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The Narrowing GAAP

The convergence of foreign and domestic accounting rules could catch some U.S. companies by surprise.
Tim Reason, CFO Magazine
December 1, 2005

Pressed last March to describe the biggest controversy between U.S. and international accounting standards setters, Robert H. Herz replied, "I like one brand of Scotch, and Tweedie likes another."

Herz, the often-droll chairman of the Financial Accounting Standards Board (FASB), was referring to Sir David Tweedie, the soft-spoken Scot who is his counterpart on the International Accounting Standards Board (IASB). But there's more than a dram of truth to Herz's answer.

Although many differences remain between U.S. generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS), they are being eliminated faster than anyone, even Herz or Tweedie, could have imagined. In April, FASB and the IASB agreed that all major projects going forward would be conducted jointly. That same month, the Securities and Exchange Commission said that, as soon as 2007, it might allow foreign companies to use IFRS to raise capital in the United States, eliminating the current requirement that they reconcile their statements to U.S. GAAP.

The change is all the more remarkable given that the IASB was formed only four years ago, and has rushed to complete 25 new or revamped standards in time for all 25 countries in the European Union to adopt IFRS by this year. By next year, some 100 countries will be using IFRS. "We reckon it will be 150 in five years," marvels Tweedie. "That leaves only 50 out."

This development has gone largely unnoticed by many, if not most, U.S. finance chiefs. And the process may not seem to merit attention. After all, convergence is supposed to ease the task of raising capital. Once the process is complete, investors will need less help comparing results of competing firms based in different countries. U.S. companies that conform to GAAP will be able to raise capital abroad without reconciling their results to IFRS.

For a long time, American firms have tacitly assumed that the rest of the world would simply sign on to some version of U.S. GAAP (an assumption shared, and feared, by many non-American firms). But such is not the case. By design, the process is changing accounting both here and abroad. And it may produce financial results for American firms that are quite distinct from those they report now. Along the way, then, convergence may complicate rather than simplify efforts to raise capital — particularly for firms that have allowed U.S. GAAP reporting to shape their economic choices.

"The fact that the IASB is influencing accounting standards throughout the world, including the United States, is something that every U.S. company should pay attention to," observes Grant Thornton CEO Edward Nusbaum, who sits on FASB's advisory council. Herz agrees. "Even in non-joint projects, the thinking of one board will influence the thinking of the other," he says.

"Companies need to pay attention to what's going on at the IASB, even if they operate only in the United States," says Nusbaum. "And I think today, most [U.S.] companies — even international U.S. companies — don't pay attention to the IASB."

Must Be Better
To understand what they're missing, recall that one of Herz's first acts after assuming the chairmanship at FASB in July 2002 was to push for what became the Norwalk Agreement. Issued in October 2002, it committed both boards to work toward convergence. A key pillar of the agreement: standards could not be converged just for the sake of it — they had to improve GAAP or IFRS, or both. "A change that is simply going to get rid of differences is not good enough," remarks Suzanne Q. Bielstein, who oversees convergence as FASB's director of major projects.

That approach pretty much guarantees accounting changes for companies on at least one side of the Atlantic, if not both, any time a standard converges. Such changes can be a headache for companies, but Bielstein notes that this approach serves as a triage tool when selecting projects. "It absolutely has an effect on how we choose projects. We are not going to make users go through a change when we think the value is dubious."

Bielstein points to reporting of accounting changes — part of a recent package of relatively small "short-term convergence" efforts — as a good example. Under U.S. GAAP, companies reported any effect of voluntary accounting changes (and, in some cases, those changed by standard setters) in net income.

But IAS 8, the international accounting standard, required that the change be applied to previous financial statements. "FASB took a look at the IASB's answer and said, 'The IASB has a better way of reporting accounting changes,'" says Bielstein. "That's a case where we eliminated the difference and improved reporting here [in the United States]. It allows the user of financial statements to make period-over-period comparisons, without the noise of an accounting change."

