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One Standard, Many Laws

Accounting convergence could be derailed by countries making too many modifications.
Alan Rappeport, CFO Magazine
April 1, 2008

When he wanted to reprint U.S. accounting standards in a textbook he was writing, Lawrence Cunningham, a professor of accounting and law at George Washington University, was told he would have to pay. That's because the Financial Accounting Standards Board holds copyright to its pronouncements — everything from statements to interpretations to technical bulletins — and sells them in bound volumes. According to the Financial Accounting Foundation, which oversees FASB, the board earns $17 million a year from sales of such tomes and other products.

Eventually, Cunningham agreed to pay $3,000 for the rights to republish the standards in question. Had he sought instead to reprint International Financial Reporting Standards (IFRS), which are used by much of the rest of the world, he could have done so without paying a cent. Mark Byatt, a spokesperson for the International Accounting Standards Board (IASB), notes that the text of IFRS must be written into the law of each country that adopts the standards. "In most countries the text of law is freely available," says Byatt, "so we waive copyright for the bare standards in each adopting country to allow this to happen."

This contrast between proprietary and free highlights a fundamental difference between U.S. GAAP and other countries' accounting standards — and is one of several reasons that convergence may be more complicated than people think. In the United States, accounting is governed by a common-law system modeled after that of Great Britain. Rules are created independently, function as best practices, and are enforced through litigation. They can be copyrighted and sold.

But many countries, including Germany, France, Italy, Belgium, and Spain, are governed by code (or civil) law, and hence much of Europe (as well as Asia) uses a code-law system of accounting. Code laws, dating back from when they were still literally etched in stone, were always intended to be free.

The distinction between code-law and common-law accounting systems might seem academic, but it has real-world ramifications. Academics and accountants generally agree that common-law systems are better, because they are more efficient, created by experts, and less likely to be compromised. Whenever the Securities and Exchange Commission or Congress attempts to influence accounting rules, purists complain they are becoming "codified" and thus tainted.

The distinction is also important for the world's push toward a single, global set of accounting standards. IFRS are rooted in common law, but many of the countries adopting them traditionally use code law, with their governments creating and enforcing accounting rules. Will IFRS survive intact as they are adopted by code-law countries, or will they morph into a number of different, even contradictory, country-specific versions?

Why Common Is Superior
Popularity aside, among the benefits of the growing acceptance of IFRS is that common-law standards are supposed to be top quality. Those who favor accounting systems based on common rather than code law contend they produce timelier financial information and make companies more efficient, because of the threat of lawsuits from shareholders or regulators. The threat of shareholder litigation encourages more-timely loss recognition published in financial statements, says Ray Ball, a professor of accounting at the University of Chicago Graduate School of Business. Hence, managers become more attuned to decreases in expected future cash flows, says Ball, making them more likely to shift investments and strategies to make the company more efficient.

Code-law accounting systems, by comparison, are less market-oriented and rely more on private information. The accounting code is written by the government, which also levies penalties for violations. Code-law standards give managers more wiggle room to make accounting estimates while leaving policing and punishment to the government.

Like GAAP, IFRS are based on common-law standards, created by the IASB. While European code-law countries have expressed concern that adopting IFRS best practices effectively allows outsiders to make their laws, the subjectivity of enforcement might be the undoing of accounting's convergence goal. Ball notes that Europe's policies on enforcement vary by country, and that places such as Italy give their companies plenty of leeway when it comes to accounting.

"Implementation is the Achilles' heel of IFRS," says Ball. "There are overwhelming reasons to expect IFRS to be uneven around the world." Without perfectly integrated markets, attempts to regulate international accounting standards could become heavily politicized and contentious, as a one-size set of standards might not fit everyone's needs.

Most recently, common law and code law clashed last year when the European Union created a "carve-out" in IFRS to change a rule about hedge accounting. Code law prevailed and the carve-out was kept. The EU has also considered toying with a rule on business-segment reporting. Such changes have created fears that the ideal of a universal reporting standard could unravel. Last year James Leisenring, an IASB member, called carve-outs the biggest threat to convergence and said, "Our mission fails completely if that's tolerated and allowed to continue."


Meanwhile, the anxieties of European countries go beyond the IASB exporting law into the EU. Their greatest fear seems to be the role of the United States in the creation of international standards. America's involvement, they fear, may impart more cumbersome, rules-based accounting on them. "We're even less popular than we were before," FASB chairman Bob Herz remarked at a panel last October. "There is a view in particular parts of Europe that having the IASB work with FASB will allow the importation into IFRS of bad American things."

Drifting Toward Code Law
The United States has its own concerns about IFRS, despite sharing a common-law sensibility. Observers and regulators have been fearful that accepting IFRS's looser principles could water down the benefits of U.S. GAAP. As with European countries, the United States also wants to have significant input into the development of IFRS to prevent outsiders from having undue influence on its accounting system, and therefore its markets.

All of this international gamesmanship reveals how blurry the distinction between code and common law can be. Some fear that the American system has been tainted already, and that it bears a growing resemblance to code law. "I see a move toward more politicization," says Ball. "The drift is clearly toward Washington becoming more concerned with financial reporting."

Although FASB has usually maintained relative independence, it has bowed over the years to pressure from Congress or the SEC. The most notable interventions have occurred because of failing markets, such as during the controversy over oil and gas drilling and accounting for inflation in the 1970s, or stock-option expensing and accounting for derivatives in the 1990s. Some also argue that the recent mortgage-bailout plan, approved by the SEC's chief accountant, strains accounting principles.

Accounting purists consider greater politicization problematic because it moves GAAP closer to a code-law system, which would potentially erode the quality of the accounting standards. Says Lawrence Cunningham: "If you let Congress set up the accounting code the same way they set up the tax code, you would have a mess."

Alan Rappeport is a reporter for CFO.




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