The Elusive Quest for a Financial Esperanto
June 2, 2014 --
It is one of the fundamental issues for global economic integration: the ability of investors and regulators to look at a company’s financial statements—regardless of where it’s domiciled—and be able to understand what the numbers mean. As the Nobel laureate economist Joseph Stiglitz has written, “If you can’t have faith in a company’s numbers, then you can’t have faith in anything about a company at all.”
The financial crisis provided a potent reminder that numbers are not always what they seem. And Dodd-Frank and other regulatory changes notwithstanding, today there is still one large obstacle to cross-border transparency about companies’ numbers: different countries use different accounting standards. More than 100 countries—including more than two-thirds of G-20 members—require the use of what’s known as International Financial Reporting Standards (IFRS). But U.S.-headquartered, publicly-traded companies are required to use Generally Accepted Accounting Principles (GAAP), while companies in some other jurisdictions, such as Japan, employ their own standards.
We will spare you all the gory details of the differences between IFRS and GAAP (you can read about many of them here). But here is one real-life example that makes the point. It involves Deutsche Bank, which reports its balance sheet under both IFRS and GAPP. One economist summed up the difference based on review of the company’s financial results from 2008 thus:
The key difference between IFRS and GAAP is the treatment of the item called (under IFRS) “positive market values from derivatives,” which equals €1.224 billion on Deutsche Bank’s IFRS balance sheet. Under GAAP, however, this item would shrink to about one-tenth of that figure, with only €128 billion appearing under “derivatives post netting.” A similar observation applies to the liability side of the balance sheet. With IFRS, Deutsche Bank also shows over €1.2 billion in liabilities under “market values of derivatives,” which presumably would also be reduced by a factor of about 10 under GAAP.
A €1 billion difference related to derivatives underscores that dueling accounting standards are far from ideal. As the then-CEO of Ernst & Young, a global accounting firm, once wrote, the current arrangement is “confusing, inefficient, and outmoded.” Indeed, companies operating in multiple jurisdictions often need to keep multiple sets of books in order to comply with different standards. And investors have to make apples-to-oranges comparisons when making decisions about where to invest, which can drive up the cost of capital. Different accounting standards are akin to sand in the wheels of the global economy. Interfering with the free flow of capital is particularly worrying at a time when the world’s cross-border capital flows remain 70 percent below their pre-recession peak (as documented in a recent report that one of us contributed to for the McKinsey Global Institute).
Bridging the gap between GAAP and IFRS has been the work of the regulators who oversee standards, and the ultimate objective is to get more of the world’s large economies (like the United States) to embrace IFRS. The regulators achieved a milestone last week, announcing the issuance of a converged standard on the recognition of revenue from contracts with customers. What may seem like a small issue nonetheless highlights the complexity of achieving harmonization in financial reporting: it took regulators 10 years to reach agreement on the revised standard. And, remember that the WorldCom scandal, which led to one of America’s largest bankruptcies ever, was largely about fraudulent reporting of revenue.
Whether IFRS will ever completely displace GAAP remains to be seen (there are legitimate concerns about the transition costs). But a key principle to remember is the value of common standards. Across a range of products and industries, the emergence of a marketplace standard that’s widely used – think of the IBM-compatible personal computer – can generate network effects that drive efficiency, scale, and cooperation. Companies – and countries – need to work together to build support for (and embrace) common standards if they are going attract investment and maximize the opportunities afforded by a more global economy. Indeed, harmonizing standards are an essential part of the current worldwide negotiations of the Trans-Pacific Partnership and the Trans-Atlantic Trade and Investment Partnership.
The quest for a common accounting standard reminds us of an even more ambitious initiative that got underway in the late 19th century: developing a single worldwide language. Although such a language exists – it’s called Esperanto – it has never come close to achieving critical mass (see it spoken here). The failure to achieve linguistic integration only underscores the importance of developing a financial Esperanto that can foster deeper economic integration and unleash benefits that come from that integration. Last week’s agreement on achieving a common standard for revenue recognition marks important progress. Let’s hope more is ahead.
Articles © 2014 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2014 Trustees of Dartmouth College. All rights reserved.