Changing the rules: the world gets serious about global accounting standards.

After decades of pondering the feasibility of global accounting standards, this year the world's securities regulators will take a serious look at which standards are acceptable for cross-border listings on stock exchanges. Inevitably, the solution will mean a stamp of approval for a global standard - a concept once considered impossible. The principal catalysts have been the world's capital markets and, more recently, the International Accounting Standards Committee (IASC) completing its core standards project.

The project's completion late last year is forcing earnest debate over whether the resulting international accounting standards, or IAS, should be accepted for use in filings with the SEC by non-U.S. companies - an issue that has significant implications for the future of accounting standards and financial reporting in the United States. A related, and perhaps consequential, issue is whether the IASC should be fundamentally changed to ensure that it can function as the agent for convergence of national accounting standards in the future. U.S. corporations will be asked to take a position on both issues in 1999. To make an informed decision, it is important to know where we stand today, to understand how IAS compare to US GAAP and to evaluate the merits of the options that exist.

How Level Is the Playing Field?

Both suppliers and purchasers of securities know they compete in a global capital market. Any delusions that this was not so should have been shattered by the collapse of financial markets in mid-1998 and the huge cross-border mergers announced that year. But what exactly does this competition mean? We've all heard about Daimler-Benz's move to US GAAP as a landmark event and how this facilitated the merger with Chrysler several years later. But what about Volkswagen, the other German automaking giant, which has chosen to avoid US GAAP and a U.S. listing? Are U.S. companies competing with VW for U.S. investors' capital? Absolutely! If you call your broker and ask to buy shares in VW, you'll be sold U.S. dollar "shares" (actually American Depositary Receipts, or ADRs) that have the exact look and feel of Daimler's pre-merger ADRs.

Most investors wouldn't know that VW isn't registered with the SEC and uses traditional German reporting, with its ADRs traded in the over-the-counter (OTC) market. But who owns these ADRs? Clearly, individual U.S. investors who don't want the hassle of buying the shares in Frankfurt or London. But toward the end of 1998, the largest owners of the ADRs were Capital Growth Management, with 18.5 million, and Texas Teachers Retirement System, with 1.8 million. What about the large mutual funds? They usually won't bother with unlisted ADRs, but buy the ordinary shares in London or Frankfurt. Clearly, the lack of a U.S. listing hasn't significantly hindered VW's ability to compete for U.S. investors' funds at both institutional and individual levels.

Is VW an aberration? Hardly. Among the top 20 non-U.S. companies traded by Nasdaq (by market capitalization) are such household names as Toyota (number 1) and Nissan Motor (number 14). You can find these companies on Nasdaq's web site, and without further research you'd have no idea that they're not registered with the SEC and don't present the same information as non-U.S. companies that are registered. The list of non-U.S. companies trading on the OTC market, without SEC oversight, is large and also has its share of household names.

So what about the companies listed on the NYSE and Nasdaq that are registered with the SEC? Most (but not all) are required to register annual financials with the SEC. Yet as long as there's a summary reconciliation to US GAAP of the earnings and equity reported under their local GAAP and certain supplemental disclosures, the companies don't have to prepare US GAAP financial statements. For all the effort they require, these reconciliations don't provide sufficient information to reconstruct US GAAP income statements or balance sheets. Does this matter? Are the reconciliations useful to investors? At some level yes, but it's virtually impossible to use the reconciling items in an earnings forecast. So most analysts essentially ignore them in making their estimates. Also, non-U.S. companies that are listed and registered with the SEC aren't required to file quarterly reports here if they don't report quarterly in their home countries.

But why are non-U.S. companies so averse to a reconciliation? One issue is the annual cost to prepare the extra data - estimated by one such company at $5 million. Second, non-U.S. companies must deal with a public relations and non-financial management issue of explaining two different net earnings figures for the same reporting period, a prospect that poses a multitude of risks and difficulties.

