1.1 Opening Scenario: International Accounting and the IASB

It all started with a French accountant named René Ricol. In mid-2008, Mr. Ricol was commissioned by French President Nicolas Sarkozy to write a report on the impact of the worldwide financial crisis of 2007 and 2008.1 This 148-page report covers a variety of topics including the origins of the crisis, the ongoing response by governments and business, and 30 detailed recommendations for additional actions. But on page 53, Mr. Ricol wrote something that was to have explosive consequences. He wrote: “At present, it is important to ensure that . . . a level playing field between European and U.S. [accounting] rules is achieved.” By implication, according to Mr. Ricol, one reason that European banks were having such severe difficulties in the third quarter of 2008 was that U.S. accounting rules were giving an advantage to U.S. banks.

Mr. Sarkozy passed Mr. Ricol’s report along to the assembled EU Finance Ministers, who happened to be meeting in Paris. These ministers were shocked— shocked to learn that U.S. accounting rules were creating an “unlevel playing field” to the advantage of U.S. banks. The Finance Ministers issued a communiqué on October 7, 2008, calling for: “[T]he necessity of avoiding any distortion of treatment between U.S. and European banks due to differences in accounting rules. . . . We also consider that the issue of asset reclassification must be resolved quickly. . . . We expect this issue to be solved by the end of the month, with the objective to implement as of the third quarter.”2

So, to whom was the call to arms addressed? To the International Accounting Standards Board (IASB), based in London and designated by the European Union as the approved source of accounting standards for all EU nations. IASB standards, collectively known as International Financial Reporting Standards (IFRS), are also recognized as the source of generally accepted accounting principles in every sizable economy in the world . . . every sizable economy except one, the United States.

Attention turned to Sir David Tweedie, chairman of the IASB. Sir David was told that the IASB had three days to revise IFRS. Three days? The due process requirements of both the IASB and its U.S. counterpart, the Financial Accounting Standards Board (FASB), typically result in proposed accounting standards being circulated and discussed for years, not days. However, Sir David was told that without an immediate rule change, the EU would go around the IASB and unilaterally change the accounting rules for companies in its constituent countries. It is reported that Sir David considered resigning.3 However, in order to live to fight another day, he succumbed to the EU pressure and rushed through the accounting change.

So, what was this accounting rule that was viewed as threatening the very survival of European banks? The accountants call it “fair value accounting,” and in the business press it is often called “mark-to-market accounting.” For companies, such as banks, that actively trade stocks and bonds, the mark-to-market rule says that the investments must be reported on the company’s books at current market value, with any paper gains or losses (called “unrealized” gains or losses by the accountants) being reported in the company’s income statement. Well, during the third quarter of 2008 (from July 2008 through September 2008), there had been HUGE paper losses for banks and other investors all over the world. These losses reduced the recorded capital of banks and threatened to put many banks in violation of their regulatory capital requirements. So, you can see why banks in particular were upset at “mark-to-market accounting.” Note: No one seemed to complain much about mark-to-market accounting in the years when the market was up.

Back to Mr. Ricol. He claimed to have found a provision in the U.S. accounting rules that allowed U.S. banks to reclassify their investment securities into a category that accountants call “held to maturity.” The important thing about held-to-maturity securities is that they are reported in the balance sheet at their original cost, not their current market value, with any changes in value being ignored. Thus, this appears to be a loophole that U.S. banks could use to sidestep the harsh impact of mark-to-market accounting. At least that is the way this U.S. rule was explained to the EU Finance Ministers. What the Finance Ministers were not told is that this reclassification is so rare that no one can think of an example of a U.S. company ever actually doing it. In addition, the U.S. rule requires the reclassification to “held-to-maturity” to be done at the prevailing market value on the date of the reclassification, so any paper gains or losses must be recorded in full on that day. This doesn’t seem like much of a loophole. But remember, the EU Finance Ministers probably weren’t given a full briefing on all the aspects of the U.S. rule; they were only told that this U.S. loophole allowed U.S. banks to avoid mark-to-market accounting, thus appearing to create an unlevel international playing field with European banks being the losers.

Now the story gets really interesting. In drafting the hasty revision to its rules, someone in the IASB (no one is saying who) made the IASB version of this reclassification rule applicable retroactively to July 1, 2008. Very clever. The IASB rule was approved on October 13, 2008, two weeks AFTER the end of the fiscal third quarter of the year.4 By that time, European banks were able to see which of their investments had gone up and which had gone down during the third quarter. This new IASB rule allowed the European banks to roll back the clock to July 1, 2008, and with the benefit of hindsight, designate some investments to be accounted for using mark-to-market accounting (probably the ones that they now knew went up during the third quarter) and some investments to be reclassified as “held to maturity” at the value existing as of July 1 (probably the ones that they knew, with hindsight, went down during the third quarter).