Of course, not everyone agreed. "We question whether the proposed change would result in a higher-quality standard than already exists in the United States," stated Dow Chemical vice president and controller Frank Brod in April 2004, writing as chair of Financial Executives International's (FEI) Committee on Corporate Reporting.


Today, with the standard passed, says Brod, "we [still] don't think this is a better solution." Although FASB renamed such changes "retrospective applications," Brod worries that they still look like restatements, which tend to alarm investors. "There's always this notion that something is wrong. It adds an element of confusion," he says.

Despite the complaint, Brod says FEI's reporting committee is broadly supportive of convergence. His own company operates in 175 countries, and despite Europe's move to IFRS this year, he says, tax authorities in the 20 European Union member countries where Dow operates still require local GAAP as a starting point. "At the current time, it just adds another set of books," he says. "If our accounts in all 175 countries had to keep track of only GAAP and IFRS," notes Brod, "that would be a plus in the long run."

Also, he says, companies represented on FEI's committee "compete against organizations all over the world. To put [corporate accounting] on a comparable basis worldwide allows investors to make global decisions." Brod, who sits on FASB's Emerging Issues Task Force as FEI's representative, recently joined the IASB's advisory panel as well.

Convergence as Cudgel?
Being a front-and-center participant gives Brod and FEI a better opportunity to anticipate, and influence, the course of convergence. And such influence may be more necessary than it once was. Convergence helps each board pursue unpopular standards, as each conceivably can serve as a stalking horse for the other. Herz and Tweedie wave away the notion that they deliberately use each other this way, but the boards' joined — if not joint — efforts clearly give them more capacity to overcome opposition.

A vivid case in point: the rule FASB adopted in December 2004 requiring stock-option expensing, which Bielstein cites as "one good example of where we followed the IASB's lead."

In 1995, Congress threatened FASB with extinction if it pursued expensing. This time, much of Corporate America's initial ire was expended on Tweedie. That may have smoothed the path for incoming chairman Herz, who, as it happens, was still a member of the IASB when American companies first began warning Tweedie not to pursue stock-option expensing.

Although Herz was later grilled repeatedly by Congress, the debate early on had a sense of inevitability, with many opponents shifting their focus from outright opposition to lobbying for pricing models that would minimize income-statement effects.

"Certainly international convergence was a factor" in passing stock-option expensing, says Grant Thornton's Nusbaum, though other factors, notably the various accounting scandals, also made passage more likely.

How much might such a tactic help in the future, as the boards tackle such thorny issues as leasing or pension accounting? FASB's current leasing and pension accounting standards reflect compromises made years ago to minimize the impact on reported results. "Clearly, the IASB would go in a different direction on both defined-benefit plans and lease accounting than what we have in the U.S.," observes Nusbaum. In fact, the IASB already has an active research project on leasing, and may take the lead on developing the initial proposal. Its research to date — recently endorsed by the SEC — suggests that a likely outcome is to require capitalizing most leases. "Frankly, that's the way I think it is going to go," says Tweedie. If he's right (chairman or not, Tweedie is just one vote on the IASB), that would significantly increase the assets and liabilities of companies such as retailers, which currently keep large amounts of leasing activity off their balance sheets.

New pension accounting, by contrast, will be developed initially by FASB, which formally added a two-phase project on postretirement benefits to its agenda as CFO went to press. But U.S. companies should still pay attention to Tweedie and his colleagues in the coming debate. As chairman of the UK's accounting standards board, Tweedie oversaw adoption of virtually unsmoothed pension reporting, with annual changes in pension surpluses and deficits reported in other comprehensive income. The initial phase of FASB's project does not propose such a step. (It proposes that a company balance sheet show the difference between the fair value of pension assets and the company's estimated future obligations.) The second phase, however, will likely be developed in concert with the IASB. Observers predict that phase will likely eliminate smoothing, or restrict it to the actuarial calculations of a company's obligations.

