IFRS Scams to Come
November 19, 2009

Once again I will put my securities analyst hat (after spending couple decades as one) on as I write this blog.

I’ve commented on International Financial Reporting Standards (IFRS) in terms of its impact on the IT environment (See: "IFRS and IT Choices: Are You Planning?"). The Financial Accounting Standards Board (FASB) recently reaffirmed its intention of harmonizing US-GAAP with IFRS so that there will be something approaching a world standard. While the shift to a US IFRS may be an improvement over US GAAP, it will not be without a number of issues.

I’ve been a frequent critic of the current state of US GAAP, which to my taste has listed too far to a rules-based approach to accounting (as opposed to a principles-based one). People who are not well versed in it generally are under the impression that accounting is an exact science. Not so. While (as the old saying goes) bookkeeping is a matter of facts, accounting is a matter of opinion. Like any kind of analysis, the accounting standards for the presentation of the bookkeeping “facts” have a great deal to do with the answers you are seeking (and therefore the questions you are asking). Some of these answers are inherently more or less objective which limits the degree of interpretation that can take place. But not always and not always in areas you would think are straightforward. Take revenues, which should be straightforward – right? I sell something, I collect the money, and I call it revenue. Whoa! Not so fast buddy. I won’t bore you with the myriad rules covering the way accountants are supposed to handle revenue recognition (that is, count a sale as a “sale”) under US GAAP, but over the past decade the complexities have multiplied. That’s just revenues. Expenses, the treatment of the valuation of assets and liabilities, accounting for leases and stock options, how you depreciate property, how you handle retirement benefit obligations and so on, have all added layers of complexity. One of the oft-stated reasons why FASB has piled on so many rules over the past 15 years (echoed by most major media outlet business writers that I read) is to give the little guy – the individual investor – a more “accurate” measure of a company’s results. Unfortunately, I believe the opposite has occurred. Exhibit A is a recent move in Apple’s shares when a change in revenue recognition accounting for the iPhone (US GAAP forced the company to take a revenue recognition approach that was wildly understated relative to cash flows) caused a spike up in the stock. Most professional investors that understood the accounting issue but individual investors who were not paying attention to (or ignoring) the non-GAAP treatment were left to chase the move up. Worse, I know from personal experience that companies are doing dumb things for the sake of accounting. There’s nothing new in that, but the as the rules multiply the number of dumb things seems to have gone up.

Both the US Securities and Exchange Commission (SEC) and FASB (which has responsibility for interpreting US GAAP) have decided to punt and adopt IFRS, a principles based accounting standard that has been adopted by the European Union countries and, soon, Canada, among other countries. The shift reflects the increasing global nature of financial markets and therefore a desire to harmonize US accounting rules with the rest of the world. I think it also is an admission that all the rule making has made a mess out of US GAAP and the easiest way to address this is to adopt IFRS.

At this point, the switch is supposed to take place in 2014, but 2016 seems like the earliest it will happen. One of the major sticking points in harmonizing is revenue recognition. Many of these rules stemmed from a very fast and loose approach practiced by the high tech industry – software in particular – in the 1980s and 1990s. There was a time when securities analysts were as concerned with a software company’s “days sales outstanding” as reported revenue, since practices that accelerated contracts (but not cash collection) such as channel stuffing and recognizing revenue for software that hadn’t even been written were not uncommon. Principles-based accounting handles this by allowing companies to define their own rules and forcing them to stick by them. Investor pressure is supposed to ensure that the standard is more or less upheld at a minimum level, but it isn’t guaranteed. It’s not clear at this point how tightly FASB will want to control “rev rec” under IFRS.

Now, just because it’s “International” doesn’t make it good. IFRS allows companies to capitalize R&D expense – amount spent are booked as an asset and depreciated over its ‘useful life.’ US companies are required to expense it, which results in lower reported earnings. There are arguments for and against capitalizing (US GAAP requires some R&D spending to be capitalized – usually a very small portion). Those who recall the 1960s go-go years will remember that the reason US GAAP requires R&D to be expensed was that small tech companies were playing fast and loose in what it classified as R&D (advertising to launch a new product, for example), reporting strong EPS gains and very negative cash flow. I my opinion, the revenue recognition rules have gone too far in micromanaging how companies accrue revenues, but a return to the shenanigans of the 1980s and early 1990s would not represent progress for investors. You might think that since people know that scam it’s unlikely to work again. I think that’s a bit naïve. In the 1980s, for example, several British companies (such as Babcock & Wilcox UK) were able to manufacture earnings and inflate their stock price in much the same way that the US conglomerates of the 1960s go-go years (such as Gulf & Western and LTV) did. Ultimately they crashed burned and took investors’ savings with them. IFRS also does not allow last-in-first-out (LIFO) accounting. While this makes a company’s balance sheet more realistic, it also results in a steady stream of phantom inventory profits during periods of inflation. Moreover, at the moment, the XBRL taxonomy for IFRS is threadbare compared to US GAAP. Unless this changes, when the shift takes place to IFRS, investors that had been enjoying a relatively rich taxonomy will be getting less useful information.

The devil is always in the details and details are what matter in accounting. I believe anything is better than US GAAP now, but the transition from the one system to the other is likely to have many bumps on the way from an investor’s standpoint.

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Regards,

Robert D. Kugel - SVP Research


 

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