So, this IASB rule revision, intended to “level” the international playing field, substantially tilted the playing field in favor of those European banks that chose to use it. Some European banks quickly backed away from this blatant manipulation of the accounting rules for their benefit. For example, in its third quarter 2008 financial report, BNP Paribas specifically stated that: “BNP Paribas did not use, in the third quarter 2008, the amendment to the IAS 39 accounting standard authorising the transfer of certain assets . . . from the trading book to other portfolios.”5 On the other hand, Deutsche Bank gratefully used the retroactive provision to turn a loss into a profit. Without the retroactive reclassifications, Deutsche Bank would have reported a pretax loss of €732 million for the third quarter. With the reclassifications, Deutsche Bank was able report a pretax profit of €93 million, which it proudly hailed in its third quarter report.6

There are certainly historical examples of U.S. politicians putting pressure on the FASB to revise its rules for some perceived benefit or another. But in the United States, the FASB is somewhat shielded from these pressures by the Securities and Exchange Commission (SEC). Internationally, there is no global SEC, so the IASB was left on its own to experience the full force of the European Union’s political pressure. Predictably, when faced with an EU ultimatum, the IASB buckled.

Across the Atlantic, U.S. regulators and the U.S. business community could only stand back and watch this political power play with a mixture of amazement and disgust. As of October 2008, the SEC had an announced policy, a “time line,” for shifting all U.S. accounting rulemaking responsibility to the IASB by 2014. This policy stemmed from two incontrovertible facts: (1) global capital markets demand a uniform set of accounting rules, and (2) the world will never accept “Yankee” control of this one-world standard. So, the SEC had the choice of either watching the international harmonization parade go by or getting in line behind the IASB banner. However, the October 2008 IASB debacle caused both the SEC and the U.S. business community to reevaluate the benefits of ceding standard-setting power to the IASB, an organization that had now revealed itself as being subject to powers more interested in the well-being of European banks than in any abstract notion of global accounting harmony. It was time to rethink the “time line.”

SEC Chairman Mary Shapiro was never as enthusiastic about international accounting convergence as her predecessor, Christopher Cox, was. She was fearful of “convergence” really being a “race to the bottom” in terms of a degradation in the quality of the U.S. financial reporting environment. During 2009, Chairman Shapiro said cautiously that the “time line” was on hold until the SEC determined exactly how it wanted to proceed.

While the SEC is still convinced that “a single set of high-quality globally accepted accounting standards would benefit U.S. investors," the SEC has expressed concern about both the quality of the international standards and the process by which those standards are set. Specifically, before ceding standard-making authority to the IASB (or any other international body, for that matter), the SEC wants to ensure that “accounting standards are set by an independent standard-setter and for the benefit of investors.” The implication is that the SEC wants to be convinced that the IASB won’t again cave in to EU pressure to twist an accounting rule to the benefit of European banks or some other powerful EU constituency. Along those lines, in July 2012, the SEC staff issued a report on the issue and concluded that the adoption of IFRS wasn’t feasible (in the short-term, at least) due to 1) the need for the U.S. to maintain a significant influence on the standard setting process 2) the cost burden required of companies to convert to IFRS, and 3) the prohibitive effort required to revise the extensive references to U.S. GAAP “embedded throughout laws and regulations and in a significant number of private contracts.”7

The IASB has since attempted to create a barrier between itself and the political pressure aimed at it—a Monitoring Board that includes representation from a number of important international regulators, including SEC chair Shapiro. It isn’t clear yet whether this Monitoring Board has or can serve as a shield between the IASB and international political pressure. Time will tell.

So, what has been the result of that report written by René Ricol? The primary result has been to bring home, dramatically, the remaining barriers to international convergence in financial reporting. The U.S. business community was forced to face the reality that it really doesn’t want its reporting rules set by a London-based group that is essentially controlled by the European Union. In addition, all interested parties, both in the United States and overseas, have seen that the IASB differs from the FASB in one extremely important way—the pronouncements of the FASB have the force of law because the regulatory power of the SEC is behind them. But who will enforce the pronouncements of the IASB? Who will ensure that the provisions are applied in a consistent way in each country around the world? Will it ever really be possible to have one truly global set of accounting standards, uniformly interpreted, implemented, and audited? For now, it looks like the answer may be: No.