GAAP in Peril

Effective corporate governance requires reliable and consistent financial statements. Investors depend upon auditors to verify what management has done each year in innumerable corporate transactions. For decades, the American generally-accepted accounting principles (GAAP) have admirably and ably provided reliable reporting on a vast array of modern business situations.

Yet a serious drive to eliminate American GAAP, and replace them with the International Financial Reporting Standards (IFRS), is underway. A coalition has led a well-financed campaign to “dumb down” the financial reporting system that we all have grown to know, love, and trust.

Corporate management, of course, are behind this drive, hoping for their own convenience to be less accountable. This is understandable. But major American accounting firms have, surprisingly, joined with management. And the Securities and Exchange Commission, under Chairman Christopher Cox, has put more widespread use of the IFRS onto its active agenda.

Indeed, the process of replacing GAAP seems already to have begun. On November 15, the SEC adopted a Rule that will allow foreign firms on U. S. stock exchanges to use IFRS instead of the currently required GAAP. This two-tiered approach has obvious discriminatory implications, which commenters urged the Commission to consider before adopting the Rule.

Another SEC initiative, however, is even more destructive. That proposal would allow all American publicly-traded corporations to substitute IFRS for GAAP. As commenters on the proposal have pointed out, such an approach would soon spread from publicly-traded corporations to the entire economy, permitting use of IFRS for millions of private corporations, charitable organizations, unincorporated partnerships, associations, trusts, and sole proprietorships.

It’s hard to find any good rationale to accept anything less than the well-accepted GAAP. GAAP consist of about 2000 multi-page statements and guides for the myriad business activities that make up our modern economy. They offer thorough discussion and guidance that the IFRS lack.

Moreover, GAAP are predicated on American commercial law, with all of its attendant property rights and fiduciary responsibilities. The IFRS are not. Indeed, the IFRS consist principally of a compilation of rules by the International Accounting Standards Board, headquartered in London. Yet many of the Board’s participating governments apply different versions of the IFRS than others.

Daimler-Benz offers an instructive example. In 1993, when it wanted to trade on the New York Stock Exchange, it had to convert its German financial statements to GAAP-compliant disclosures. German rules showed net income of $120 million; but GAAP showed a loss of $579 million. An Associated Press account noted that Chairman Edzart Reuter later acknowledged that under the previous reporting system his and other German companies “had obscured operating losses or propped up gains in lean quarters by injecting income from the fat ones.”

Another problem is that the IFRS are not taught in American business schools–even in CPA programs. Nor are the principles understood by any appreciable part of American financial professionals or business managers.

The SEC is a political animal, subject like any other to lobbying by interest groups. In 1996, for example, the SEC considered approving a New York Stock Exchange rule that would have allowed foreign firms to be traded without any GAAP reporting. Fortunately, the uproar from the investing and accounting professions quashed that initiative.

Notably, some heavyweights are opposing the SEC’s recent moves towards adoption of the IFRS. These include the CFA Institute, whose members, Certified Financial Analysts, are the users of financial statements for investment advice and management; the American Accounting Association; and a special committee of the Financial Accounting Standards Board, which develops and refines the GAAP.

Now is the time for the investing and accounting community to defend the use of GAAP and urge the SEC to require continued GAAP use for American public companies. American investors deserve to have the financial protections of clear and consisting reporting on the trillions of dollars in corporate transactions conducted each year.