All this might suggest that, far from moving standards toward U.S. GAAP, convergence is favoring standards developed overseas. Both Herz and Tweedie would dispute that conclusion, arguing that their boards are simply moving toward better accounting standards, regardless of origin. "When you see an area where the accounting is not very good," observes Herz, "it usually turns out that's where problems develop — including public-policy problems." He points out that FASB presciently acknowledged the shortcomings of both pension smoothing and footnote disclosure of stock options when it wrote the original standards. What convergence appears to be doing, then, is loosening the political constraints under which FASB has historically labored.


Added Clout
Both FASB and IASB officials agree that international consensus gives them added clout to fix past mistakes — or move into uncharted accounting territory. "There's always safety in numbers," remarks FASB's Bielstein. "There's always going to be debate whether you do it separately or together. But what does help produce high-quality standards is when you have a vigorous debate around the world."

The boards' close working relationship also expands their resources. Staff are often shared between the two boards. And although both boards must still follow an extensive process of exposure drafts and comment periods among their own constituents, they increasingly make use of each other's early work.

Sometimes FASB has been far ahead of the IASB, as it is, for example, on creating a framework for measuring fair values. FASB's final standard will likely be issued as a proposal by the IASB, allowing international constituents an opportunity to comment.

In effect, such an approach may allow some projects to be developed off the radar screen, but observers dismiss any suggestion that FASB would ever use such an approach to hide behind the IASB, even on issues likely to be more controversial in the United States. "FASB certainly wants the IASB to work with it to fight these battles, and perhaps take some of the lead," says Nusbaum. "But FASB also has tremendous self-confidence."

"When it comes to dealing with resistance to change," says Herz, "there is power in working together, because global investors, some large companies, the public, and policy makers can see the big picture. They see the potential benefits to world trade and capital markets."

In fact, any impression that one board acts as a stalking horse for the other may ultimately be the result of the boards' own learning curve. "The boards are developing a variety of techniques," says Bielstein, characterizing the share-based payment and fair-value measurement projects as examples of a "pure lead/lag" approach, in which one board issues a final standard before the other begins deliberations.

Increasingly, however, FASB and the IASB are turning to what they call the "modified joint approach," in which one board develops the initial thinking about a standard, but the resulting discussion paper (as the IASB calls it) or preliminary views (FASB's term) is issued to constituents in the United States and abroad simultaneously, with the ultimate goal of issuing the final standard simultaneously as well.

For example, says Bielstein, the IASB has been working for some time on an insurance-standard project. "When the IASB is ready to issue a discussion paper, we'll issue that to our constituents as well," she says. That's still a very early stage in the process of adopting an accounting standard, but it does underscore why U.S. companies would do well to stay apprised of activities in the IASB's London office. There are, for example, already indications that the IASB views most insurance contracts essentially as a type of financial instrument, a view that could have significant balance-sheet implications for both insurance companies using reinsurance (the cause of the recent AIG scandal) and their customers.

The newly added project on pensions and other postretirement benefits appears to be another example of the modified joint approach — this time with FASB in the lead.

"The boards work very well together," notes Bear, Stearns & Co. senior managing director Patricia A. McConnell. Going forward, she predicts, "it is less likely that they will be playing leapfrog with standards."

Indeed, when it comes to other major projects, even controversial ones, FASB and the IASB are beginning to work essentially as one board. Consider the proposal on business combinations, which would effectively require companies to expense acquisition costs rather than include them in the purchase price. "That's a bitter pill," notes Nusbaum, especially for serial acquirers. But the business-combinations proposal is a truly joint effort. "The exposure drafts that were issued internationally and domestically were actually the same document — drafted by one staff person — but with s's instead of z's and different logos," says Bielstein. A second project, on revenue recognition — one that would potentially eliminate hundreds of pages of U.S. GAAP guidance — also follows this approach.

The New Income Statement
Another sign of FASB and the IASB's preference for joint projects is their decision this past April to join forces on ambitious but slow-moving efforts to redraw the income statement — known as the performance-reporting project. Earlier independent efforts on both sides had stalled.

