Accounting for Quality: the Quality of Accounting

Accounting is esoteric.  :(  I say this as one who has never taken an accounting course in his life, but has written papers on accounting standards, and has had to implement them in the life insurance industry, which is possibly the industry with the most complex accounting of any industry.  (Okay, if we did the investment banks properly, they would be more complex.)

My post is prompted by Barry’s post.  I have known for a while, and commented here that the SEC is planning on abandoning GAAP for IFRS.  Why are they suggesting this?

  • IFRS is not that much different from GAAP.
  • They want to have every company in the developed world on a similar accounting basis, even if the basis is slightly worse than the existing standards.
  • Then perhaps, foreign companies will once again list their equities in the US.

You can get the same information in different ways from:

The latter two links do not directly address the issue, but they write intelligently about accounting.

This download is big, but it summarizes the differences between FAS and IFRS (in 77 pages).

My short take is this:

  • IFRS is a more liberal accounting standard.  Not by a lot, but significantly.
  • There will be a ton of retraining for accountants in the US, and financial analysts (ouch).
  • Earnings will rise, but P/E multiples will fall.  The intial net effect should be small.
  • Value investors will fare relatively better, as they spend more time on the balance sheet, income statement, and other earnings quality issues.
  • Exchanges in the US might get more foreign listings, if Sarbox were repealed.  Moving to IFRS is not enough.
  • If I were on the SEC, I would not care about global comparability, I would stick with GAAP, and stand alone if necessary, among the nations of the world.  Why move to a less informative, and more rubbery standard?  I don’t see a good reason.

IFRS is more flexible, which means that companies under it are less comparable.  I don’t see the advantage in our moving away from GAAP, which has its problems, but less than IFRS.  When I get the web address to post complaints, I will post it here, and I will be writing the SEC to stop this foolishness.

6 Comments

  • matt says:

    I posted several times at Barry’s blog and I generally disagree with anyone who says that IFRS is more “liberal.” How about you be more specific instead of use terms like “rubbery,” “less informative,” “more flexible,” etc?

    Certainly, the manner in which some items are reported is descretionary. For example, (if I remember correctly) dividends can be reported under investing or operating sections of the cash flow statement under IFRS. Sure, it’s flexible, but does it really hurt analysts? Your calculator has + and – buttons. I’m not an accountant, but from what I have seen of IFRS, these are the “flexible” parts that you are talking about. They have no material affect.

    As I mentioned at Barry’s site, inventory is a big deal and as we both pointed out (me at Barry’s site), this will cause differences in balance sheets and income statements. With IFRS, you get a more accurate balance sheet; with USGAAP, you get a more accurate income statement. You pick.

    Your job probably requires that you interpret financial statements. Are you just an old dog that doesn’t want to learn new tricks?

  • No, I will learn new tricks. I am a learner by nature. I just don’t see the value in making financial statements less comparable. I also don’t like spending a lot of time learning if the ultimate payoff is small.

    I’m thinking of putting out a shorter summary of the most significant differences between GAAP and IFRS. There are some places where IFRS is an improvement, such as the handling of goodwill. But the main difference is how it is applied: in the hands of good men, a flexible, principles-based accounting system will be used for good, and it will improve accuracy of reporting. But we live in a world where some manipulate accounting results in the short run to achieve their goals. I prefer a rigid accounting standard, more rigid than GAAP, that may be less accurate at points, but gives a neutral rendering of results that financial analysts can then make their “ad hoc” adjustments to, in order to correct the inadequacies.

    Marty Whitman has commented on this for years. Flexible accounting systems lessen comparability of results across companies.

    PS — I’m not sure IFRS gives a more accurate balance sheet. I will study it, though.

  • Milt says:

    David,

    You write, “Earnings will rise, but P/E multiples will fall. The intial net effect should be small.”

    I don’t understand this. Is this some kind of statistical look at PEs of companies using IFRS versus similar companies using GAAP? My guess is the PE stays the same and the stock price and earnings go up.

    So company A, a NYSE or NASDAQ listed company, changes from GAAP to IFRS on say July 1, 2009. Analysts will upgrade before the date expecting reported earnings to rise. The stock price starts to increase in anticipation. By the time the quarter ends,, Sep’09 and the company reports earnings, the stock price is up so that the PE is in line with what it was before the company announced it was changing to IFRS.

    My guess is during the transition period US listed stocks trade the same whether they use IFRS or GAAP. And that since IFRS stocks earnings are higher, their stock prices will be higher. I just don’t believe Wall Street is that concerned about earnings quality as you are or other value inverstors are. There are just way too many examples of earnings chicanery and executive spin. First example that comes to mind is AMAT. Horrible earnings and sales performance, but stock is doing fine, PE is high, based on hype about future sales growth to solar fab chip companies. Mind you this future has been promised for about 1 year.

  • Michael says:

    “PS — I’m not sure IFRS gives a more accurate balance sheet. I will study it, though.”

    David, it’s simple: LIFO inventory accounting is not permitted under IFRS, but it is under GAAP. Since LIFO reports COGS at current market prices, it results in a more accurate income statement at the expense of the balance sheet, where LIFO inventories are valued at historical (not current) cost. With FIFO, it’s just the opposite.

    Furthermore, since LIFO uses higher COGS (assuming rising prices over time), it lowers pre-tax earnings and taxes, thus *increasing* after-tax earnings (a major reason why almost every US company uses it). Any blanket claim to the contrary is misleading at best.

  • Milton, every study I have seen on accounting rule changes says that they have no effect on average on stock prices. Stocks are valued off of free cash flows, which are unaffected by accounting rules.

    Michael, okay, good for industrial companies, but what about financial assets. From what I have read on IFRS, there is more flexibility to value assets, and to revalue them upward. That’s my concern.

  • pcyhuang says:

    I think that this sudden emphasis by the SEC in talking about the IFRS is really throwing a smoke screen about the SEC’s lack of will power in executing a strict enforcement about the abusive naked selling issues.