Origin of Non-U.S. Companies Listed on the NYSE
(as of 11/30/1998)

Region/Country                                                Number

Australia and New Zealand                                       13
Bahamas and Caribbean                                           10
Canada                                                          69
China and Hong Kong                                             19
Europe (excluding France, Netherlands and U.K.)                 46
France and Netherlands                                          34
Japan                                                           12
South and Central America                                       90
Southeast Asia (excluding China, Hong Kong and Japan)           11
United Kingdom                                                  44
Other emerging markets                                          14
Total (excluding Canada, 293)                                  362

So why do companies go through the effort of a U.S. listing with all the hassles and cost? There are many reasons, but the credibility of SEC registration and oversight, and a U.S. listing, do count for something. This is especially true for companies from emerging and higher risk markets. As the table above shows, when Canada is excluded, about half of the non-U.S. companies listed on the NYSE are from these countries. Most of the large, well-known companies competing for U.S. capital are not listed here. Senior managers of the NYSE have stated over the years that the primary (but not sole) reason such companies avoid a U.S. listing is the US GAAP reconciliation requirement.

Bottom line: U.S. corporations compete for U.S. investors' capital with their non-U.S. counterparts on a very uneven playing field.

But what about the size of the field? After all, if these issues affect a small niche in the overall capital market, why worry? The answer is that the aggregate size of these markets is very large - and growing rapidly. The graph on page 34 refers only to exchange-traded ADRs. There also is trading of unlisted (via "pink sheets" or "Electronic Bulletin Board") and non-ADR foreign equities in the United States and direct purchases and sales on foreign exchanges. Including these activities would significantly increase the annual volumes and the capital involved.

Making Comparisons

How do IAS and US GAAP compare? It's a difficult question to answer because it depends on how you decide to measure differences. Clearly, standard setting in the United States established the global yardstick for investor-oriented financial reporting. However, as investor litigation became more aggressive and as pressure to produce improved results has continued to build, we've seen a steady move toward more prescriptive rule-making in the United States. New FASB and AICPA standards, EITF decisions, SEC Staff Accounting Bulletins and the rest of the GAAP hierarchy have created a vast, codified accounting system.

While IAS share the same objective as US GAAP, their development reflects the needs of countries and markets outside the United States. As a result, IAS tend to be much less prescriptive. For example, the FASB issued a new standard on derivatives that was 245 pages long. In June of last year, the IASC issued an exposure draft that covered the accounting for all financial assets and liabilities, including derivatives, that ran 63 pages. Certainly, the U.S. approach has allowed for stricter interpretation of some standards. But has greater prescription enhanced investors' ability to forecast future earnings and cash flows? Many analysts would argue that additional detail in the rules hasn't helped at all. Certainly the degree of prescription required will be at the core of any debate about the extent to which IAS and US GAAP can be compared.

In addition to the degree of guidance provided, there also are substantive differences in accounting principles between IAS and US GAAP. For example, IAS requires capitalization of development costs if certain criteria are met, while US GAAP requires those costs to be expensed. IAS permits revaluation of long-lived assets to fair value as an allowed accounting alternative (with changes in fair value offset to share owners' equity), while US GAAP requires historical cost. However, the fact that differences in accounting principles exist between the two bodies of standards doesn't imply that acceptance of IAS by the SEC is a bad idea. For one thing, investors don't automatically prefer US GAAP accounting in all cases - revaluation of fixed assets under IAS is considered by many to be helpful to the analysis process. Moreover, since there are accounting principles in IAS that are more advanced than their US GAAP counterparts (and vice versa), is reversing the effects of better accounting out of financial statements via reconciliation to US GAAP justifiable? Apparent comparability isn't useful if it occurs at the expense of relevant information. Also, the SEC could override the accounting principles in a particular IAS where the commission isn't satisfied with the answer (we'll get to that later).

Therefore, it's difficult to reach a definitive conclusion on whether specific differences in principles between US GAAP and IAS represent significant stumbling blocks to acceptance until we see how the SEC handles them in rulemaking proposals.

