ISG Software Research Analyst Perspectives

Hans Hoogervorst, who just succeeded Sir David Tweedie as the chairman of the International Accounting Standards Board (IASB), recently said he is “optimistic the SEC will move to fully incorporate IFRS [International Financial Reporting Standards] shortly.” I find it hard to see why, unless one has a fairly elastic definition of “fully,” “incorporate” and “shortly” (or at least two out of three). Then again, one shouldn’t fault the head of an organization for expressing undue optimism since that’s what he or she is supposed to do. Elasticity is in order because sentiment regarding IFRS has been shifting in the United States away from full adoption on an aggressive timetable to something less than that. Early on, it became clear that IFRS was going to be an option for non-public companies. Since they do not report their results broadly, it was hard to argue that comparability was necessary and there was no obvious regulatory mechanism that would force such adoption. Then, in December 2010, Paul Beswick, deputy chief accountant of the SEC laid out that agency’s thinking on IFRS. While declaring that a single international accounting approach is a good idea, the SEC’s immediate objective is “condorsement,” an intersection of convergence (incorporating IFRS as the standard over time but always allowing for exceptions) and endorsement (full acceptance). This would mean assessing IFRS “on a standard-by-standard basis, if existing IFRS standards are suitable for our capital markets.” In other words, get ready for an elastic IFRS conversion process. The result for the next decade or so may well be something best termed “US-IFRS” because of the substantive differences that remain. As a practical matter, I think the SEC’s “condorsement” reflects a pragmatic approach to getting something like IFRS in place as soon as possible while dealing with the seemingly intractable differences that still exist between FASB (the U.S. Financial Accounting Standards Board) and the IASB. It also will lessen the burdens that such a shift will impose on reporting companies. Revenue recognition and balance sheet consolidation are a couple of those big remaining differences that I don’t believe can be fully resolved anytime soon. A part of me (the pragmatic side) thinks the condorsement approach is, indeed, the best one for the United States for all the reasons that its supporters cite. It’s not as if US-GAAP is a bad standard (although I have deep reservations about some aspects – more on this below). And the two standards don’t produce very different results often, only in some instances – and one might quibble about the threshold of the adjective “very.” As a generalization, one can argue that US-GAAP and IFRS are closer in most respects than the country-by-country GAAPs were in the 1970s and even 1980s. Moreover, SAP dropped US-GAAP but, as detailed in its public statement footnotes, the difference between its results reported under IFRS and GAAP were de minimis. And, after the Sarbanes-Oxley implementation debacle, it’s not as if a measured approach is out of line. Still, the purist in me wants US-GAAP to go away ASAP. Most commentators and supporters of IFRS focus on the value of adopting an “international” (by which they mean universal) accounting standard. In theory, this would mean comparability of financial statements regardless of the country. (In a future blog item I plan to muse on how bitterly disappointed some of these folks are going to be in this expectation.) I think a more important reason for ditching US-GAAP and adopting IFRS is to return the U.S. to a principles-based accounting standard and away from the increasingly rules-based approach FASB (“fazbee,” the organization that administers generally accepted accounting principles – GAAP – in the U.S.) began adopting in the 1980s. I suspect that at least some at FASB have come to see the cumulative result of this rules-based approach as a hash, and an increasingly unwieldy hash at that. Adopting IFRS rather than trying to reform US-GAAP is arguably the less difficult way to achieve this shift in approach. I think the rules-based based approach is misguided because it tries to impose uniformity in interpretation across all types of business. And in setting rules, FASB seems to revel in what I refer to with a smile as “hair shirt accounting,” where the objective is to delay revenue recognition as long as possible as well as accelerate and maximize expense recognition, all with the objective of putting a company’s accounting results in the worst possible light. This strikes me as an unbalanced application of accounting principles. Why does a severe interpretation of the principle of conservatism always trump the equally basic principle of period matching? Unfortunately, the hair shirt accounting approach is no more accurate a depiction of a company’s results and condition than an overly lax and optimistic interpretation. In both cases, it favors professional investors who have the time and training to see past the distortion and can ferret out the true economic results. For example, earlier this year, Apple Computer’s shares popped when people finally recognized the cumulative impact that its deferred revenues would have on reported results. Here’s a small example of an unwarranted hair shirt approach where a more flexible accounting treatment is in order: FASB concluded large professional services firms were overstating profitability because client reimbursements of expenses such as travel and accommodations, which can add up, were not being included in revenues. So for the past decade or so US-GAAP has required that these amounts be included in revenues. There’s no difference in reported earnings, since the amount is fully offset by an expense item, but reported margins are narrower. It’s hard for me to see why this is a better representation of the economic reality of these companies or how investors are better served by this information. Worse, it also applies to the consulting arms of software companies, whose company revenues are inflated by including hundreds of hotel night stays and miles driven to a tally of application sales and consulting hours provided. Rather than there being a hard and fast rule, recognizing reimbursable expenses as a revenue component ought to apply where it is a meaningful component of the service provided and not across the board. As well, FASB has outlawed all use of pooling accounting for mergers because of the distortions this caused in the tech bubble of the late 1990s. This will work until we find ourselves in an equity market environment similar to the mid-1960s in the U.S. and the 1980s in the U.K., when corporations like LTV and FEI Electricals respectively scammed the investing public by using purchase accounting to create the illusion of growth. There are times when pooling better captures the economics of a business combination; a principles-based accounting standard ought to allow this. From an information technology standpoint, if the United States winds up with a measured incorporation of IFRS it will be that much harder for software vendors and consultants to use the transition challenge as a sales peg to convince companies to upgrade existing systems. It’s a bit Pollyannaish of me, but I think that would be a good thing, since it forces vendors and buyers to concentrate on the inherent business value of buying new software rather than on external regulatory requirements. In the case of IFRS, it may make sense for a company to buy new software for that reason, but there may be any number of other reasons as well. New software may be in order because the company’s current consolidation and reporting software will not handle IFRS without making modifications that are so costly that it would be more cost-effective to rip and replace, especially if the change includes implementing an automated external financial reporting application to address the SEC’s “Interactive Data” tagging mandate. However, there may be many other reasons why replacing an existing consolidation system is warranted right now, even without the need to shift accounting standards, especially if the current system requires too many manual processes or sub-processes or does not support a greater degree of collaboration among people working at different times and different places (in dispersed offices of a global organization, for example). For the past several years, accounting firms have been advising U.S. corporations that file public statements to begin the process of gearing up for IFRS adoption. Some have, but more have not to any substantive degree. The latter group has not lost much by sticking with not-best practices. Out of the current situation I draw three conclusions. First, a more measured transition is the more practical approach to transitioning to IFRS. Second, the shift from US-GAAP to IFRS (or “US-IFRS”) must include a shift in FASB’s approach away from the current rules-based climate to more of a principles-based standard. Third, most companies’ accounting close-to-report cycle is riddled with inefficiencies that inflate administrative costs and needlessly delay providing executives and managers with important performance information. With or without a shift to IFRS, all finance departments must periodically assess their process and the supporting information and technology dimensions to find opportunities for improvement. Regards, Robert Kugel – SVP Research

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