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Mind the GAAP? No, scrap the GAAP

The Generally Accepted Accounting Principles (GAAP) used across the
USA for financial reporting appear to be fatally flawed. As a result,
America is scrapping GAAP to move towards the International Financial
Reporting Standards (IFRS) used around the rest of the world. The
question is how fast can this be achieved?

Part of the reason for the urgency of scrapping GAAP is that many
believe the GAAP methods contributed heavily towards the subprime credit
crisis. This is down to the fact that American banks used insurance
services to manage debt exposures and move them off-balance sheet.

GAAP allows this because it is applied differently to insurers and
banks, as explained brilliantly in this Business
Week
account last week: the Death of the Bond Insurer.

In summary, the GAAP method allows banks to post profits on
securities the day they book them, by swapping the risk with their
insurance friends.

Under GAAP, banks have to recognise any exposure on the value of a
security at prices which are mark-to-market. Therefore, a bank has to
report any losses every quarter, even if those are only paper losses. On
the other hand, insurers only have to state such losses if their
investment is terminal such that it is likely to result in an insurance
claim.

This fundamental difference meant that banks used insurers as a
method of accounting arbitrage, by using Structured Investment Vehicles
(SIVs), such as Collateralised Debt Obligations (CDOs), and then
swapping them with their insurance arms as Credit Default Swaps (CDS).
What this actually means is swapping the likelihood of the CDO going
wrong with the insurer.

Perfectly acceptable under GAAP methods, but actually just moving the
risk from one side to another whilst leaving the exposure in place.

Why would this be critical?

Because it allowed banks to book profits early and created the credit
bubble that we are grappling with today, post explosion.

Using GAAP methods, a bank could buy an SIV which pays interest at
0.5% above base rates and then purchase insurance, a CDS, at 0.2% above
base. The result is that the banks could book the difference of 0.3% as
profit, which they did the day they took out the insurance. Banks
profits looked great and credit boomed, because firms were reporting the
profits of derivatives that spanned 5 to 10 years the day they bought
them.

This is why GAAP is being scrapped, to be replaced with the more
globalised IFRS standards, but the problem is that not everyone wants to
move at the same pace, creating a scrap between the American Financial
Accounting Standards Board (FASB) and the Securities Exchange Commission
(SEC).

The SEC wants firms to move to IFRS accounting right now, whilst the
FASB wants it phased in gradually. This is not to say that the FASB is
unsupportive of scrapping GAAP. They firmly are in favour of IFRS. Their
issue is less haste, more speed. The FASB think that the SEC is trying
to do it too fast, too arbitrarily, and it is just not that easy.

For example, in a survey of 137 corporations, the FASB found over
1,000 differences between the accounting rules of the IFRS versus GAAP,
with IFRS allowing earnings to be inflated by up to 11% as a result. The
main differences occur in the reporting of pensions (99 differences),
derivatives (53) and share-based compensation schemes (52).
As can be seen, the 53 differences in the reporting of derivatives catch
the eye, and support the previous dialogue around accounting principles
between banks and insurers.

So there are efforts to create a common, high quality, global
financial reporting systems that can be used for decision making
purposes across borders, and this formed the basis of an in-depth
presentation this week from Dan Young, an executive on the Board of the
FASB.

Dan noted that there are many countries adopting IFRS. The only
exceptions are Brazil, India, Mexico, Canada … and America; but these
countries are rapidly converging towards a global standard.

For example, the International Accounting Standards Board (IASB) was
created in 2001 with the support of the SEC and the FASB. This led to
the Norwalk Agreement in 2002. This Agreement set a working agenda to
move GAAP towards IFRS standards as soon as practical. This was followed
by a Memorandum of Agreement (MOU) in 2006 between the FASB and IASB to
move this further forward.

And yet, six years after the Norwalk Agreement and two years after
the MOU, there is little progress.

Sure, there's been movement on key areas, such as the presentation of
financial statements, but other area such as revenue recognition, 'fair
value' measurement, leases, intangibles, financial instruments and so
on and so forth are way behind.

So the SEC has decided to stop the messing around and has pressed the
'go' button.

In 2007, the SEC allowed foreign firms to list shares in the USA
without reconciling financial statement to GAAP methods, but to just use
IFRS if that is what they want to use; and now the SEC is saying that
even American firms can choose how they want to report apparently. They
can use either GAAP or IFRS. It is totally at the discretion of the
business.

This issue is cited as a major one, as the FASB cannot condone a two
stream reporting system. It needs to be consistent. After all, how can
investors determine the value of a firm, if one has used IFRS reporting
to inflate earnings by 11% compared to another who uses FASB?

So what is needed for a global accounting standard? The ideal system
requires:

  • A single set of high quality accounting standards, developed by
    an independent, well funded, global standard-setting organisation;
  • Cooperative international regulatory, enforcement and corporate
    governance regimes;
  • Common, high quality auditing standards; and
  • Systems for training and educating capital market participants

These points were, once again, a scene setter towards an audience
vote.

Bearing in mind that the audience comprised around 500 mainly
American (both North and Latin) corporations and financiers, here's the
results:

What is the best way to achieve convergence of GAAP to IFRS
accounting standards?

49%   After completing critical projects to align the two, adopt IFRS
27%   Just name a date to adopt IFRS as soon as possible
16%   Joint work for gradual convergence on a project-by-project basis
8%      Let the market decide

What is the best way to achieve a cooperative international
regulatory, enforcement and corporate governance regime?
1 We don't need one – let the market decide                  5%

2 Home country rule – company (head office base)      6%
3 Home country rule – investor (equity listed)                 1%
4 Coordinated global regulation                                      41%

5 Combination of 2 and
4                                                47%

When will the majority of the S&P 500 companies be using
IFRS?

2012 or
sooner                                                                   
37%
2013 to
2015                                                                       
29%
After
2015                                                                           
28%
Never                                                                                     7%

You can read more on the FASB's views here.

The bottom-line is that accounting arbitrage, particularly of financial
instruments and derivatives, has led to significant issues in the
market. The current credit crisis was hidden through such accounting
arbitrage, and has led to the current market crisis. Without alignment
of accounting principles worldwide, such crisis could repeat itself over
and over again.

We need to baton the hatches and plug the gaps, not just locally,
domestically or regionally … but globally.

The only question left in my mind is: who will lead that charge?

About Chris M Skinner

Chris M Skinner

Chris Skinner is best known as an independent commentator on the financial markets through his blog, the Finanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here…

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