Financial Reporting Reliability & Transparency: Activities of FASB & the ASBJ during the Financial Crisis

October 20, 2009

SPEAKERS:
Robert Herz, Chairman, Financial Accounting Standards Board
Ikuo Nishikawa, Chairman, Accounting Standards Board of Japan

PRESIDER:
James Quigley, Chief Executive Officer, Deloitte Touche Tohmatsu; Director, Japan Society

Robert Herz, Chairman of the Financial Accounting Standards Board and Ikuo Nishikawa, Chairman of the Accounting Standards Board of Japan, visited Japan Society to discuss the drive towards convergence in international accounting standards and the response of the standard setting community to the global financial crisis.

A year ago, the European Commission ruled that Japanese GAAP is equivalent to International Financial Reporting Standards, Mr. Nishikawa noted. Thus, beginning in 2010, Japanese issuers will be able to use financial statements prepared in accordance with Japanese GAAP in EU markets.

Meanwhile, the Business Accounting Council, which advises the Financial Services Agency, has called for certain Japanese listed companies to adopt IFRS on a voluntary basis beginning with the fiscal year ending March 31, 2010. The Council's roadmap contemplates a decision on mandatory use of IFRS in 2012, with a three-year transition period thereafter. If this timeline holds, Japanese companies will begin to use IFRS on a mandatory basis in 2015 or 2016.

"To facilitate a smooth transition from Japanese GAAP to IFRS, the roadmap recommends the ASBJ to continue and accelerate the convergence of accounting standards," Mr. Nishikawa explained. To this end, the ASBJ plans to publish a Japanese translation of IFRS 2009 by the end of 2009. The organization will also support educational activities on IFRS in Japan and participate in the IFRS Council, a private-sector organization recently established to work on the objectives set forth in the roadmap.

In response to the global financial crisis, the ASBJ has launched a Fair Value Measurement project, which aims to enhance fair value disclosures, and a Scope of Consolidation project, which is working to eliminate the exemption for special purpose entities. The ASBJ is on track to issue exposure drafts on both projects during the first quarter of 2010, Mr. Nishikawa indicated.

His personal view is that the IASB's amortized cost category ought to be brought into alignment with the FASB's fair value-other comprehensive income (FV-OCI) category. "The so-called strategic investments should be considered for classification and measurement," he added. However, including in financial statements the "fair value of investments in equity instruments whose fair value cannot reliably be measured does not provide decision-useful information."

On financial reporting, Mr. Nishikawa said, "I believe that the mixed measurement attribute model, which has been adopted" for both financial and nonfinancial assets, "provides useful information that reflects the entity's business activity." Finally, "I believe that presentation of both comprehensive income and net income is useful and essential for the users of financial reporting, because net income is a total performance indicator."

When the FASB was established in the early 1970s, "the idea of global standards was only really a glint in a few people's eyes," but today it's a central aspect of the FASB's mission, said Mr. Herz. "In fact, the FASB and the SEC were very much behind the establishment of the global body, the IASB, back in 2000" when Mr. Herz served as an original founding member of the IASB before returning to the U.S.

Because so many Americans depend financially on their stock market investments, there's a tradition in the U.S., indeed a bias, towards investor protection and transparency, which is not the case all over the world, he observed. "On the other hand, for good or for bad, we are very enforcement rich. We've got lots of lawyers, lots of litigation that leads to lots of rules." To ensure that global standards function well, "they probably need to be more at a higher-level, principles-based," but this isn't easy to do in the U.S. environment "without constantly supplementing the principles with lots and lots and lots of guidance."

As U.S. standard-setters respond to the global financial crisis, the main issues include the valuation of financial assets, particularly CDOs and other complex assets where there were no standardized information systems to turn to; the adequacy of loan loss reserves; standards on securitization and off-balance-sheet vehicles; and disclosure and transparency.

This year, some 100 banks have failed in the U.S.; back in the days of the S&L crisis, a thousand financial institutions failed. With most of the banks today that have collapsed, "what you will find is that the GAAP reporting shows some positive equity, and the regulatory reporting shows even more positive equity at the time they go under, and that doesn't seem right--so we've got to work on that."

The case for international convergence in accounting standards is simply put, Mr. Herz said: "It's really to try and make the infrastructure of a market match the market. If you have a global capital market, you want an infrastructure that is coincident with that market." A decade or so ago, the attitude in the U.S. might have been "'Yeah, I'm in favor of global standards. Make them do it our way'"--but "I can tell you that won't fly," for not all American standards work when transplanted to other environments.

The FASB and the ASBJ have been working for some years to try to eliminate some of the biggest differences between the two sets of standards, he noted. In fact, many big Japanese companies use U.S. GAAP because they are registered in the U.S.