An early effort by the IASB to develop a matrix-style income statement was stopped some 18 months ago after negative reactions to field tests. "The field test was a failure, really," says Tweedie. Intended to be a complete statement of all changes in equity, with no profit figure presented at all, the proposal was field tested in part because it lacked support among some IASB members. But the test also inadvertently alarmed the business community. Recalls Tweedie: "People saw massive change coming through the performance-reporting project, and that wasn't the intention."


But is it possible the new project will also mean dramatic changes to the income statement as companies know it? "Absolutely," says Herz, but he is careful to add that "the project doesn't really redo any of the accounting. It's all [about changing the] display and disaggregation to give a richer picture of what's really going on."

By that he means an income statement that resembles, and is easier to compare with, a cash-flow statement. Herz anticipates that the new income statement will "differentiate between [income from] operating activities, financing activities, and maybe other gains and losses," just as a cash-flow statement does today. That, hopes Herz, would allow users "to see that the income statement and cash-flow statement are two different ways of looking at performance — one on an accrual basis and one on a cash basis — and use them together."

Of course, changing the presentation still would have significant implications. For one thing, the two boards recently decided to pursue the IASB's initial approach, which requires management to conform to a standardized definition of financing, instead of FASB's approach, which would have allowed management to determine whether income was the result of operations or financing. That constraint could displease companies with big financing arms, such as General Electric Co. and Caterpillar.

Blessed with Guidance
Despite Herz's quip, there is still more that separates FASB and the IASB than brands of Scotch. Even on stock-option expensing, for example, the boards disagree on the correct income-tax accounting. A far greater issue is the voluminous nature of U.S. GAAP. "We have guidance on everything six times over," says Herz, "and you can quote me on that." Tweedie agrees; one of the agenda items in October was an administrative meeting to discuss how the accounting regime might move more toward standards in principle, rather than ones that attempt to include guidance covering all possible scenarios.

Brod says the members of FEI's Committee on Corporate Reporting prefer the simplicity of IFRS. But that's a Catch-22 for FASB, which constantly hears that its constituents prefer principles-based rules, but also must deal with the U.S. legal system and a shell-shocked accounting industry, both of which demand detailed guidance. This may prove to be yet another area where the IASB can help its U.S. counterpart deal with its sometimes difficult constituencies.

Of course, the IASB has its own difficulties with its constituents. Indeed, the flip side to any suggestion that the two boards have an easier time passing standards together is that joint efforts expose them to twice the friction from politicians and constituents. On the first day of the October meeting, members of both boards were abuzz about news reports of a speech the previous day by European commissioner Charlie McCreevy in which he said, "I would like to stress that convergence is not an invitation to standard setters to try and advance the theoretical frontiers of accounting. I will not take on board any revolutionary new standards.... The main objective is to try and narrow the differences between the existing standards, not to make accounts even more indigestible with a whole set of new standards."

That appears to fly in the face of the Norwalk Agreement, and illustrates how standard setters remain the target of considerable pressure. But the boards are now in a stronger position to resist it, and that's reason enough for finance executives to take notice.

Tim Reason is a senior editor at CFO.


All A Board
Now, which of you folks actually live in Norwalk?

At the joint Financial Accounting Standards Board-International Accounting Standards Board meeting this past October at FASB's Norwalk, Connecticut, headquarters, it wasn't hard to see why convergence of U.S. and international accounting standards is moving so quickly. In fact, it was harder to tell the two boards apart. The respective heads of FASB and the IASB, Robert H. Herz and Sir David Tweedie, were seated side by side and took turns chairing, while members of both boards and their staffs sat evenly interspersed around the rectangle of tables in the small amphitheater that serves as FASB's boardroom. The October gathering was the seventh such meeting, held in Norwalk each fall and in London each spring.

Although the boards meet in person only twice a year, their staffs work together daily via phone, E-mail, and video conference, exhibiting the easy familiarity of co-workers from the same office. And while debates often grow intense — even heated — over accounting questions, they offer observers little sense of any parochial differences. (With four North Americans on the IASB, even accents aren't a foolproof gauge.)

