As we noted last week, meaningful financial statement reform cannot be the result of knee-jerk legislation and/or influence-peddling by a Congress that – at best – has only a modicum of understanding of the challenges facing U.S.-based businesses. Similarly, standard-setting bodies divorced from in-the-trenches corporate accounting, tax and legal professionals and their advisors are also not capable of championing meaningful financial statement reform.

With the U.S. converging with IASB and IFRS, the point may seem moot. It’s not. FASB has adopted an aggressive timetable for convergence. However, it has also indicated that convergence does not mean agreement. Thus, differences between U.S. GAAP and IFRS will continue to exist. If the U.S. seeks convergence with IFRS it is crucial for FASB to demonstrate an understanding of the impact of both in-place and proposed standards on the day-to-day legal and tax-related considerations of U.S. companies. Case in point: FIN 48.

It is interesting that accounting for tax-benefits and related contingencies has one set of standards and yet other contingencies – which are very often more relevant to financial statement end-users – are left to be accounted for under SFAS 5, the old “probable and estimable” standard that rarely, if ever, gets triggered. Pending litigation, environmental contingencies, FCPA investigations, employment disputes and a whole host of other uncertainties are in all likelihood far more relevant to potential investors than uncertain tax positions relating to R&D credits and potential NOLs. However, these items are generally not contained in the financial statements or, at best, are mentioned in vague terms.

Adoption of IFRS in the U.S. may or may not resolve the foregoing dichotomy. There is no IAS equivalent of FIN 48. The closest standard is provided by IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) which employs a one-step approach to recognizing a provision when: 1) An enterprise has a present obligation as a result of a past event, 2) It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and 3) A reliable estimate can be made of the amount of the obligation. The term “probable” is defined in IAS 37 as “more likely than not.” If these conditions are not met, no provision is recognized. This standard provides no greater clarity and, if anything, would lead to less disclosure as opposed to greater transparency.

FASB must be focused on the needs of the end user – the analyst community and accredited investors – and taking steps to increase accessibility and readability by lay people, not creating additional standards with no teeth and promulgating divergent standards for different types of liabilities (e.g., income taxes versus other contingencies). If, as FASB has contended for some time now, the balance sheet is the Holy Grail of financial reporting, it seems wrong-headed to have inapposite standards for recording liabilities.

Moreover, the fact that end users have increasingly relied on non-GAAP measures, (e.g., EBITDA, EBIT, ROCE) in analyzing financial statements suggests that the information set forth in financial statements is not sufficient on a standalone basis to facilitate analysts’ review and/or to make investment decisions.  This is important as it is the foundation of U.S. financial reporting and raises many questions, chiefly: Why have end-users – especially the investment community – been left out of the standard-setting process? Relying on academics and bureaucrats for financial statement reform is a terrible idea.

The Financial Accounting Foundation and the FASB need to implement some aggressive change management practices and listen to their constituents – not just the U.S. Congress—with respect to financial statement reform.

IFRS is not a panacea. A return to principles-based reporting is a step backwards at a time when the U.S. needs to march forward. Balance and common sense must return. The amount of time and resources corporations must devote to reporting must enter into the equation, lest there be more people accounting for a transaction than transacting businesses on behalf of an issuer. When it takes more lawyers and accountants to report the business than there are resources transacting business the train has come off the tracks.

Given that we are in the middle of the most devastating financial crisis since the Great Depression when there has been a clarion call of epic proportions for greater transparency and more usable financial statement information, why FASB is embracing IFRS – a principles-based set of standards, as opposed to continuing to evolve the U.S. GAAP rules-based system – is beyond belief. Those of us who have been practicing for more than two decades remember the principles-based approach under U.S. GAAP that, with pressure from Congress, the SEC and investors, became rules-based over the past two decades.

Based on the teachings from recent CPE seminars I have attended in the last two weeks, it seems that the accounting standard-setting bodies have run amok. Consider the proposal on lease accounting. Under IFRS and revised U.S. GAAP, the expectation is that operating leases will be eliminated. As a result, lessees will have to capitalize the asset and amortize or depreciate that asset; details to follow later. Conceptually this seems odd as in many instances the lessor clearly retains title to the property and, in the case of commercial real estate, has no intention of conveying same to the lessee. Put differently, the lessor is not necessarily providing financing to the lessee.

Alternatively, consider commercial real estate leases – typically operating leases – where the lessee has a right to occupy the premises owned by the landlord. Now, consider the implications of capitalizing these leases and treating the lessee as having an ownership interest in the property – which in theory implies that the transaction is a form of financing. In point of fact, nothing could be further from the truth. The economic reality, accounting notwithstanding, is that the lessee has an occupancy right to the premises provided payments and lease terms are satisfied. So, how could this be a capitalized asset?

Add on the tax implications of such arrangements, as it is unlikely there will be a basis for arguing that the lessee has a depreciable asset, aside from leasehold improvements. Thus, it seems likely that there will be even more book/tax differences to account for – which adds increased complexity to an already overly complex set of provisions. How does this change help users of the financial statements? It seems that there will be more people required to account for transactions than there are generating revenue and transacting business.

Meaningful financial statement reform must be based on the needs of the end user. The capital markets won’t recover until investors are confident in the information they are receiving. Until balance and incremental change return to the standard-setting process the capital markets will likely remain tepid at best. Unlike the Pirate Code, accounting standards in the U.S. cannot be “more guidelines than actual rules.” FASB needs to rethink the wisdom of moving the U.S. to a principles-based set of standards given the current economic climate and the needs of U.S. businesses and their investors particularly in view of the fact that we have already been down this road.

The so-called Holy Grail of transfer pricing has long been the comparable uncontrolled price (or transaction). The elusive publicly reported transaction between third parties which nearly perfectly matches the facts and circumstances of the related group transaction seldom exists. As such, taxpayers around the world most often rely on a range of results derived from uncontrolled parties – known as comparables – as the basis for determining whether or not the results of the transaction under review satisfy the arm’s length standard. The reference companies selected for comparability need not only meet certain functional and operational criteria in order to be comparable (e.g., functions performed, assets employed, risks borne), but financial standards as well. Differences between revenue, expense, asset, liability and equity treatment between IFRS and U.S. GAAP are significant. In the short-term there may be difficulty establishing comparability between the financial data of companies reporting under IFRS versus those reporting under U.S. GAAP. While the IRS requires U.S. GAAP to be used by all U.S. taxpayers if the comparable companies under consideration are non-U.S. companies traded on foreign stock exchanges the same rules do not apply. As can be seen from the example below, a small difference in the manner in which cost is reported (e.g., above or below the operating income line) can have a major impact on the ultimate result.

For example:

For U.S. taxpayers examining the results of potentially comparable companies from around the world this development means a tremendous amount of extra effort – either the taxpayers must reconcile the financial statements of all potential comparables back to U.S. GAAP in order to perform the analysis or the taxpayer must find and use only those companies who report their results under U.S. GAAP. Ultimately both choices are poor and will lead to less accurate and complete analyses. It remains to be seen to what extent IFRS and U.S. GAAP will impact comparability for transfer pricing purposes and how the lack of convergence will affect U.S.-based multinationals. If recent trends associated with companies adopting IFRS hold, it is likely that net income under IFRS will likely exceed the amount reported under other comprehensive bases of accounting. Given all of these factors, it is likely that – for the foreseeable future – transfer pricing will need to start with local country GAAP reporting rather than IFRS.