Substance Matters

Part of our continuing series examining the potential ramifications of IFRS on U.S. multinationals.

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.