In the end, these debates will no doubt come full circle and focus on how to improve the way U.S. capital markets work today. From that perspective, IAS have a number of advantages. Both IAS and US GAAP are investor-oriented and aim to provide high-quality information. IAS tend to be closer to US GAAP than many national accounting standards and, while there certainly is less prescription to assist in the implementation and interpretation of the IAS compared with US GAAP, most other national accounting standards don't rate any better. The other major criticism against IAS in the United States focuses on the process by which the standards are set - an issue the IASC is addressing (but more on that later, too).

Decisions, Decisions

With the completion of the core standards project, the issue is now before the International Organization of Securities Commissions and the SEC. At Financial Executives Institute's Current Financial Reporting Issues Conference in November 1998, SEC Chairman Arthur Levitt called on U.S. registrants to actively participate in the process by which the SEC would consider and possibly implement changes to regulations governing non-U.S. registrants. To that end, the commission is likely to issue a concept release soon, seeking public comment on the issues associated with the proposed change.

In developing a position, U.S. companies must evaluate whether they'll be better off under a new model than they are under the present system. Therefore, companies should consider the merits of each of three options.

Option 1 is to stay with the present system and force a full reconciliation of earnings and equity wherever there are differences from US GAAP. With this choice we'll see some non-U.S. companies continue to list on the NYSE and go through the reconciliation process. Many others will choose to remain unlisted and unregulated by the SEC. But U.S. investors will continue to invest in these companies with all the caveats associated with the imperfect financial information they provide. In either case, investors will continue to propel the unabated growth in the ADR market - perpetuating investment decisions based primarily on local country GAAP financial data.

Option 2 is to accept certain IAS standards as an alternative to US GAAP, but also to specify additional requirements in areas where the SEC is dissatisfied with IAS or where no IAS exists. The objective of such requirements would not be to achieve parity with US GAAP as under option 1. Rather, accounting principles the commission finds unacceptable would be changed, or supplemental disclosure of the financial effects of that accounting would be required to make the financial statements more transparent. Even today the SEC has different rules for non-U.S. registrants. And just as it interprets US GAAP via staff accounting bulletins, the SEC can ensure high-quality interpretations of IAS through IAS-specific rule-making. This approach would presumably be less offensive to non-U.S. corporations because they wouldn't require two sets of equity and net income figures.

Option 3 is outright acceptance of IAS for non-U.S. registrants. Like option 2, companies would still have to follow US GAAP where IAS doesn't exist - for example, in accounting by insurance companies where the IASC is actively working but hasn't yet developed a final standard. In all other matters IAS would be accepted and enforced as written. However, for a host of good reasons, this alternative also has little chance of being acceptable to the SEC.

The principal attraction of options 2 and 3 is that they're more likely to bring non-U.S. companies with which we compete under the watchful eye of the SEC and the U.S. financial press. Consequently, acceptance of either one would engender direct benefits to U.S. companies with regard to the fairness and efficiency of capital allocation decisions by U.S. investors:

* If one accepts the premise that full IAS financial statements are more useful than local GAAP financial data supplemented by summary reconciliations, the financial information provided by non-U.S. companies for investment decisions will improve.

* Eliminating the need for reporting two sets of income and equity measures will mean more non-U.S. companies list here and become subject to SEC oversight. Should these companies choose not to list, they'll give investors a negative signal and will face increased scrutiny of their financial disclosures.

* IAS standardization would let the SEC raise the rigor of enforcement of non-U.S. registrants. Today, the commission must monitor and enforce reconciliations from dozens of national standards - one accountant familiar with the process estimates the actual number to be north of 40. Enough said.

It's reasonable to assume options 2 and 3 would also provide a significant cost incentive for foreign companies to change their internal accounting and reporting systems from local GAAP to IAS. We've already seen this in many emerging markets as well as Germany, France and other continental European countries. As acceptance of IAS becomes more pervasive outside the United States, U.S. corporations will experience indirect benefits, too:

* If foreign subsidiaries of U.S. corporations convert to IAS for local country reporting, operational decision-making would likely improve. Like US GAAP, IAS standards focus sharply on investor needs for information, in contrast to standards in a number of other countries that follow a tax or regulatory model.