The FASB has also been working with the IASB on a range of topics, with progress to date in major areas, including share-based payments, business combinations, income taxes and segment reporting. "If we worked another 10 or 15 years we would probably have U.S. GAAP and IFRS looking exactly the same," he added. But "I don't think that is likely to happen, because the pace of the world is moving too quickly" and because there are other countries, Japan and China included, that want to have a voice in the process.

If the U.S. were to adopt IFRS, fundamentally the decision to do so would rest with the SEC, Mr. Herz noted. "But I have no doubt that Congress will have something to say about this, because there are strong views on both sides of this as to whether and how quickly we ought to move to international standards."

Shortly after President Obama's election, the SEC put out a proposed timeline calling for a go/no-go decision in 2011 on whether to adopt IFRS for U.S. companies. With the change in administrations, the agency is now reviewing the issue, and meantime has had a lot of other things on its plate, including the Madoff scandal.

Whatever the decision, "there are some givens," Mr. Herz said: The IASB needs better funding, better governance, a bigger staff and a greater presence beyond London. Thus the IASB should set up offices in big financial centers and actually "meet in those major capital markets of the world, and make sure that it engages very heavily with the constituents around the world."

In the past few years, non-U.S. companies have been allowed to access American capital markets without having to switch to U.S. GAAP or prepare reconciliations, he noted. Alternatives to the current system are being vigorously debated, including allowing U.S. companies to choose between U.S. GAAP and IFRS, moving towards a switch from U.S. GAAP to IFRS, or continuing to work with the IASB to narrow the differences between the two sets of standards.

"We have an extremely good reporting system here in this country" and American capital markets are strong, so "the cost/benefit relationship" in switching to IFRS "may be a little different for us than certain other countries," Mr. Herz commented.

"On the other hand, I am a strong believer that you've got to look to the future, and if you look to the future, like it or not, I think it's a good thing. I think we won the Cold War. I think that the U.S.'s percentage of global GDP and global capital markets is going to shrink, and I think that's just a good thing. Other people have kind of come our way. So, I think we do have to look to global structures and the like."

"I've been doing this for, between the IASB and the FASB, nine years now, and it's been a very busy period," Mr. Herz concluded. "But I foresee that the next few years may be even busier as we try to get to this goal of quality standards across the major capital markets."

***
Q&A from the audience followed.

How do you estimate fair market value for off-balance-sheet items, such as credit default swaps, when there is no active market and no informational parameters available?

The market infrastructure for credit default swaps presents many issues, "although it's improving," Mr. Herz responded. On non-traded items, a loan for example, what's used is essentially a present-value technique that applies a current discount rate to expected cash flows.

Are you saying that in order to estimate fair market value, it has to have a relevant future, not historical but future, benefit stream?

"Any financial asset is based upon the projection of future cash flows," Mr. Herz responded. "If you buy IBM stock, in theory it's based upon the discounted dividend flow." Complex products like CDOs and CDO-squared aren't as simple as this, both because of the lack of standardized data on the underlying obligations and the complex mechanics of the payment promises to investors.

Are you aware of any large companies that have chosen voluntarily to adopt IFRS beginning in March 2010?

News reports do indicate a couple of trading companies will be using IFRS in this initial year, Mr. Nishikawa answered.

FASB has changed its fair-value measurement accounting standard to give companies more discretion. How have users reacted to this, and does FASB have any plan to go back to previous standards in this area?

The first stage of the FASB's response on this wasn't to change standards, but simply to offer more guidance on what to do in illiquid circumstances, Mr. Herz said. The second stage, which did constitute a change, relates to accounting for impairments. The approach is to separate an estimate of the credit portion, which goes through earnings, from the rest of the change in the value, which goes through other comprehensive income.

"I would say the reaction initially of users was mixed," he added, with some believing that "people should be marking everything to fire-sale prices, and fully reflecting that in earnings. I think more and more, though, people believe it was a good move... and that it kind of makes sense given the highly unusual circumstances." The FASB doesn't plan to reverse this change, and in fact the current project on accounting for financial instruments is designed to build on this approach.

How is the convergence process affected by cultural differences among users and regulators?

There are some differences in business culture, Mr. Nishikawa said. For example, long-term cross-holdings are part of Japan's customs, but are rare in the U.S. A new IFRS proposal calls for a FV-OCI exception for long-term holding of stocks, but the U.S. proposal doesn't have such a provision--"not yet," Mr. Herz said to the amusement of the audience.

"Clearly some of the things that we hold dear, other people don't, and vice versa," Mr. Herz said. "The one thing I will say, though, is we will not sacrifice on quality. In other words, I'm not about going to the lowest common denominator in order just to get a satisfactory answer. It's got to be of sufficient quality, otherwise it doesn't make sense for the U.S. markets."

--Katherine Hyde