Indeed, although the purpose of the semiannual meeting is to hammer out those areas in which the boards don't agree, debate doesn't necessarily split along those lines. In a discussion on revenue recognition this past October, for example, it quickly became clear that members of each of the boards were divided among themselves. "There are a lot of different views within FASB and within the IASB," says Ed Nusbaum, CEO of Grant Thornton and an adviser to FASB. "They're not unified on some of the concepts, particularly when it comes to fair value. Where they are unified is in the desire to have convergence." — T.R.



On the Agenda
A look at how convergence has changed, or is likely to change, particular areas of accounting, based on CFO's analysis. The arrows, though only a rough indicator, point to whichever board was more influential in the development of the standard, either because that board took the lead in developing the standard, or because the final standard adopted more-closely resembled existing U.S. GAAP or IFRS.

Completed Projects
Share-based payment FASB IASB Touted as a joint project, although FASB followed IASB's lead. Some differences in income-tax treatment remain.
Inventories FASB IASB FASB changed its accounting guidance to require all abnormal manufacturing costs to be recognized as an expense. Although essentially a minor wording change, the result moved the standard toward IFRS.
Asset exchanges FASB IASB FASB eliminated an exception to the fair-value measurement principle in existing U.S. GAAP, resulting in a standard that is simpler to apply and converged with IFRS.
Voluntary changes in accounting policies FASB IASB Requires "retrospective application" of certain voluntary changes in accounting policy, which critics complained could be confused with restatements.
Discounted activities FASB IASB Moved international accounting closer to U.S. GAAP with regard to assets held for sale and the timing of classification of operations as discontinued. FASB and IASB definitions of discontinued operations remain divergent.
Depreciation on assets held for disposal or idle assets FASB IASB Moved international accounting closer to U.S. GAAP.
Projects Under Way
Business combinations and reporting non-controlling interests FASB + IASB The first joint project in which FASB and IASB issued a common exposure draft. The principles it describes would effectively require expensing of acquistion costs, and also would be likely to eliminate many of the greatest differences currently seen when foreign issuers reconcile their accounting to U.S. GAAP.
Revenue recognition FASB + IASB The second of the two boards' joint projects. One of the primary goals is to eliminate more than 180 pieces of different, and sometimes conflicting, revenue-recognition guidance that exist in U.S. GAAP.
Financial-performance reporting FASB + IASB Replaces separate efforts by the boards to revamp the income statement. Initital definitions of "financing" follow IASB's approach, requiring companies to conform to the definition, rather than choose whether they consider income items to be derived from financing or operations.
Liabilities and equity FASB IASB Currently under development by FASB, the resulting discussion paper (on how to account for financial instruments with characteristics of both debt and equity) will be issued by IASB for comment by its constituents—an example of the modified joint approach, in which one board does the initial development work, with the goal of then proceeding as a joint project.
Insurance contracts FASB IASB Another modified joint approach project, in this case led by IASB, which views many insurance contracts as a type of financial instrument. FASB expects to issue the resulting IASB discussion paper for comment by its constituents.
Income taxes FASB IASB An exposure draft expected next year will aim to eliminate differences among existing standards. Both IASB and FASB propose to adopt elements of each other's standards.
Postretirement benefits FASB + IASB FASB added this project to its agenda last month, and proposes requiring balance sheets to reflect the status of pension funding based on the fair value of pension assets. Experts predict a joint FASB-IASB second phase will eliminate or reduce smoothing.
Major Future Projects
Leasing FASB IASB Not formally on FASB's agenda, but long expected and recently endorsed by the SEC. IASB has an active research project on the topic. Most observers expect that the boards will ultimately require all leases to be capitalized.
Intangible assets Unknown Would seek to recognize internally developed intangible assets, such as patents and copyrights, on the financial statements. IASB has an active research project on the topic.



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