* Conversion of financial statements from IAS to US GAAP is likely to be less involved than from local country GAAP and would be amenable to global standardization. Accordingly, if foreign subsidiaries of U.S. companies were to adopt IAS, processes for conversion of affiliate financial data could be streamlined.

* Use of IAS at foreign companies may take some guesswork out of analyzing the financial data of a potential acquisition. Acquisition teams could develop toolkits that identify all key differences from US GAAP to ensure focused review by accounting due diligence teams.

* More pervasive use of IAS may make it easier to find qualified professionals from the local country labor market who have experience with accounting standards similar to US GAAP.

Changing the IASC Structure and Process

In accepting IAS standards for use in U.S. capital markets, the SEC isn't just buying into the product of the core standards project - it's implicitly buying into the IASC process. Thus, some expect the SEC to quietly insist that the IASC adopt changes proposed in a discussion paper issued in December 1998 with a comment deadline of April 30, 1999.

In brief, that proposal would create a bicameral structure in which the representatives of the world's major standard setters work as a committee to develop proposed standards that would be voted on by the IASC board. As part of the plan, those standard setters would coordinate their agendas with the IASC and follow local due process procedures to incorporate the principles in the final IAS into local country GAAP.

The pros and cons of the proposed change will no doubt be the subject of vigorous debate. U.S. corporations should study the proposal closely, with particular focus on the division of power between the national standard setters' committee and the board, a pivotal issue in the discussion paper. Detailed information about the proposal and issues upon which comment is requested can be found on the IASC web site (www.iasc.org.uk).

There are clearly pros and cons to acceptance of IAS for non-U.S. registrants. The debate is heating up, and there will be plenty rhetoric from all sides. But U.S. corporations need to be heard. In forming your views, we encourage you to think in the context of what exists today. It should be clear from the discussion here that non-U.S. companies are competing for U.S. investor capital. And even if they are registered with the SEC and listed on a U.S. market, these foreign companies don't usually provide US GAAP financials.

RELATED ARTICLE: A Brief History of IAS

The IASC began its international standard-setting work in 1973. Compromises were made to accommodate different countries' practices, and the resulting standards were too general to be useful. But in 1987 the International Organization of Securities Commissions (IOSCO)joined the IASC's Consultative Group. Together they embarked on the comparability project to tighten the standards and ensure their high quality. In 1988 the FASB joined the deliberations as an observer with all rights of a board member other than voting. Other countries with active standard setters also joined the board, so the IASC has had significant input from all the world's key players.

As the globalization of capital markets continued to move rapidly forward, the need for a more level playing field was increasingly apparent. Rather than start a whole new process, regulators turned to the IASC to forge a global consensus. In 1993, after completing the comparability project, IOSCO (with significant influence from the SEC) and the IASC agreed to a work plan, commonly known as the core standards project. This plan was aimed at finally solving the vexing problem facing IOSCO: how to eliminate the roadblock of divergent national accounting standards while maintaining a high level of investor protection.

Daimler-Benz's 1993 listing on the NYSE was another watershed. Daimler-Benz's large difference between German and US GAAP income (mainly the result of a onetime adjustment of past cumulative reserves through German earnings) shocked German and Swiss companies into a re-evaluation of their past resistance to the investor-oriented reporting of IAS and US GAAP. By 1994 companies in these and other countries began moving to IAS, and the business communities in these countries became actively involved in the IASC board's activities.

In 1995 the IASC agreed to an aggressive work program to complete the core standards by March 1999; this was moved up a year at the behest of various IOSCO members. The program was completed in December 1998. Both the SEC and FASB have reviewed and commented on each new IAS standard developed under the core standards initiative.

Mitchell Danaher is assistant comptroller at General Electric and a member of the U.S. Delegation to the IASC. Trevor Harris is Jerome A. Chazen Professor of International Business and Morgan Stanley Dean Witter Research Scholar at Columbia Business School and a consultant on accounting and valuation for MSDW. The analysis presented reflects the personal opinions of the authors.