Information Age: Closing the Information GAAP
By L. Gordon Crovitz
8 September 2008
What’s the definition of an accountant? Someone who solves a problem you didn’t know you had in a way you don’t understand.
What’s an auditor? Someone who arrives after the battle and bayonets the wounded.
And drum roll, please: What are Generally Accepted Accounting Principles? The difference between accounting theory and practice.
No joke, accountants are the Rodney Dangerfields of business. But perhaps they deserve some respect after all. Accountants in the U.S. are signing up for a fundamental rethinking of how they do their jobs. As a result, it should finally be possible for global investing and trade to operate on a common understanding, or accounting, of businesses.
The Securities and Exchange Commission recently announced that the U.S. will abandon Generally Accepted Accounting Principles — for almost 75 years, the bible for U.S. accountants — joining more than 100 countries around the world instead in using the London-based International Financial Reporting Standards. Pointing to the “remarkably quickening pace of acceptance of a true lingua franca for accounting,” SEC Chairman Chris Cox set out a timetable for all U.S. companies to drop GAAP by 2016, with the largest companies switching as early as next year.
There are specific differences between the two systems; for example, the international system only allows the first-in, first-out inventory accounting system. The most important difference is that the international standard is based on principles, whereas GAAP is based on rules. GAAP suffers from the complexity of trying to set rules for all situations, a complexity that often masks economic reality.
GAAP rules fill a nine-inch, three-volume set of pronouncements plus interpretive information. In contrast, IFRS is a slim two-inch book. GAAP was crafted in part by the pressures of the U.S. legal system. Companies have been glad for GAAP rules as defenses for claims of accounting irregularities. But these rules often only pretend to provide clarity. There are hundreds of pages of GAAP covering how to account for derivatives, but this didn’t stop opaque pricing mismatches, which helped create the credit crunch. GAAP rules allowed trillions of dollars in securitized financial assets and liabilities to stay off the books of U.S. financial firms, while the international standard, by focusing on the true underlying economics, kept these on the books for firms based elsewhere.
It’s surprising that there is no common language for measuring the performance of companies. Until recently, all major countries had their own accounting rules, but IFRS has become the approach of choice. Inconsistent approaches to accounting make it hard to compare an energy company based in Texas with one based in Amsterdam, a bank in New York with one in London, or a biotech firm in Boston with one in Singapore. A single set of accounting rules would mean more effective global disclosure and transparency. It would reduce costs for multinationals that must now prepare multiple books. It would also make U.S. exchanges more competitive for listings by eliminating accounting differences.
A measure of the importance of a single standard is the dislocation that getting there will cause. It will mean rewriting business school texts and retraining of corporate finance departments. The forensic accountants who sniff out problems will have to develop instincts using a new set of measures. The transition will also be tough on investors. Under the SEC proposal, larger companies in the same industry would switch to the international standard before smaller companies do. Investors for the transition period would have to compare similar companies using different accounting.
The big U.S.-based accounting firms generally support the abandonment of GAAP. Skeptics could call this switch in systems the equivalent of the accountant full-employment act for many years, but the profession itself also recognizes that GAAP often fails to reflect underlying economics.
A PriceWaterhouseCoopers briefing document for executives on the accounting change notes that changes will also be necessary in the law. “If an accounting and reporting framework that relies on professional judgment rather than detailed rules is to flourish in the U.S., the legal and regulatory environment will need to evolve in ways that remain to be seen.” These include that “regulators will need to respect well-reasoned professional judgments.”
A system based on principles could create new defenses for company boards and accountants who try to do the right thing, if they fully disclose why they thought that a particular accounting treatment made sense. The law will have to adjust to accept more ambiguity in accounting, as a necessary condition for reporting with maximum accuracy.