is, you don’t run the debit thru P&L [profit and loss or the income statement], you can charge it directly to equity, but it gets the obligation on the balance sheet right away; whereas U.S. GAAP - although I know its been amended now - US GAAP, it was the other way around: yes, you’ve got to put the debit thru the income stmt, ergo U.S. GAAP income is lower, but you don’t put the obligation on the books until ultimately its been amortized over a number of years through income, so it’s like a tradeoff, you can say U.S. GAAP income is lower than IFRS, but in the IFRS balance sheet the equity is lower, because they’ve actually shown what the obligation is sooner.”

Erhardt added, “I’m always curious, if you have access to more information I’d be glad to have it.. when they look at the full picture, the other part, the balance sheet as well, I think some of the tradeoffs, it’s just pick your poison in the accounting model, vs. one sort of perpetually leans one way or the other, we don’t have to do that now, but if there’s other aspects, if you’d send that along, I’d appreciate it.”

There were many valuable insights added by all the panelists. If I had to zero in on one panelist’s remarks as giving a general flavor for the panel, (with the exception of the investor representatives cited above) I’d cite KPMG partner Paul Munter, who said:

“Many, [and] I am one of those, that think we have to have a date certain to march towards to address education and training, systems issues… what that also speaks to is… it doesn’t necessarily mean you have to wait for convergence.”

He added, “the fact that there are differences doesn’t speak to which body of literature is higher quality - there are differences that in some cases you can argue IFRS is higher quality, in other cases argue U.S. GAAP is higher… the real question is, are IFRS a comprehensive body of literature and a high quality body of literature, in my own judgment, the answer to that is yes. I also think there are some potential benefits from a less mature body of literature, in that [IFRS] hasn’t had time to develop a lot of existing practices and implementation that in fact give you conflicting answers.”

From a regulator’s perspective, Paul Boyle, Chief Executive of the U.K. Financial Reporting Council, noted, “One of the highest profile tragedies was the bank known as Northern Rock, [which] made extensive use of securitizations.” He observed, “all the SPEs [were] fully consolidated, there was full disclosure of what they were doing, they just took a risk and it didn’t work out. We wouldn’t see that as a financial reporting difficulty, it was underlying business difficulty. Our sense is that, to the extent that there has been a loss of investor confidence in financial institutions … it has not been … due to a loss of confidence in financial reporting… To extent [there has been a] loss of confidence, [it has] more to do with investors understanding the numbers and not liking what the numbers tell them, [they] lost confidence in management to run [the] business with an acceptable risk/reward tradeoff.” He acknowledged, “There have been some surprises., things popped back on balance sheet, to some extent,” but he believes those companies “made a different business decision [reputational] to bring [those assets] back on the balance sheet.” Boyle said, “Perhaps there’s a new category of assets and liabilities we ought to disclose, the ‘just off balance sheet’ assets and liabilities.”

Corp Fin Chief Accountant Wayne Carnall, one of the moderators of the panel, likened that to “Broadway, off Broadway, and off-off Broadway.”

Read more details from the SEC’s Aug. 4 roundtable (including a discussion of placement of disclosure in MD&A vs. the audited footnotes) in our updated summary of “
additional highlights” (FEI members only).

For More Information...
KPMG's IFRS Institute will be featuring an audio-cast at 11am EDT on Thurs. Aug. 28 summarizing the decision reached at SEC's Aug. 27 open commission meeting and the implications for financial reporting in the U.S., check it out at

Read about Canada's experience in moving to adopt IFRS in Darla Sycamore's blog,
IFRS Canada: The Devil is in the Details. Sycamore is a member of FEI Canada and a Trustee of FEI Canada's Financial Executives Research Foundation; she writes her blog in her personal capacity.

And, here's a new blog that's come to my attention: see
Discussion Heats Up on IFRS by Travis Drouin in Moody, Famiglietti & Andronico's (MFA) blog.

Update on FAS 5
Last week, the Wall Street Journal published a letter to the editor from FASB Chairman Robert Herz, “
FASB Seeks To Inform Investors, Not Whack Companies,” in response to an earlier editorial published by the WSJ on FASB’s Exposure Draft, Disclosure of Certain Loss Contingencies, which will amend FASB Statements No. 5 and 141(R). As of today (Aug. 26) FASB has received 234 comment letters on the proposal; including comment letters filed by a number of FEI’s technical committees.

COSO Update
We previously reported that FEI’s Task Force on Monitoring filed its comment letter on
COSO’s Exposure Draft on Monitoring Internal Control Systems. COSO has since posted all comment letters received. The comment deadline was Aug. 15, and COSO is currently reviewing comments received with an aim toward issuing final guidance this year.

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