Last week, a revised version of “A Research Based Perspective on the SEC’s Proposed Rule on Roadmap for Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards (IFRS) by U.S. Issuers,” comments from the Financial Accounting Standards Committee of the American Accounting Association, appeared on SSRN.  In this post, I offer a few observations on this paper.

While I am currently the FASB Research Fellow, I emphasize that these comments are my own and do not reflect official positions of the FASB. 

“Is there a need for a single global set of financial statements” [I believe the authors meant to say "financial accounting standards".]

The paper states: “Our view is that comparability and consistency should not be the main goals of financial reporting.”  It goes on to explain in some detail two perspectives on the purpose of standards, a minimum quality function and a coordination function.  In my view, this line of argument is a red herring.  I don’t believe that the FASB nor the IASB nor proponents of a single set of global standards think that that comparability and consistency are the main objectives of financial reporting. 

In fact, the accounting standards currently endorsed by the SEC for regulatory reporting and the standards used in most of the world (U.S. GAAP and IFRS) are  based upon conceptual frameworks that clearly identify decision usefulness as the primary goal of financial reporting.   In the well-known figure, “A Hierarchy of Accounting Qualities” in FASB Statement of Concepts No. 2, comparability and consistency are labeled as “secondary and interactive qualities.”   Paragraph 34 of FASB Statement of Concepts No. 1 and paragraph 12 of the IASB “Framework for the Preparation and Presentation of Financial Statements” both identify the objective of financial reporting as providing information that is useful in decision making; neither paragraph makes any mention of comparability or consistency.  Moreover, the joint IASB-FASB conceptual framework project’s Exposure Draft, “The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information” reaffirms this primary objective: “The objective of financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions…” (paragraph S2 of the ED).

Rather than debating the objective of standards, a more productive framing of the question is the following: given standards whose primary objective is facilitating the production of decision-useful information, would added comparability and consistency across national borders provide incremental benefit to financial statement users?

Turning to that question, I agree with the observation made in the paper that extant academic research supports the argument that standards are just one of many factors that influence the degree of comparability of financial reports.  Other factors, such as incentives and institutional and cultural differences are likely more important.  This evidence supports the conclusion that common global standards alone are likely insufficient to guarantee comparable financial reports. 

However, the absence of global standards will also be likely insufficient to guarantee comparable financial reports.  Hence the question is not whether global standards will lead to perfect comparability but rather whether increasing the uniformity of standards and reducing the degree of permissible variation will lead to more comparable financial reports.  Rejecting global standards on the basis that they cannot lead to perfect comparability ignores the potential incremental improvements in comparability that many believe may result from global standards.

“Robust Competition Between Standard Setters”

The paper puts forward the idea that standard setters should compete by allowing issuers to choose between IFRS and U.S. GAAP.  If indeed the world of standard setting resembled the theoretical notion of “perfect competition,” it would follow that such a setting would lead to innovation and quality improvement that market participants want from accounting standards.  However, in many important respects the present configuration departs from that theoretical depiction. 

There are but two major standard setters.  Each currently operates as a regional monopoly, as each is designated by governments in selected countries as the creator of standards for capital market purposes.  The IASB and FASB have worked closely together since the IASB’s inception on standard setting, and their standards derive from conceptual frameworks that are quite similar.   These are clearly attributes that depart from the notion of a perfectly competitive market for accounting rules.

As a result, it is hard to imagine what a full-scale competition between them might look like.  Given their histories, the constituencies that they serve, and their highly overlapping philosophical views about accounting standards, I don’t envision that left entirely separate there would be meaningful differences in the standards that they would set.  However, we have recently witnessed a limited amount of competition that has proven to be destructive to the quality of accounting standards.  Under pressure caused by the global financial crisis, selected constituent groups combed IFRS and U.S. GAAP in search of slight differences in accounting for financial instruments, and when some were found, they put extraordinary pressure on the standard setter with the stronger, higher-quality standard to weaken the standard to match that of the lower-quality standard.  This is often referred to as the “race to the bottom.”  Surely this is not the kind of outcome that is desired, but it seems to be the natural result of “competition” between two regional monopolies.  Whatever the relative weaknesses of a single standard setter, at least such a configuration would not be subject to this particular weakness.

Finally, any evaluation of the proposal to allow choice between standards must fully take into account the aggregate societal costs of maintaining the flexibility needed to make that possible.  These costs include training of all financial market participants to be fluent in both IFRS and U.S. GAAP, redesigning contracts so as to be able to be flexible for different measures that would result from different standards, expansion of the capabilities of regulators, investors, creditors, and other users of financial statements to be able to accurately comprehend the meaning of financial statements prepared under two different bases of accounting, and other related costs.  I don’t believe that the paper adequately sorts through these costs in comparison to the anticipated benefits of multiple sets of standards.

Clearly the future direction of global standard setting is an issue of great importance for the U.S. and other nations.  Continued thoughtful debate among academics and others is an important part of a process that can lead to wise policy choices by those who will ultimately make the decisions.  However, it is crucial that such debate be informed and that arguments be made carefully and realistically consider the important complexities that are part of a proposed transition of this magnitude.