Balancing the Books

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When the East Asian financial crisis exploded in 1997, Western investors were shocked to find that many blue chip companies turned out to be remarkably hollow. Some of those unpleasant surprises resulted from out-and-out fraud by the managers of the firms, but many more had engaged in accounting legerdemain that was perfectly legal according to local rules and regulations. In Japan, for instance, the accounts made public by parent firms frequently--and quite legally--omit mention of the red ink gushing from their subsidiaries.

Many countries in the region don't require companies to report foreign exchange losses, either. When one Asian economy after another floundered in 1997, followed in 1998 by Russia and Brazil, disparate and often misleading accounting practices contributed to the mess. "I'm not saying global standards would have prevented [those crises], but they would have mitigated the effects," says Mark Vaessen, at the accounting firm KPMG in London. Economists, global business leaders and international financial officials all agree that a uniform set of accounting principles offering fuller disclosure and transparency is crucial to maintaining order in a global financial system. Trouble is, those guys in the green eyeshades--the world's accountants--can't agree which standards to use.

Most of the world has rallied around a set of 40 rules devised over the last 26 years by the International Accounting Standards Committee, a London-based group of professional accountants representing 104 countries. But the United States is reluctant to accept the IASC standards, which it thinks pale in comparison to its own. And that's the quandary. Global standards snubbed by the U.S, with the world's largest, most vibrant equity markets, wouldn't be truly global. But the rest of the world has little interest in adopting the U.S. model, which is viewed as outdated and overladen with unnecessary prohibitions.

Meanwhile, confusion reigns. Global shareholders must grapple with different sets of rules--of widely varying quality--in the countries in which they invest. One of the key differences involves corporate takeovers. The acquiring firm usually pays more than the stated book value of the assets. That excess amount is called goodwill and the IASC allows that cost to be written off against taxes well into the future, perhaps for as long as 100 years. The U.S. Generally Accepted Accounting Principles (GAAP) cap the so-called amortization of goodwill at 40 years. For investors trying to ascertain the true profitability of foreign companies, it's a bit like trying to negotiate Byzantium without a street map. And the results can be just as frustrating and, as demonstrated in 1997-98, even catastrophic.

Earlier this year, the IASC submitted its standards for approval to the International Organization of Securities Commissions, a group of financial market regulators from 100 countries, including the U.S.'s powerful Securities and Exchange Commission. IOSCO is expected to recommend acceptance of IASC standards early in 2000. The sec must then decide whether to concur, or at least allow foreign companies that want to list on U.S. markets to use the international rules. But the Financial Accounting Standards Board (FASB)--which writes the American standards, the U.S. GAAP--opposes the IASC's standards.

European accountants and regulators, as well as others around the world, are in no mood to submit to what they see as the U.S.'s demand that they use standards developed without their input. Moreover, many no longer regard U.S. GAAP as bookkeeping's gold standard. Says Allister Wilson, a partner at accountant Ernst & Young, London, "There is no chance that U.S. GAAP will dominate the world."

Perhaps not. But recently the IASC took the first step toward an internal revamping that could some day give FASB more say within the body. If the restructuring plan receives final approval next May, the IASC's 14 standards board members would be appointed based on their "technical expertise" and geographical considerations would have no bearing. In theory, that could mean that future versions of the IASC standards could conceivably have more of a U.S. imprint. A 19-member board of trustees will choose the standards board, and a committee named last month to appoint the trustees is headed by Arthur Levitt, chairman of the U.S. sec. Levitt's appointment further heightens fears among European and Asian members of creeping U.S. influence within the IASC. Wilson admits he's unhappy with these developments, but thinks opponents of the U.S. way of doing things within the IASC still have time to make their case. "It's not all done and dusted."

Wilson calls U.S. regulations overly technical and unsympathetic to political considerations. And what's worse, he says, U.S. GAAP, on a technical basis, are 15 years out of date and full of loopholes. "There are huge abuses and a lot of creative accounting going on under U.S. GAAP." Europeans dislike U.S. rules that allow an acquiring company to charge some research and development costs to income, because they say it distorts post-acquisition earnings.

Overall, the two sets of rules share a common goal: shedding light on corporate books so that investors can make judgments about a company's earnings potential based on its current finances. "They are both investor-driven and the idea behind both of them is disclosure and transparency," explains Trevor S. Harris, a Columbia University accounting professor. For instance, both sets of rules would disallow a German practice that lets firms stash capital into hidden reserves which lower their taxes in good times and which can artificially boost profits when times get tough.

But though their shared goal is transparency, they take widely different paths to get there. U.S. GAAP are very detailed, rule-based and restrictive, written in a way that anticipates litigation. "Every i is dotted, every t is crossed," notes Michael Bromwich, a London School of Economics accounting expert. "Trying to follow them would cause an enormous amount of overload for some countries." The IASC rules are less specific; they're more a guiding set of principles that allow some flexibility. "Americans may feel a bit uncomfortable with that," Vaessen admits.

FASB says the international rules aren't just flexible, they're pliable, overly vague and ambiguous. And it worries that they cater to political pressure from members' governments and homegrown multinationals, the result of too many compromises between so many countries. Vaessen cheerfully concedes compromises have been made. "There are always compromises. There are compromises within U.S. GAAP."

And Paul Pacter, a project manager at IASC, contends that FASB's perception of the international rules is outdated. Up until a year ago, they didn't require companies to list operating results by industry or geography; now they must. Another discarded rule let companies report investments in common stocks at cost, below cost or at market value. "It was anything goes," Pacter admits. Now they must be reported at fair market value. The IASC standards have their champions. Most countries, other than the U.S. and Canada, accept them on some level. Britain, for instance, allows foreign companies to use the international standards, but not its domestic firms. The European Union is keen to see the new rules adopted as a way to unify the currently disparate accounting practices of its 15 member states.

Perhaps more importantly, the international standards are backed by the world's big capital markets, particularly those in the U.S. Of over 3,000 companies that now list on the New York Stock Exchange, only 13% are foreign-owned. But the exchange wants to woo more foreign companies and sees sec acceptance of the IASC rules as a means to make it easier for non-American companies to list. Indeed, companies such as Germany's BMW and Switzerland's Roche Holdings will consider a U.S. flotation if they can use IASC accounting. Currently, foreign companies listed on U.S. exchanges can use domestic accounting methods, but must reconcile the differences to U.S. GAAP--a procedure that's costly to them and confusing to investors.

IASC's short-term goal is to win SEC approval for foreign companies to list on American markets using its standards without reconciliation. And Pacter thinks that could happen within two or three years, though the SEC will likely ask for a few important amendments. Chances for such a deal are endangered by fears that if U.S. companies think they are being held to a tougher standard than their foreign counterparts, it could lead to lawsuits. But Harris doubts that. The ongoing "farce" of reconciliation hasn't sparked litigation, he says, so it's unlikely that use of international standards would either.

Will the day come when U.S. regulators okay IASC standards for U.S. companies as well? Pacter predicts that U.S. domestic use of IASC's rules is at least 10 years away. In the meantime, if the U.S. does permit foreign firms wishing to raise capital in American equity markets to use the new rules, that could speed acceptance of the standards in emerging markets like Asia. And that in turn might make the next financial meltdown a lot less dangerous for the global economy.