Robert Kugel's Analyst Perspectives

The melding of the world’s two main financial accounting standards – United States Generally Accepted Accounting Standards (US-GAAP) and International Financial Reporting Standards (IFRS) – continues apace. Initially, the idea was to converge the two into a single, global standard. Although there was general agreement that the concept was a noble one, there were enough differences to produce practical concerns about implementing these changes, especially in the United States. Then, in December 2010, the U.S. Securities and Exchange Commission (SEC), which mandates accounting standards for publicly traded companies, indicated that while in principle it favors a single international accounting standard, the Commission was going to take a “condorsement” approach, which I covered in a note last year. The SEC’s move essentially derailed the prior objective of replacing US-GAAP with IFRS by the middle of this decade. Still, the coming together of US-GAAP and IFRS continues to forge ahead even without acceptance of full adoption in the U.S. The two bodies that administer accounting standards, the Financial Accounting Standards Board (FASB), which manages US-GAAP, and the International Accounting Standards Board (IASB), which manages IFRS, are attempting to standardize wherever possible and harmonize as best they can elsewhere. One important area where there’s been significant progress is revenue recognition.

The SEC’s “condorsement” term points to a buffet-style mixture of convergence (incorporating IFRS as the standard over time but allowing for exceptions) and endorsement (full acceptance of IFRS). From the SEC’s vantage, condorsement means assessing IFRS on a standard-by-standard basis and adopting IFRS only where it is suitable to the U.S. The result is an elastic process of conversion to IFRS that ultimately produces something that might be termed “US-IFRS.” Some unification of accounting standards is happening on the IFRS side, too, as the IASB adopts standards that are in US-GAAP but did not or do not exist in IFRS, or modifies its standards to conform more to the U.S. approach. In any case, differences are likely to remain between the two systems.

Moreover, I expect full endorsement will continue to be hampered by a broad institutional desire in this country for the United States to exert final say on accounting standards. FASB as well as some corporations and accountants believe that the U.S. has enough unique accounting and auditing issues to warrant having an independent standards-setting body based here.

As it turns out, “condorsement” is also the most practical approach because retaining the US-GAAP label sidesteps an unintended (yet considerable) burden that would be imposed by having to change large numbers of contracts and regulations that require the use of “US-GAAP.” I believe it’s also more practical to have corporations and accountants and auditors adopt changes step-by-step rather than switch overnight in a big-bang approach. The SEC, in putting forth its “condorsement” manifesto, also observed that the U.S. system is not broken, and so there was no need to generate pandemonium to produce what amounted to limited gains from having a single standard.

Moreover, full endorsement of IFRS in the U.S. was generally believed to require a shift to a more principles-based approach to accounting and auditing, which is the norm in European countries, and away from the more rules-based approach that FASB has favored over the past three decades. I think that human nature makes a rules-based mindset hard to lose, and so I expect that a sharp tack back to a principles-focused regime would have been disruptive to a generation of accounting professionals in the U.S. and is part of the broad institutional support for a more gradual convergence.

That noted, one important area where convergence is occurring faster than I thought possible is in revenue recognition, which is one of several fault lines where rules-based and principles-based accounting styles collide. Essentially, FASB is moving to more of a principles-based approach. One reason is that US-GAAP has more than 100 requirements governing recognition of revenues and gains, some of which are industry-specific. Revenue recognition rules have grown in scope and specificity in response to numerous scams and scandals perpetrated on investors over the past three decades that have involved overstating sales. In the 1980s, investors in the budding technology sector had to balance reported revenues against the days-sales-outstanding metric in order to better judge whether a company’s top line was real or inflated. (Channel-stuffing schemes, for example, involve last-minute sales to friendly buyers that will be cancelled in the following accounting period before payment is made, boosting the top line and inflating accounts receivable.) For this reason, SOP 91-1 was issued in 1991 to deal with the substantial diversity in revenue recognition practices ranging from very conservative (that is, when customer payment occurred) to very aggressive (at the time the contract was signed). Yet less than three years later this remedy proved inadequate, as the Platinum Software case showed. Several additional rounds of new and increasingly more specific rules ensued. FASB recognizes that these efforts have not adequately addressed the issues because “US-GAAP comprises broad revenue recognition concepts and numerous requirements for particular industries or transactions that can result in different accounting for economically similar transactions.” Moreover, even with all those rules US-GAAP still has no general principles for recognizing revenue from services. International accounting standards have more principles to guide accounting treatment and are less complex, but they also are less comprehensive and harder to interpret. For instance, they say little about how to handle contracts with multiple elements – software and services, for example. For that reason, FASB and IASB have gone back to first principles to devise a common approach, which is summarized in the current exposure draft.

After receiving comments from interested parties on the second exposure draft through March of this year (there were enough concerns raised in the first round of comments to warrant this second round), FASB and IASB expect to complete the revised standards by the end of 2012. The rules would not go into effect until 2015, however. (If the revisions are delayed into 2013, the earliest effective year would be 2016.) I believe the proposed amendments to revenue recognition will meet FASB’s objective of providing “a more robust framework for addressing revenue issues” and will remove at least some of the inconsistencies and weaknesses in existing rules. In my judgment, fundamental changes to revenue recognition are necessary because FASB’s rules-heavy approach has made it harder for nonprofessionals to understand financial statements. It has given a substantial advantage to skeptical securities analysts and others who read SEC filings for a living. I hope that, once enacted, it will achieve FASB’s goal of simplifying financial statement preparation and increasing the comparability of revenue statements by like entities across capital markets and jurisdictions.

Regards,

Robert Kugel CFA – SVP of Research